It is almost half-a-century since economist James Tobin proposed a small transaction tax to stabilise volatile global capital flows.
Tobin’s proposal followed the breakdown of the Bretton-Woods fixed exchange rate system in 1971. A tiny once-off transaction tax wouldn’t have much effect on medium and longer-term flows but would impinge more heavily on short-term flows. Tobin described it as “throwing sand in the wheels” of the speculative flows that had caused regular crises during the pre-Second World War gold-standard period.
Among the policy-wonks in Jakarta, the focus is on how to make the portfolio flows more ‘sticky’ so that funds stay put when global sentiment turns.
The idea fell on barren ground. It was overwhelmed by the ascendency of the “efficient markets” doctrine – financial markets were efficient in price discovery. Any transaction tax, no matter how tiny, would be distortionary and thus, by definition, a Bad Thing. For more self-interested reasons, professional currency traders opposed such a tax wholeheartedly. This doctrine was incorporated into the Washington Consensus, with the International Monetary Fund becoming the defender of free capital flows.
Many countries (such as Australia) adapted over time to the post-Bretton-Woods world. Crises were common enough – such as sterling in 1992 – but were not attributable to volatile capital flows as such. For emerging markets, however, flighty capital flows were a key vulnerability. Excessive inflows followed by sharp reversals were the central element in the 1997 Asian financial crisis.
Some academics retained doubts about “efficient markets” (including some who vigorously promoted deregulated financial markets while in policy roles), and the 2008 global financial crisis encouraged a re-think.
Over the past decade the IMF has belatedly come to accept that “capital flow management” (what formerly was dismissively termed “capital controls”) was a legitimate policy response for those emerging economies, which have from time-to-time been whip-sawed by volatile short-term capital flows.
Indonesia illustrates the issues. The response to the disaster of the 1997 crisis was to restrain growth and accumulate foreign exchange reserves. Even this was not enough to insulate Indonesia from the 2013 “Taper Tantrum”. 2018 saw another episode of capital flow reversal. A year ago, foreigners owned 42% of government bonds on issue. When the market mood shifted six months ago, what had been regarded as a sign of confidence in Indonesia morphed to become a vulnerability, with foreign bond-holding falling below 37%.
Around half of Indonesia’s capital inflow is in the form of portfolio investment – the restless money constantly scouring the globe for the highest yield, ready to react to the latest shift in risk-on/risk-off mood.
Indonesian policy-makers have learned how to handle these swings in foreign sentiment. They raise interest rates, tighten fiscal policy, and stand ready to intervene to defend the currency from extreme movements.
They did this last year and the drama was soon over. But this policy has a cost. Investment is discouraged, growth is trimmed, important budget expenditures are delayed, and financial markets are disrupted.
There ought to be a better way. If this short-term capital is so volatile, is it worth having? You can’t fund longer-term investment with money that is withdrawn on a market whim. Indonesia gains little benefit from these fickle funds, as it has to maintain substantial foreign exchange reserves to cope with the incipient outflow. The priority should be for stable flows rather than maximum inflow.
What might be done? First-best is an increased role for foreign direct investment – not only more stable but more beneficial. By international comparison, Indonesia’s FDI inflow is small: less than 2% of GDP. In dollar terms, FDI to Indonesia is not much larger than to Vietnam – a much smaller economy. In recent years Indonesia has encouraged FDI, shifting from 129th in the World Bank’s ranking on “ease of doing business” to 73rd. But a post-colonial nationalistic sentiment is never far below the surface when the going gets tough on the hustings, so vigorously promoting foreign ownership is not going to win April’s election.
Among the policy-wonks in Jakarta, the focus is on how to make the portfolio flows more “sticky” so that funds stay put when global sentiment turns. Hence the interest in some version of a Tobin tax.
Now that the Washington Consensus is (properly) seen as a general policy framework rather than a dogmatic doctrine, such ideas can be discussed without derision from Washington, although financial markets are still very ready to pour cold water on any idea which constrains their flexibility and profits.
The lead-up to a presidential election is no time for esoteric economic debates. Neither of the presidential candidates shows much interest in macroeconomics. As well, the precondition for such a tax is to find alternative inflows or reduce the current account deficit that has to be funded.
For the immediate future, Indonesia will have to accept the unpalatable deal which global financial markets offer: “we will lend you money in good times, but we’ll take it back whenever we have a fit of nerves”. But some variant on a Tobin tax seems an idea whose time is coming for Indonesia.