Krugman & The Tobin Tax
He first quotes James Tobin's argument for the proposed tax named after him:
"Tobin argued that currency speculation — money moving internationally to bet on fluctuations in exchange rates — was having a disruptive effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies.
Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a major disincentive for people trying to make a fast buck (or euro, or yen) by outguessing the markets over the course of a few days or weeks. It would, as Tobin said, “throw some sand in the well-greased wheels” of speculation."
But first of all, while it is often true that currency speculation can be disruptive (that is a reason why the system of freely floating fiat national currencies isn't an ideal situation, despite Krugman's previous assertion to the contrary), that is not necessarily related to the kind of low return transactions that would be hit particularly hard by the Tobin tax. The transactions that would be particularly discouraged by a Tobin tax would be arbitrage type dealings trying to close discrepancies in pricing. Ending arbitrage trade would represent a big reduction economic efficiency.
And furthermore, by reducing trading volumes, slippage (the decrease/increase in price caused by an individual actor's sale/purchase, something which prevents the realization of potential gains through transactions) would increase, something which would produce non-trivial costs for people engaged in foreign trade and long-term investments.
Thus, problems with large exchange rate fluctuations are not the result of “speculation”, but are inherent in the nature of fluctuating currency exchange rates. Given that system however, short-term speculation is a force that reduces, and not aggravates the problem. This applies to short-term speculation in other markets too.
Later, Krugman, who again wants to apply the tax to other markets in addition to the currency markets argues against the objection that the tax wouldn't address the real problems, based on the specific effect it would have on the credit markets ( the below thus doesn't apply to other markets):
"What about the claim that a financial transactions tax doesn’t address the real problem? It’s true that a transactions tax wouldn’t have stopped lenders from making bad loans, or gullible investors from buying toxic waste backed by those loans.
But bad investments aren’t the whole story of the crisis. What turned those bad investments into catastrophe was the financial system’s excessive reliance on short-term money.
As Gary Gorton and Andrew Metrick of Yale have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions, in which financial institutions sell assets to investors while promising to buy them back after a short period — often a single day. Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a “run on repo.”"
But why would banks want to rely on such short-term financing? Wouldn't they all other things being equal want longer term financing so as to reduce the risk of becoming illiquid or be forced to pay higher interest rates? Yes, of course they would, so why would they want to borrow through repo transactions? The answer is that the Fed has systematically held down short-term rates, making it cheaper to borrow through repos and other form of short-term contracts, than through long term contracts.
And the reason why the Fed did that was that they on the advice of Keynesians like Krugman wanted to encourage borrowing -including subprime borrowing- in order to close a perceived "output gap", which is to say the very thing that Krugman now says he wants to discourage. The problem thus lies in the kind of inflationary Fed policies that Krugman has always recommended. And if the kind of tax that Krugman now argues for was imposed on bond markets it would have a deflationary effect.
Meaning that fiscal and monetary policy makers would given the current Keynesian paradigm of trying to close "output gaps" have to use other policies like even lower interest rates, unorthodox monetary policy measures or higher budget deficits that would produce the exact same kind of mess or some other form of mess (a higher budget deficit instead of a lower cost of capital would have meant a smaller housing bubble, but would have produced problems in the form of a structurally higher government deficit and therefore also a higher level of government debt).
And just like in other markets, such a tax would reduce arbitrage and increase slippage and thus produce even worse results than during the current system.