**Weltwirtschaft, Ökologie & Entwicklung**
**World Economy, Ecology & Development**

<figure><img src="image_1.png" /></figure>

weed

**Ready for Implementation**

Technical and Legal Aspects of a
Currency Transaction Tax
and Its Implementation in the EU

Bruno Jetin / Lieven Denys
**Title:**

Ready for Implementation

Technical and Legal Aspects of a Currency Transaction Tax and Its Im-
plementation in the EU

Authors:

Bruno Jetin and Lieven Denys

Editor:

Thomas Kalinowski

Translation of chapter 3.2 and 3.3:

Ann Stafford

This document has been produced with the financial assistance of the European Uni-
on. The contents of this document are the sole responsibility of WEED and can under
no circumstances be regarded as reflecting the position of the European Union.

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ISBN: 3-937383-32-8

Berlin, November 2005
# TABLE OF CONTENTS

<table><tr><td>TABLE OF CONTENTS</td><td>3</td></tr></table>

<table><tr><td>ABBREVIATIONS</td><td>7</td></tr></table>

<table><tr><td>EXECUTIVE SUMMARY</td><td>8</td></tr></table>

## PART I by Bruno Jetin: Technical, Institutional and Political Issues

### 1 THE CASE FOR A CURRENCY TRANSACTION TAX 14

1.1 INTRODUCTION: "TIME FOR TOBIN?" 14

1.2 The original objectives of the tax: Reducing short-term speculation and increasing national policy autonomy 16

1.3 How to resolve the problem of arbitrage and speculation? 18

1.3.1 A world currency 18

1.3.2 Capital controls and the Currency Transaction Tax (CTT) 22

1.4 The additional objective of the CTT: financing development and global public goods 23

1.5 Why does exchange rate volatility matter? 26

1.5.1 A negative impact on international trade 28

1.5.2 A negative impact on foreign and domestic investment 29

1.5.3 A negative impact on employment 30

1.5.4 A negative impact on real wages 32

1.5.5 Is the volatility of the euro exchange rate important? 33

1.6 How can we stabilize the volatility of the exchange rate? 36

1.6.1 Coordinating economic policies and monitoring foreign exchange markets 37

1.6.2 Creating a world currency 39

1.6.3 The Target zone 41

1.7 The efficiency of the two-tier currency transaction tax 46

1.7.1 P.B. Spahn's two-tier CTT proposal 46

1.7.2 What would be the purpose of the "normal" tax? 47

1.7.3 How does the surcharge work? 48

1.7.4 How well does the two-tier CTT contribute to James Tobin's objectives? 48

1.7.5 Diverging paths 50

1.8 A two tier CTT for an alternative economic policy 50

1.8.1 The leverage effect of the ordinary tax 52

1.8.2 Is it fair to tax all transactions? 54

1.8.3 How can we explain these evolutions? 55

1.8.4 Is the 0.1% ordinary rate so high that the market could shrink too much and disappear? 57

1.8.5 The protected monetary zone 58

### 2 THE FEASIBILITY OF THE CURRENCY TRANSACTION TAX 61

2.1 The specific nature of the foreign exchange markets 61

2.2 The different steps of a foreign exchange transaction 66

2.2.1 Step 1: the pre-trade preparation 69

2.2.2 Step 2: Trade capture 70

2.2.3 Step 3: Confirmation 78

2.2.4 Step 4. Netting 80

2.2.4.1 The role of Euro 1 82

2.2.4.2 The launch of CLS 83

2.2.4.3 How to collect the tax at CLS? 88

2.2.5 Step 5. Settlement 92

2.2.5.1 The role of TARGET, the European RTGS 94

2.2.5.2 The geographical coverage of TARGET 96

2.2.5.3 How does TARGET work? 102

2.2.5.4 What conclusions can we draw from the present TARGET characteristics? 104
<table><tr><td>2.2.5.5 The critical importance of SWIFT Message-Types used in TARGET</td><td>108</td></tr><tr><td>2.2.5.6 Data included in a message when a customer makes a forex transaction</td><td>109</td></tr><tr><td>2.2.5.7 Data included in a message in case of interbank transaction (MT202)</td><td>116</td></tr><tr><td>2.3 Collecting securities transaction taxes (STT) through settlement systems already exists</td><td>119</td></tr><tr><td>2.4 SWIFT's strategic role in combating money laundering</td><td>122</td></tr><tr><td>2.4.1 The EU reaction to FATF recommendations</td><td>125</td></tr></table>

<table><tr><td>3 FISCAL REVENUES, THEIR MANAGEMENT AND USE</td><td>128</td></tr><tr><td>3.1 ESTIMATION OF THE REVENUES</td><td>130</td></tr><tr><td>3.1.1 Estimates based on unique tax rates and the same elasticity for the whole foreign exchange market</td><td>135</td></tr><tr><td>3.1.2 Estimates based on a specific tax rate for banks, financial customers and non-financial customers</td><td>140</td></tr><tr><td>3.2 HOW SHOULD THE REVENUE BE SPENT?</td><td>152</td></tr><tr><td>3.2.1 Financing "global public good"</td><td>153</td></tr><tr><td>3.2.2 What would be the Probable Cost of Financing Global Public Goods?</td><td>158</td></tr><tr><td>3.2.3 Universal Access to Basic Social Services</td><td>161</td></tr><tr><td>3.2.4 What do these figures tell us?</td><td>163</td></tr><tr><td>3.3 WHICH GLOBAL INSTITUTION SHOULD MANAGE THE REVENUES?</td><td>166</td></tr><tr><td>3.3.1 Objectives and principles of the institution</td><td>166</td></tr><tr><td>3.3.2 Does an adequate institution already exist?</td><td>167</td></tr><tr><td>3.3.3 Are the Bretton Woods institutions more adequate?</td><td>169</td></tr><tr><td>3.3.4 The structure of the new international institution (SFSD)</td><td>171</td></tr><tr><td>3.3.5 What should the budget debate be based on?</td><td>173</td></tr></table>

## PART II by Lieven Denys: Legal Issues in the EU Context

<table><tr><td>4 IMPLEMENTATION OF THE CURRENCY TRANSACTION TAX IN THE EU LEGAL CONTEXT</td><td>184</td></tr><tr><td>4.1 The implementation of a CTT in the EU Treaty Framework</td><td>187</td></tr><tr><td>4.1.1 General objectives and principles of the EU Treaties</td><td>187</td></tr><tr><td>4.1.1.1 Non-discrimination principle</td><td>187</td></tr><tr><td>4.1.1.2 Internal market principles</td><td>188</td></tr><tr><td>4.1.2 The institutional framework</td><td>190</td></tr><tr><td>4.1.2.1 EU competences in general in view of a CTT</td><td>190</td></tr><tr><td>4.1.2.2 The EU Fiscal provisions</td><td>191</td></tr><tr><td>4.1.2.3 The Economic and Monetary Union</td><td>193</td></tr><tr><td>4.1.2.4 The EU development cooperation</td><td>194</td></tr><tr><td>4.1.2.5 Conclusion</td><td>195</td></tr><tr><td>4.1.3 Legal Assessment of the European Central Bank of the Belgian CTT - law and Comments by the EU Commissioner for Taxation</td><td>196</td></tr><tr><td>4.1.3.1 Introductory note</td><td>196</td></tr><tr><td>4.1.3.2 The opinion of the ECB and comments</td><td>197</td></tr><tr><td>4.1.3.3 Comments of EU Commissioner for Taxation</td><td>203</td></tr><tr><td>4.2 Further Implementation of a CTT in the EU Legal Framework: EU enforcement</td><td>205</td></tr><tr><td>4.2.1 European administrative cooperation in tax matters</td><td>205</td></tr><tr><td>4.2.2 Monitoring through the European System of Central Banks</td><td>207</td></tr><tr><td>4.2.3 From anti-money laundering to EU protection of the financial system</td><td>211</td></tr><tr><td>4.2.4 Judicial and administrative cooperation in criminal matters</td><td>214</td></tr><tr><td>4.3 Conclusion</td><td>215</td></tr></table>

<table><tr><td>5 BIBLIOGRAPHY</td><td>229</td></tr></table>
## Tables

<table><tr><td>Table 1-1: Cost of Crises in Lost Output Relative to Trend</td><td>15</td></tr><tr><td>Table 1-2: Required CTT Rate to Curb Speculation in Case of an Anticipated Depreciation of the Exchange Rate, in %</td><td>51</td></tr><tr><td>Table 1-3: The Evolution of the Relative Share of Banks and Customers on the Foreign Exchange Market (as a percentage of global turnover)</td><td>55</td></tr><tr><td>Table 2-1: Global Forex Market by Type of Transaction</td><td>65</td></tr><tr><td>Table 2-2: Market Share of the Main Countries, in % of the World Foreign Exchange Market</td><td>77</td></tr><tr><td>Table 2-3: MT 103 Format Specifications</td><td>109</td></tr><tr><td>Table 2-4: MT 202 Format Specifications</td><td>116</td></tr><tr><td>Table 2-5: Some Characteristic of Selected Large-Value Payment Systems</td><td>127</td></tr><tr><td>Table 3-1: SURVEY OF PREVIOUS REVENUES ESTIMATES</td><td>131</td></tr><tr><td>Table 3-2: REVENUE ESTIMATES AT THE WORLD LEVEL</td><td>137</td></tr><tr><td>Table 3-3: Revenue Estimates at the Euro Area Level</td><td>140</td></tr><tr><td>Table 3-4: Revenues Estimates According the Methodology of the Ministry of Finance of Belgium and Finland for the World Level in 2004</td><td>142</td></tr><tr><td>Table 3-5: Revenues Estimates According the Methodology of the Ministry of Finance of Belgium and Finland for the Euro Zone in 2004</td><td>147</td></tr><tr><td>Table 3-6: Revenues Estimates According the Methodology of the Ministry of Finance of Belgium and Finland for the EU-15 Level in 2004</td><td>149</td></tr><tr><td>Table 3-7: Revenues Estimates According the Methodology of the Ministry of Finance of Belgium and Finland for the EU15 Level +Norway and Switzerland</td><td>150</td></tr><tr><td>Table 3-8: Taxonomy of Global Public Goods According to Their Characteristics</td><td>155</td></tr><tr><td>Table 3-9: CTT Annual Revenues at the World Level for Different Years and Tax Levels</td><td>177</td></tr><tr><td>Table 3-10: Estimates of the CTT Annual Revenues at Euro Area Level According to the Methodology of the French Ministry of Finance</td><td>178</td></tr><tr><td>Table 3-11: Reduction of Market Volume According to the Tax Rate, the Elasticity and Pre-Tax Transaction Costs</td><td>179</td></tr><tr><td>Table 3-12: Revenues Estimates According to the Methodology of the Ministry of Finance of Belgium and Finland</td><td>180</td></tr><tr><td>Table 3-13: Hypotheses Concerning the Revenue Estimates According to the Methodology of the Ministry of Finance of Belgium and Finland for the Euro Zone</td><td>181</td></tr><tr><td>Table 3-14: Hypotheses Concerning the Level of Fiscal Evasion According to the geographical Coverage and the CTT Rate</td><td>182</td></tr></table>

## Figures

<table><tr><td>Fig. 1-1: Difference of the log monthly US nominal effective exchange rate</td><td>17</td></tr><tr><td>Fig. 1-2: The political trilemma of the world economy</td><td>20</td></tr><tr><td>Fig. 1-3: Euro Area and US Economic Growth (%), and €/$ exchange rate, 1990-2000</td><td>35</td></tr><tr><td>Fig. 1-4: Illustration of the Working of the Exchange Surcharge</td><td>47</td></tr><tr><td>Fig. 2-1: Evolution of Foreign Exchange Turnover by Counterparty</td><td>63</td></tr><tr><td>Fig. 2-2: The FX Process Flow</td><td>66</td></tr><tr><td>Fig. 2-3: The Circadian Rhythm of the FX Market</td><td>77</td></tr><tr><td>Fig. 2-4: Message routing and real-time processing</td><td>82</td></tr><tr><td>Fig. 2-5: Settlement of a Forex Transaction Via Correspondent Banks</td><td>84</td></tr><tr><td>Fig. 2-6: CLS Settlement Process Timeline</td><td>85</td></tr><tr><td>Fig. 2-7: CLS Value Against the BIS Survey by Currency</td><td>87</td></tr><tr><td>Fig. 2-8: SWIFT "CLS Third Party Service"</td><td>90</td></tr><tr><td>Fig. 2-9: Bank a Has Struck a Deal With a Counterparty "KSAGBANK"</td><td>91</td></tr><tr><td>Fig. 2-10: FXall Settlement Methods</td><td>92</td></tr><tr><td>Fig. 2-11: Hypothetical Example of Linkages Between Settlement Systems</td><td>93</td></tr><tr><td>Fig. 2-12: Country Example: Integration of Infrastructure in France</td><td>95</td></tr><tr><td>Fig. 2-13: Share of 2003 Cross-Border TARGET Payments by TARGET Component (a)</td><td>97</td></tr><tr><td>Fig. 2-14: Daily Values Settled by Euro Payment Systems Located Outside the Euro Area (EUR bln., logarithmical scale)</td><td>98</td></tr><tr><td>Fig. 2-15: CMU Linkages with ICSD</td><td>101</td></tr><tr><td>Fig. 2-16: PVP Facility</td><td>102</td></tr></table>
<table><tr><td>Fig. 2-17 : TARGET Cross Border Processing</td><td>103</td></tr><tr><td>Fig. 2-18 : Message Flow Structure</td><td>106</td></tr><tr><td>Fig. 2-19 : Cross Border Euro Customer Payment Through TARGET</td><td>108</td></tr><tr><td>Fig. 2-20 : Example: Charging Option is OUR</td><td>115</td></tr><tr><td>Fig. 3-1 : CTT Revenues Estimates According to the Tax Rate at the World Level</td><td>138</td></tr><tr><td>Fig. 3-2 : World Revenues in 2004 by Sector Fossussing on Small Tax Rates</td><td>143</td></tr><tr><td>Fig. 3-3 : Share of the Tax by Sector According to the Tax Rate</td><td>145</td></tr><tr><td>Fig. 3-4 : Revenues Estimates of the CTT According to the Tax Rate at the World Level</td><td>145</td></tr><tr><td>Fig. 3-5 : Summary of Revue Estimates According to the Geographical Coverage in 2001 and 2004</td><td>151</td></tr></table>

## Boxes

<table><tr><td>Box 1-1 : The Political Trilemma of the World Economy</td><td>19</td></tr><tr><td>Box 1-2 : The Golden Straightjacket: The End of Politics?</td><td>20</td></tr><tr><td>Box 1-3 : The crawling band and the monitoring band</td><td>42</td></tr><tr><td>Box 1-4 : What is the required level of the ordinary tax to provide some autonomy to monetary policy?</td><td>51</td></tr><tr><td>Box 2-1 : The Different Categories of Foreign Exchange Transactions and Their Definitions</td><td>64</td></tr><tr><td>Box 2-2 : The Seven Steps of a Foreign Exchange Transaction. Definition and Explanations</td><td>68</td></tr><tr><td>Box 2-3 : Connection of Euro RTGS Systems of Non-Euro Central Banks to Target</td><td>97</td></tr><tr><td>Box 2-4 : New Dimension in Correspondent Banking</td><td>99</td></tr><tr><td>Box 2-5 : MT 103: Specific Validation Within EU Countries</td><td>113</td></tr><tr><td>Box 2-6 : Excerpt from the Second Giovanni Report</td><td>120</td></tr><tr><td>Box 2-7 : CREST - Electronic Transfer of Shares System (Capital Taxes)</td><td>121</td></tr><tr><td>Box 2-8 : FATF Recommendation No. 5</td><td>124</td></tr><tr><td>Box 3-1 : GLOBAL PUBLIC GOODS DEFINED IN THE PREPARATORY PROCESS FOR THE MONTERREY CONFERENCE (March 2001)</td><td>154</td></tr><tr><td>Box 3-2 : ESTIMATE OF ANNUAL COSTS OF GLOBAL PUBLIC GOODS</td><td>159</td></tr><tr><td>Box 3-3 : Where the Money is Missing</td><td>162</td></tr><tr><td>Box 3-4 : Excerpt from the "Millennium Declaration" adopted by the heads of state and government at the "Millennium Summit", 6 - 8 September 2001 at the UNO</td><td>164</td></tr><tr><td>Box 3-5 : THE UNDP HUMAN DEVELOPMENT INDICATORS</td><td>174</td></tr></table>
ABBREVIATIONS

<table><tr><td>BIS</td><td>Bank for International Settlements</td></tr><tr><td>CLS Bank</td><td>Continuous Link Settlement Bank</td></tr><tr><td>CTT</td><td>Currency Transaction Tax</td></tr><tr><td>EC</td><td>European Community</td></tr><tr><td>ECB</td><td>European Central Bank</td></tr><tr><td>EEC</td><td>European Economic Community</td></tr><tr><td>EMS</td><td>European Monetary System</td></tr><tr><td>EMU</td><td>Economic and Monetary Union</td></tr><tr><td>ERM</td><td>Exchange Rate Mechanism</td></tr><tr><td>ESCB</td><td>European System of Central Banks</td></tr><tr><td>EU</td><td>European Union</td></tr><tr><td>EUC</td><td>European Union Constitution 2004</td></tr><tr><td>ECJ</td><td>European Court of Justice</td></tr><tr><td>Eurogroup</td><td>Group of member states of the European Union whose currency is the euro</td></tr><tr><td>FATF</td><td>Financial Action Task Force</td></tr><tr><td>FOREX</td><td>Foreign Exchange</td></tr><tr><td>GATS</td><td>General Agreement on Trade in Services</td></tr><tr><td>GNP</td><td>Gross National Product</td></tr><tr><td>ML Directives</td><td>European Union Directives on Money Laundering</td></tr><tr><td>MDG</td><td>Millennium Development Goals</td></tr><tr><td>MS</td><td>Member States of the European Union</td></tr><tr><td>NDF</td><td>non-deliverable forwards</td></tr><tr><td>NGO</td><td>Non Governmental Organisation</td></tr><tr><td>IMF</td><td>International Monetary Fund</td></tr><tr><td>KYC</td><td>Know Your Customer</td></tr><tr><td>ODA</td><td>Official Development Aid</td></tr><tr><td>OTC</td><td>Over-The-Counter</td></tr><tr><td>OECD</td><td>Organisation for Economic Cooperation and Development</td></tr><tr><td>OLAF</td><td>Office Européen de Lutte Anti-Fraude (European Anti-Fraud Office)</td></tr><tr><td>RTGS</td><td>Real-Time Gross Settlement</td></tr><tr><td>SFSD</td><td>Solidarity Fund for Sustainable Development</td></tr><tr><td>SWIFT</td><td>Society for Worldwide Interbank Financial Telecommunication</td></tr><tr><td>TEC</td><td>Treaty establishing the European Community</td></tr><tr><td>TEU</td><td>Treaty of the European Union</td></tr><tr><td>UN</td><td>United Nations</td></tr><tr><td>VAT</td><td>Value-added tax</td></tr><tr><td>WTO</td><td>World Trade Organisation</td></tr></table>
# EXECUTIVE SUMMARY

This study brings the important technical and legal details of the Currency Transaction Tax (CTT) to the debate table. It proves explicitly the feasibility of a CTT implementation and clarifies its political, technical, institutional and legal aspects. It is, so far, the most in-depth analysis of the possibilities of an implementation of the CTT and the challenges emerging from this implementation.

Eventually the implementation of a CTT depends on the political will and especially the pressure by the global justice movement on governments and decision makers. The technical feasibility of a sound project does not ensure its implementation, as politics are shaped by interest groups and power struggles. However, this study shows that there are no more formal, legal or technical excuses behind which opponents or hesitant supporters of a CTT can hide.

## PART I: TECHNICAL, INSTITUTIONAL AND POLITICAL ISSUES

### 1.Chapter: THE CASE FOR A CURRENCY TRANSACTION TAX

In the first chapter, Bruno Jetin introduces the concept of the Currency Transaction Tax (CTT). After the Bretton Woods system of fixed exchange rates was abolished and substituted by a non-system of freely-floating currencies, the volatility of currencies and financial markets became one of the major sources of crises, especially in the developing world. James Tobin's idea of a currency transaction tax ("Tobin tax") was aimed at curbing volatility and preventing financial crises. More generally, the CTT is designed to restore national policy autonomy by governing the international foreign exchange market.

The author comes to the conclusion that "exchange rate volatility matters" because it negatively affects economic growth, international trade, investment, employment and wages. This is not only the case for developing countries with weak currencies, but also true for huge markets with strong currencies like the Euro zone.

Exchange rates can be stabilized in different ways: by international cooperation in economic policies, by creating a "world currency", by creating "target zones" for currencies, by capital controls and finally, by a CTT. The pros and cons of each method are discussed. The idea of a world currency is rejected as politically problematic and a step back from a perspective of social justice and democracy. The concept of target zones for currencies is supported as an important instrument, but defending the target zones by central banks without any restriction to capital mobility is seen critically because currency volatility might be substituted by interest rate volatility. By limiting inflows and outflows of capital, the CTT turns target zones into a viable instrument of exchange rate policy. Capital control is also a concept that is supported, but rather as a part of a new international financial system than as a measure for short term reforms that any country could enforce unilaterally indefinitely.

The CTT is an effective concept to curb currency volatility and to fight speculation. In contrast to nationally applied capital controls it also has the advantage that it is an international tool that can open a perspective for more international political cooperation in order to govern economic globalization.

When talking about the CTT the study more precisely refers to the two-tier currency transaction tax, which is a modification of the Tobin tax by Paul Bernd Spahn. The first tier is equivalent to the classical Tobin tax, with a very low tax on all currency transactions (e.g. 0.01%) focussed on the day-to-day currency speculation that derives profits from
market volatility. This first tier is the main creator of revenues from the tax. However, the first tier is not able to prevent speculation during currency crises, because these huge currency fluctuations allow gigantic profits that would not be substantially diminished by such a low tax. This is where the second tier proposed by Spahn comes into action.

The second tier is a flexible tax rate that is only applied in the event of a currency crisis. It is used to tax away the profits from speculation and the windfall profits from large currency appreciations or depreciations. Following Spahn's definition, the tax is automatically applied when a currency leaves a defined exchange rate band. In combination, both tiers can effectively curb speculation, reduce the volatility on the currency market and prevent currency crises.

But the study makes departures from P. B. Spahn's proposal in several aspects. The first tier should be much higher, up to 0.1%, even for currencies such as the euro, to more efficiently tackle the short-term volatility of currencies. The second tier should also be much higher, and even reach prohibitive rates in case of currency attacks. In such exceptional circumstances, the CTT could lead automatically to a temporary shutdown of the foreign exchange markets. This is especially important in developing countries. CTT rates must also be higher if one wants to keep alive the original reason why James Tobin invented the so-called "Tobin tax": preserving the autonomy of monetary policy. In today's global financial markets, deviating from the international interest rates that markets have decided condemn countries, and especially developing countries, to capital outflows and currency attacks. If a democratically elected government chooses an alternative economic policy based (among other elements) on low interest rates, it will be sanctioned by financial markets. The same is true for the EU member states if they opt for the "new economic policy" defended by some European radical economists. There is no other solution to this problem than endorsing the fact that market freedom, excessive liquidity and unconstrained arbitrage must be restricted. Higher CTT rates are a part of these restrictions.

Otherwise, there is no "sand in the wheels" at all, and these wheels are already far too well greased.

## 2. Chapter: THE FEASIBILITY OF THE CURRENCY TRANSACTION TAX

The second chapter deals with the feasibility and the technical implementation of the CTT. It offers the most detailed insight into the working of the forex market and the possibility of levying the taxes that have been published so far. It introduces some new innovations, like an electronic tag that is applied to all currency transactions and makes them identifiable through all stages of the transaction. As a currency transaction involves several actors, stages, monitoring and clearing systems, the tag helps to identify each transaction and ensures that the tax is paid. Thus each currency transaction can be identified and monitored at a very early stage and the tax can be paid at each stage or at the final one, when currency transactions have already been netted and are settled through an electronic system.

It is important to realize that the introduction of the CTT benefits from technical progress and the centralization of the forex system. Today, the electronic brokerage platforms EBS and Reuters handle nearly all the forex trade. Such a centralisation has always been suggested by proponents of the CTT and previously seemed unrealistic – but has now been achieved by market forces. Nowadays, collecting the CTT would be as easy as paying the commercial fees for the use of these private electronic platforms. Other electronic systems like SWIFT manage the exchange of information between the trading parties, provide the necessary information for the netting (also called clearing) of transactions, and their settlement in national payment systems, European payment systems like Euro 1 or
TARGET, or international payment systems like CLS. Institutions that trade currency, or
settlement institutions like the CLS bank have to cooperate with the central banks, and
thus can be committed to levy the tax.

Legal issues are also discussed. As the business of forex transactions is considered
to be an investment business by European law, it is no problem to tax the transaction in
legal terms. However, it does not make sense to levy the tax just in one country – rather,
an implementation at the EU level would be appropriate. The already existing EU legisla-
tion could be mobilised in this perspective. Although tax evasion might still be possible, it is
shown that this would be a minor difficulty at most. It would be possible to move the forex
market somewhere else, but to put this into reality is not easy. London is the most import-
ant marketplace for currency transactions, and one of the most expensive cities in the
world. Would a small tax like the CTT make a difference? The forex market needs a good
infrastructure which only a few cities can offer. Most importantly London has the geograph-
ic advantage of having overlapping working hours with the two other important economic
regions: North America and East Asia. This is crucial for an effective and inexpensive set-
tlement process.

Another argument supports the feasibility of the tax, and that is the Security Trans-
action Tax (STT) that is levied by several EU member states like the UK, Ireland and Bel-
gium. The STT is automatically collected through the settlement systems - a method that
could be used by the CTT as well. It is important to know that the EU institutions are not
asking these countries to suppress STT taxes, but to let foreign firms compete in collecting
the tax in an increasingly efficient way. Finally, anti-money laundering measures can be
used to identify currency transactions, as shown in a detailed analysis by the recommend-
ation of the G7 Financial Action Task Force (FATF). In this field again, it is important to ob-
serve that the EU has adopted a comprehensive legislation against money laundering,
which goes deep into the practical details of forex and other financial transactions that take
place in the EU. SWIFT, the major information conveyor of forex transactions, had to
change the content of its message to respect this EU legislation. Due to these changes, all
the information needed to tax currency in the EU is already at the disposal of member
states.

3.Chapter: FISCAL REVENUES, THEIR MANAGEMENT AND USE

The third chapter estimates the revenues of the CTT and offers proposals on how to manage and spend them. The original purpose of the CTT was not to create revenues, but to curb speculation and stabilise the currency market. However, as with taxes on tobacco or alcohol there is no principle contradiction between creating revenues and sanctioning behaviour with negative consequences for the society. A huge number of studies are presented that estimate the potential revenues from the CTT. Different scenarios and calculations are used that estimate the revenue worldwide from $19 billion to $31 billion for a tax rate of 0.01%, and $34 billion to $125 billion for a rate of 0.1% in 2004. For the Euro zone, the estimates range from $6 to $10 billion for 0.01% and $10 to $46 billion for 0.1% in 2004. The author also calculates revenues for split tax rates of 0.02% for banks and 0.1% for customers, as banks would have a very high elasticity on the CTT. This scenario would result in revenues of US$ 97.4 billion at world level and between $29 and $38 billion in the Euro zone.

Revenues should be used to finance global public goods and development in the
poorer countries, not to consolidate national accounts in the industrialized countries. The
author proposes to spend the revenues for the establishment of a reserve currency fund in
order to achieve the public good of more exchange rate stability, as well as for the funding of ecological and social programmes in order to achieve the public good of sustainable development and social security.(e.g. the fight against tuberculosis and malaria would cost around $2 billion, and against AIDS $7-10 billion). The UN estimates that satisfying the needs in global public goods would probably require a minimum of $20 billion a year. The author also pleads for an international emergency fund for disasters.

The third part of chapter 3 deals with the important institutional aspects of who will collect the CTT and distribute the revenues. It is argued that the tax should be collected by established institutions on the national level. For the management of the revenues, different existing organisations like the UN, UNSOC, UNDP, UNCTAD, IMF, World Bank and BIS are discussed and rejected. The solution proposed is to establish a new organization, which could be called the “Solidarity Fund for Sustainable Development”, and which co-operates with national governments and the BIS concerning the levying of the tax. and with UNDP and UNCTAD concerning the distribution of the revenues. A detailed concept of the governance structure of the fund is presented.

The principle should be that poor countries receive more funds in the beginning. However, funds would be linked to performance criteria, such as an improvement in human development, gender related development and ecological sustainable development.

# PART II: LEGAL ISSUES

## 4.Chapter: THE IMPLEMENTATION OF THE CURRENCY TRANSACTION TAX IN THE EU LEGAL CONTEXT

The fourth chapter by Lieven Denys deals with the implementation of the CTT in the legal context of the EU. It also elaborates on the opportunities available at the EU level to ensure correct application of the tax and prevent fraud. The conclusion of this chapter is that a CTT is in line with European law.

First of all, it inquires on possible contradictions of national CTT laws and EU law. This is done for the case of the Belgian CTT law passed by the Belgium parliament on July 1st 2004 and in whose formulation the author participated. The author disproves criticism on the Belgian CTT by the ECB and the European Commission. From the institutional perspective, it can be concluded that the EU has no exclusive competence in indirect taxation and that Member States are thus free to introduce a CTT. Tax disparities are not prohibited by EU law. The Member States have indeed in principle the right to introduce new indirect taxation, until the EU enacts measures in that area.

Since the EU has exclusive competence in the area of monetary policy for the Euro Member States, the second tier of the CTT would need approval of the EU. The second tier of the CTT is a monetary surcharge in order to prevent harmful currency fluctuation and thus an intervention in monetary policy. Therefore, it would have to be regulated by the EU.

The author proves that the CTT is compatible with the European non-discrimination principle. The CTT is not discriminatory because it taxes all currency transactions regardless of the currencies involved and regardless of the nationality or residence of the trading parties.

The second potential problem is the compatibility with the Internal Market's four fundamental principles of freedom of movement. It is argued that the first tier of the CTT does not restrict capital flows as it does not distinguish according to the origin of the currencies involved nor their use (or destination). The legal principle of the free movement of capital is moreover not an absolute freedom: the first tier CTT is justified under the rule of reason by
one of the fundamental EU objectives, i.e. (funding) development cooperation. Moreover the first tier does not affect access to the capital market, and the levy is too negligible to cause a restriction of free movement or to hinder the free internal market because of its very low rate of 0.02 or less. Indeed the financial markets can smoothly absorb the low rate levies. However, the case is different for the second tier of the CTT that restricts capital flows through a very high tax in the event of a large harmful currency fluctuation. Provided it is implemented as an EU monetary instrument, this second tier is justified in order to stabilize currencies and the economy. As a tool for monetary policies at EU level it is not in contradiction to EU law as international monetary stability is an important aim of the EU.

Next to the stabilization of currencies, financing development from the CTT revenues is the second important goal of the CTT. To improve financing for development is not only an important aim of the EU, but furthermore, the EU has explicitly committed itself to increase spending on developmental aid in order to achieve the UN Millennium Development Goals for 2015.

Finally the author proposes to introduce the CTT through an EU directive, similar to the EU VAT directive. This would bind EU member states to the introduction of a CTT but leave the details of implementation, as well as the administration, to the individual states. National and EU institutions like the central banks and the ECB could be instrumental in the implementation and expansion of the CTT to non-Euro member states of the EU and third states, including offshore centres and others, through a cooperation with multinational private financial institutions and settlement organisations, which they license to operate in the EU. EU anti-money laundering measures and the cooperation of Europol and Eurojust in criminal matters can effectively serve as the deterrent against the evasion of the tax.

Thomas Kalinowski

Berlin, November 2005
# PART I

## BRUNO JETIN*

### TECHNICAL, INSTITUTIONAL AND POLITICAL ISSUES

<footnote>* Bruno Jetin, Ph.D., University of Paris Nord, Economist Member of ATTAC France Scientific Committee, (bjetin@yahoo.fr)</footnote>
# 1 THE CASE FOR A CURRENCY TRANSACTION TAX

## 1.1 INTRODUCTION: “TIME FOR TOBIN?”

“Since 1992, crises in world financial markets have been the norm rather than the exception. In 1992-1993, The European Union (EU) experienced the virtual collapse of the European Exchange Rate Monetary Mechanism (ERM) despite its tentative defeat speculation. In 1994-95, the Mexican currency and financial crisis saw the collapse of the peso with negative contagion effect on Argentina and Brazil (the so-called “Tequila effect”). In 1997 came the East Asian crises, which started somewhat innocuously with a run on the Thai Baht, but spread swiftly to a number of other regional currencies. The five crisis-hit Asian economies (Indonesia, Korea, Malaysia, Thailand and, to a lesser extent, the Philippines) suffered a single year capital reversal of about $105 billion between 1997-98. Socio-political repercussions in the East Asian economies have been far reaching. In January 1999, the Brazilian Real was devalued, and lost over 40% of its value relative to the US dollar within two months”. This chronicle of financial and economical disasters was made by G. Bird and R. S. Rajan in 1999. Unfortunately, the story is not finished. We can add to the list Turkey in 2000, and Argentina in December 2001. Argentina, who had decided to peg its currency to the US dollar under the form of a currency board, was running out of dollars and was forced to float its currency. The currency collapsed immediately, triggering a catastrophic economic and socio-political crisis.

The economic and social losses of these crises have been dramatic, especially for the developing world. Table 1-1, (IMF 1998, p 79) shows that between 1975-1997, there have been: 158 currency crises (1), of which 116 were in emerging countries; 55 currency crashes (2), of which 42 were in emerging countries; 54 banking crises (3), of which 42 were in emerging countries; and 32 currency and banking crises, of which 26 occurred in emerging countries. Even if the average recovery time is usually short, (between one to two years) the cumulative loss of output is severe: 7.1% of GNP when a currency crisis occurs, 10.1% in case of a currency crash, 14.2% for a banking crisis, and 18.5 % when currency and banking crises are linked.

These recurrent economic crises are the bitter fruits of the globalisation process that has suppressed nearly all public controls on financial markets. The renewed liberty of movement of financial capital will provoke new crises in the near future. Something must be done. We cannot wait for the next crisis and witness its disastrous consequences.

The proposals of the international institutions (i.e the IMF, World Bank, and the Bank for International Settlement, among others) and of the banking community are not only pointless, but they point in the wrong direction. Basically, they rely on prudential regulations and self-control by banks. Prudential regulations can be useful but have never impeded a financial crisis (D. Felix, 1999). Self-control by banks is hypocrisy. Banks are now allowed to define their own norms of control and are responsible to control themselves, instead of being controlled by public authorities according to transparent common criteria. After the long list of financial scandals (Enron, Global Crossing ...) who can believe that

<footnote n="1">1) “A currency crisis may be said to occur when a speculative attack on the exchange value of a currency results in a devaluation (or sharp depreciation) of the currency, or forces the authorities to defend the currency by expending large volumes of international reserves or by sharply raising interest rates” (IMF, 1998, p 74).</footnote>

<footnote n="2">2) “Currency crashes are identified by crises where the currency component of the exchange market pressure index accounts for 75% or more of the index when the index signals a crisis” (IMF, 1998, p 79).</footnote>

<footnote n="3">3) “A banking crisis refers to a situation on which actual or potential bank runs or failures induce banks to suspend the internal convertibility of their liabilities or which compels the government to intervene to prevent this by extending assistance on a large scale” (IMF, 1998, p74-75).</footnote>
private banks and corporations can seriously control themselves? Not to mention that some important financial agents like hedge funds are not liable to any control, and that no effective decisions have been taken against tax havens, these lawless territories where legal and illegal finance meet.

<table><caption>Table 1-1: Cost of Crises in Lost Output Relative to Trend</caption><thead><tr><th></th><th>Number of Crises</th><th>Average Recovery Time<fnref n="1" /> (in years)</th><th>Cumulative Loss of Output per Crisis<fnref n="2" /> (in percentage points)</th><th>Crises with Output Losses<fnref n="3" /> (in percent)</th><th>Cumulative Loss of Output per Crisis with Output Loss<fnref n="4" /> (in percentage points)</th></tr></thead><tbody><tr><td>Currency crises</td><td>158</td><td>1.6</td><td>4.3</td><td>61</td><td>7.1</td></tr><tr><td>Industrial</td><td>42</td><td>1.9</td><td>3.1</td><td>55</td><td>5.6</td></tr><tr><td>Emerging market</td><td>116</td><td>1.5</td><td>4.8</td><td>64</td><td>7.6</td></tr><tr><td>Currency crashes<fnref n="5" /></td><td>55</td><td>2.0</td><td>7.1</td><td>71</td><td>10.1</td></tr><tr><td>Industrial</td><td>13</td><td>2.1</td><td>5.0</td><td>62</td><td>8.0</td></tr><tr><td>Emerging market</td><td>42</td><td>1.9</td><td>7.9</td><td>74</td><td>10.7</td></tr><tr><td>Banking crises</td><td>54</td><td>3.1</td><td>11.6</td><td>82</td><td>14.2</td></tr><tr><td>Industrial</td><td>12</td><td>4.1</td><td>10.2</td><td>67</td><td>15.2</td></tr><tr><td>Emerging market</td><td>42</td><td>2.8</td><td>12.1</td><td>86</td><td>14.0</td></tr><tr><td>Currency and banking crises<fnref n="6" /></td><td>32</td><td>3.2</td><td>14.4</td><td>78</td><td>18.5</td></tr><tr><td>Industrial</td><td>6</td><td>5.8</td><td>17.6</td><td>100</td><td>17.6</td></tr><tr><td>Emerging market</td><td>26</td><td>2.6</td><td>13.6</td><td>73</td><td>18.8</td></tr></tbody></table>

Source: “World Economic Outlook”, May 1998, Chapter 4, p 79, IMF.

It is the great merit of James Tobin (1918-2002) to have anticipated these repeated crises right after the breakdown of the International Monetary System in 1972. Clearly, he had rightly anticipated the global financial process that would emerge from Bretton Woods' ruins. He feared that key economic variables like interest and exchange rates would be submitted to the whims of speculation on financial markets and no longer subject to the public interest.

The so-called Bretton Woods agreements, signed in 1944, had established a worldwide system of exchange rates based on semi-convertible currencies managed by a new institution, the International Monetary Fund (IMF). International capital mobility and the exchange of currencies were restricted to achieve exchange rate stability.

The articles of the IMF did not, and still do not, require its members to make their currency wholly convertible. They only require that foreigners be free to convert any of a country's currency they earn in trade of goods and services, what is called "current account convertibility". But it was not required that any holder of a currency, resident or non-resident, would be free to buy foreign-currency assets, what is called "capital account convertibility". Currency convertibility was then linked to the needs of international trade, and capital controls restricted the international mobility of financial capital

This monetary system enabled relative exchange rate stability while allowing a necessary flexibility. All currencies had a fixed but adjustable rate with the US dollar which was then convertible in gold at a fixed price ($35 an ounce). Countries' peg to gold and the

<footnote n="1">¹Average amount of time until GDP growth returned to trend. Because GDP growth data are available for all countries only on an annual basis, by construction the minimum recovery time was one year.</footnote>

<footnote n="2">²Calculated by summing the differences between trend growth and output growth after the crisis began until the time when annual output growth returned to its trend and by averaging over all crises.</footnote>

<footnote n="3">³Percent of crises in which output was lower than trend after the crisis began.</footnote>

<footnote n="4">⁴Calculated by summing the differences between trend growth and output growth after the crisis began until the time when annual output growth returned to its trend and by averaging over all crises that had output losses.</footnote>

<footnote n="5">⁵Currency “crashes” are identified by crises where the currency component of the exchange market pressure index accounts for 75 percent or more of the index when the index signals a crisis.</footnote>

<footnote n="6">⁶Identified when a banking crisis occurred within a year of a currency crisis.</footnote>
dollar were adjustable and devaluations were frequent for some currencies. For some eco-
nomists (J. Eatwell and L. Taylor, 2000), it is not a coincidence that the Bretton Woods
system was contemporary with the most prosperous period of growth that the world has
registered, the so-called “golden age” (1950-73). Financial and monetary stability is favour-
able to high growth and catching up for the developing world.

However, James Tobin was not a nostalgic of Bretton Woods (J. Tobin, 1993,1998).
His purpose was not to return to a new Bretton Woods system. He recalled that Bretton
Woods was an asymmetric system which had also its weaknesses and constraints.

Countries with current account deficit were faced with the choice of reducing their rate of growth and increasing their unemployment to eliminate their deficit, or to defend their fixed exchange rate until they ran out of reserves and international credit. They were then forced to devalue and suffered an economic crisis to the great benefit of speculators who had anticipated the change in the exchange rate. Countries with current account surplus could accumulate indefinitely foreign reserves and there was nothing to stop them. The Bretton Woods system engendered inequality between weak and strong countries.

This is why J.M. Keynes had defended a far more ambitious international monetary system during the Bretton Woods negotiations. Surplus countries should be compelled to finance deficit countries through the intermediary of an international clearing system that would issue an international currency. There would be no more incentive for a country to accumulate surplus at the expense of others. Competition would be substituted by cooperation. Post-Keynesians like P. Davidson (1992) have kept on developing Keynes's proposals and these are certainly the core principles for a new international system based on equality between nations.

But when the Bretton Woods system disappeared in 1971-72, there was no political will to establish such a new international monetary order; and with the exception of developing countries, the new direction was quite to the contrary. The American government had sabotaged the Bretton Woods system because it was no longer useful for them and soon, after some attempts at collective action, all rich countries decided to engage in the individual adventure of floating rates.

James Tobin had a mixed feeling about floating rates. On the one hand he acknow-
ledges that they allow desirable currency adjustments without currency crises (J. Tobin,
1998, p 3). As opposed to fixed rates that make speculation so easy in case of excessive
and unsustainable appreciation of the exchange rate. On the other hand, since the demise
of Bretton Woods floating rates have been very volatile (See figure 1-1) because they are
also prone to speculation and do not guarantee the necessary short-term autonomy for
macroeconomic policy.

## 1.2 The original objectives of the tax: Reducing short-term speculation and increasing national policy autonomy

James Tobin wants exchange rates to reflect more precisely long-run economic de-
terminants rather than the reaction to short-term news. He thinks that speculators concen-
trate on how “the market” will respond to news, not on basic economic meanings. Taxing
currency transactions would diminish excess volatility of the exchange rates (See Fig. 1-1),
insofar as speculators have shorter horizons and holding periods than market participants
oriented to long-run determinants, the so-called “fundamentalists”. Taxing currency trans-
actions would also reduce capital mobility that gives considerable power to speculators,
creating room to manoeuvre for national economic policy.
<figure><img src="image_2.png" /><figcaption>Fig. 1-1 : Difference of the log monthly US nominal effective exchange rate</figcaption></figure>

Source: G. Karras et al. (2005), "Sources of exchange-rate volatility: Impulses or propagation?", International Review of Economics & Finance, Volume 14, Issue 2, 2005, Pages 213-226.

Autonomy for macroeconomic policy is James Tobin's real concern (4). As a Keynesian, J. Tobin believes that the State has a legitimate role to play to achieve full employment through active fiscal and monetary short-term policies. In case of recession, the State must stimulate growth with an appropriate combination of expansionary fiscal and monetary stimulus, the so-called "policy mix". Fiscal policy includes increased public spending or tax rebates while monetary policy is mainly implemented through interest rate decreases. With the demise of Bretton Woods, J. Tobin fears that states lose their ability to intervene in the course of economic affairs.

International capital mobility is at the root of the loss of economic policy autonomy.

Standard economic theory has demonstrated in the early sixties that in a world of international capital mobility, domestic monetary policy is inhibited when exchange rates are fixed and domestic fiscal policy when exchange rates are flexible. Moreover, the remaining instrument of economic policy in either regime is frequently constrained by domestic institutional, political and economics factors (5). As a consequence, states lose one policy instrument and retain maybe half of the last one.

Standard economic theory also demonstrates that countries cannot simultaneously maintain independent monetary policies, fixed exchange rates, and capital account convertibility. This result due to R. Mundell (1961) is known as the "impossible trinity" or "open-economy trilemma". Even if this trilemma is questionable as we shall see below, it is useful as a starting point to organise discussion.

A country has to choose two of the three possible objectives (see the top panel figure 1-2 below). For instance, a government and a central bank that wish to reduce unemployment by raising aggregate demands for the goods its country produces may cut interest rates to stimulate consumption and investments and make its products more competitive abroad. But it is not possible with fixed exchange rate and full international capital

<footnote n="4">4) "In any case, the principal purpose of the tax is to expand the autonomy of national monetary policies". J. Tobin, (1996, p 496).</footnote>

<footnote n="5">5) See J. Tobin 1978, p 155.</footnote>
mobility. Capital will flow abroad forcing the central bank to devalue. The government will have to choose between floating the currency or to impose capital controls. Bretton Woods was a combination of (semi) fixed exchange rates and monetary autonomy. The post Bretton Woods world and the ongoing process of financial integration are now based on capital mobility (⁶) and theoretically, monetary autonomy. As a consequence, countries had to renounce fixed exchange rates.

Advocates of floating rates had argued that they would free the remaining instrument of economic policy, i.e. monetary policies, from constraints imposed by commitments to defend official parities. Exchange rates could be left completely to private markets, governments practising an official neglect of them. But this neoliberal claim is in large degree illusory for at least two reasons.

First, governments cannot be indifferent to currency markets because, as we shall see in part one, volatility in exchange rates induced by speculation and free capital flows can have real economic consequences devastating for particular sectors or whole economies.

And second, floating rates do not guarantee monetary autonomy. The main reason is arbitrage on interest rates.

Arbitrage is the opportunity to buy an asset (or a currency) at a low price and then immediately sell it on a different market for a higher price. Strictly speaking it involves no risk because the arbitrageur is only exploiting an opportunity that already exists to buy cheap and sell at a higher price. Under a fixed exchange rate, when a central bank reduces its interest rate under the foreign rate to stimulate the economy, arbitrageurs will borrow in the national currency, exchange it into foreign currency and apply the money abroad to benefit from the higher interest rate. When the central bank runs out of international currency, it is forced to devalue. Floating rates do not resolve the problem but make it more difficult. "If similar financial assets denominated in two different currencies are perfect substitutes in private portfolios, they cannot bear different interest returns in their domestic currencies unless those differences are offset by expected exchange rate movements" (⁷). In other terms, if the foreign interest rate is 2% higher than the domestic one, arbitrageurs will sell the national currency and buy the foreign currency until it costs 2% more to buy the foreign currency, which offsets the difference in interest rate.

In J. Tobin's terms "... the boundless resources of private arbitrageurs will just erase any rate differentials the national authorities try to create and sustain" (⁸).

Integration of international financial markets due to innovations in computation and communications, together with deregulation, has made arbitrage very easy and costless. The same holds true for speculation, which only differs from arbitrage insofar as the speculator deliberately takes a risk to make a profit.

## 1.3 How to resolve the problem of arbitrage and speculation?

According to J. Tobin, there are two ways to go (⁹).

### 1.3.1 A world currency

With a world currency, in fully integrated financial and capital markets, "... movements of funds to exploit interest rate arbitrage or to speculate on exchange rate fluctu-

<footnote n="6">⁶) The last remaining capital controls were dismantled in Europe in the eighties.</footnote>

<footnote n="7">⁷) J. Tobin, 1996 p 495.</footnote>

<footnote n="8">⁸) J. Tobin, 1998, p 4.</footnote>

<footnote n="9">⁹) See J. Tobin's seminal paper: "A Proposal for International Monetary Reform", 1978, p 154-55. The alternative between a world currency on the one hand, and a degree of financial segmentation on the other hand will be present in numerous papers he wrote later on the CTT.</footnote>
ations cannot be sources of disturbances and painful interregional adjustments" (J. Tobin, 1978, p 155). This solution has a cost because it means going to the end of the road of international economic and financial integration, i.e. full globalisation.

In a certain way, the Euro zone materialises this proposal at a small scale. In the European Union, the euro was created after the achievement of the common deregulated market, as a kind of corner-stone. The economic policy is subordinated to "price stability", meaning that governments can no longer use monetary policy to stimulate growth and that fiscal policy is strictly bounded by the objective of surplus budget and limited indebtedness.

At the world level, that means achieving the free trade process organised by the World Trade Organisation (WTO), completing the deregulation of labour markets, and co-ordinating fiscal and monetary policies between at least the G7 countries in order to keep inflation at a low level. The loss of political sovereignty and of democracy, not to say the social consequences, would be tremendous.

To convince oneself of this fact, let's make a political fiction exercise. D. Rodrik (2000, p180) extrapolates from the economical trilemma presented above to consider what he calls "the political trilemma of the world economy" (See box. 1-1 and the bottom panel of figure 1-2). The theoretical exercise is worthwhile as it illustrates what would remain of politics with full globalisation. It is also useful to shed light on the present crisis of politics.

Box 1-1 : The Political Trilemma of the World Economy

"The three nodes of the extended trilemma are international economic integration, the nation-state, and mass politics. I use the term "nation-state" to refer to territorial- jurisdictional entities with independent powers of making and administering the law. I use the term "mass politics" to refer to political systems where:

a) the franchise is unrestricted; b) there is a high degree of political mobilization; and c) political institutions are responsive to mobilized groups.

The implied claim, as in the standard trilemma, is that we can have at most two of these three things. If we want true international economic integration we have to go either with the nation-state, in which case the domain of national politics will have to be significantly restricted, or else with mass politics, in which case we will have to give up the nation-state in favour of global federalism. If we want highly participatory political regimes, we have to choose between the nation-state and international economic integration. If we want to keep the nation-state, we have to choose between mass politics and international economic integration".

Source: D. Rodrik (2000, p 180), "How Far will International Economic Integration Go?"

As in the economical trilemma, we cannot achieve the three objectives simultaneously. International economic integration, i.e. full globalisation, has to go either with the Nation-State or else with "mass politics", in which case Nation-State will have to be abandoned in favour of global federalism. If highly participatory political regimes are the priority, a choice has to be made between the Nation-State and international economic integration. If the preservation of the Nation-State is the priority, either mass politics or international economic integration must sacrificed.

Consider the hypothesis of a perfectly integrated world economy. Nations could no longer interfere with arbitrage in markets for goods, services or capital. "Transaction costs and tax differential would be minor". The CTT would then be outlawed. Convergence in prices, wages and profit would be almost complete. Global federalism would be necessary "to align jurisdictions with the market and remove the "border effects". "... The entire world – or at least the parts that matter economically – would be organised along the lines of the U.S. system. A world government would take care of a world market" (p 181-182).

Instead of global federalism, international economic integration could cohabit with Nation-States provided that "they do not get in the way of economic transactions", and try
...to appear attractive to international markets". "The only local public goods provided would be those that are compatible with integrated markets" (p 182). In summary, the price to pay for the survival of Nation-States in this neoliberal dream and citizen nightmare is that politics are reduced to nearly nothing. T. Friedman (1999, p 87, cited by D. Rodrik) calls it the "golden straitjacket" (see box 1-2). One is free to decide if he recognises some features of its own country.

Box 1-2 : The Golden Straightjacket: The End of Politics?

"As your country puts on the Golden Straitjacket, two things tend to happen: your economy grows and four politics shrinks. . . . [The] Golden Straitjacket narrows the political and economic policy choices of those in power to relatively tight parameters.

That is why it is increasingly difficult these days to find any real differences between ruling and op-
position parties in those countries that have put on the Golden Straitjacket. Once your country puts on the
Golden Straitjacket, its political choices get reduced to Pepsi or Coke- to slight nuances or tastes, slight
nuances of policy, slight alterations in design to account for local traditions, some loosening here or there,
but never any major deviation from the core golden rules".

Source: T. Friedman (1999, p 87, cited by D. Rodrik, 2000).

<figure><img src="image_3.png" /><figcaption>Fig. 1-2 : The political trilemma of the world economy</figcaption></figure>

Source: D. Rodrik (2000).
The shrinkage of politics means that economic policy-making bodies (central banks, fiscal authorities and so on) should be insulated from political participation and debate, the disappearance (or privatisation) of social insurance, and the replacement of development goals with the need to maintain market confidence.

"The essential point is this: once the rules of the game are set by the requirements of the global economy, the ability of mobilised popular groups to access and influence national economic policy-making has to be restricted" The experience of the gold standard during the interwar period shows that "... as the franchise was fully extended and labour became more organised, national governments found that they could no longer pursue gold standard economic policy", D. Rodrik, (2000, p 183).

Some may argue that the creation of a world currency could originate from a less ambitious project (10) and that it is not necessary to go to full globalisation. A two tier monetary system would be sufficient. The first tier would a fixed exchange rate between the hard currencies, the US dollar, the euro and the yen. The second tier would be constituted by fixed rates between the currencies of the rest of the world, and in particular those of the developing countries, and one of the "hard" currencies. The dollarisation process and the more modest "euroisation" process are already under way in lots of European, transition and developing countries giving some credibility to this scenario.

The trouble is that countries pegging their currencies, establishing a currency board (like Argentina until its recent collapse), or even adopting the dollar as the means of payment and unit of account (like Panama), surrenders completely their independent monetary policy and acknowledges vassaldom. It is nothing less than the return of colonialism in financial forms. "Unfortunately Federal Reserve policy-makers are not going to weigh macroeconomic problems in Patagonia even as much as those in Idaho. But this is the destination to which financial globalisation is taking developing countries, whether the IMF, the U.S. Treasury, and the lords of International finance acknowledge it or not" (J. Tobin, 1998, p 10-11).

The lesson is clear: if countries want to preserve not only economic autonomy, but more fundamentally democracy and the right to choose at the national level where democracy is exercised, then the process of complete international integration should be slowed up in favour of what D. Rodrik calls a new "Bretton Woods compromise".

During Bretton Woods, it was decided that the economic integration process should be partial. In the trade area, before the WTO, the GATT recognised that developed and developing countries were not submitted to the same rules. The right to erect trade barriers (tariffs being preferred to quantitative restrictions), and financial barriers (capital controls, taxes on interest rates) was also accepted and exercised.

J. Tobin comes also to this conclusion but only for the financial integration process. He welcomes free trade for transactions on goods and services, but not for financial transactions.

If governments want to restore some autonomy to monetary policy, there is no escape from the necessity to reduce in some way the international mobility of financial capital and the integration of financial markets.

"The other way is toward greater financial segmentation (we underline) between nations or currency areas, permitting their central banks and governments greater autonomy in policies tailored to their specific economic institutions and objectives" (J. Tobin, 1978, p 154). The world currency, however theoretically appealing for J. Tobin, is not a viable option for the near future. He therefore "regretfully recommends the second, and his proposal

<footnote n="10">10) We will return to the world currency in more details in part 1, section 3, by discussing R. Mundell's proposal who is one of its most prominent proponent.</footnote>
is to throw some sand in the wheels of our excessively efficient international money market”.

The objective is clearly to allow different interest rate levels by impeding full arbitrage on money markets (we underline), and thereby restricting international capital mobility (11).

### 1.3.2 Capital controls and the Currency Transaction Tax (CTT)

Restricting the international mobility of capital could be done in a radical way by returning to the limited convertibility of currencies that prevailed during Bretton Woods.

After all, China has escaped from the contagious 1997-98 financial crisis precisely because it allows no exchange of currencies linked to financial transactions (capital account convertibility), only exchange of currencies due to international trade (“current account convertibility”) like European countries in the early days of Bretton Woods. Taiwan and India were also immune from the contagion because they were still applying in some ways restrictions to financial transactions. These capital controls have not impeded China in becoming the most important beneficiary of Foreign Direct Investments (FDI) with $ 53.3 billion in 2003, ahead the USA and European countries.

But China is a very special case. Not only because of its historical heritage as an ex-planned economy, but also because it now enjoys a huge current account surplus and has a currency pegged to the dollar. The vast majority of developing countries have trouble with their current account balance and cannot sustain for a long time a fixed exchange rate with a hard currency.

Any new desirable international monetary system will have to restrict and control international financial transactions, but until then it is necessary to conceive intermediary steps that allow countries to live in a world of floating exchange rates without suffering from its dangerous drawbacks: loss of policy autonomy and instability due to speculation.

The CTT is one of these intermediary steps between the present state of globalised and deregulated financial markets and a future new international monetary system.

The basic idea is to tax foreign exchange transactions at a small rate in order to separate financial transactions motivated by arbitrage and speculation from those related to international trade and productive investments.

Foreign exchange (forex) transactions related to international trade and Foreign Direct Investments (FDI) are medium (3 months to 6 months) and long term transactions (once per year or more). Trade and FDI would not be subject to the tax frequently and hence would not be inhibited. But arbitrage and speculation, insofar as they are short-term transactions would be penalised because they would frequently pay the tax.

The CTT has some advantages that capital controls applied at the country level do not have. As an international measure to slow down flows of “hot money” it has a collective and cooperative dimension that capital controls at national level don’t have. It offers a solution to countries who don’t want to peg their currency nor practise pure floating. As we shall see, with the CTT they can manage the floating of their currency more easily and protect it against speculation.

<footnote n="11">11) The link between interest rate arbitrage on money markets and the tax on currency transactions is even more explicit in the first paper that J. Tobin dedicated to monetary autonomy in 1972. "The most important barrier to flexible monetary autonomy is the ever-increasing international mobility of capital. The Eurodollar market is unifying the short-term money markets of the major countries on both sides of the Atlantic". "... It is clearly desirable to preserve some possibilities of autonomy in national or continental monetary policies and to defend them against the growing internationalization of money markets". "... How can some international monetary autonomy be preserved? Some sand has to be thrown into the well-greased channels of the Eurodollar market". See J. Tobin, 1974.</footnote>
The CTT delivers its full potential if applied at a regional level between countries from the same continent who want to establish a common protection against speculation and who want to stabilise the exchange rates of their currencies in order to avoid beggar-my-neighbour policies.

The example of the Mercosur is illustrative. Argentina and Brazil, the two major Mercosur countries, had pegged their currencies to the dollar during the nineties. In the case of Argentina, the objective was to tie tightly and permanently the peso to the US dollar, while in Brazil, the peg was more flexible and temporary. In reaction to the 1997-98 Asian financial crisis, Brazil untied its currency from the dollar in 1999, and the real soon depreciated by 30%. The consequence for Argentina was dramatic. Argentinean exports to Brazil plummeted, while Brazilian products invaded the Argentinean market.

These events could have been avoided if Mercosur had created a regional monetary system stabilizing the exchange rates of their currencies and establishing a common floating of their currencies in relation to hard currencies such as the US dollar, the euro and the yen. The CTT could have protected this regional monetary system against speculation.

In fact, the CTT offers an alternative to “dollarisation”, “yennisation” or “euroisation” and its complete loss of sovereignty, and to pure float that ties a country’s fate to the whims of private markets. That is the essence of the contribution of the CTT to an exchange rate policy that targets stability. This exchange rate policy has to be some type of managed float, or “dirty floating”, with or without an explicit band of fluctuations. The CTT will help to protect this exchange rate policy from speculation with the help of capital controls.

## 1.4 The additional objective of the CTT: financing development and global public goods

As we have seen, the primary goal of the CTT was the autonomy of economic policy. As J. Tobin says, his proposal made in 1972 and renewed in 1978 “did not make much of a ripple” and “sank like a rock” because most professional economists simply ignored it as they ignore anything coined as an interference with market competition. Since then, the CTT was taken out of oblivion by the chronic crises of globalisation, by the growing inequalities that globalisation has increased, and by the emergence of “global bads” that country-states cannot resolve on their own.

In fact, public opinion’s support for the tax swings between the necessity to do something against speculation and financial crises, and the urgency to find new funds for financing development and global public goods.

The crisis of the European Monetary System of 1992-93 had clearly shown that the power of speculation overwhelms the power of even rich countries’ central banks. The Mexican crisis of 1994-95, and especially the Asian crisis of 1997-98, were flat denials that free global finance could contribute positively to development. Quite to the contrary, the public opinion (re)discovered that when investors anticipated a serious economic difficulty, they would take their money out of the country as quickly as possible and leave ruins behind them. These repeated crises had renewed the interest in the CTT, but as J. Tobin says “the interest would then die out when the crisis passed from the headlines” (1996, p 10).

This was not exactly the case with the 1997-98 Asian crisis. A new social movement, soon to be called “anti-globalisation” by the media, had grown in the meanwhile, and since 1998-99 has turned the so-called “Tobin Tax” into one of its major demands, among many others such as the free trade dispute and the contestation of the WTO, the IMF and
the World Bank. In Europe first, then in other continents, NGOs have been campaigning with some significant success for the CTT as a simple and efficient solution against the noxious activity of financial speculation. During the years 1998-2001, the motivation for supporting the CTT was clearly the need to curb speculation, in line with the preoccupations of J. Tobin himself. In the USA, the bursting of the speculative bubble in March 2000 and the ensuing financial scandals created resentment against "Wall Street", and the idea of a "Security Transaction Tax" (STT) was more appealing than the CTT, which appeared too abstract and remote. However, these two taxes are related and complementary.

But after 2001, the interest in the CTT shifted from speculation to its potential as a generator of revenues. This does not mean that speculation had disappeared from people's minds, but the dramatic events of the Asian crisis were fading out while another perennial issue, poverty, was growing in importance. The centre of gravity had changed because there were new opportunities on the political agenda to make new progress. In a certain way, the CTT curse – "the interest dies out when the crisis passes from the headlines" – was repeating again, but not completely, because the CTT had sprung up again as a levy for development.

The debt cancellation campaign, the pandemic of AIDS, the first "world social summit" organised by the United Nations in Copenhagen in 1994, the second summit held in Geneva in 1999, the "Millennium Development Goals" (12) decided in New York by heads of government under the auspices of the United Nations, and finally the "financing for development" summit in Monterrey in 2002, organised by the UN as a follow-up of the Millennium Declaration, brought to public attention that new stable sources of financing had to be found.

This time it seems that the feeling that "something has to be done" to reach the Millennium Development Goals (MDG) is not dying out. Since 2001, the Official Development Aid (ODA) is increasing again after years of decrease and official "aid fatigue". The year 2001 is certainly not an accident. Governments have more or less admitted that terrorism is built upon poverty and that it was also in their interest to achieve the MDG. This explains why some countries, such as France and Belgium, have passed a law in favour of the CTT, and why some governments like France, Germany, Spain, Brazil and Chile, have officially proposed the creation of "global taxes", including the CTT, at an international conference organised at the United Nations in New York in 2004. The United Nations itself has not dismissed the "global taxes" as alternatives sources of financing due to the persistent action of NGOs that insist on keeping them on the agenda.

The necessity to finance the global common good is a new justification for global taxes such as the CTT. Ecological problems such as pollution, green house gas emissions, deforestation, and biodiversity are international problems in essence. So is the preservation of natural resources such as pure water. Epidemics like AIDS, foot and mouth disease; and SARS have reinforced the idea that borders are no longer protections. Emergency aid to the growing number of refugees, victims of war, drought, or natural disasters, calls for international action. On a different ground, the contagious character of the last financial crises is another example of the international dimension of major problems.

When this kind of problem arises at the national level, it is the duty of the State to provide a solution. In rich countries, the State can do it because of the fiscal revenues coming from the various taxes and duties it levies. The common good is the justification to taxes, just as paying taxes is one attribute of citizenship.

<footnote n="12">12) The Millennium Development Goals were signed by 189 countries in September 2000. 8 objectives have been selected due to be realised in 2015. Among them: reducing by half the proportion of the world population whose revenue is one US dollar per day, guaranteeing access to "basic social services", stopping the diffusion of AIDS and other widespread diseases like malaria, protecting the environment through "sustainable development", and creating world partnership for development.</footnote>
At the international level, there is neither state nor taxes. Global taxes managed by international institutions should fill this gap. At the national level, taxes have two functions. They can reduce a problem, like pollution, and generate revenues. At the international level, they should do the same.

This raises old and new questions: The old one is that it would be impossible for one policy instrument to tackle two problems. The CTT could not at the same time curb speculation and generate revenues. The more efficient the tax is against speculation, the less revenues are generated or conversely.

The contradiction holds in theory but not in practice. No one imagines that speculation would reduce to nothing, unfortunately, because it is inherent to private markets. So, the CTT can reduce to some degree speculation and simultaneously generate revenue, like "sin taxes" in the US generate revenues and contain alcoholism and nicotine addiction without eradicating them.

Furthermore, as we shall see below, the original CTT imagined by J. Tobin has profoundly evolved thanks to P.B. Spahn (1995, 2002) and is now conceived as a two-tier transaction tax. A first tier would be an ordinary tax at a very small rate dedicated to revenue generation. A second tier would be a surcharge, at a high rate, to curb speculation. So, there would be actually two instruments for two objectives.

The new question is that if the CTT is now exclusively conceived as a revenue generator, one loses completely its first objective: reducing short-term speculation and increasing national policy autonomy. A balance must found between the two objectives. After the creation of the CTT, learning by doing will help to fine-tune the appropriate rates of the two-tier CTT. But this will be only possible if the two objectives are maintained. The present temptation is to abandon the struggle against speculation, which opposes directly the formidable interests of the financial community, with the hope that a nearly zero tax presented as a levy for development would be more politically acceptable.

If that was the case, those who support this project would miss the point. Unfortunately, sooner or later, there will be another financial crisis that will spread like an epidemic. The CTT, as an instrument against speculation, more than a levy for development, will then come to the fore. And if the CTT is set too low, it will prove its inefficacy.

That is the reason why the set purpose of this report will be to analyse the CTT as a policy instrument, against speculation and for national policy autonomy on the one hand, and as levy for development and global public goods on the other hand, without giving priority to the one to the detriment of the other.

This report will not be written in a polemic nor a consensual tone. We will stress what makes consensus between the proponents of the tax, but also what is still a subject of disagreement and debate. For instance, we have stressed our agreement with J. Tobin's view about the importance to reduce the international capital mobility and speculation. But that does not mean that we agree with J. Tobin when he welcomes free trade, recalls his trust in the IMF and the World Bank. In the last months of his life, he took care to make a clear difference with him and the "anti-globalisation" movement. He was probably misinformed about the reality of the vast galaxy of NGO's, but he was right to recall that he was in favour of the neo-liberal globalisation led by the WTO, the IMF, and the World Bank, while the majority of NGOs are in favour of another globalised world, based not on competition but cooperation.

This last point leads to another divide. Some proponents of the CTT want to interfere as little as possible with the free working of markets, either because they think that on the whole, private markets work well and only need some slight regulations, or because they think that it will be more politically acceptable. The CTT should therefore slip into the
mould cast by financial markets. This bounds profoundly the limits of the intellectual reas-
oning, and also the ambition, of the project.

If “another world is possible”, it will probably not be with the markets the way they
are. Financial markets perform badly. They are plagued by numerous failures. They do not
efficiently satisfy social needs, because that is not their object. We will not bind our minds
with the dogma that markets are untouchable. If not, it would not be possible to realise a
greater financial segmentation between nations.

The first part of this study will be organised as the following: In chapter one, we will study the root of the problem: why exchange rate volatility matters for the economical and social situation (chapter 1.5), with a special emphasis on the euro (chapter 1.5.5). We will then review various propositions to stabilise the exchange rate to show their limits (chapter 1.6). We will then present in detail and discuss the CTT and its improvements due to P.B Spahn (1995, 2001), (chapter 1.7). Although the now called “Spahn tax” is a major conceptual breakthrough that makes the CTT more powerful, it has some limitations if we want the CTT to contribute positively to an alternative economic policy in the European Union. We will address these limitations by presenting our own views (chapter 1.8).

Chapter two is dedicated to the feasibility problem in the international and European context. We will show that the CTT is technically feasible. We will draw upon previous studies on the subject, especially Rodney Schmidt's proposal to use the core of a national system of payments, managed by central banks, i.e. the Real Time Gross Settlement system (RTGS) (chapter 2.1). We will focalise on the E.U. case, and present how the European system of payment works, to show that it can really be done (chapter 2.2). But unfortunately, collecting the tax through the central bank network does not solve all problems. We will propose a more pragmatic and more comprehensive view, i.e. to mobilise the order message carriers like SWIFT, and also private networks like international clearing houses, CLS and others like the Banking Union for the euro, based in Paris (chapter 2.4).

Chapter three provides some estimation of the fiscal revenues. We will review the previous estimations and their methodology at the international and European level (chapter 3.1). We will then present our own methodology and estimation. We will turn to the social and ecological needs that could be financed and their cost (section 3.2). And finally, we will discuss the question regarding the institutions that should manage the revenues. There are various propositions at the international level, and a few at the European level. We propose a new institution at the international level, or at the European level in the case that the EU is the first region to implement the tax. This new institution would be far more democratic than the present EU institutions to the extent that it should include representatives of the civil society (chapter 3.3).

1.5 Why does exchange rate volatility matter?

If they were naturally stable, the question of volatility would not exist. But as R. Mac Donald (2000) puts its, there are some stylised facts attached to flexible exchange rate that raise the question of its volatility.

"First, when exchange rates are flexible, they tend to be highly volatile. This volatility is gauged in a number of ways: on an historical basis when comparing the recent flexible rate experience with fixed but adjustable such as the Bretton Woods regime. Exchange rates are volatile relative to some measure of the expected exchange rate, such as the forward exchange rate or the expectation implied by survey data. Exchange rates are volatile relative to certain fundamentals such as relative prices and money supplies". (op cit p 5).
The latter has been demonstrated in a number of studies: there appears to be no corresponding volatility between the exchange rate and the so-called fundamentals that are supposed to be the driving forces of the exchange rates (above all inflation rate, interest rates, current account balances, fiscal deficits, growth rates of real GDP or money stocks).

"A second stylised fact is that there is a close correspondence between real and nominal exchange rates". (op cit p 6). Although it is controversial, R. MacDonald argues that it is the nominal exchange rate which drives the real exchange rate and not the level of prices, which tends to be very low and stable in rich countries since the generalisation of anti-inflation policies that took place in the eighties. It means that the market forces that drive the nominal exchange rate are primarily responsible for the volatility of the real exchange rate, with potential negative effect for the productive sphere.

"A third stylised fact about the behaviour of real exchange rates is that once a real exchange rate change occurs that change tends to be highly persistent, or indeed permanent". (op cit p 6) It means that the "law of one price" (13) which is often taken as a reference to determine equilibrium exchange rates is systematically violated, and the return to this equilibrium is so slow, that it never happens. For instance, the exchange rate of the dollar rose steadily from the end of 1980, to peak 50% above its Purchasing Power Parity (PPP) level in 1985. It did not return to the original level until the end of the decade. And it was probably a statistical freak.

In these circumstances, J. Williamson (1999, p 1) summarizes clearly why it is not possible to adopt free floating: "The case for rejecting floating is based on the evidence that asset markets in general, and the foreign exchange markets in particular, are driven by herd behaviour rather than rational expectations".

In summary, the volatility of exchange rates is defined by the short and medium-term movements that push the exchange rates away from their tendencies. Volatility is thus defined in relation with what is supposed to be a "normal" level or evolution of the exchange rate, whatever it is, but also by erratic fluctuations that generate uncertainty.

One has to make a distinction between very short-term volatility, which occurs during the day and is called intra-day volatility, and medium-term volatility, which is registered on a monthly or quarterly basis. This medium-term volatility is much more relevant for the macro-economic evolution because it may affect decisions to invest or to consume.

The importance of exchange rates for growth is not immediately apparent. The idea that a financial price can influence the productive sphere can seem odd at first glance for those who believe that the financial sphere is subordinated to the productive sphere. Indeed some economic theories analyse exactly the reverse causality: how the growth process determines the exchange rates (14). But both approaches are not contradictory and can even be complementary. The growth process determines the exchange rate in the long run, but not on the short and medium term, and this opens the possibility for ex-

<footnote n="13">¹³) The law of one price supposes the existence of a unified world market with pure and perfect competition that would determine one unique world price for each good and service thanks to the interaction of supply and demand. Exchange rates should only reflect the amount of units, in each currency, to buy the same quantity of goods and services. At these rates, a consumer with a given amount of money would find his or her purchasing power identical, no matter in which currency the sum was denominated. For instance, the Purchasing Power Parity rates are those at which the real price of a standard "Big Mac" is the same in all countries.</footnote>

<footnote n="14">¹⁴) For instance the so-called "Balassa-Samuelson effect" posits that a country which has a relatively high productivity in its traded goods sector, compared to its non-traded goods sector, will have an overvalued currency relative to its trading partners. An alternative perspective is the so-called "Houthaker-Magge-Krugman" (HMK) hypothesis. It suggests that countries with different long term growth rates, relative to their trading partners, may suffer secular changes in their real exchange rates (for further details see R. MacDonald, 2000).</footnote>
change rates to influence the growth process. "... Under flexible exchange rates even a reverse causation is possible, in a way the "fundamentals" are determined by the developments of the exchange rate" (Euro parliament, 1999, p 21).

How can the exchange rate volatility dampen growth? Through two main channels: volatility will affect the profitability of international trade, and it will also affect the profitability of investment.

If the link between investment and growth is uncontested, the link between trade and growth is controversial. For supporters of free trade there is no controversy: trade allows an efficient allocation of scarce resources through specialisation in comparative advantages, and this specialisation stimulates productivity, which is a major engine for growth. Trade also enhances the ability of a country to exploit increasing returns due to the access to larger markets, allows the transfer of technology, and increases the incentive to undertake research.

In reality, free trade, by promoting competition between countries of very different economical strengths and political powers, increases inequality between winners and losers. Not every country benefits from trade. The annual UNCTAD report (2003) has shown that some countries that have recently opened their market to trade have suffered a reduction of their growth rate. The World Bank has also produced a study showing that the promises of free trade are inflated. The gains for the developing world if rich countries were to eliminate all of their subsidies, and open all of their markets completely to every export – manufactured as well as agricultural goods – from low and middle-income countries would turn out to be an extra 0.6% of income. In other words, a country with an income of $ 1,000 per capita would move up to $ 1,006.

Nevertheless, for those countries that do possess the minimum conditions to benefit from trade, the question remains: how does the exchange rate affect international trade and therefore growth?

### 1.5.1 A negative impact on international trade

Traditional economic research has encountered difficulties in determining the effect of exchange rate volatility on trade. The adverse effect, if any, was supposed to be minimal. The debate dried up without any firm conclusion. But new theoretical approaches and new empirical studies have renewed the debate.

"Recent literature estimates data with panel techniques modelled in a gravity-like functional form. Pugh and al. (1999) estimates 16 OECD countries in the period 1980-1992 and find that exchange rate volatility leads to a decrease in the level of trade by about 8%. Dell Ariccia (1998) also finds a significant and substantially negative effect of exchange rate volatility on bilateral flows of the fifteen actual countries and Switzerland. By taking the Standard deviation of the real exchange rate and the forward error as proxies for exchange rate uncertainty, the resulting trade gains from the elimination of the exchange rate volatility are respectively 13% and 10%" (cited by D. Taglioni, 2002).

For developing countries as well, exchange rate volatility is a concern for trade. For instance, K. Doroodian (1999) found that exchange rate volatility has a negative and significant effect on trade flows in the case of India, South Korea and Malaysia. Another recent study shows that "... the rise in exchange rate volatility had adverse consequences on both exports and imports of Thailand with the Japanese market, and the imports of Thailand from the US during the period of two decades before the break of the 1997 East Asian financial crisis" (T. Rahmastsyah et al., 2002). However less conclusive evidence was found for Thailand's exports to the US market.
The dollarisation of some developing countries economies and the creation of the euro have also given a new impetus to the debate. How much would the radical elimination of exchange rate volatility (materialized by the adoption of a single currency) enhance international trade?

A.K. Rose (2000) for instance, using a so-called gravity model and data on trade between some 186 countries, dependencies, colonies and territories in five separate years from 1970 to 1990, estimates the effects of a number of variables on trade flows between two countries. Besides a common currency and exchange rate volatility, these variables include such factors as distance, economic size, per-capita output, and political and linguistic ties.

Other things being equal, he finds that reduced exchange rate volatility increases trade between two nations. Sharing a common currency has a far more potent effect. Nations with the same currency trade three times as much with each other than they would with different currencies.

To many economists, this effect looked implausibly large. Historical ties between countries creating a currency union would simply generate higher trade volumes even before the creation of the currency union. Leaving them out would exaggerate the estimates of the effect on trade of currency-union membership. Subsequent research by A.K. Rose and others has sought to overcome these criticisms. The general conclusion has confirmed that currency unions boost trade, but tempered the order of magnitude. But the fact that a permanent zero volatility, i.e. a single currency, has a positive effect on trade is widely accepted and customarily known as the “Rose effect”.

### 1.5.2 A negative impact on foreign and domestic investment

Theoretically, the impact of the volatility of the exchange rate on Foreign Direct Investment (FDI) is ambiguous. Volatility can discourage FDI because of the uncertainty pending on the profitability of this investment. But volatility can also encourage foreign investment because localizing its activity abroad can be an efficient way for a firm to hedge against losses due exchange rate fluctuations. But empirical analyses have shown a negative influence of exchange rate volatility on foreign direct investment.

As far as domestic investment is concerned, empirical studies are less clear cut. Studies at the aggregate level tends to conclude that the volatility of the exchange rate have no significant impact on domestic investment. But studies that make a distinction between competitive sectors and non-competitive sectors do establish a negative effect of volatility on domestic investment. Firms are more sensitive to exchange rate volatility when they are exposed to foreign competition and when they sell on a competitive market where profit margins are rather thin. The degree of competition can be evaluated by taking into account the kind of international trade that characterizes a country (J.L. Guerin, A. Lahrèche-Révil, 2001). The international trade can be intersectoral, i.e. the exchange of different products, or intrasectoral, i.e. the exchange of differentiated but similar products. The impact of the exchange rate volatility on the trade of different products is a priori neutral. The impact on similar products depends on the kind of differentiation. If products are of different quality, for instance a popular car versus a luxury car of the same size (what is called vertical differentiation), again the impact of the exchange rate volatility should be neutral. But if the products are differentiated but very close (what is called horizontal differentiation), for instance two popular cars of the same size but from two different brand names, then the difference in price becomes crucial for the choice of the consumer. Firms will have to compete on price and their profit margins will be thin. They will be sensitive to the volatility of the exchange rate because it can make their product more expensive. If the
exchange rate appreciates, then they will have to choose between reducing their profit margin or losing their customers. If the volatility of the exchange rate is high, then the firm will decide that it is not worth investing because profit is at risk. The more the importance of the intrasectoral horizontal trade in the global trade of a country, the more this country is sensitive to exchange rate volatility.

Empirical results confirm this theoretical reasoning (J.L. Guerin, A. Lahrèche-Révil, 2001, p 17-19). 14 members of the European Union are analysed (the 15 previous members less Luxemburg) for the period 1980-1996). The volatility of the exchange rate has a negative impact on domestic investment. The more a country is open to international trade, the more volatility has a negative impact for domestic investment. For a given level of volatility, investment is even more affected if the country is open to international trade and if firms are specialized in intrasectoral horizontal trade. In different terms, the more a country trades similar products for which price competition is high, the more volatility is negative for investment, for a given degree of openness. To the contrary, for a given degree of openness, the volatility of the exchange rate has no significant impact on domestic investment when the intrasectoral vertical trade is only considered.

These results show that countries have an interest in stabilizing their exchange rate if they want to stimulate investment and therefore growth and employment, provided they are mutually open to each other and close enough to dedicate a significant part of their trade to the exchange of similar products.

As for developing countries, an empirical study by L. Serven (2002) finds that exchange rate volatility has a strong negative impact on domestic investment (after controlling for other standard investment determinants). The empirical investigation draws on a large sample of 61 developing countries, spanning the years 1970 to 1995. The impact of uncertainty is not uniform, however. Uncertainty only matters when it exceeds some critical level and is significantly larger in economies that are highly open and in those with less developed financial systems.

As low income developing countries are characterised by weak financial systems, this suggests that their investment is more affected by the exchange rate uncertainty. Conversely, in less-open economies with well-developed financial systems, the impact is significantly positive. This suggests that these countries can limit the negative side of exchange rate volatility and benefit from the opportunities that it presents at times.

### 1.5.3 A negative impact on employment

If exchange rate volatility negatively affects trade and investment, and therefore growth, it should negatively affect employment.

Some studies have tried to evaluate the impact of exchange rate volatility on employment. The point has been investigated for different parts of the world: the US, the European Union (EU), the EU candidate countries, and the South American cone (Mercurius countries).

The rationale is similar to the preceding rationale presented on the impact of exchange rates on investment. Recruitment decisions, like investment decisions, have some degree of irreversibility. To create jobs, firms have to pay a start-up cost which reflects the cost of hiring, training and the provision of job-specific capital. These costs will be lost if a firm decides not to produce after all, for whatever reasons. In Western Europe, where workers cannot be fired immediately thanks to job protection legislations, export-oriented firms will decide not to create jobs and wait for more propitious times if they fear an appreciation of the exchange rate. The value of waiting is increased by the fact that wages and
social protection are rather high compared with the US and developing countries. So ex-
change rate volatility will reduce job creation in high social standards countries like West-
ern Europe. But advocating for flexible labour markets- the right for firm to recruit temporary
workers and to fire them without notice- is no solution. In this case exchange rate
volatility will increase job destruction. In so far as the labour force is increasing each year,
job destruction and the lack of job creation will increase unemployment.

Empirical investigations of this theoretical reasoning lead to the following results:

> "For Euroland, a decrease of one percentage point in the variability of the _effective nominal exchange rate_<fnref n="15" /> is associated during the same year with a decrease in the Euroland unemployment rate of nearly two-thirds of a percentage point ; and this is followed two years later by another reduction in the unemployment rate of 0.82 percentage point" (A. Bleke, L. Kaas 2002, p 16). Job creation is increased by 0.63% and by 1.21% the second year. This is modest but non negligible. The effect is weaker when the _bilateral exchange rate_<fnref n="16" /> between the euro and the dollar is taken into account but still significant: the unemployment rate is reduced by 0.41% and job creation enhanced by 0.57% in just one year.

> For the US, the results are quite opposite. A decrease of 1% of the effective nominal exchange rate leads to a reduction of the unemployment rate of 0.50% the first year and an increase of employment of 0.28% (A. Bleke, L. Kaas 2002, p 16). But the bilateral exchange rate between the euro and the dollar has a stronger effect. Unemployment rate is reduced by 0.41% but employment is increased by 0.69% one year later. These differences between Europe and the US could be explained by the fact that the share of trade in national income is weaker in the US than in Euroland and therefore the US are less exposed than Euroland to the volatility of their currency. Another explanation is that the US labour market is more flexible: hiring and firing costs are lower than in Euroland. The degree of irreversibility of job creation being lower, job creation is less discouraged by the volatility of the exchange rate.

> For the new European members of the EU, « ... exchange rate variability has a statistically significant negative impact on the unemployment rate in a number of countries, among them the Visegrad countries (Poland, Czech Republic, Hungary and Slovak Republic), ... and the outliers Bulgaria and Rumania (A. Bleke, R. Setzer 2003, p 27). For instance, a decrease of 1% of the volatility of the nominal effective exchange rate reduces the unemployment rate by 1.99 percentage points in Poland, 1.78 in Slovakia, 0.85 in the Czech Republic and 0.43 in Hungaria during the first year, with cumulative effect the second year (op cit p 42). For these countries, reducing the volatility of the exchange rate would have a much stronger positive effect on the unemployment rate than in western Europe.

> In the case of Mercosur countries there is also a negative impact of exchange rate volatility on unemployment, and employment (A. Belke, D. Gros, 2002, p 26-27). Foreign exchange volatility is much higher than in Europe. The average variability of nominal dollar exchange rate of the Argentinean peso during the whole period under study (1970-2000) has been 7.32%, that of the Brazilian real 3.69% and 2.11% and 2.52% for Paraguayan and Uruguayan currencies. Also in nominal terms, interest rate variability reaches the aberrant level of 31.87% in Argentina, 28% in

<footnote n="15">¹⁵ The effective nominal exchange rate is the average exchange rate of the major trading partners of a de-
termined country pondered by the weigh of each partner in the total exports of the country, or in the total im-
ports of the country or both of them. Nominal means that inflation is not discounted from the value of the ex-
change rate.</footnote>

<footnote n="16">¹⁶ Contrary to the effective exchange rate, the bilateral nominal exchange rate measures the value of a country's currency to the value of another country's currency.</footnote>
Brazil, 11% for Paraguay, and 4.57% for Uruguay. The variability of the real exchange rate is much lower than the nominal one, but still high by European standards, at 6.38% for Argentina and 2.54% for Brazil.

However, the whole period (1970-2000) includes very different episodes in terms of volatility. For example, Argentina suffered a period of extreme instability at the end of the 1980's, followed by a period of extreme stability during the first years of the currency board in the nineties. Brazil also experienced high instability in the eighties until the stabilization plan creating the Real in 1994. It is therefore necessary to split the sample for each country and focus on episodes of high volatility. With such high level of volatility one might expect strong negative impact on employment and unemployment. In fact, it is not the case. For Argentina during the period 1973-1990 (17) a decrease of 1% in the variability of the exchange rate between the euro and the US dollar would have reduced the unemployment rate by 1.38% percentage points and increased employment by 0.52% after one year. For Brazil the dollar/euro exchange rate is not as important due to the difference in the geographical distribution of exports. But a decrease of 1% of the nominal bilateral exchange rate volatility of the real vis-à-vis the US dollar is associated during the period up to 1993 with a reduction of 0.11% in the unemployment rate and an increase of employment by 0.5% with a delay of one year. The result is slightly stronger vis-à-vis the euro. These negative impacts on unemployment and employment may seem weak for such instable countries. One explanation brought by the authors is that Brazilian and Argentinean firms have learnt to cope with macroeconomic uncertainty and especially foreign exchange volatility. It is true that these firms try to rely exclusively on internal funds, leaving in a kind of financial autarchy, limiting as much as possible the use of banking credit or corporate bonds.

Another consequence of the foreign exchange volatility during the period under review (the eighties) was the fall in the investment rate and the obsolescence of the productive capacities. Indeed, the high volatility of the foreign exchange rate, the interest rates and domestic prices (hyperinflation) during the eighties lead to a prolonged economic downturn known as the “lost decade” in the southern cone. It is only with the temporary come back of stability at the beginning of the nineties that investment recovered. But unemployment remained high because the new investments were very intensive in capital and technology and because firms maintained their efforts of adaptation to macroeconomic uncertainty. They introduced new organizational productive models more fitted to economic instability. For instance, externalisation was pushed to the extreme together with labour flexibility. In such conditions, the negative impact on employment is structural, and it is not surprising that short-term variables such as foreign exchange volatility have a weak effect on employment.

### 1.5.4 A negative impact on real wages

The volatility of the exchange rate has a negative impact on real wages because it stimulates inflation. This phenomenon is known as the “pass-through” effect. Exchange rate “pass-through” can be defined as the degree to which exchange rate changes are reflected in domestic prices of a particular country. Imported goods cost more when the domestic currency depreciates, and this is passed on through producer prices and then consumer prices, reducing the purchasing power of wage earners. Even worse, an “independ-

<footnote>(17) i.e. before the establishment of the currency board in 1991, which created a fixed exchange rate of the Argentinean peso against the dollar.</footnote>
ent” blind-minded central bank like the ECB can react with an increase of the interest rate if it fears so-called “secondary effects”: wage earners will ask nominal wage increases to compensate for the increase of consumer prices and this can degenerate into general inflation. Citizens are then doubly punished: first by the inflation, and second by the economic slowdown and the subsequent loss of jobs.

The “pass-through” effect varies across countries. It is generally significant, but is more modest in developed countries and much higher in developing countries, because these countries generally import more critical goods such as consumer goods, intermediary products and capital goods.

How important is the pass-through for the E.U? Anderson analyses the pass-through of changes in the effective exchange rate of the euro to extra-euro area import prices to manufacturing. His results indicate a pass-through of around 50% to 70%. At least half of the impact is passed through within one quarter, while most of the effect occurs after about five quarters.

In a recent paper, Elke Hahn (2003) estimates a total pass-through of exchange rate shocks on import prices of 50% (after three quarters). These results are broadly in line with the findings of Anderson (2003). He also finds a total effect of exchange rate shocks on the Harmonized Inflation Consumer Price Index of the E.U. of 16%.

Overall, even if the results are different from one country to another, they show that there is a case for stabilizing the exchange rate. Trade, investment and growth, purchasing power and employment would be favoured.

### 1.5.5 Is the volatility of the euro exchange rate important?

“No”, would answer a majority of those who strongly supported the creation of the euro. The exchange rate of the euro is not to be considered important because the Eurozone countries trade mostly between themselves in euro. The euro should preserve the country members from the adverse effect of exchange rate fluctuations, because trade with external countries is now a minor share of total trade of the Eurozone countries. The GDP share of the euro area’s trade with other countries is now about 16% compared to 30% before the euro. This ratio is comparable with the figures for the US (10%) and Japan (9%). With the entry of newcomers, the share of external trade should lower still, and if the UK, Sweden and Denmark join the euro area, the ratio should fall to about 10%.

In 1997, when the exchange rates of the majority of the European currencies were already fixed, the euro was presented in France as a “monetary shield” against the aftermaths of the Asian crisis. In 2001 Didier Reinders, Belgian Ministry of Finance at the time, declared that the euro was “our Tobin tax”. In other terms, because of the self-centred character of the euro area, country members could benefit from internal stability and, like the US, could afford the luxury of a benign neglect policy for the external value of the euro. In the medium-long term, the euro should become as strong as the dollar, providing the euro area the same privileges than the US are enjoying since the dollar has replaced the sterling pound as the major currency. These privileges include the possibility to pay a significant share of its imports in its own currency, which strongly reduces the balance of payment constraint, and the possibility to determine the interest rate on world financial markets. For the moment, the euro has not yet replaced the US dollar, and will probably never do it (B.J. Cohen, 2003).

The European Central Bank (ECB) has fully agreed with the idea that the exchange rate of the euro is not important but for different reasons. Not because it shares the project of grandeur for the euro, but because it leaves the bank free to decide what should be the appropriate interest rate for price stability. The ECB does not want to be constrained by
any exchange rate policy. It would only takes into account the exchange rate of the euro if it threatens price stability.

The primary and unique objective of the ECB's monetary policy, laid down in the Maastricht Treaty (Article 105, paragraph 1.) is indeed to preserve price stability, i.e. the internal purchasing power of the euro. The bank has defined this as a rate of inflation, as indicated by the EU's Harmonized Index of Consumer Prices (HICP), of less than 2% per annum. The ECB ruled out any exchange rate policy, even before its official creation in 1999, for fear that it could endanger price stability.

"An exchange rate policy is not considered appropriate since, for an area potentially as large as the euro area, such an approach might be inconsistent with the internal goal of price stability" (European Monetary Institute, 1997) For instance, if the ECB had to reduce its interest rate to help depreciate the exchange rate, it could be contradictory with the necessity to increase the interest rate in order to reduce inflation.

This attitude was reaffirmed in 1999: "As the Eurosystem's monetary policy does not embody an exchange rate target for the euro, the task of focusing on the maintenance of price stability in the euro area is facilitated" (ECB, 1999, p 42). In other terms, the ECB feels free to increase or reduce its interest rates without taking into account its consequences on the exchange rate of the euro.

Officially, the ECB neglects the exchange rate of the euro: "Not having an exchange rate policy - and we have no policy - does not mean that there is benign or malign neglect. For the time being there is neglect" (Wim Duisenberg before the European Parliament's Economic and Monetary Committee in April 1999).

But in early 2000 however, the ECB was obliged to change its position. "Combined with the sharp rise in oil prices, the falling parity of the euro was putting an "upward pressure on import and producer prices". This, in turn, threatened to trigger secondary effects, notably increased wage demands." (European Parliament, 2000, p 10). By March 2000, the inflation rate had reached 2.1%, exceeding for the first time the 2% definition of price stability, and 2.4% in June. The ECB reacted by raising its interest rates in February 2000, and again in March, April, June and August.

These interest rate rises had no apparent effect on the exchange rate of the euro that continued to depreciate vis-à-vis the US dollar, but it did slow down European growth.

In summary, the EU growth is plagued by a policy of benign neglect for the external value of the euro consistent with neo-liberal economic policy on the internal front.

If neo-liberal policies sanctified by the Maastricht Treaty and the Amsterdam stability pact were rejected and replaced by a "alternative" economic policy<fnref n="18" />, would it be still possible and desirable to pursue a policy of neglect for the exchange rate of the euro?

No, because the policy of "benign" neglect is flawed. The relatively low share of extra eurozone trade does not mean that the euro exchange rate fluctuations could be neglected.

Even a relatively closed economy remains sensitive to its exchange rate value. The case of Japan is illustrative.

"Incessant pressure-implicit and explicit- from the United States to make the yen appreciate from 360 to the dollar in 1971 to just 80 in 1995 is the historical origin of Japan's deflationary psychology today" (R.Mc Kinnon, 1999, 77).

For the EU too, exchange rate volatility of the euro has a direct impact on growth and employment. The following chart shows this impact by comparing the growth differential between the US and the euro area (left scale) and the exchange rate between the euro and the US$ (right scale). (See figure 1-3)

<footnote n="18">¹⁸ What we call a "progressive economic policy" is defined and discussed in "European Economists for an Alternative Economic Policy in Europe" 2001, 2003.</footnote>
<figure><img src="image_4.png" /><figcaption>Fig. 1-3 : Euro Area and US Economic Growth (%), and €/$ exchange rate, 1990-2000</figcaption></figure>

Source: B. Patterson, D. Sienkewicz, X. Avial, 2000, p 48.

As long as the (proto)euro remained above 1.10 euro per dollar, the US grew faster. But we can see that after 1993, the growth differential in favour of the US tends to decrease in response of the declining tendency of the euro. After the launch of the euro in 1999, the euro decline accelerates, boosting export and growth in the euro area. In Germany, for instance, during the first quarter of 2000, exports were at a level over 20% higher than in 1999.

According to a simulation of the OECD using its interlink model (J. Coppel, M. Durand, I. Visco, 2000), a 30% decline in the effective exchange rate of the US$ relative to its baseline from 2000 onwards, would subtract 0.75% to real output growth in each of the first two years of the simulation, which is really high in comparison to the small rate of growth in the euro area (between 1.5-2% on average). In Japan, the impact is substantially larger, with real growth almost 1.5% lower in the two following years.

This simulation was one among many that were done in this period because lots of economists and institutions were predicting in 1999-2000 that the fiscal and current account of the US were unsustainable and incompatible with the “strong dollar” policy and that a depreciation of the US$ between 30% to 40% was necessary to correct them.

This correction started in June 2002 and the sharp appreciation of the euro against the dollar reached 45% at the end of 2003, from 0.85 US$ to 1.26 US$. In effective terms, the appreciation has reached 30%.

This appreciation appears to be the main factor behind Euroland's shallow recession in the first half of 2003. The INSEE quarterly econometric model (19) built and estimated for the euro area taken as a single entity, shows that Euroland's GDP would typically react with almost no lags to a currency shock, the maximum impact (a temporary 1% GDP decline following a 10% rise of the euro) being recorded only two quarters after the shock

<footnote>(19) The Institut de la Statistique et des Etudes Economiques (INSEE) is the main public institution of economic research in France.</footnote>
(0.6% the first quarter after the shock, 0.4% the second quarter). Another interesting result of the INSEE model is that a change in short-term interest rate takes much longer to feed through the euro zone economy than a change in currency rates would do. For instance, a 1% cut in short-term rates would eventually add 0.8% to GDP (comparable to the effect of a 10% of the euro) but only 20% of the full effect would appear after two quarters, versus 100% for the exchange rate. Currency fluctuations have immediate effects on output, whereas monetary policy works with considerable inertia.

Another estimation, realized by the French Bank, Société Générale, shows that the sharp appreciation of the euro has led to a significant reduction of exports and profit margins, but not of inflation (V. Riches-Flores, 2004). Since 2002, the market shares of European exports have fallen by 8% with a subsequent direct reduction of growth by 1.1% (0.55% each year) <sup>(20)</sup>. But in the hypothetical case that the euro reaches US$1.40 in 2004, i.e. another 20% increase relative to 2003, there would be an extra fall of European export market shares of 0.8% to 1.1% and another direct effect on growth between 0.63 to 0.66% according to the hypotheses.

Even if the euro does not reach such a historical level, the preceding figures show how much a policy of benign neglect for the euro would also be a benign neglect of growth and unemployment.

There is another reason why a relatively closed economy is not immune to exchange rate fluctuations. Even if the importance of its trade is reduced, its exposure to international financial flows can be high. Since the beginning of the financial globalisation process in the eighties that generalised free capital movements, a majority of countries, the EU and developing countries included, are financially integrated. International portfolios and direct investments can dramatically change the exchange rate and fix it at values incompatible with the necessities of trade.

Chile for example experienced in the eighties an increase of its exchange rate because of excessive portfolios and direct investments. This appreciation of the Chilean currency was a bad news for Chilean exporters that saw their products becoming too expensive for foreign customers. This led the Chilean government to create a one-year non-remunerated 30% mandatory deposit for each new capital inflow with the aim to curb short term capital but not FDI.

In 1997, Asian countries suffered a major currency crisis due to large capital outflows. Net private capital to Asia that had reached a record peak surplus of US $ 99 billion in 1996, fell to US $ 28 billion surplus in 1997, and then turned into an abyssal deficit of US $ - 44 billion in 1998 (IMF, chapter 2, September 1998). As a consequence exchange rates experienced a dramatic fall. Within the 14 months to September 1998, the Real effective exchange rate of Korea, Malaysia, the Philippines, and Thailand declined by 18-28% and that of Indonesia by 60% (IMF, Chapter 2, September 1998).

## 1.6 How can we stabilize the volatility of the exchange rate?

If we agree that there is a case for stabilizing the exchange rate, the question pending is: what is the best way to achieve this stability? Is the CTT the best solution? Is it more or less realistic than other proposed solutions?

To answer these questions, it is necessary to review some other proposals. We will begin with the more simplistic and modest proposal, apparently a more realistic one: it consists of coordinating economic policies and monitoring foreign exchange markets. We will then return to a proposal presented in the introduction that appears as far more ambi-

<footnote><sup>(20)</sup> The difference with the INSEE result is that in the Société Générale estimation, the induced effect on growth is not taken into account.</footnote>
tious and radical: the creation of a single world currency that would tackle the problem to its root: with a single currency, there would be no more speculation and no more instability.

Between these two extremes, we will consider what we call the “intermediate solutions”, e.g. the “target zone” proposal. To our view, the target zone is the solution best suited to deal with the present dangers of financial globalisation, provided it is designed in a cooperative way and relies on instruments of protection against speculation and financial instability in general.

This is where the CTT comes in. It can be one of the instruments of protection, but probably not the only one. In period of crises, it can be combined with other instruments of capital control.

### 1.6.1 Coordinating economic policies and monitoring foreign exchange markets

Under the promising title “the case against benign neglect of exchange rate stability” (B. Coeuré, J. Pisani-Ferry, 1999) the authors present what was more or less the position of the French government at the end of the nineties. It consists of a “two handed approach”.

The first “hand” coordinates responses to macroeconomic shocks. If responses were coordinated and known in advance by market participants, exchange rate would be more stable. For instance, during the Russian crisis of August 1998, the market knew in advance that the US would react by cutting its interest rate and that the EU would keep its interest rate stable. The dollar depreciated by more than 10% in a few weeks. The EU finally cut its interest rate on December 1998 and April 1999, and it helped to reverse the depreciation of the dollar. By the spring of 1999, the euro-dollar exchange rate had returned to the level of the previous summer. If the US and the EU had cut their interest rate at the same moment in reaction to the Russian crisis, these exchange rate swings could have been avoided.

To systematise this kind of coordinated response to international macroeconomic shocks such as the Russian crisis, Europe, Japan and the United States should agree in advance on a “core set of broad macroeconomic policy principles” that would sort out the roles of fiscal and monetary policy in responding to shocks. Neither the exchange rate nor numerical exchange rates targets should be included as policy tools.

The basis for such a convergence is the “common economic philosophy” developed over the years by the Group of Seven countries. This common philosophy has come to favour a monetary policy with a single main objective: domestic price stability. “As a result, monetary policy can be used to coordinate policies at the international level only if external objectives are consistent with domestic monetary strategies” (we underline).

Under these conditions, the effective action decided collectively by the G7 in response to shocks can only be very limited. For one, because the monetary policy is the main instrument considered, it presupposes that exchange rates are always sensitive to the interest rate, which is not the case.

Second, each time a country decides that it cannot change its monetary policy for domestic reasons, it will not join the collective response. In the previous example, why did the EU not cut its interest rate together with the US? Because it thought that it was bad for European price stability. And when the ECB finally cut its interest rate, it was not to help Russia, but because the devaluation of the US$ was interpreted as a threat to price stability.

What's worse, it is hard to imagine that “the core set of broad macroeconomic policy principles” could be applied when the EU, Japan or the US are victim of a unilateral shock. Especially because these principles, “would not be binding rules but, rather, tools for redu-
cing uncertainty and cutting transaction costs, and they would provide a structure for policy discussion". In case of unilateral shock, each country would have to react on its own through monetary policy and there would not be any coordinated response nor exchange rate stability. The use of monetary policy can even amplify the effects of shocks on exchange rates. For instance, if Europe suffers a demand shock, followed by capital outflows that migrate to the US to exploit better profit opportunities, the euro will depreciate. If the ECB increases its interest rate for fear of inflation, it can stimulate the depreciation of the euro instead of raising its value. This is what happened in the EU in 2000 (B. Patterson, D. Sienkiewicz, X. Avila, 2000, p 42).

The second "hand" monitors foreign exchange markets in order to improve the flow of information to market participants so as to limit market-induced volatility. For example, "aggregate information on positions and return expectations would be released to the markets on a regular basis and without delay" to help explaining the timing and magnitude of portfolio shifts. The chairman of the Financial Stability Forum "... could confidentially signal to the Group of Seven the existence of an abnormal risk exposure, so that ministers and governors could issue appropriate warnings to the market" (B. Coeuré, J. Pisani-Ferry, 1999).

These proposals are welcomed but one cannot expect too much of them. First, it may be possible that transparency is more destabilising than stabilizing. Knowing the timing and magnitude of portfolio shifts may accelerate these shifts because of herding behaviour.

Second, better information is an already old proposal that did not prove very efficient until now. D. Felix (1999) tells the story. In 1979, two years before the Third-World countries' "debt crisis", there was already much joy over the fact that better economic information published by the BIS, IMF and World Bank had allowed banks to improve their decision-making process for foreign loans and credit risk assessment, with the result that no countries had yet been forced to default. Working for improved transparency was also the G7 countries' response in 1995 after the 1994-95 Mexican crisis, when they asked the IMF to publish the relevant economic information. Two years later, the Asian crisis led the BIS to note "that despite BIS statistical data being available beforehand, showing the increasing vulnerability of several countries to a sudden withdrawal of short-term international capital, the volume of loans granted by banks never ceased to increase" (BIS 1998). The story goes on with the proposals, made in particular by the IMF, G22 and the "Forum for International Stability"(21), which emphasises the need for increased transparency and prudential controls.

In synthesis, better information to public authorities is useful if they are decided to take action and not only issue "appropriate signals to the market". When the FED chairman warned the market of the existence of "irrational exuberance", it did not deflate the speculative bubble; rather, it kept on inflating for two more years, for the simplest reason that market participants had an interest in continuing to speculate.

In conclusion, we would say that this first proposal lacks so much ambition that it is condemned to inefficiency. At the opposite of the span, R. Mundell makes a very ambitious proposal: creating a world currency.

<footnote>(21) The "Forum for International Stability" was created in February, 1999 at the G7 countries' request with the purpose of drawing up proposals for reforming the international financial system. It is made up by the finance ministers, central bank directors, OECD representatives, national supervisory authorities, IMF, World Bank and BIS (Bank for International Settlement).</footnote>
1.6.2 Creating a world currency

The design for a new global exchange rate system advocated by R. Mundell (2000) is the most ambitious and the exact opposite of the previous proposal that only pleaded for economic policy coordination with no binding rules. Given the high degree of inflation convergence among the major currency areas (22) he argues that some sort of monetary union between the US, Europe and Japan (the G3), that produces 60% of world output is desirable and feasible. This monetary union would be desirable because it would foster monetary stability of the G3 countries and this would be beneficial for outsider countries too.

A fixed exchange rate is a monetary rule, one approach to price stability. The other monetary rules are inflation targeting and money supply targeting. A big country like the US, or Japan, or the EU, has no other choice than to adopt an inflation or money supply target, because there is no point in fixing its currency to the currency of a smaller state. But an intermediate or a small country has the option of fixing exchange rates as an alternative to inflation or monetary targeting. "Austria, Holland and Belgium-Luxembourg, for example, achieved inflation rates comparable with the best in the world by fixing their currencies to the mark" (p 287). The same is true for Canada and Mexico, during periods when they fixed their exchange rate with the US dollar. The stabilization of the G3 currencies would benefit the rest of the world, and in particular developing countries. "A stabilization of the yen-dollar rate would be a great benefit for the rest of Asia, just as a stabilization of the dollar-euro rate would be a great benefit to Europe and Africa" (R. Mundell, op cit, p 289).

The key initial condition is a commitment of countries to price stability, which also appeared in the previous proposal as the primary objective of economic policy.

When inflation is similar between countries, there is no need for significant exchange rate changes. If exchange rates fluctuate enormously, as the yen-dollar rate during the nineties, it is not to fulfil any economic function except for "... stuffing the socks of hedge funds..." (p 295). Fixing the exchanges rates between the core currencies, to start with, then creating a true single world currency, would eradicate speculation on these currencies. For the small countries (meaning the rest of the world) "... the best way to protect their currencies from speculative attacks is to fix their currencies to one the big three currencies, making sure that the money supply is allowed to - and is perceived to be allowed to - move with the balance of payments without sterilization" (op cit, p 285).

According to R. Mundell this monetary union between the G3 is feasible. The creation of a real single world currency among the Big Three right from the start would be the best solution but would not be politically feasible. "National egos would get in the way in the case of the United States and Japan, and Europe would not be willing to scrap a new currency that it worked so long to prepare" (p 297-298). Instead of creating a single world currency the Big Three could fix their exchange rate, taking one of the currency, say the dollar, as a pivot currency. For example, 100 yen = 1 US dollar = 1 euro. "The three currencies would be simply different denominations of the same currency. The new name of the cent or centime would be the yen!" (op cit p 293)

To manage this monetary system based on fixed rates of the G3 countries, a world central bank should be created, producing an international asset backed by reserves of dollars, yens, euros and gold. This world central bank would target an agreed inflation index, common to the three countries and try to achieve it through the management of the single currency money supply. A fair distribution of international seigniorage should be agreed. Other countries could then decide to fix their currencies to the new world currency and benefit from monetary stability. The world central bank initially composed by a trium-

<footnote n="22"><sup>22</sup> Between 0-2% for Europe and the US, 0-3% for Japan.</footnote>
virate of the Federal Reserve, the European Central Bank and the Bank of Japan, could then admit new members from other countries. At the final stage, the world central bank and the world single currency would be the property of all nations.

Mundell's proposal has triggered an ongoing academic debate about the desirability of a single world currency. Rogoff (2001) for instance identifies a number of fundamental reasons against a global currency unification, including: (i) no adequate checks and balances on the global central bank due to the absence of a global government; (ii) international decision making could make it difficult to agree on appointing central bankers who place a strong weight on inflation; (iii) global currency competition provides a check on inflation.

In our view, the creation of a single world currency managed by a world central bank in the present process of globalisation of capitalist economies would be a major step back from a social and democratic perspective.

1. We have already discussed the importance of price stability for neo-liberal policies. Price stability is an ideological justification for refusing wages increases and more generally what is called the labour cost which includes contribution to social security. Price stability is necessary to guarantee the real gains of bond holders and stockholders. In today's world, adopting price stability as the primary objective of economic policy is nothing less than fixing for eternity the increasing inequality of revenues between wages earners and rentiers.

2. The creation of a single world currency in the present circumstances where competition between nations and workers is already systematically organised by the World Trade Organisation through the pretext of free trade would worsen this competition with negative consequences on wages and employment. The comparison can be made to a certain extent with the creation of the euro. The euro was created as the corner stone of the single European market that institutes competition as the driving force of growth and social progress. Without the possibility to change the exchange rate, and in a context of low inflation, the full weight of economic adjustment falls on wages and employment. It is not by chance that the euro area scored the lowest growth rates among rich countries. A single world currency would have the same negative effect for labour, but with an aggravating factor. Most of the EU countries are welfare states, but it is not the rule, rather the exception in developing countries. In the poor countries there is no social safety net. The negative effect of a single world currency for workers would be devastating. With free trade, Indian peasants that produce corn in the Mexican state of Chiapas have to compete with big North American producers that use capital-intensive means of production. With a single world currency (the dollar?) they could not even count on a weak peso to reduce some of their competitive lag. This is not to say that a single world currency is a bad idea in itself. The euro is not a bad idea in itself too <sup>(23)</sup>. The question is on which economic ground and to serve which social purposes a single currency is created.

3. The creation of a world central bank poses a real problem of democracy. Here again the comparison with the ECB is enlightening. The ECB has an enormous power in the EU: the right to determine the monetary policy in an area where the budget policy is corseted by the “stability pact”. This power is not democratically legitimated by any citizen choice. The governors of the ECB are appointed by the EU states without any consultation of the European Parliament. The ECB is not accountable to the Parliament or the European Commission, or the European Council

<footnote><sup>(23)</sup> We can say on the same line that the majority of NGO that critics globalisation is not against globalisation in itself but against neo liberal globalisation.</footnote>
as it is institutionally independent if not politically independent. It counts no representatives of trade unions in its rank to defend the interests of wage earners and unemployed. Lots of criticisms have been raised against this bureaucratic institution in Europe. Now let's imagine how democratic an institution of this type at the world level could be, without any "world government", nor "world parliament" to give account to? How would the governors of this world bank be designated? How could this institution appear legitimate to decide the future of citizens of very different countries?

A world bank to manage a world currency in the present situation can only be a new instrument of power for the interest of the rich countries. As R. Mundell recalls it himself, previous historical examples of nearly "world currency" are to be found in the currency of empires that dominated parts of the world like the Roman Empire. In today's world, "dollarisation" or "euroisation" is nothing more than monetary colonialism. It is hard to imagine why the merger of these currencies and their geographical extension would serve the cause of multilateralism and power sharing. A world central bank would be dominated by the US, or a modern triumvirate of the big three.

R. Mundell's proposal is not only totally unrealistic and far more demanding than the CTT, but it is also socially and democratically dangerous. This is one reason to reject it and to defend an alternative. It is a right for each country or group of countries to possess their own currency or monetary system to preserve margins of autonomy to decide their own policies and future. This involves the possibility to change the exchange rate when necessary, which does not mean that exchange rates should be totally flexible and fully determined by the market. Exchange rates should be allowed to fluctuate around a targeted average determined by economic policy. The target zone is a first step toward this direction.

### 1.6.3 The Target zone

A number of proposals advocate the creation of a target zone for bilateral (nominal) exchange rates. Target zone proposals can vary regarding the size of the band and the rules for intervention and of course the appropriate exchange rate that should be targeted. A "Target zone" in its broad sense is simply a system of limited flexibility in the sense that the exchange rate vary inside a wide band without any reference to a central parity. The crawling band and the monitoring band do have a reference to a central parity (see box 1-3).
Box 1-3 : The crawling band and the monitoring band

"A crawling band involves a central bank undertaking a public obligation to maintain its country exchange rate within a wide, publicly-announced, band around a parity that is periodically adjusted in relatively small steps in a way intended to keep the band in line with the fundamentals. The band width has typically been envisaged as something like +/- 10% around a parity... The principal cause of the change of the parity – the crawl – is typically the inflation differential to ensure that domestic inflation does not lead to a progressive erosion in international competitiveness... The parity changes must be made in incremental small steps in order to avoid speculators to anticipate correctly an impending parity change.

The key difference between a crawling band and a monitoring band is that the latter does not involve an obligation to defend the edge of the band. The market expects it, but the authorities may choose to allow the rate to go outside the band. The difference with a floating regime is that traders know the band in advance and that the central bank may intervene to defend the band. The fear of the intervention may refrain the traders from pushing to the exchange rate too far."

Source: J. Williamson, 1999.

The main advantage of bands, according to J. Williamson, is that they perform "... the function of crystallising market expectations of where the equilibrium lies, and thus makes expectations stabilizing at the time horizons relevant for influencing market behaviour. This is the fundamental reason for preferring a band system, rather than allowing the exchange rate to float" (1999).

The requirement is that the band must be at least partly credible, and that implies choosing the right parity, the right band, and a central bank that appears capable of defending the band by judicious interventions. As long as the band is credible, the central bank has no necessity to intervene. But in case of a macroeconomic shock, intervention is unavoidable.

The problem is that a central bank can try to defend its currency in the situation of a depreciation of its currency up to a certain limit. This limit is the budget constraint of a given amount of foreign exchange reserves. As the speculators are able to anticipate the running out of reserves, or even provoke it by selling the currency, the central bank is vulnerable to speculative attacks

"But the situation is completely different if a central bank tries to limit the appreciation of its currency. In this situation, the central banks buy foreign exchange against central bank deposits (denominated in its own currency) that it can supply without any quantitative limit. As there exists in principle no budget constraint, speculative attacks by the markets are no longer a real threat". (P. Bofinger, 1999).

The only problem is that if the ECB buys foreign exchange from a commercial bank, it credits the equivalent of the bank's ECB account in euros. As a result, the euro area monetary base increases, pushing the interest rate down with possible inflationary consequences. We find here again the price stability argument. As the OECD (J. Coppel, M. Durand, I. Visco, 1999) puts it:

"Such interest rates moves may not necessarily be consistent with price stability and thus there is a risk that credibility of monetary policy may be lost, raising the risk premia and undoing part of the benefits of monetary unions" (p 11).

The solution is for the central bank to "sterilise", i.e. neutralise, the effect of interventions on the monetary base in such a way that the domestic money market rate remains constant. "This can be done by reducing the credits that the central bank offers to commercial banks, or/and by offering commercial banks interest-bearing deposits with the central bank that cannot be used for domestic credit expansion. The ECB, for instance, has the
newly created instrument of a “deposit facility” at its disposal for that purpose” (P. Bofinger, 1999).

The main problem with sterilisation is that it can impose losses to central banks. It occurs when the domestic interest rate is higher than the foreign one. It may not be a problem for rich countries which sometimes have lower interest rates than abroad, for instance Japan during the nineties with the zero interest rate, or the US which have most of the times lower interest rates than the EU. But for the EU, and last but not least for developing countries that generally suffer from higher interest rates, it can be a real problem. In this case, the interest income that the central bank obtains from its foreign assets is lower than the interest costs of the deposit facility. Many central banks have been confronted with this problem in the past. As such costs cannot be borne without limit, especially by central banks of developing countries, sterilised intervention is again confronted with a budget limit and the intervention policy is again vulnerable to speculative attacks.

The solution is to match the interest income loss with a profit coming from the difference of value between the two currencies. “This requires that the central bank targets the exchange rate in such a way that the home currency is depreciated vis-à-vis the foreign currency according to the prevailing interest rate differential” (P. Bofinger, 1999). For instance, let’s assume that the FED would have been willing to prevent the euro from depreciating against the dollar in the first half of 1999, fixing a limit of 1 $ = 1 euro. With an interest rate differential of 1.75% to 2.25% in favour of the dollar the FED would have incurred losses. “This could have been avoided by adjusting the exchange target rate in a way that it allows a depreciation of the dollar vis-à-vis the euro which exactly corresponds to the interest rate differential. For instance, the FED adjust this limit after one year to about 1.02 dollar” (op cit p 21). It would have been possible since a central bank is always able to depreciate its own currency with sterilised interventions.

To summarise, if a central bank targets its exchange rate along a path that is determined by the interest rate differential, sterilised interventions are profitless and costless and do not endanger the price stability objective.

The advantage of such proposals is that it proves that countries can intervene efficiently even against supposedly overpowered markets. And of paramount importance, they can do it on their own without asking the permission of the US, for instance.

The weak point is that it provides no rules in case of swings in the opposite direction, i.e. a sharp devaluation of the euro or the yen. It may not be a concern for the EU and Japan, but it is a major point for developing countries who are especially confronted with speculative attacks that destroy their currency. The second disadvantage is that it alienates again the interest rate and the monetary policy to the defence of the exchange rate target.

One solution to the problem of sharp devaluation is a bilateral or even multilateral agreement on bilateral target rates (T. Palley 2003, P. Bofinger, 1999). The EU and the US could agree on an exchange rate band with the following division of labour:

The ECB intervenes to defend an upper limit of the euro's dollar exchange rate, say 1.20 dollar per euro. The FED intervenes to defend a lower limit of the euro's dollar exchange rate, which is equivalent to an upper limit of the dollar's euro exchange rate, say at 1.00 dollar per euro.

Defining the appropriate exchange rate and the width of the band is still pending. P. Bofinger proposes again the interest rate differential. T. Palley (2003) proposes to take into account the Fundamental Equilibrium Exchange Rate (FEER), which raises some problems.

The basic notion of the FEER, proposed by J. Williamson (1994) is that participating countries select a set of exchange rates consistent with their targeted current account and
GDP outcomes. The FEER differs from Purchasing Power Parity by emphasising real macroeconomic factors rather than the nominal factors of monetary aggregates, inflation and exchange rates. The aim is calculating the real exchange rate consequences of trend developments in demand, GDP growth, competitiveness, fiscal policies, etc.

The problem with the FEER is conceptual and empirical. First, it is necessary for participating countries to agree on a consistent set of national current account targets as not all countries can run surpluses. Some countries will have to accept deficits of their current accounts. This implies a high degree of political agreement and economic coordination that does not exist presently at least between the big three.

R.Dornbusch (1999) explains it brutally: "There is no chance that America will join a scheme that limits its flexibility and puts responsibility for US economic performance in the hands of financially inexperienced and statist-minded socialist governments. Equally remote is the chance that the US will agree with Japan on narrow exchange rate margins; the Japanese can't manage their own economy, so why should America tie itself to their misfortunes?"

We are again confronted by the unwillingness of the US government to do anything collectively, because it enjoys a monopoly rent situation.

The second problem is empirical. The empirical investigations give a wide range of estimates, reflecting large uncertainty, and are of little practical use. For instance, a report of the French council of economic advisers (CAE, 1999) calculated a range of $ 1.07 to $ 1.43 against the euro depending on the assumptions based on past behavioural relationships.

But more decisive is the following criticism against target zones and any attempt to stabilize or even fix exchange rates.

"Some claim that under a regime of fixed exchange rates, monetary policy itself can become a genuine source of policy shocks (C.M. Reinhart, V.R. Reinhart, 2001). With free capital movements, G3 authorities have to use domestic monetary policy as a tool to stabilize exchange rates.

As a result, the variability of interest rates and monetary induced changes in domestic income and demand may rise. Against this background, the benefits for emerging countries from stabilising exchange rates between the G3 countries are therefore not clear cut. While under a system of target zones, the relative prices for emerging market economies may become more stable as G3 exchange rates become more predictable, the increased variability of interest rates and G3 income may increase uncertainties for emerging economies related to external financing and external demand. ... To the extent that an emerging market economy is vulnerable to high and volatile world interest rates, the consequences of the trade-off implied by a G3 target may be considerable" (EU Commission Report, 2002).

G.A. Calvo and C.M. Reinhardt (2000) apply a similar argument directly to emerging market economies. Because of a "fear of floating", governments of emerging countries adopt monetary policies aimed at stabilising the exchange rate, but thereby increase the interest rate volatility.

The answer to this decisive point is twofold: First, according to J.A. Aizenman, (2001), the existing literature is sceptical about the existence of a trade-off between exchange rate and interest rate volatility. Flood and Rose (1995, p 17) failed to find such trade-off. O. Jeanne and Rose (1999) develop a model of a pure floating exchange rate with an endogenous number of noise traders that can generate multiple equilibria of high and low exchange rate volatility. The same macro fundamentals are consistent with a "good equilibrium (low exchange rate volatility and a low number of noise traders) or an inefficient equilibrium, (high exchange rate volatility and a high number of noise traders). "In
such an economy, a target zone may eliminate the inefficient equilibrium, by restricting the feasible range of exchange rate volatility. In this case there is "free lunch" in the sense that there is no trade off between exchange rate volatility and interest rate volatility- the good equilibrium is associated with lower exchange rate volatility as well as with a lower risk premium and lower interest rate volatility" (J.A. Aizenman, 2001, p 3).

Second, the arbitrage hypothesis can also be contested empirically. Even if one admits the existence of a trade-off for the G3 countries, this may not be the case for developing countries where exchange rates and interest rates are driven by specific factors such as the confidence in the ability to serve external debt, the solidity of domestic political institutions, and the inflow of foreign capital. This last factor in particular implies that exchange and interest rates volatility move together, contradicting the existence of a trade-off described by G.A. Calvo and C.M. Reinhardt (2000). During the Mexican, Asian, Russian, and other crises, exchange rates usually depreciate and interest rates increase together. A. Belke and D. Gros (2002) found in the case of the Mercosur countries, though subject to speculative attacks and bouts of hyperinflation, that exchange and interest rates volatility do move together although the relation is less tight during periods of calm.

They also found that the dollar and the euro exchange rates are not strongly correlated with interest rate volatility in the Mercosur countries, which gives no support to the existence of a trade-off between G3 currencies volatility and emerging market interest rate volatility.

To summarize, there is a case for stabilizing the exchange rate through a band of fluctuations. There is concrete evidence that target zones achieved exchange rate stability, at least in some cases, and that a more volatile exchange rate is not the price of foreign exchange stability.

But target zones have also some flaws that cannot be ignored:

There is no autonomy for the monetary policy since the interest rate must be mobilized to maintain the exchange rate inside the band. The exchange rate stabilization is fragile. The target zone is always under surveillance by market operators, and if there is any sign of macroeconomic difficulties, speculation will start destabilizing the exchange rate. In case of a speculative attack, there is no efficient defence instrument and public authorities often have to abandon the exchange rate target.

The CTT can help resolve these two problems: The risk that the volatility can be shifted from the exchange to the interest rate can be suppressed either by the CTT or capital controls. This is acknowledged by C.M. Reinhardt and V.R. Reinhardt (2001) but disregarded because "restricting capital mobility is against the consensus". But if public authorities have the courage to restrict capital mobility then monetary autonomy can be restored. For this purpose, a CTT can "... drive a wedge between short-term interest rates in different national markets" (J. Tobin, 1998, p 5).

The CTT can protect a target zone against speculation more efficiently than mere central bank intervention or even an interest rate change. This possibility is criticised with irony by J. Williamson (1999), for whom fending off speculation with reserve requirements (such as in Chile) is "pie-in-the sky". "It is even more difficult to imagine that a Tobin tax (...) would make epsilon's worth of difference in stemming a speculative run in which the potential gains are perceived as hundreds or thousands of basis points" (op cit).

This may be true if one considered the original J. Tobin's proposal of a uniform tax on currency transactions. But as we will now explain in the next section, proponents of the CTT have improved the original proposal to take criticisms into account and to adapt J. Tobin's idea to the much more integrated financial markets of today's world.
# 1.7 The efficiency of the two-tier currency transaction tax

The major innovation to improve and actualise the “Tobin tax” has been made by Paul Bernd Spahn (1995, 2002) with the two-tier Currency Transaction Tax (hereafter CTT). A small CTT could curb ordinary speculation that occurs during “normal times” and a high prohibitive tax would be applied to deter big speculative attacks that strike especially, but not exclusively, developing countries. This innovation is now widely accepted by proponents of the CTT.

But it does not mean the end of the debate, because P.B. Spahn makes policy decisions that not everyone can share and we would like to open the debate by bringing in some different choices.

Furthermore, the two-tier CTT has to be adapted to the economic and political context of developing countries. For instance, a fine tuned two tier CTT could discourage, if not suppress, capital flights that plague fragile developing countries before and after the burst of an economic crisis.

And finally, one has to admit that a CTT cannot do everything, and it is important to determine its limits and complete the CTT by a set of complementary measures including capital controls. Rather than looking for the magic wand, it is wiser to combine a full array of instruments at hand to reconstruct a safe financial environment for progressive economic policies.

## 1.7.1 P.B. Spahn's two-tier CTT proposal

The basic principle is the following: as long as the daily fluctuations of the exchange rate remain small, a small tax is applied to the currency transaction. If the daily fluctuations go beyond a predetermined threshold, a surcharge is applied.

The following chart illustrates how it works. (See fig. 1-4) Let's consider the US dollar against the euro market. The foreign exchange rate between the two currencies fluctuate everyday as it is shown. It is possible to calculate the average on the last 20 days, 30 days, or for even longer spans. As the foreign exchange fluctuates anew every day, the average will change in accordance (hence the name “mobile average”). From then it is possible to determine each day an upper limit of say 2.5 % above the average and a lower limit of 2.5 % under the average that creates a band of fluctuations of 5%. As long as the exchange rate determined by the market stays inside the band, a small “normal” tax is applied on each transaction.
<figure><img src="image_5.png" /><figcaption>Fig. 1-4 : Illustration of the Working of the Exchange Surcharge</figcaption></figure>

Source: Spahn (2002)

1.7.2 What would be the purpose of the “normal” tax?

The “normal” tax is the main source of fiscal revenues because it is levied on ordi-
ary transactions that occur every day. If the CTT is appropriately designed, the surcharge
must not be triggered frequently and therefore cannot generate much revenue. At the ex-
treme, if the surcharge leads to a market closure, the fiscal revenues will be null. So the
normal tax will provide the bulk of the fiscal revenues.

But the ordinary tax would also smooth the daily fluctuations of the foreign ex-
change rate. As we have seen, most of the transactions are not justified by customer or-
ders but by the interpretation of news that fuels speculation and bandwagon effects. "This
has the following consequence: a rise in price generates a larger rise in expected price;
leading to increased demand now in anticipation of higher future prices, thereby exacer-
bating the rise in price. This phenomenon of destabilizing speculation can be observed at
short terms horizons, a few hours up to 3 to 6 months, according to empirical surveys of
the foreign exchange markets (J. Frankel, 1996) (24). After the 3 to 6 month period, there is
a switch in traders' anticipations. Traders expect a depreciation in the coming months to-
ward a "fundamental value" in the very broad sense (25).

The CTT is expected to work in the following manner: "a rise in the exchange rate above its "norms" would not lead agents to expect further rises (...) because they would see the tax as operating as a disincentive to the market activity necessary to produce such a rise" (P. Arestis, M. Sawyer, 1997, p 760, see also J. Frankel, 1996, pp 54-59). Short-term speculators would be affected by the tax but not long-term investors who would bene-

<footnote n="24">24) For empirical surveys, see J. Frankel and K.A. Froot, 1987, 1990; K.A. Froot and T. Ito, 1989, M. Chinn and J. Frankel, 1994, Y.-Wong Cheung, M. D. Chinn, I. W. Marsh, (2000).</footnote>

<footnote n="25">25) As we have already said, fundamental values and equilibrium are two different things. This leaves much room for a Keynesian interpretation where the "fundamental value" is nothing else than what average opinion believes what average opinion to be.</footnote>
fit from stability. This is exactly the objective pursued by J.M. Keynes and J. Tobin. The CTT can be seen as an “uncertainty-reducing-institution” (P. Arestis and M. Sawyer, 1997, p 760), stemming destabilization through its effect on agents’ expectations.

### 1.7.3 How does the surcharge work?

If the “normal” tax proves insufficient because speculators bet on big profits in the coming three or four weeks, and not on small profits coming from intraday fluctuations between the euro and the US dollar each day of the year, then a surcharge will be automatically applied. This will be the case when the daily foreign exchange rate reaches the upper or the lower limit of the band. The surcharge (50%, 100%, or more) will be calculated on the difference between the exchange rate outside the band (for example 1 $ = 2.4 euros on the 16th day on the chart) and the upper limit of the exchange rate (around 1.3 euros for 1 $ on the chart) multiplied by the amount of money traded this day by the speculator.

Speculation is defined precisely as trading outside the band and the objective of the surcharge is to hold back speculation with a high tax that will rip the speculative profit. In Spahn’s words (2002, chapter 2, p 20): the surcharge “... is not applied to the value of the transaction as such (...) but only on the externality, i.e. that part of the price that lies outside the corridor”. The surcharge “... increases with the degree of deviation from the target zone” from 50% to 100% for instance.

If the mechanism is announced in advance it should discourage speculators and if not, it will punish them until they trade inside the band. At the extreme, the surcharge can lead to a temporary closing of the foreign exchange market in much the same way as the circuit breakers in force on the US stock exchanges. Since 1989, computers are automatically disconnected whenever the share prices move up or down by more than 10%. It avoids a crack and gives time to economic agents to change their mind. But the difference with the stock exchange circuit breakers is that in this case speculators on the foreign exchange markets who trade outside the band have to pay a prohibitive tax.

For these reason we think that the surcharge will act strongly as an anchor for medium/long term expectations about the future exchange rate. Because strong deviations from the medium/long term conventional exchange rate are prevented by the surcharge, traders will know that short-term volatility will be confined inside the band. This will uphold the credibility of the ordinary tax.

### 1.7.4 How well does the two-tier CTT contribute to James Tobin's objectives?

The two-tier CTT as proposed by P.B. Spahn himself fits nicely with at least one of James Tobin's objectives: curbing speculation and stabilizing exchange rates. But one can be more sceptical about improved monetary autonomy.

#### ➤ Speculation and exchange rate volatility should be reduced

There is no central parity that the central bank is committed to defend, since the average exchange rate is defined by the market itself. This eliminates the possibility that the exchange rate could be progressively overvalued and contribute to an unsustainable current account deficit. Any medium and long-term move toward an appreciation or depreciation of the exchange rate will be progressively incorporated into the mobile average. This includes foreign exchange transactions induced by trade and foreign direct investment and long term portfolio investment. But short-term speculative transactions and short-term portfolio investments should be reduced and would not influence the exchange rate as much
as they used to. Short-term exchange rate volatility should shrink without impeding medium and long-term fluctuation of the exchange rate. As we have explained previously, this is what James Tobin had in mind when he declared “let the currency float” (1998, p 11) but not freely.

The speed of variation of the medium/long-term exchange rate will depend on the course of macroeconomic events (bad or good unanticipated or anticipated news, shocks etc...) and on the definition of the period of reference of the moving average. The longer the period, the slower the speed of variation for the medium/long-term exchange rate. The exact period will have to be defined pragmatically but there is room to manoeuvre for the monetary authority, to delay the incorporation of news and to smooth the medium/long term fluctuations of the exchange rate. This would give time for policy makers to define the appropriate response to macroeconomic shocks and to private firms to revise their business plans.

This should also oblige traders, at least in part, to stop trying to guess what their colleagues are expecting and leads them to pay more attention to medium/long-term economic analysis. In more conventional terms, chartists' influence on exchange rates will decrease in favour of fundamentalists' (26). This is exactly what J. M. Keynes and J. Tobin had in mind.

## But monetary autonomy would not increase much

Theoretically, the two-tier CTT should allow more autonomy to monetary policy. If the surcharge is an effective and credible deterrent to speculative attacks, then the ordinary small tax can operate as it was primarily conceived by J. Tobin: “To create room for differences in domestic interest rates, allowing monetary policies to respond to domestic macroeconomics needs” (J. Tobin, 1996a, p 496).

But the magnitude of this room depends on the level of the ordinary tax, on who bears it, and on the stabilizing joint-effect of the ordinary tax and the surcharge on expectations. We will develop this point further below but first we would like to present P.B. Spahn's own ideas.

P. B. Spahn's conceptions on these points are the following. The level of the ordinary tax should be determined in relation to the level of transaction cost practised by banks and wholesale dealers on the interbank market. Concretely, the tax rate should be somewhere between 50% and 100% of this transaction cost. Due to technical progress and competition this transaction cost between the dollar and the major currencies has fallen from 1% in the seventies, to 0.05% in 1995 and 0.01% in 2002 for the dollar/euro market for instance. Therefore the ordinary tax should be somewhere between 0.005 and 0.01%.

The rationale is that a higher ordinary tax would make it difficult for bank traders to sell the currencies they have just bought from other traders according to the “hot potato chain” principle. These market makers activities would be hit, and the liquidity of the market, identified to the volume of the market, would shrink. This would be contrary to the objective of stabilizing the exchange rate as a less liquid market is said to be more volatile.

The question is what remains of the “principle purpose of the proposed tax which is to expand the autonomy of national monetary regime” to quote J. Tobin (1996a, p 496)? According to P.B. Spahn (chapter 2, p 22), the surcharge will “procure the necessary room for monetary abstinence by the central bank and allow it to focus mainly on domestic objectives”. And this non intervention is even mandatory when the surcharge is applied “... because traders would otherwise attempt to shift the burden of the tax onto the central bank” (idem). In other terms, when a non prohibitive surcharge is triggered, and speculat-

<footnote>(26) this point will be further developed in a following section.</footnote>
ors are still trading, they could sell their currency to the central bank that would have to
pay the tax.

This is a very important progress because it means that central banks will not have
to defend their currency while under attack by a massive increase of the interest rate. And
these extraordinary increases in interest rates recommended by economic orthodoxy and
its obedient servant the IMF, is a major cause of recession.

But what about monetary autonomy when the country is not confronted with a spec-
ulative attack? In periods of tranquillity, the surcharge is not enforced and it falls to the or-
dinary tax to assure margins of autonomy.

It is clear that with an ordinary tax so close to zero, the margins of autonomy are
non existent. If the central bank decides to lower its interest rate to stimulate the growth
rate, a nearly zero ordinary tax will not be sufficient to refrain capital outflows in search of
arbitrage. The exchange rate will probably hit the band and the surcharge will then be ap-
plied too frequently.

1.7.5 Diverging paths

If the objective is to protect a country against speculative attacks, but also to pro-
mote more autonomy for economic policy after the crisis is overcome, we think it neces-
sary to consider a higher ordinary tax for the euro/dollar transactions, and higher still for
developing countries. It is not a mere question of numbers even if numbers do matter.

More fundamentally, the question is the following: must the CTT be feasible under
the present characteristics of financial markets that have been recently deregulated? Do
we have to limit our ambition in order to avoid any disturbance of markets that are not effi-
cient, are prone to crisis, and left to themselves do not achieve fundamental objectives
such as full employment and increase revenues?

Because markets are given more power and unregulated freedom to decide, the
scope for political reform is narrowing if we do not question the prerogatives they have re-
ceived. Financial markets are getting even more integrated and frictionless. One can follow
this process by observing that transaction costs between banks and wholesale traders are
nearly equal to zero. Capital mobility is far more important now than in the seventies.

The mere application of a Keynesian economic policy advocated by James Tobin,
which used to be orthodox economic policy in the sixties, now appears as a radical move,
given that the neo-liberal ideology and tool box have shifted the centre of gravity in favour
of unregulated markets "who always know best", and away from suspect policy makers
"who always do worse".

But such a move is necessary, as the objective is not only to deprive speculation of
its harmful power, but to reopen room to manoeuvre for alternative economic policies, giv-
ing priority to full employment, sustainable growth and social justice <sup>(27)</sup>. We will now
present the basic elements of this more ambitious proposal.

1.8 A two tier CTT for an alternative economic policy

Let's begin with a simple question. What should be the level of the ordinary tax? As we know, the exchange rate is free to fluctuate inside the band of fluctuation. So, it is possible that the exchange rate depreciates – say, 2%. In case of a round trip, it means that

<footnote><sup>(27)</sup> See, for instance, in the European context, the “New Economic Policy” advocated by the “the European Economists for an Alternative Economic Policy, (2001, 2003) and the “Full Employment, Growth and Stability Pact” formulated by P. Arestis, K. McCauley and M. Sawyer (2001).</footnote>
an investor who sends this money abroad and invests it with a return of i* (say 6%) after some period (one day, one week, one month, etc...), will also gain from the exchange because when he repatriates his money he will have 2% more of his domestic currency. Given the level of the domestic interest rate i (say 4%), we can calculate the level of the ordinary tax t required to rip the profit that the investor can make by sending his money abroad (see box 1-4) (B. Jetin 2001).

**Box 1-4 : What is the required level of the ordinary tax to provide some autonomy to monetary policy?**

The basic formula is the following:

$$ (1+i)^{1/p} = (1-t)^2 (1+i^*)^{1/p} (1 + \delta e) $$

Where i is the annual domestic rate of interest, i* is the annual foreign rate of interest, t is the rate of the CTT, δ e is the anticipated variation of the exchange rate during the period of investment in the foreign asset. (δ e > 0 means a depreciation of the domestic currency). p is the number of transactions per year, and 1/p is the duration of the investment for which a foreign investment is held. The basic unit is 1 year meaning that if the investment is held for 1 year, 1/p = 1. If it is held for 6 months, 1/p = 1/2, and p = 2 gives the number of transactions per year. If the investment is held one month, 1/p = 12, and the number of transactions per year is p = 12, etc...

From this equation, we can rearrange the term to calculate to express t, the level of the CTT, in function of the other parameters, i= 4%, i*= 6%, δ e = 1% to 10%.

$$ t = 1 - \left[ \left( \frac{1+i}{1+i^*} \right)^{\frac{1}{2p}} \times \left( \frac{1}{1+\delta e} \right)^{\frac{1}{2}} \right] $$

The results are presented in table 1-2.

<table><caption>**Table 1-2: Required CTT Rate to Curb Speculation in Case of an Anticipated Depreciation of the Exchange Rate, in %**</caption><thead><tr><th rowspan="2">FOREX DEPRE -<br/>CIATION, IN %</th><th colspan="6">FREQUENCY OF ROUND TRIPS BETWEEN THE TWO CURRENCIES</th></tr><tr><th>1 DAY</th><th>1 WEEK</th><th>1 MONTH</th><th>3 MONTHS</th><th>6 MONTHS</th><th>1 YEAR</th></tr></thead><tbody><tr><td>1</td><td>0,50</td><td>0,51</td><td>0,58</td><td>0,73</td><td>0,97</td><td>1,44</td></tr><tr><td>2</td><td>0,99</td><td>1,00</td><td>1,06</td><td>1,22</td><td>1,46</td><td>1,92</td></tr><tr><td>3</td><td>1,47</td><td>1,49</td><td>1,55</td><td>1,70</td><td>1,94</td><td>2,40</td></tr><tr><td>4</td><td>1,95</td><td>1,96</td><td>2,02</td><td>2,18</td><td>2,41</td><td>2,87</td></tr><tr><td>5</td><td>2,41</td><td>2,43</td><td>2,49</td><td>2,64</td><td>2,87</td><td>3,34</td></tr><tr><td>6</td><td>2,88</td><td>2,89</td><td>2,95</td><td>3,10</td><td>3,33</td><td>3,79</td></tr><tr><td>7</td><td>3,33</td><td>3,34</td><td>3,40</td><td>3,56</td><td>3,79</td><td>4,24</td></tr><tr><td>8</td><td>3,78</td><td>3,79</td><td>3,85</td><td>4,00</td><td>4,23</td><td>4,69</td></tr><tr><td>9</td><td>4,22</td><td>4,23</td><td>4,29</td><td>4,45</td><td>4,67</td><td>5,13</td></tr><tr><td>10</td><td>4,66</td><td>4,67</td><td>4,73</td><td>4,88</td><td>5,11</td><td>5,56</td></tr></tbody></table>

NOTES : i = 4%, i* = 6%, 240 DAYS.

Source: B. Jetin (2001).
One can see, for instance, that for a depreciation of the exchange rate of only 1%, the ordinary rate must be around 0.5% if the round trips are daily, weekly or monthly ones, and between 0.7% and 1.4% if the round trips are made every 3 months, twice or once a year. This is an expected result because when the transactions are made very frequently, the taxpayer pays very often the tax and a small ordinary rate, but yet much higher than considered by P.B. Spahn, will offset the gain of the depreciation of the exchange rate.

One can check why the surcharge is necessary. A speculative attack will anticipate a significant depreciation of the exchange rate, say 5% or 10% in one month or three months. Table 1-2 shows that if a country whose currency is attacked wants to keep its domestic interest rate 2% below the international level, it must raise the CTT at 2,5% if the anticipated depreciation of the forex is 5% in one month, and to 4,7% if the anticipated depreciation of the forex is 10% (28). Clearly, one cannot raise a currency transaction tax at such a high level without shutting down for good the foreign exchange market. The surcharge conceived by P.B. Spahn offers the solution by taxing the part of the price that lies outside the band (29).

These results confirm the previous one. In case of even a small depreciation of the exchange rates, a small ordinary rate, inferior to 0.1% is too low to guarantee an interest rate differential of 2%. The volatility of the big three countries being between 2% to 3% (30) an ordinary tax of 1% appears to be the minimum to offset short term fluctuations.

Monthly fluctuations of developing countries' currencies vis-à-vis the dollar are superior to 5%. In this case a higher ordinary rate of around 2.5% must be considered in relation with the surcharge. Clearly, a small CTT of the magnitude of the transaction costs on the interbank wholesale exchange market cannot perform the job. But is it possible to consider a high CTT rate?

### 1.8.1 The leverage effect of the ordinary tax

The problem is how to reach a high level of CTT without provoking the disappearance of the exchange market? The answer will depend on who will pay effectively the CTT, the banks or their customers (multinational firms, pension funds, hedge funds, mutual funds, insurance companies, etc...)? (31) What are the existing transaction costs of these economic agents? Is there a cumulative effect of the CTT and how to figure it?

The interbank commission fees are between 1 and 2 basis point (0.01% to 0.02%), and these figures are often taken as the relevant starting point to analyse the impact of the CTT on the volume and the structure of the exchange market. These transaction costs only cover the technical transactions costs between two banks. When banks sell currencies to their (big) final customers, they charge around 0.1%.

We think that taking these figures as the relevant references to judge the impact of the CTT is misleading.

First, it is obvious that banks will try to shift at least a fraction of the CTT to their final customers. It is a bit like the value added tax principle, but not exactly. Due to the fact that the banking sector is a competitive one, banks will have to charge a fraction of the CTT. Exactly how large their share of the burden will be is difficult to say.

<footnote>(28) These results are not sensitive to the levels of the interest rates. If i = 6% and i* = 5%, the required levels for the CTT rates are nearly the same until the one month horizon, but fall a bit for the longer horizons.</footnote>

<footnote>(29) If the lower band is 2% away from the average exchange rate and a speculative attack expects a 8% decrease the surcharge applies to the difference, i.e. 8%.</footnote>

<footnote>(30) Source: T. Berglund, S. Honkapohja, A. Mikkola, A. Suvanto, 2001, p 45, quoted in Conseil Supérieur des finances de Belgique, 2001.</footnote>

<footnote>(31) J. Tobin's view (1996) is that banks should be exempted of the tax and would only pay the tax on their net daily open positions, the bulk of the tax being paid by their customers.</footnote>
Second, it follows that we have to consider the accumulated taxation along the whole chain of transactions: one customer order engenders between 4 and 5 transactions between banks before another final non bank customer is found.

Third, these figures correspond to developed countries during “ordinary” periods. For developing countries and in periods of tension, the transactions costs are much higher because they include search costs and risk premia that are much higher than in developed countries.

According to D. Felix and R. Sau (1996), the pre-tax transaction costs are around five to ten times higher (0.05% to 0.1%) than the ones frequently assumed in the literature based on the interbank commission fees (0.01% to 0.02%).

“The scope of transaction costs should, we believe, include the cost of carrying out the full array of financial exchanges needed to complete a primary transfer, as well as search cost and risk premia” (we underline). Hence the relevant pre-tax transactions costs are much higher than the interbank commission fees. This is why the authors pledge for a phased-in 0.25% tax in four years.

But even if the CTT level is fixed to 0.1%, its final effect on speculation would be higher than expected. This is due to what is called the “hot potato principle” to which the underlined part of the previous quotation refers: dealing banks typically engage in multiple follow-up trades with other dealing banks (4 or 5), after a primary foreign exchange trade has unbalanced the proportions of different currencies they want to maintain on their books.

These follow-up exchanges fraction the initial transfer and restore the desired balance. “The fractions would likely, on average, to sum to more than one, so that the total impact of a 0.1% Tobin Tax would likely be superior to 0.2%. If the bank’s pre-tax charge to a hedge fund or multinational corporation were 0.05%, a 0.1% tax would raise the charge to an amount superior to 0.25%. For currency speculation, a similar cost would apply to the repatriated funds, which raises the cost of the speculative round trip from a pre-tax 0.1% to a post-tax 0.5%. For large volume-low margin covered interest rate arbitrating that’s a substantial deterrent; for open speculative attacks perhaps less so” (D. FELIX, 2001).

This is what we call the “leverage effect” of the ordinary tax. It will be useful to ensure monetary autonomy while the surcharge will deal with speculative attacks. In effect, Table 1-2 shows that a 0.5% ordinary tax is efficient in case of a depreciation of 1% for daily and weekly transactions (and for longer terms when the interest rates are equal).

Paul De Grauwe (2000), who opposes the Tobin Tax, used a microstructure model developed by A. Lyons (1999) to reach the same kind of conclusion but with stronger results. He thinks that the impact of a 0.1% (³²) would be much higher. He takes the example of a speculator who buys dollars and sells euros to a dealing bank. The first dealer obtaining the euros will want to unload them, but not the full amount. Because of the drop of the price of the euro, the dealer has an incentive to hold a fraction of these cheap euros. Suppose he holds 5%. He then unloads the other 95% to another dealer, who has the same incentive to hold a fraction and to unload the rest.... After five dealers, the rest is unloaded to another speculator willing to take a reverse position. The chain of taxes (assuming an ordinary Tax of 0.1%) will be:

$$100*0.001 [1 + 0.95 + 0.95^2 + 0.95^3 + 0.95^4] = 0.45\%$$

<footnote n="32">³²) In his paper, Paul De Grauwe takes the example of a 1% CTT and assumes that there are two different speculators making a one way trip. We have modified his example, assuming that the CTT rate is 0,1% and that there is only one speculator making a round trip.</footnote>
This means that the last bank buying the rest of the euros would be taxed at a rate of 0.45%. If the bank's pre-tax charge to a hedge fund or multinational corporation is 0.05%, the final charge for a one way trip is 0.45% + 0.05% = 0.50%, and 1% for a round trip (33).

This level of taxation is sufficient to curb speculation on a monthly basis in case of a depreciation of the exchange rate of 2%, and when the domestic interest rate is 2% below the foreign interest rate (see Table 1-2).

But this is not the same for an ordinary tax of 0.01% (one basis point) which would lead to an accumulated taxation for the last bank of 0.045%, 0.050% for the customer, and 0.1% for a round trip. This is clearly insufficient to reduce short-term volatility of exchange rate inside the band.

In synthesis, the leverage effect of the CTT on the whole chain of exchange transactions allows an ordinary rate, say 0.1%, to be efficient to offset a 2% depreciation of the exchange rate. We will take this as a reference for the ordinary tax level in developed countries.

## 1.8.2 Is it fair to tax all transactions?

Yes because banks and their big customers such as multinational firms, insurance companies, mutual, pension and hedge funds engage frequently in speculation. Speculators are not an easily identifiable group of villains. So the ordinary tax should be paid by all of them. Only small firms and households should be exempted of the tax if their transactions do not exceed a certain amount.

To better understand the importance of each category of economic agents on the foreign exchange market it is useful to size the relative importance of transactions made by banks and their customers (See table 1-3).

As we can see, the relative share of banks has been decreasing strongly during the nineties (-24% between 1992 and 2004) and especially in the end of the period. The relative share of "non financial institutions" which are industrial companies and non financial service companies has also been decreasing significantly on the period (-21%) even if the trend is not as regular and if the share has stabilized at 13-14%. On the contrary, the "other financial institutions" which are insurance companies, mutual funds, pension funds and hedge funds, have more than doubled their share on the whole period, from 12.5% in 1992 to 33% in 2004.

<footnote n="33">33) If dealing banks sell 100% of the euros, the final speculator would pay 0.5% + 0.05% = 0.55% for a one way trip, and 1,1% for a round trip). This does not change the results significantly.</footnote>
<table><caption>Table 1-3 : The Evolution of the Relative Share of Banks and Customers on the Foreign Exchange Market (as a percentage of global turnover)</caption><thead><tr><th>YEARS</th><th>1992</th><th>1995</th><th>1998</th><th>2001</th><th>2004</th><th>% CHANGE (2001/1998)</th><th>% CHANGE (2004/2001)</th><th>% CHANGE (2004/1992)</th></tr></thead><tbody><tr><td>BANKS</td><td>69,8</td><td>64</td><td>64</td><td>59</td><td>53</td><td>-8</td><td>-10</td><td>-24</td></tr><tr><td>WITH OTHER FINANCIAL INSTITUTIONS</td><td>12,5</td><td>20</td><td>20</td><td>28</td><td>33</td><td>40</td><td>18</td><td>164</td></tr><tr><td>WITH NON-FINANCIAL CUSTOMERS</td><td>17,7</td><td>16</td><td>17</td><td>13</td><td>14</td><td>-24</td><td>8</td><td>-21</td></tr><tr><td>TOTAL</td><td>100</td><td>100</td><td>100</td><td>100</td><td>100</td><td></td><td></td><td></td></tr></tbody></table>

Source: Survey of the foreign exchange market, various issues, BIS.

The volume of forex transactions realised by financial companies is now more than two times superior to the volume of transactions realized by industrial and non financial services companies.

### 1.8.3 How can we explain these evolutions?

The decreasing share of banks is explained by the merger and acquisition process and their cost reduction strategy in a context of fierce competition. In the 2001 BIS survey on the foreign exchange market there were 2,772 reporting banks from 48 countries down from 3,087 reporting banks in 1998 from 43 countries.

At the same time, competition has lead to a reduction of spread between bid and ask prices that determines their profit margin on each transaction, while risks and costs stayed at a high level because of risks and strong investments in information technology (B. Estecahandy, 2002). They have centralised their market making activity in one place per time zone, for instance only one in Europe, holding only secondary trading rooms in cities where they deal with their customers. Some have even abandoned some of their market making activities to specialise on some products where they hope to increase their market share, realising economies of scale. Increasing volume is the only way to make a profit because it is impossible to increase spreads. The other advantage of being big is that it allows in real time to better understand what is going on, what the competitors are doing, and that can be determinant to take the right decisions when banks are engaged in proprietary trading, which is nothing less than pure speculation (34).

One cannot find a better example than Deutsche Bank, the biggest German bank, which will soon not be much of a bank but rather a "giant hedge fund" to quote the review "the Economist", ("A giant hedge fund", August 28th, 2004) and which cannot be suspected of sympathy for anti-globalisation protesters. The Deutsche Bank wants to create a 25% return on equity. "if that cannot be done by serving customers, domestic or otherwise, the it must be reached by trading for its own account- by becoming, in other words, a hedge funds". At least 30% of its trading positions were taken for its own account. Deutsche Bank has lent money to independent hedge funds, but it runs also its own in-house hedge funds, and provides seed money to talented traders to set up hedge funds outside the bank, even when they are previous in-house hedge funds managers who left Deutsche Bank to create

<footnote n="34">34) In 1999, a survey among US traders, show that 50% of respondents believed that the pound/dollar market is dominated by a few big players, and 60% indicated that big players exert dominance on the Swiss Franc/dollar market. See Cheung Y., Chinn, M.D. (2000)</footnote>
their own company. And the article concludes: "The biggest problem with Deutsche's metamorphosis into a trading firm is that everybody else is doing the same, and the number of strategies and talented traders is limited".

In sum, because of their high investments and the profit they make in speculative activities, banks have a vested interest in growing and volatile currency markets, disguising it as "more liquid" markets. With stable markets they would lose money. It is clear that they should be taxed.

Industrial and non financial service companies have also joined the merger and acquisition trend and rationalise their corporate treasury activities at the international level. Big multinational firms have centralised their treasury management by continent or even in a unique world centre. The movement has been particularly strong in the EU with the introduction of the euro. Together, these trends explain why the number of transactions has decreased by 36%. It seems that fewer companies use their treasury to speculate on currencies because of heavy losses experienced by some of them and because of new accounting rules (IAS 39 in Europe and FAS 133 in the US) oblige them to document precisely each hedging operations. However, when firms have a particular view on the evolution of the exchange rate they do try to profit from it. In a recent survey, G.M. Bodnar and G. Gebhardt (1998) show that "25% of German firms alter the timing or size of the hedge based upon their market view whereas only a small group of US firms follow such active strategies. In addition to altering time and size hedges, a considerable number of German firms (50.6%) and US firms (41.2%) indicated that they at least take active position based on their market view" (p 16).

Finally, we turn to the strong trading increase of financial institutions. This is explained by the important role played by hedge funds, by the growing internationalisation of portfolio management and the attention they pay to the foreign exchange market per se.

At the end of the eighties, the so-called macro hedge funds appeared as new big players on the foreign exchange market. They played a major role, allied with banks, in the collapse of the EMS in 1992-93 where they gained huge profits, and tried to renew the score during the Asian crisis. But some of them lost also a lot of money, and from this it seems that macro hedge funds withdrew from the foreign exchange in favour of the equity market where the volatility and profit opportunities were higher. At the time, some concluded that speculation on the foreign exchange market was part of history. The situation has changed once again with the burst of the equity bubble and hedge funds are back on the foreign exchange market.

The fashion is "alternative management" and it materialises by the creation of numerous small and medium hedge funds (from tens of millions of US dollars to some hundred of millions of US dollars of capital). They use the "technical analysis" and other sophisticated statistical models to speculate. Meanwhile, there is a growing international diversification of portfolios investments and a more active currency management in order to improve the return on investment. To state it more clearly, they speculate more on currency markets.

In sum, the evolution of the trading activity of banks and their customers confirm that it is not only fair but legitimate and necessary to tax them all if the objective is to curb speculation and restore some monetary autonomy.
### 1.8.4 Is the 0.1% ordinary rate so high that the market could shrink too much and disappear?

Yes, if it is demonstrated that the banks won't be able to shift a sufficient part of the burden of the tax to their final customers. In this case, the foreign exchange market would evolve quickly from the present price-driven market to an order-driven market like the ones that exist in the stock markets. It is not proved that markets driven by orders are less liquid, and less efficient for risk spreading.

No, if it is accepted that part or the total of the tax will be passed along to the final customers. In this case, banks are not fully taxed even if the rate is set to 0.5%. There would be some shortening of the multi-dealer chain and some centralisation of the market but without a total transformation of the structure of the market.

It is important to make this point clear. If the burden of the tax is in part shifted by banks, who play the role of market makers on the foreign exchange market, to their customers, it is not possible to say at the same moment that a reasonably high ordinary tax, 0.1% for the big three currency, will smash up the market. The experience of the Value Added Tax (VAT) is again illustrative, because like the CTT, it is included in price. When it was first introduced in France, all companies complained that it would hit the market. It did not. The difference between the CTT and the VAT is that it would be paid by private companies and not households.

By the way, as we said, the market will not disappear, but its way of working will change. How? We can have an idea by observing what is already going on as a consequence of technical and organisational innovations. The impact of the tax would probably be to accelerate the pace of change. These innovations are driven by the progress of electronic trading.

According to G. Galati and K. Tsatsaronis (2001), in 2000, 85%-95% of interbank trading in the major currencies was said to be conducted using electronic brokers, up from about 50% in 1998 and 20%-30% in 1995. Before electronic brokerage, dealers tended to execute small trades regularly throughout the trading session to gather information about the current price and be continuously informed. "In 2001, any dealing room with an EBS terminal instantly knows the current dollar price of the euro and yen, certainly for trades of the size typically dealt through EBS" (35) (A. Chaboud, S. Weinberg, 2003). This means that the decrease in volume implied by the CTT won't alter the price discovery process, because this one has already changed by itself through the implementation of technical progress.

As a consequence, trading is moving from a bilateral over-the-counter (OTC) relationship towards a market place with more centralized price discovery and transparency (BIS, CGFS, 2001, p 1). So far, these trends have only affected the interdealer market (banks and brokers) and not much the dealer-to-customer market.

But this could change. Electronic trading makes it technically feasible for the market structure to move to a centralized order book where final customers can transact directly with each other. Trading platforms (36) have appeared on the dealer-to-customer market. Banks are resisting this trend because they have a vested interest in the current segmented market but the balance of power seems to be shifting in favour of final customers. We

<footnote n="35">³⁵) Electronic Broking Service (EBS) is an electronic broker formed by a large group of dealing banks in 1993. It covers mostly trades in the dollar, euro, yen and Swiss franc. The other electronic broker, Reuters, covers mostly transactions involving sterling.</footnote>

<footnote n="36">³⁶) A trading platform is an infrastructure or mechanism aimed at facilitating securities or foreign exchanges transactions between those who wish to buy and sell. A trading platform could be a legal entity recognized as an exchange or an integrated part of a stock exchange.</footnote>