November 7, 2009

Why Gordon Brown's Notion of Taxing Speculation is a Very Bad Idea

Nov. 7 (Bloomberg) -- U.K. Prime Minister Gordon Brown said the Group of 20 nations should consider measures such as taxing financial transactions to penalize excessive risk taking and limit the burden on taxpayers of bank failures.

“It cannot be acceptable that the benefits of success in this sector are reaped by the few but the costs of its failure are borne by all of us,” Brown told G-20 finance ministers and central bankers at a meeting today in St. Andrews, Scotland. Tighter capital rules and pooled bank resolution funds could also be considered, he said.

The idea of putting a tax on speculation is not new. However, it is arbitrary.

Speculation is guided by two notions - intent and perception.

Ones own perception of the risk of any investment guides our beliefs as to what degree we our speculating, when we risk capital. Those who observe (or participate through loan) to our allocation of capital assign their own degree of speculation, based upon external information and their own internal risk preferences.

If we could all agree on risk in the first place prices would only move when new material information became available. The continuous nature of Capital market asset pricing has proven that this is certainly not the case. Risk is perceptual and not static.

The financial leverage afforded a borrower and the cost of capital lent is guided by the lenders perception of the "riskiness" (substitute level of speculation) of the enterprise to which lent capital is being deployed.

And here is were Gordon Brown misses the point - Capital Markets already taxes speculation through lending rates and loan terms and conditions.

Either Gordon Brown does not understand this, or he is attempting to repair his governments own speculative balance sheet with popularist rhetoric.

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