Post-Robin Hood tax: liquidity is about quality not quantity?

Today, UK Prime Minister David Cameron is meeting German Chancellor Angela Merkel to iron out a deal on strengthening the economic union in the Eurozone, while also safeguarding the UK from sweeping European Union (EU) legislation.

One of the sticking points is the controversial financial transaction tax (FTT).

In an interview with the German broadsheet, Die Welt, German Finance Minister Wolfgang Schaeuble said that the financial transaction tax could be an appropriate instrument to calm financial markets.

The financial transaction tax (FTT) - dubbed the Robin Hood tax – is meant to take about 0.05% on securities transactions, such as stocks, bonds, foreign exchange and has been estimated to generate £250 billion a year globally.

However, there has been mixed reaction to the tax as higher costs mean less liquidity, which of course means less lending, funding and in turn, growth. Countries with large financial sectors, such as the UK, would be the worst hit. 

Already we hear from the Institute of International Finance about how the widespread financial market reforms across the globe will pull back growth due to the high level of costs it would take to implement these changes.

And surely the FTT will be the straw that broke the camel’s back?

While everyone has been focusing on the cost impacting liquidity and therefore growth, could the FTT, in fact help markets in the long run through slow growing yet more stable marketplaces, by paring down liquidity?

It's just a thought.

Interestingly, an old academic paper by Professors Lorin Hitt and Bin Gu at The Wharton School at the University of Pennslyvania, fell on my desk today, to remind me of the correlation between transaction costs and market efficiency and the quality not quantity of liquidity can in fact promote more stable markets and social welfare. 

The crux of the piece says: 

"Previous research suggests that a decline in transactions costs leads to improved economic efficiency. In this paper, we show that such a decline will introduce increasingly uninformed consumers into established markets.

Using a model of financial market inefficiency, we show that this increase in uninformed individuals can increase market risk (volatility), can decrease efficiency ..."

So yes, the level of liquidity will fall, but the quality of sophisticated investors remain buoyant.

Just a thought.