Sand in the Wheels of International Finance: Revisiting the Debate in Light of the East Asian Mayhem

The turmoil that has characterised the global financial markets since the 1990s, and particularly the crisis in East Asia, has generated a great deal of support for proposals to add some frictions to the wheels of international finance, as part of overall reforms to the global financial architecture. With this in view, this paper explores the economic effects of and rationale for imposing levies on capital flows in general, and a Tobin tax in particular. It is argued that the primary aim of such a levy ought to be to act as a measure to prevent for a crisis from building up (i.e. a domestic boom fuelled by short-term capital inflows), rather than as a means of countering or providing breathing space for necessary adjustments once a crisis erupts (or threatens to do so). The Tobin tax needs to be fairly universal in its coverage, failing which there would be a migration of foreign exchange flows to tax havens. Admittedly, the political will to arrive at an international agreement on such a levy is far from assured. However, to the extent that developing economies are most impacted by the vagaries of the financial markets, each may find it in its best interest to unilaterally examine the efficacy of imposing Chilean-type measures of restraining capital flows, as appropriate and aggressive steps are taken to enhance the soundness and transparency of the banking and financial systems. [Working Paper No. 7]