At last, European leaders have revealed their top-secret plan for solving the euro’s crisis. And it is—drum roll —a version of the “Tobin tax”, a levy on financial transactions first suggested in 1972 by the Nobel laureate James Tobin.

Now, 40 years later, the European Commission (EC) has proposed—and French President Nicolas Sarkozy and German Chancellor Angela Merkel have endorsed—a turnover tax on all financial transactions, varying from 0.1% on stocks to 0.01% on financial derivatives such as futures and credit default swaps. If the tax can’t be imposed globally or even Europe-wide, France and Germany will go it alone.

Photo: Bloomberg

European leaders claim that they can create mechanisms to ensure that their residents pay the tax, regardless of where trades are booked. But banks are widely reported to be devising new instruments to enable their clients to avoid the tax.

If the aim is to augment revenues, a Tobin tax is the wrong tool. Indeed, Tobin designed it to solve an entirely different problem: excessive volatility in currency markets. By discouraging foreign-exchange transactions, Tobin’s proposal sought to promote exchange rate stability by preventing national currencies from coming under speculative attack.

The irony, of course, is that euro zone members have no national currencies to attack. As members of a monetary union, they enjoy a relatively high degree of exchange rate stability. In current circumstances, with much of Europe lacking competitiveness, a weaker exchange rate is precisely what the continent needs.

European leaders sometimes extend Tobin’s logic from the currency market to financial markets generally. An across-the-board tax on transactions, they argue, would dampen financial volatility.  What we know is that a tax on transactions would result in fewer transactions. Some investors would exit the market. But which ones—the opportunist speculators, who sell when everyone else is selling, or the contrarian speculators, who do the opposite and stabilize volatile markets?

May be a Tobin tax is intended to shrink Europe’s bloated financial sector. In that case, it is, once again, misdirected. Europe’s problem is its banks, which are too big to fail—and also too big to save. A Tobin tax would do nothing to shrink them. On the contrary, by discouraging trading in securities, it would encourage investors to shift their funds into bank accounts and certificates of deposit.

Forgive my naiveté, but I have begun to think that politics rather than economics explains European leaders’ enthusiasm for a Tobin tax. Sarkozy can preempt a long-standing proposal of the Socialists in the run-up to this spring’s presidential election. By supporting Sarkozy, Merkel can get in return what she really wants: French support for stronger fiscal rules. And EU leaders can claim that the financial sector is being made to contribute to the costs of Europe’s financial clean-up.

Though no one can say for sure what Tobin would have thought of Europe’s crisis, his priority was always the pursuit of full employment. One suspects that he would have urged European policymakers to dispense with their silly fixation on a financial transactions tax and instead repair their broken banking systems and use all monetary and fiscal means at their disposal to jump-start growth.

Barry Eichengreen is professor of economics and political science at the University of California, Berkeley.

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