Almost 40 years ago, James Tobin, one of the greatest economists of all time, proposed that a small tax be imposed on every foreign exchange transaction. He was absolutely right.

Adair Turner, the UK’s chief financial regulator, has called for a tax on all financial transactions. Gordon Brown, the British Prime Minister, presented this expanded version of the Tobin tax at the recent G20 meeting. Paul Krugman and others are pushing this idea as well.

Tobin, like most economists, favored freely floating exchange rates. But unlike most economists, he knew that currency markets did not follow the simple behavior of the competitive market paradigm which underlies most economic theories. To some degree, financial markets are competitive, reacting very quickly to new information.

However, there are two critical differences. There are some players who have a competitive advantage because of their positions at the nexus of information. Second, these markets behave as the logic of competitive markets suggests, but not like the math of these models.

Despite the claim by the Goldman Sachs CEO that his company does “God’s work”, the Goldman Sachs’s of the world make most of their profits from proprietary trading. Why is this so profitable? Because they are at the epi-center of the continuous flows of important information about markets – demand, supply, trends, rumors, etc.  Together with powerful computers and sophisticated trading algorithms, they are able to capitalize on their superior information. With trading costs largely irrelevant (the legacy of deregulation), even very small profits per trade multiplied by millions of trades produce enormous profits and bonuses.

What does the hyper-trading do, other than enrich a handful of lucky individuals? It makes financial markets extremely volatile. The volatility – momentum trading reinforced by speculation and the herd mentality – moves prices well above their equilibrium levels based on their respective market fundamentals, and when the momentum fades and bubbles burst, prices move well below their equilibria.

Volatility increases uncertainty for companies and individuals who rely on price signals, and dramatically increases the costs of hedging. Sharp movements in prices – the oil price surge between mid-year 2007 and mid-year 2008, driven largely by speculators – also wreak havoc on the real economy. The bubble in oil prices was a contributing factor to the recession.

Tobin knew that currency markets were inherently unstable. He wanted to reduce the speculative and momentum trading which generated substantial real economic costs. If he had lived to see what has been happening in all financial asset markets, he would have been at the forefront in proposing that his tax be applied to all financial transactions.

The opponents to the tax claim it is unworkable. There always will be flaws, but concerted actions among some or all of the leading financial centers to impose this tax and supporting regulations could go a long way towards slowing the turbulence and excessive speculation in financial markets.

As for the opponents’ claim that active trading actually produces some positive effects, their arguments are self-serving and wrong! Krugman is right when he says: “after the debacle of the past two years, there’s broad agreement with Mr. Turner’s assertion that a lot of what Wall Street and the City do is “socially useless””.

Off with the speculators’ heads, and on with the Tobin tax!