Mr Q – James Tobin

by | Apr 1, 2015

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Born 1918 in Champaign, Illinois  Died 2002 in New Haven, Connecticut

“Throw sand in the wheels”

Immortality Comes Twice

It’s not very common for an essentially theoretical economist from a university to make such an impact that he lends his name forever to not one but two great theories. If his famous and eminently practical “Tobin’s Q” ratio hadn’t already secured his place in history, the much later proposal of a “Tobin tax” to “throw sand in the wheels” of the financial system would have done it for him.

Tobin’s 1981 Nobel Prize for economics was “for his analysis of financial markets and their relations to expenditure decisions, employment, production, and prices.” Which sounds thoroughly Keynesian, so no surprises that that was how he described himself.

Having entered Harvard in 1935, a year before Keynes’s General Theory of Employment, Interest and Money was published, Tobin lost no time in engaging with its exploration of the interaction of money, motivation and non-mathematical influences. And it was Keynesian research that took him through the next 15 years at Harvard (excluding a period in the armed forces), then another 38 years at Yale, where he became Sterling Professor. With a brief leave of absence in 1961/62 to serve on President John F. Kennedy’s Council of Economic Advisers.

The Q Ratio

Predictably, Tobin rejected the idea that merely knowing the basic numbers about the interest rate or the rate of growth could enable one to predict the effect that monetary policy might have on economic output – or, for that matter, on unemployment. Instead, he argued, we should expand our parameters to include other factors, notably capital investment. And capital investment in turn could be affected by all sorts of factors, both social and economic.

Faced with the impossibility of identifying all these factors, Tobin went for a top-down hypothesized that said that the combined market value of all listed companies ought to roughly equal their replacement costs. And that by dividing the company’s market value by the replacement value of its assets, we could arrive at a ‘Q’ value which would give us a good clue as to whether it was overvalued or undervalued. A Q value of less than 1 would imply that its stock was undervalued, and anything above 1 suggested it was overvalued. Simple, and yet surprisingly effective in the real world.

The Tobin Tax

But it’s the so-called Tobin Tax, originally proposed in 1972, that’s been getting more attention. Even though the current usage of the term doesn’t relate very much to his original idea. Yes, the Eurozone’s Financial Transactions Tax (voluntarily approved by eleven Euro Club members, and loudly decried by Chancellor George Osborne) is a reworking of an idea in which Tobin had proposed a very tiny tax on all payments from one currency to another – the general idea being to reduce the destabilising effect of vast capital movements between foreign currency exchanges – often to the detriment of emerging economies.

Tobin’s original idea was that the cash raised should be used to help developing countries; today’s Eurozone version, however, sees the funds going back into the European coffers. But the effect is still the same, in that the tiny levy puts a brake on excessive trading and reduces volatility.

What would Tobin have thought of the Eurozone’s adoption of his idea? Not a lot, probably: he was never in favour of letting the fat cats keep the proceeds. Instead, he said, it was about making the financial system return something useful in return for its socially harmful effects.

 

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