Economics focus

A worldly philosopher
Mar 14th 2002
From The Economist print edition


James Tobin, Nobel laureate, died on March 11th, aged 84.
His wealth of economic ideas will outlive recent attempts to
hijack his namesake tax

ANTI-GLOBALISATION mobs
running riot in Seattle,
Genoa and Prague thought
they had found a patron
saint in James Tobin. How
wrong they were.
Undoubtedly, the Yale
professor had conceived his
now-famous Tobin tax, a
small levy on
foreign-currency trades, in
1971 with the aim of
shielding poor countries from the whims of financial markets.
Though flawed in practice, the tax's ultimate goal was clear: to
help bring the benefits of free trade to the world's poor. To his
great dismay, radical groups some time later tried to turn his tax
against his own free-trade ideals.

Unlike those anti-globalisers who romanticise poverty from afar, Mr
Tobin had seen it first-hand. Coming of age in the American
mid-west during the great depression, a period when rich countries
shut their borders to trade, Mr Tobin said he embraced economics
to “better the lot of mankind”. In that spirit, while an
undergraduate at Harvard in 1936, he discovered the work of John
Maynard Keynes.

After a wartime stint on the American destroyer USS Kearny, Mr
Tobin spent his early academic career developing and promoting
Keynes's revolutionary theories. He brought them nearer to the
real world, eventually winning a Nobel prize for his efforts.

Keynes expressed his ideas in a literary style that left a lot to the
imagination. One crucial question which Mr Tobin refined was how
to calculate the demand for holding cash—essential for determining
the overall level of demand in an economy. Keynes's approach had
been to draw a vague distinction between money and some notion
of “capital”. Mr Tobin saw that, in the real world, a whole range of
financial assets could sometimes serve both purposes.

This led him to create a theory of portfolio choice, ie, of the ways
that people and firms allocate their wealth among a variety of
assets, from property to shares and debt. His work, with that of
Harry Markowitz, a fellow laureate, paved the way for nearly all
modern theories of investment and corporate finance, and linked
financial markets to the world of goods and services. People who
now put their retirement savings into a diversified portfolio of
shares are paying silent tribute. “Don't put all your eggs in one
basket,” was his homespun version.

He was of a generation of economists who felt that government
intervention, through monetary or fiscal policy, could smooth out
business cycles, helping to prevent the misery of unemployment.
Yet, despite Mr Tobin's faith in government's benevolent power, he
championed the role of incentives in economic policy. In the
1960s, before the flaws became apparent in America's “great
society” welfare programmes, Mr Tobin knew that government
grants provided a disincentive for seeking work. Along with Milton
Friedman, in one of their rare moments of agreement, Mr Tobin
came out for a negative income tax, a forerunner of many of
today's tax policies.

Perhaps it was Mr Tobin's experiences in the 1930s and 1940s that
made him a foe of the “rational expectations” revolution of the
1970s. This school of thought argued that, given perfectly
competitive markets, people would adapt their behaviour to a tax
cut or to deficit spending, rendering it impotent. Given this, the
best thing government could do was nothing at all. While
acknowledging the logic of the theory, Mr Tobin thought this
“policy irrelevance” proposition silly in practice: simply, people are
not as rational as economists suppose.


Renaissance man

More than two centuries ago, Adam Smith explained the benefits
of the division of labour. It is more efficient for each worker to
focus on one task than for each to perform every task himself.
Economists have taken his message rather too literally to heart
over the past three decades, delving into narrow specialities,
abstract theories and exotic mathematics. The rise of ever more
powerful computers has only whetted their appetite for
complicated models at the expense of formulating and testing
policy.

Mr Tobin remained firmly of the old school. According to a former
colleague, Robert Solow, Mr Tobin “was never interested in a
problem for its own sake”. Remaining true to his interests, the vast
scope of his writing, ranging from sociology to macroeconomics
and banking and finance, puts most contemporary economists to
shame.

Today's environmentalists, for example, are in debt to Mr Tobin.
Working with a colleague at Yale, William Nordhaus, he was among
the first to adjust GDP figures to reflect the true costs of
environmental degradation as well as of traffic congestion and
crime. He also dared to question conventional wisdom on economic
equality, crafting a theory of “specific egalitarianism”: why, for
example, should governments worry so much about equalising
incomes, when in America health care and higher education are
left to the markets?

Mr Tobin was as deft with maths as he was with policy. He
developed a statistical technique for analysing spending
decisions—the Tobit regression, named after a character based on
him in the “The Caine Mutiny”, a novel written by his old Navy
buddy, Herman Wouk. And despite the lack of computing power in
his day, his research stands the test of time; a conference in
England's Cambridge tried to pick holes in his early work with the
fanciest tools, yet Mr Tobin came up trumps.

Tobin's Q, a measure of the relative value of
equities that compares stockmarket values with
the replacement cost of net assets, is probably his
most enduring monument. It now shows that
shares are greatly overvalued. On the question of
whether people are rational, Mr Tobin has made
his case.

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