Who was James Tobin?
James Tobin was a New Keynesian economist who received the Nobel Prize in economics in 1981 for his research on the relationships between financial markets and macroeconomics. Tobin has served on the Board of Governors of the Federal Reserve and the Council of Economic Advisers, and has taught at Yale and Harvard. Outside the academic world, his best-known idea is the “Tobin tax”, a tax on foreign exchange transactions to reduce currency speculation, which Tobin considered unnecessary and counterproductive for economic growth.
Key points to remember
- James Tobin was a New Keynesian economist who studied the relationships between the financial market and macroeconomics.
- Tobin was best known for his development of the theory of portfolio selection and his proposal to tax foreign exchange transactions.
- Tobin received the Nobel Prize in economics in 1981.
Understanding James Tobin
James Tobin was born March 5, 1918 in Champaign, Illinois. He was an early student who passed the Harvard entrance exam mostly on a whim, because his father suggested he take it and he made no attempt to prepare for it. He attended school on a national scholarship and developed a strong interest in Keynesian economic ideas. He graduated summa cum laude in 1939 and pursued higher education, also at Harvard. He received his master’s degree in 1940 before leaving to work for the Office of Price Administration and Civilian Supply and the War Production Board in Washington, D.C. He joined the United States Navy after the attack on Pearl Harbor.
After the war, he returned to Harvard to obtain his doctorate in economics, which he completed in 1947. That year, he was elected Junior Fellow of the Harvard Society of Fellows. After doing research abroad for three years, he went to Yale in 1950. In 1957, he was appointed professor of economics at Yale. In addition to teaching and research, Tobin also acted as a consultant and contributor to several magazines and newspapers, commenting on current events and their economic implications. He was appointed to the Council of Economic Advisers to President Kennedy, and continued to play his consultative role during the presidency of Lyndon Johnson. Rejected by Johnson’s successor Richard Nixon, Tobin became president of the American Economic Association in 1971.
After winning the Nobel Prize in economics in 1981, Tobin retired from teaching in 1983. He continued to write until his death on March 11, 2002. It was not until 2009, when Adair Turner suggested a “Tobin tax” to remove an ever-growing speculation market, which Turner called “inflated to the point where it is too big for society”, that Tobin’s work would make the headlines international newspapers.
As a New Keynesian, Tobin has spent much of his career helping to develop the microeconomic foundations of Keynesian macroeconomic theories and models, with a particular interest in financial markets and their macroeconomic implications.
Portfolio selection theory
James Tobin won the Nobel Prize in economics in 1981 for his development of the theory of portfolio selection. The theory of portfolio selection describes how changes in the financial markets influence the investment decisions of households and businesses on different asset classes. Theoretically, households and businesses will choose from a variety of real and financial assets to hold (or debts to contract) in their portfolios based on risk-weighted and expected rates of return. Tobin stressed that portfolio selection is the transmission mechanism through which government monetary and fiscal policy can influence macroeconomic aggregates, such as consumption, investment spending, employment and inflation.
In the wake of the collapse of the Bretton Woods accord and the development of various indexed and floating exchange rates around the world, Tobin proposed that a small transaction tax on foreign exchange transactions to discourage speculation under the form of frequent, large, short-term currency transactions. Given the size of large international financial institutions relative to the size of many developing economies, large speculative currency fluctuations can have significant macroeconomic consequences for small economies. A Tobin tax aims to cushion the effect of such speculation on these savings. Later, economists and financiers would propose similar taxes on other types of financial asset transactions, particularly in the aftermath of the global financial crisis and the Great Recession.
Based on a previous idea from economist Nicholas Kaldor, Tobin’s Q is the ratio between the market value of an asset and its book value (or replacement cost). In financial terms, a Q value greater than one indicates an overvalued asset; less than one indicates an undervalued asset, which may represent an opportunity. In macroeconomics, Tobin’s Q must be understood as one of the determinants of business investment spending; a company with a Q greater than one should reinvest its profits in capital expenditure, thereby reducing Q to one. For the stock market as a whole, Tobin’s Q has sometimes been referred to as a leading indicator, which can decline sharply just before and during recessions. It has been widely used in business, economic and legal research to explain how various regulatory and corporate governance agreements affect the value of the business.
Tobit modeling is an econometric technique for estimating the influence that a set of independent variables can have on a dependent variable whose possible values are limited, or “censored”, above or below a given threshold (usually zero). For example, a Tobit model may be appropriate when modeling the demand for a consumer good or the hours worked by a group of workers, where negative numbers are not really possible.