Finance Open Post…the $64 Trillion Dollar Question Edition
Robert Solow poses the following:
All of which leads to a broader issue that Chairman Bernanke could not possibly mention in these lectures or elsewhere, but that I wish Professor Bernanke would think about whenever he leaves office. Any complicated economy needs a complicated financial system: to allocate dispersed capital to dispersed productive uses, to provide liquidity, to do maturity and risk transformation, and to produce market evaluations of uncertain prospects. If these functions are not performed adequately, the economy cannot produce and grow with anything like efficiency. Granted all that, however, the suspicion persists that financialization has gone too far.
What would that mean? It would mean that the last x percent of financial activity absorbs more resources (especially intellectual resources) and creates more potential instability than its additional efficiency-benefits can justify. This charmingly subversive suggestion is easy to make, but it is extremely difficult to validate. Yes, it is hard to imagine that the Hedge Fund Operator of the Year does anything that is remotely socially useful enough to justify the enormous (and lightly taxed) compensation that results; but that is not really an argument. Much more significant is the fact that the bulk of incremental financial activity is trading, and trading, while it may provide a little useful public information about market opinion, is largely a way to transfer wealth from those with inferior information and calculation ability to those with more. There is no enhancement of economic efficiency to speak of. This is, you might say, the $64 trillion question. Maybe I shouldn’t wish it on Ben Bernanke.
I have plenty of thoughts on this, but let’s hear what everyone else has to say.
Solow’s passage makes a lot of sense to me. In fact its the nugget of long standing liberal complaints about the financial sector. Finance seems self-justifying now. It is good because people do it, therefore it is Good. All that moving money around in millisecond trading must be Good because it is done and people make money off of it. Whether it benefits anybody but the people who do AND also that is affects everybody else through manipulating the world economy in myriad forms seems irrelevant. Transparency is a joke and there is massive information asymmetry. And that is the way the financial sector likes it.Report
+1 on this.
Even the credit Professor Solow gives to Trading – that ” it may provide a little useful public information about market opinion” – is overstated IMO when instant automated transactions are so prevalent.
The financial sector likes that way things work now and they have the coffers to ensure it stays that way.Report
I guess the implication is maybe the economy would come crashing down if finance were reined in a bit. As many have suggested, we could find out by placing a tiny tax on each transaction and see if anything bad happens. This would eliminate high-frequency trading and related ‘innovations’. I’m pretty sure we’d be OK despite the ominous tone in the quoted piece.Report
I would wholly support a tax on financial transactions.Report
Yay Tobin Tax! I think it’s a great idea.Report
The trouble with the Tobin Tax is that liquidity makes financial markets work better, so lowering turnover is a bad way to rein them in.
Plus it’s been proven in experiments that they can’t prevent bubbles, although basically nothing can, so how much of a downside that is depend somewhat you’re trying to accomplish.Report
The “liquidity makes financial markets work” trope is frequently repeated but poorly supported. The degree of liquidity in a market is itself an important signal and is obscured through artificial liquidity increasing means such as HFT.
Eliminating HFT has nothing to do with bubbles. The purpose is to reduce crises caused by artificial volatility such as the flash crash.Report
Trading, while it may provide a little useful public information about market opinion, is largely a way to transfer wealth from those with inferior information and calculation ability to those with more.
Or a way for a collection of actors to make a living off of transaction costs.Report
“Now tell him the *good* part, Randolph.”
“Ah-heh, the good part, William, is that no matter whether our clients make money or lose money, Duke and Duke get their commission.”
“So it seems to me that y’all just a couplea bookies.”
“See, Mortimer? I told you he’d understand!”Report
+1 ClassicReport
I have plenty of thoughts on this, but let’s hear what everyone else has to say.
You first. You’re a lot smarter than me!
I’d say that two things leap out at me in flashing lights from the quoted passage:
… This charmingly subversive suggestion is easy to make, but it is extremely difficult to validate.
and
Much more significant is the fact that the bulk of incremental financial activity … is largely a way to transfer wealth from those with inferior information and calculation ability to those with more. There is no enhancement of economic efficiency to speak of.
I think both those are true.Report
Some closure issues there. Sorry bout that.Report
Thanks!Report
Stillwater,
I think you have too much confidence in my brain, but I will answer as best I can.
I think Professor Solow’s description of financial markets and how they need to relate to our economy (or the global economy) is correct. That said, although I see his point, I am ambivalent about his description of over-financialization.
On one hand, I understand where he is going. I don’t agree with the use of his hedge fund manager, but if I’m going to go down the road of “social usefulness”, I will use one example that was a major contributor to the crisis in 2008: liar loans.
While some may suggest that they had social value by allowing people that would have otherwise not been able to get homes to get them, I would argue otherwise. Not only does the very structure of a liar loan (bad-credit no-credit so what?, negative amortization, steep unaffordable payment increase and the exit via refinancing), but the demand driver was Wall Street and the secondary markets (let’s ignore the fact that the investors in this kind of paper had no idea what they were getting until it was too late). They were useful in their ability to prolong the housing bubble. That’s pretty much it.
There’s another kind of risk that he doesn’t seem to address in his over-financialization definition: the kind that is caused by people dealing with financial instruments that have very legitimate uses (i.e. interest rate swaps and credit default swaps) in such a way that if the markets go the wrong way, the consequences can be systemic in nature (as they were with Long Term Capital Management’s near failure in 1998 and AIG’s failure in 2008).
is largely a way to transfer wealth from those with inferior information and calculation ability to those with more.
This is true. In some ways, this is the way markets operate, but in other ways, especially when the information could materially impact one’s desire to transact or transact at a given value, this is where I have a problem. You can’t completely rid the markets of information asymmetry but you can try to bridge some forms of information asymmetry through disclosure laws. People in the markets don’t police themselves.
Inferior information can also systemic consequences, as it did when hundreds of billions of dollars worth of toxic mortgage-backed securities were bought by investors that had no grasp of the underlying risk.
My apologies for the delay. I have to cut it a bit short here. I hope this helps as a starting point.Report
The only objection with a transaction tax is practical – how do you implement it rigorously and sufficiently globally to avoid everyone just going off shore or off the books? (there’s the same problem with climate change taxes)Report
Do people have the practical option of going offshore? A lot of the action takes place at the big stock exchanges (New York, etc.) – as long as those ones are covered, it will be more trouble for companies to try to build up entirely new global financial centres than it will be for them to have moderately higher transaction costs.Report
The most immediate thing is to get London and New York on the same page, which is no mean feat. Then Tokyo, Frankfort, Zurich, Toronto and Paris. (roughly in that order, but I could be wrong). Wildcards (in two plus decades from now – but these deals take decades) are Mumbai and Shanghai. (and maybe Sao Paulo). (I’m deliberately avoiding the Middle East here).
With emerging markets, I think the potential (over a generation or two – in one or two of them) to build new global financial centers is not only possible, but likely. Perhaps even inevitable.
“A lot of the action takes place at the big stock exchanges (New York, etc.) ”
That’s the thing, I don’t think that’s the case anymore. The conventional wisdom was that the NYSE sale last year was more about the value of NYSE’s holding company, with NYSE being a nice little boutique that they’re still keeping around because it makes money as a museum.
Most of the issues that we are talking about and caused all the problems are off-exchange, OTC transactions aka ‘shadow banking’.Report
That’s true.
My admittedly limited understanding is that one of the big problems with the really huge, complicated trades by the banks that sunk things is that they were not on any kind of market. Since they weren’t publicly traded, it was hard to value them.
The fact that it was a giant, private club only for gigantic banks was another, I suppose.Report
My admittedly limited understanding is that one of the big problems with the really huge, complicated trades by the banks that sunk things is that they were not on any kind of market
I’ll have to go back and re-read the report that was issued about Goldman’s CDO practices. If I recall, not only were they selling the securities directly to investors but they were also making the mark-t0-market adjustment and asking the buying party to post collateral when they bought them on margin. Conflict? NaaaahhhReport
Maybe Katherine, but there’s a prisoners dilemma there too. If any of the major exchanges either didn’t do it or did it less onerously than the rest then capital would pour into it and out of everywhere else. Capital is, both wonderfully and horribly, highly mobile. Plus there’s the eternal question of enforcement and monitoring; how many cents per trade will it cost us to extract a one cent fee per trade from the system.
That said I favor the idea, hell, if it produced enough money to eliminate the corporate tax rate and help fund the safety net I’d say it’d be a steal.Report
I’ve never quite understood the issue here. Why couldn’t the law simply be written such that the transaction wouldn’t be legal in the US unless the tax was paid?Report
The only objection with a transaction tax is practical – how do you implement it rigorously and sufficiently globally to avoid everyone just going off shore or off the books? (there’s the same problem with climate change taxes)
One thing the US Fedrul Gummint has an unquestioned authority over is foreigners making money from US sources. So I think it’s pretty simple: the tax is paid before the transaction is completed.Report
Kolohe is right; trying to tax/limit/control it only in the US would just move it off shore. Any sort of limitations has to be both relatively global and have some sort of carrot.
And the only carrot I can see out there is the ability short-term trades seem to have to distort markets; to make stocks that are not increasing in value appear hot, and cause dumping of stocks that shouldn’t be dumped. There’s little disclosure in what causes the movement; actual information that something ought be shorted or a computer program with some sort of bug or faulty data driving it.
Even limiting trades to market hours; no overnights while the living brokers sleep.Report
At least one major market is operating throughout the course of the day. What is overnight in New York may not be in London.
I will get to everyone else soon. My half marathon training program beckons 🙂Report
This is true; but as I understand it, stocks not traded on multiple markets; they’re listed with a specific market.Report
A particular security can be traded on any of a number of exchanges, if that’s what you mean; e.g., you might go to BATS or Instinet or NYSE to price a particular stock; then purchase your shares on the exchange that offers the best price.
I don’t see why you’d need a carrot to make this work. If the courts wouldn’t recognize transactions executed without the tax having been paid, I’m quite certain traders would quickly make sure it gets done for their transactions.Report
Interesting. Dual listings had either escaped my attention of been forgotten. We’ve been burned a few times with overnight trades triggering automatic sell orders; I don’t know if the stocks in question were dual listed; but by morning they’d gone done, been sold, and then bounced back, often over the course of just a few seconds. We stopped setting automatic orders because of it.
It rather reminds me of those listings for used books you see on Amazon, where there will be several copies for between $10 and $20 and then a couple for over $200 for no reason other then two computers kept feeding the price up.
That’s the real problem with it; it crowds average investors out of the markets.Report