What is good for Wall Street is not necessarily good for our country or the world. That is obvious to many people after the events since 2007, but it doesn’t keep Wall Streeters from making self-serving arguments about how society as a whole will suffer if we alter the current structure of the financial sector or practices within it. Don’t be suckered!
Take “high-frequency trading.” This is computer-driven trading of large quantities of stocks in attempts to make money from small, fleeting discrepancies in price. The possible profit per share is low, but the numbers of shares extremely high and the period the stock is held before resale very short. So the opportunities for return on capital available are high.
However, many hedge funds and investment banks compete in this game. So opportunities must be recognized and trading orders entered in fractions of a second. The player with the most powerful computer and best computer model for recognizing opportunities wins. But the nation doesn’t necessarily also benefit.
To understand why, start with an example from a physical commodity like soybeans instead of stocks or derivatives.
If the price of soybeans is 35 cents per bushel lower in Worthington than in Mankato and it costs only 30 cents to haul a bushel that distance, there is an opportunity for someone to buy low in Worthington, sell marginally higher in Mankato and pocket a nickel per bushel. This is an “arbitrage opportunity.” (However, it would net less than $100 per truckload. Moreover, in real life, it would never happen, since elevator operators are smart enough never to let such an opportunity for others to profit arise.)
To the extent that prices in competitive markets reflect true values to society, the price differential indicates that soybeans in Mankato benefit the nation more than those in Worthington. Moving some would improve economic efficiency, even if only to a tiny extent.
The function of prices in a market economy thus is to transmit information about the costs and benefits to society of some product or service. Changes in prices tell consumers and producers of the product to change their buying or producing behavior to reflect new fundamental conditions.
If, for example, there was a hard frost across large areas of soybean production in Argentina, it would be economically efficient for U.S. farmers to increase their plantings of beans the next year. Farm suppliers should prepare to sell more soybean seed and less nitrogen fertilizer for corn. Feed companies should mix rations using alternative protein sources. And there are myriad other subtle adjustments that would improve total output from available inputs by taking into account this decrease in production of an important commodity. So new information about fundamental factors in the real economy has value.
But the marginal value of getting that information more quickly tapers off drastically. Yes, it saves resources if such news of an Argentine frost arrives in one day by telegraph rather than in three weeks by ship. But little improves in the real economy if news arrives in 12 hours rather than 24 and even less for one hour rather than 12. The social benefit of knowing in one minute rather than one hour is zero.
But in the financial world of commodities trading there is money to be made by knowing news like this 10 minutes or even one minute before anyone else. An individual trader can benefit even when it makes no difference to the nation as a whole.
Transfer that analogy to stock markets. Yes, capital is used more efficiently when it is put into companies that are more productive, and hence more profitable, and when it is taken away from companies that are less profitable. And yes, efficient capital markets are vital to economic growth. Indeed, they are one reason the Netherlands, England and the United States successively led the world in economic growth over the past 400 years.
However, just as for soybeans, the extra value to society of markets reacting to new information in hours rather than days is very low. And the extra benefit to society as a whole of reacting to arbitrage opportunities in tenths of a second rather than minutes is zero.
Indeed, such speed may harm the economy as a whole even though it can enrich individual trading firms. The May 6, 2010, “flash crash” in which the Dow Jones industrial average dropped nearly 1,000 points in minutes resulted from “a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral,” according to a Securities and Exchange Commission task force that investigated it.
To borrow a term from electronics, high-frequency trading is mostly about “noise” and has little to do with “signal.” And rather than clarifying signals about the real economy, it makes them less intelligible.
Moreover, the added volatility caused by flash trading and episodic panics like the “flash crash” convince increasing numbers of small investors that financial markets are games rigged in favor of the big players. Driving such investors away hurts capital formation.
However, if you propose measures to limit such trading, such as a very small tax on each transaction, or “Tobin tax,” the big financial firms cry bloody murder, arguing that because such measures would hurt them as individual firms, they would necessarily hurt the whole nation by reducing growth output or employment.
In doing so, they are trying to make elected officials and voters fall for a classic “fallacy of composition,” the erroneous belief that what is true for one individual or company is necessarily true for a large group. Don’t believe this self-serving rhetoric. Reducing the noise and uncertainty created by high-frequency trading could benefit the nation as a whole even as it hurt big players in the game right now.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.