Archive for the 'Jack Hirshleifer' Category

The Real Problem with High-Frequency Trading

Everybody seems to be talking about Michael Lewis’s new book (Flash Boys), which has been featured on 60 Minutes and reviewed twice by the New York Times. The book is about something called high-frequency trading, which, I will admit, with some, but not too much, embarrassment, I know almost nothing about. Actually, the first time I heard of the existence of high-frequency trading was from a commenter on a post I wrote almost two years ago, about which I will have something more to say in a moment. Michael Lewis’s book is a polemic against high-frequency trading, alleging that it enables high-frequency traders to rig the stock market and exploit ordinary traders. Lewis makes his case by telling the story of a group of hedge-funds that have banded together to create an alternative trading platform IEX, thereby avoiding contact with the high-frequency platforms, which, according to Lewis and the heroes of his tale, is exploiting everyone else on the stock market.

Lots of other people have weighed in on both sides, some defending high-frequency trading against Lewis’s accusations, pointing out that high-frequency trading has added liquidity to the market and reduced bid-ask spreads, so that ordinary investors are made better off, not worse off, as Lewis charges, and others backing him up. Still others argue that any problems with high-frequency trading are caused by regulators, not by high-speed trading as such.

I think all of this misses the point. Lots of investors are indeed benefiting from the reduced bid-ask spreads resulting from low-cost high-frequency trading. Does that mean that high-frequency trading is a good thing? Um, not necessarily.

To see what I’m getting at, let’s go back to the earlier post I just mentioned. I called it “Soak the Rich?” Here’s what I said then, discussing research by Edward Saez suggesting that marginal tax rates could be increased without reducing economic growth, an idea that, to many economists, including moi, seems counterintuitive.

Is there any way of explaining why raising top marginal rates to very high levels would not cause a loss of real income? Here’s an idea. The era of low marginal tax rates in the US has been associated with a huge expansion in the US financial sector. . . . What has been the social payoff to this expansion of finance? I am not so sure. Over a century ago, Thorstein Veblen wrote his book The Theory of the Leisure Class, followed some years later by his essay “The Engineers and the Price System.” He distinguished between engineers who actually make things that people use and financiers who simply make investments on behalf of the leisure class, adding no value to society. This was a vulgar distinction, premised on the unwarranted assumption that finance is unproductive simply because it generates no tangible physical product. On that criterion, Veblen would have ranked pretty low as a contributor to social welfare. Mainstream economists felt pretty comfortable dismissing Veblen because he was presuming that only physical stuff can be valuable.

However in 1971, Jack Hirshleifer, one of my great teachers at UCLA, wrote a classic article “The Private and Social Value of Information and the Reward to Inventive Activity.” The great insight of that article is that the private value of information, say, about what the weather will be tomorrow, is greater than its value to society. The reason is that if I know that it will rain tomorrow, I can go out today and buy lots of cheap umbrellas (suppose I live in Dallas during a drought), and then sell them all tomorrow at a much higher price than I paid for them. The example does not depend on my having a monopoly in umbrellas; I sell every umbrella that I have at the rainy-day market price for umbrellas instead of the sunny-day price. The gain to me from getting that information exceeds the gain to society, because part of my gain comes at the expense of everyone who sold me an umbrella at the sunny-day price but would not have sold to me yesterday had they known that it would rain today.

Our current overblown financial sector is largely built on people hunting, scrounging, doing whatever they possibly can, to obtain any scrap of useful information — useful, that is for anticipating a price movement that can be traded on. But the net value to society from all the resources expended on that feverish, obsessive, compulsive, all-consuming search for information is close to zero (not exactly zero, but close to zero), because the gains from obtaining slightly better information are mainly obtained at some other trader’s expense. There is a net gain to society from faster adjustment of prices to their equilibrium levels, and there is a gain from the increased market liquidity resulting from increased trading generated by the acquisition of new information. But those gains are second-order compared to gains that merely reflect someone else’s losses. That’s why there is clearly overinvestment — perhaps massive overinvestment — in the mad quest for information.

So I am inclined to conjecture that over the last 30 years, reductions in top marginal tax rates may have provided a huge incentive to expand the financial services industry. The increasing importance of finance also seems to have been a significant factor in the increasing inequality in income distribution observed over the same period. But the net gain to society from an expanding financial sector has been minimal, resources devoted to finance being resources denied to activities that produce positive net returns to society. So if my conjecture is right — and I am not at all confident that it is, but if it is – then raising marginal tax rates could actually increase economic growth by inducing the financial sector and its evil twin the gaming sector — to release resources now being employed without generating any net social benefit.

And here is one of the comments I received to my post.

An example in your favor: the construction of a more direct fiber cable from NYC to Chicago in order to save 20-30 microseconds for HFTs for around $300mm and talk of a similar venture from London (Europe) to Tokyo for five times that amount. I am sure there are sound business reasons for the construction and use of such networks but on a society level a definition of insanity?

So there you have it, high-frequency trading is a new way for traders to exploit — before their competitors can — any slight and fleeting information advantage that they have expended so much effort and so many resources to acquire. In other words, with the opportunity to engage in high-frequency trading, the incentive to search for, and uncover, slight and fleeting information advantages is growing ever larger, and the waste of valuable resources in the quest for such advantages is increasing parri passu.

Felix Salmon nails this point in his review of Flash Boys, observing that Michael Lewis writes his book as a tale of good guys versus bad guys. It’s true the interests of his protagonists and antagonists are diametrically opposed. But his notion, that one side is somehow better than the other, is simply asserted without proof or evidence.

You never know which side Lewis is going to pick in his books. In The Big Short, for instance, he sided with, of all people, the hedge funds who helped destroy the world by making multibillion-dollar bets against the U.S. economy in the highly complex world of mortgage-bond derivatives. And now, in Flash Boys, he sides with a small group of stock traders, funded by some of New York’s most notorious hedge fund billionaires, who have created their own private stock exchange, IEX. Truth be told, the IEX guys are a lot more sympathetic than the guys shorting mortgages. But by creating an oppositional narrative of what he explicitly describes as “good guys and bad guys,” Lewis runs the risk of turning a highly complex issue into an unhelpfully simplistic morality tale.

What Lewis has done is to find a group of traders who find that their attempts to trade on their information advantages are being stymied by the trading strategies devised by high-frequency traders. Lewis’s guys are certainly aggrieved. But just because they have a grievance does not make them any more admirable than the high-frequency traders. Vladimir Putin has lots of grievances, too, but those grievances don’t justify his actions or his arguments. Both sides are engaged in an essentially zero-sum battle for trivial informational advantage that they can exploit at the expense of informationally disadvantaged professional traders. (All traders are sometimes informationally disadvantaged. Their goal is to be informationally advantaged often enough to turn a profit.) Lewis, channeling the story of his IEX heroes, attempts to paint “average investors” as the victims. but Salmon effectively punctures that self-serving pretense.

“[Lewis] interviews a righteous avenger by the name of John Schwall, an IEX employee with justice on his mind:

“As soon as you realize that you are not able to execute your orders because someone else is able to identify what you are trying to do and race ahead of you to the other exchanges, it’s over,” he said. “It changes your mind.” He stewed on the situation; the longer he stewed, the angrier he became. “It really just pissed me off,” he said. “That people set out in this way to make money from everyone else’s retirement account. I knew who was being screwed, people like my mom and pop, and I became hell-bent on figuring out who was doing the screwing.”

Schwall tells Lewis that HFT is “ripping off the retirement savings of the entire country through systematic fraud,” and Lewis just allows the quote to sit there, damningly, even if he would never come out and put it that way himself. After all, the fact of the matter is that of all the various actors screwing your mom and pop out of the money in their retirement account, high-frequency traders are at the very bottom of the list. If, that is, they’re on the list at all.

If your mom has a brokerage account, or a mutual fund manager, or generally entrusts her retirement savings to any kind of intermediary, then the fees charged by her broker or fund manager will dwarf any profits being skimmed from her by HFT. And if your pop invests in the market himself—if he’s among those people with a TD Ameritrade or E-Trade or Schwab account, the “easy kill” for the high-frequency algorithms, then, in reality, he is the one big winner of the high-frequency game.

Of course, the stock market is a game with winners and losers: Every time one person is buying, another person is selling. If you sell before a stock goes up, you’re a loser, but if you sell before it goes down, you’re a winner. And if you’re making your own decisions of what to buy and sell, and at exactly what price, then there is no room to blame anybody but yourself if you make bad decisions. The trading fees and the stock prices, for individual investors, are all completely transparent.

If you’re a big investor, that’s not the case. Brad Katsuyama, when he was at Royal Bank of Canada, would see thousands of shares available for sale at a certain price—but when he tried to buy them, they would suddenly disappear, and he would be forced to pay more. That was the high-frequency traders, front-running his order.

Retail investors don’t run into this problem. If they see a stock available for $50.00, they can buy it at $50.00—not $50.01 or anything higher. They get exactly what they want, at exactly the price they want, which is also the best price in the market, and they get it immediately, in a way that makes big investors rather jealous. . . .

If your mom or your pop buys or sells a stock, that order will almost certainly never make its way to any stock exchange: It will be filled by a high-frequency trading shop that is happy to pay good money for the privilege of doing so. The high-frequency traders do make money from the retail investors—but mainly they do so the old-fashioned way, just by being on the right side of the trade.

If an HFT shop simply fills every single retail order at the best price in the market, then over the course of a day, and certainly over the course of a year, it will make a decent profit. Retail investors, in aggregate, are dumb money: If you take the opposite side of their trades, you’re going to do just fine. Especially when you also buy stock off them for a penny or two less than you will sell the same stock to them. That’s called NBBO—the national best bid/offer—and it simply reflects the fact that there’s always a small gap between the highest price that someone is willing to buy, and the lowest price that someone is willing to sell.

That’s why HFTs love to give retail investors what they want: It turns out that retail investors are very good at making very bad decisions all on their own. What’s more, if you’re an HFT seeing what retail is doing at any given moment, you can use that information to inform your stock-market trades elsewhere. So mom and pop end up making you a lot of money, without your ripping them off in the slightest.

So what we have here is a war between professional traders, the practitioners of l’haute finance. The rest of us are merely bystanders in their battle, with no particular reason to consider one side or the other as representing justice, fairness, or the common good. On the contrary, their perpetual battle for new and better mechanisms for gaining temporary informational advantage make the rest of us worse off, possibly because they are causing greater volatility in them market, though that is a suggestion made by Salmon for which there is no conclusive evidence, but by diverting productive resources into socially unproductive zero-sum activities, using valuable physical and human capital to produce temporary informational advantages with little, if any, net social value, being merely the instrumentality by which to extract wealth from others who are informationally disadvantaged.

I am not a fan of Thorstein Veblens; his celebration of engineering over finance at least partly reflected a crude misunderstanding of the operation of the price system and a failure to grasp the difference between engineering efficiency and economic efficiency. But lurking in his diatribes, there may have been some inkling that much of what financiers do is a waste of real resources in a battle over the surplus generated by the real economy. It is depressing to reflect on the fact that when more than a century ago Veblen was complaining that financiers, though less productive, were more highly remunerated than engineers, the engineers were still out there designing bridges, and railroads, and other wonders of late nineteenth and early twentieth century technology, while, now in the twenty-first century, the engineers are actually employed by the financiers to design complex high-frequency trading systems, connecting New York and Chicago with fiber-optic cable to speed up trading by fractions of a second, and designing complicated software to implement trading strategies designed to exploit socially useless informational advantages. Does that sound like progress?

Falling Real Interest Rates, Winner-Take-All Markets, and Lance Armstrong

In my previous post, I suggested that real interest rates are largely determined by expectations, entrepreneurial expectations of profit and household expectations of future income. Increased entrepreneurial optimism implies that entrepreneurs are revising upwards the anticipated net cash flows from the current stock of capital assets, in other words an increasing demand for capital assets. Because the stock of capital assets doesn’t change much in the short run, an increased demand for those assets tends, in the short run, to raise real interest rates as people switch from fixed income assets (bonds) into the real assets associated with increased expected net cash flows. Increased optimism by households about their future income prospects implies that their demand for long-lived assets, real or financial, tends to decline as household devote an increased share of current income to present consumption and less to saving for future consumption, because an increase in future income reduces the amount of current savings needed to achieve a given level of future consumption. The more optimistic I am about my future income, the less I will save in the present. If I win the lottery, I will start spending even before I collect my winnings. The reduced household demand for long-lived assets with which to provide for future consumption reduces the value of such assets, implying, for given expectations of their future yields, an increased real interest rate.

This is the appropriate neoclassical (Fisherian) framework within which to think about the determination of real interest rates. The Fisherian theory may not be right, but I don’t think that we have another theory of comparable analytical power and elegance. Other theories are just ad hoc, and lack the aesthetic appeal of the Fisherian theory. Alas, the world is a messy place, and we have no guarantee that the elegant theory will always win out. Truth and beauty need not the same. (Sigh!)

Commenting on my previous post, Joshua Wojnilower characterized my explanation as “a combination of a Keynesian-demand side story in the first paragraph and an Austrian/Lachmann subjective expectations view in the second section.” I agree that Keynes emphasized the importance of changes in the state of entrepreneurial expectations in causing shifts in the marginal efficiency of capital, and that Austrian theory is notable for its single-minded emphasis on the subjectivity of expectations. But these ideas are encompassed by the Fisherian neoclassical paradigm, entrepreneurial expectations about profits determining the relevant slope of the production possibility curve embodying opportunities for the current and future production of consumption goods on the one hand, and household expectations about future income determining the slope of household indifference curves reflecting their willingness to exchange current for future consumption. So it’s all in Fisher.

Thus, as I observed, falling real interest rates could be explained, under the Fisherian theory, by deteriorating entrepreneurial expectations, or by worsening household expectations about future income (employment). In my previous post, I suggested that, at least since the 2007-09 downturn, entrepreneurial profit expectations have been declining along with the income (employment) expectations of households. However, I am reluctant to suggest that this trend of expectational pessimism started before the 2007-09 downturn. One commenter, Diego Espinosa, offered some good reasons to think that since 2009 entrepreneurial expectations have been improving, so that falling real interest rates must be attributed to monetary policy. Although I find it implausible that entrepreneurial expectations have recovered (at least fully) since the 2007-09 downturn, I take Diego’s points seriously, and I am going to try to think through his arguments carefully, and perhaps respond further in a future post.

I also suggested in my previous post that there might be other reasons why real interest rates have been falling, which brings me to the point of this post. By way of disclaimer, I would say that what follows is purely speculative, and I raise it only because the idea seems interesting and worth thinking about, not because I am convinced that it is empirically significant in causing real interest rates to decline over the past two or three decades.

Almost ten months ago, I discussed the basic idea in a post in which I speculated about why there is no evidence of a strong correlation between reductions in marginal income tax rates and economic growth, notwithstanding the seemingly powerful theoretical argument for such a correlation. Relying on Jack Hirshleifer’s important distinction between the social and private value of information, I argued that insofar as reduced marginal tax rates contributed to an expansion of the financial sector of the economy, reduced marginal tax rates may have retarded, rather than spurred, growth.  The problem with the financial sector is that the resources employed in that sector, especially resources devoted to trading, are socially wasted, the profits accruing to trading reflecting not net additions to output, but losses incurred by other traders. In their quest for such gains, trading establishments incur huge expenses with a view to obtaining information advantages by which profits can be extracted as a result of trading with the informationally disadvantaged.

But financial trading is not the only socially wasteful activity that attracted vast amounts of resources from other (socially productive) activities, i.e., making and delivering real goods and services valued by consumers. There’s a whole set of markets that fall under the heading of winner-take-all markets. There are some who attribute increasing income inequality to the recent proliferation of winner-take-all markets. What distinguishes these markets is that, as the name implies, rewards in these markets are very much skewed to the most successful participants. Participants compete for a reward, and rewards are distributed very unevenly, small differences in performance implying very large differences in reward. Because the payoff at the margin to an incremental improvement in performance is so large, the incentives to devote resources to improve performance are inefficiently exaggerated. Because of the gap between the large private return and the near-zero social return from improved performance, far too much effort and resources is wasted on achieving minor gains in performance. Lance Armstrong is but one of the unpleasant outcomes of a winner-take-all market.

It is also worth noting that competition in winner-take-all markets is far from benign. Sports leagues, which are classic examples of winner-take-all markets, operate on the premise that competition must be controlled, not just to prevent match-ups from being too lopsided, but to keep unrestricted competition from driving up costs to uneconomic levels. At one time, major league baseball had a reserve clause. The reserve clause exists no longer, but salary caps and other methods of controlling competition were needed to replace it. The main, albeit covert, function of the NCAA is to suppress competition for college athletes that would render college football and college basketball unprofitable if it were uncontrolled, with player salaries determined by supply and demand.

So if the share of economic activity taking place in winner-take-all markets has increased, the waste of resources associated with such markets has likely been increasing as well. Because of the distortion in the pricing of resources employed in winner-take-all markets, those resources typically receiving more than their net social product, employers in non-winner-take-all markets must pay an inefficient premium to employ those overpaid resources. These considerations suggest that the return on investment in non-winner-take-all markets may also be depressed because of such pricing distortions. But I am not sure that this static distortion has a straightforward implication about the trend of real interest rates over time.

A more straightforward connection between falling real interest rates and the increase in share of resources employed in winner-take-all markets might be that winner-take-all markets (e.g., most of the financial sector) are somehow diverting those most likely to innovate and generate new productive ideas into socially wasteful activities. That hypothesis certainly seems to accord with the oft-heard observation that, until recently at any rate, a disproportionate share of the best and brightest graduates of elite institutions of higher learning have been finding employment on Wall Street and in hedge funds. If so, the rate of technological advance in the productive sector of the economy would have been less rapid than the rate of advance in the unproductive sector of the economy. Somehow that doesn’t seem like a recipe for increasing the rate of economic growth and might even account for declining real interest rates. Something to think about as you watch the Lance Armstrong interview tomorrow night.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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