Normative Narratives


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Economic Outlook: High Speed Trading and the Financial Transaction Tax

Micheal Lewis’s new book, “Flash Boys”, (re)focuses the spotlight on the controversial practice of high-frequency trading (HFT) (original article):

Already, officials at the Federal Bureau of Investigation’s New York office are investigating whether such firms traded ahead of other players in the market, in what may amount to insider trading or other fraud, according to an agency spokesman. Regulators in Washington and in New York State have opened their own inquiries.

The worries are hardly new. Over the past five years or so, high-speed computers have increasingly taken over Wall Street, and trading has migrated from raucous trading floors in Lower Manhattan to far-flung electronic platforms.

Critics argue that Mr. Lewis broke no new ground (link inserted, not part of article). And a number of executives at the firms mentioned in the book said that Mr. Lewis did not double-check the facts.

High-frequency trading is almost impossible to avoid today. By some estimates, it accounts for half of all shares traded in the United States. Supporters argue that it has made the markets more efficient by creating a cadre of traders willing to buy or sell at any time.

Others are more skeptical. The New York attorney general, Eric T. Schneiderman, has put high-frequency trading on his list of top priorities. He seized the moment on Monday to discuss his yearlong investigation into the practice.

“Look, the problem here is — and I’m a fan of the markets, but I think Michael is right,” Mr. Schneiderman told Bloomberg Television. “We’ve lost a lot of credibility. A lot of investors do not have confidence in the markets and it’s up to those of us who believe in them, who enforce the law and regulate them, to restore that confidence.”

Mr. Narang, the [IEX] high-frequency trading executive, said he hoped the attention surrounding the book would quickly die down. He said that while he had turned down requests to appear on TV, he couldn’t help speaking out against the book.

“There’s no unfair advantage to using your brain, last time I checked, in a capitalist society,” he said.

Before I dive into this subject, what exactly is “high frequency trading“?

A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds. As of 2009, it is estimated more than 50% of exchange volume comes from high-frequency trading orders.

I again refer to a favorite source of mine, Keynes General Theory of Employment Interest and Money (Ch 12, Part V, #4):

“But there is one feature in particular which deserves our attention. It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.”

Now, take the “professional investor and speculator” out of the equation and replace them with a computer algorithm. Remove many of the financial sector regulations put in place after the Great Depression. Change the hypothetical thee month time horizon to fractions of a second.

In Keynes day, at least there was some work going into speculation (besides creating and refining an algorithm). If traditional investment is speculative, as Keynes suggests, we need a new word for high frequency trading

The indisputable role the financial sector played in the financial crisis has shaken confidence in the financial system. Furthermore, the deregulation of commodities markets and subsequent commoditization of traditionally non-financial assets (food, fuel, housing, etc.) has left the “real economy” much more susceptible to fluctuations in financial markets / high frequency trading.

Therefore, it is not surprising that high frequency trading has garnered the attention of regulators. As New York attorney general Eric Schneiderman correctly states, it is the job of these regulators to restore confidence in a system that many see as a potentially destabilizing tool for the rich. There are undeniably positive aspects of financial services, but these positive aspects have been largely overshadowed by speculative and predatory practices.

We cannot wind back the clock on technology to stop high frequency trading. We can, however, curb the arbitrage / rent-seeking potential of high frequency trading with financial transaction taxation (FTT), reducing its prevalence. A FTT would raise tax revenues while also restoring confidence in financial markets (potentially without any negative impact on overall economic growth).

 

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Economic Outlook: The Relationship Between Wages, Productivity, and Economic Inequality In America

Source: The Employment Policy Network (Huffington Post)

Note: Hourly compensation is of production/nonsupervisory workers in the private sector and productivity is for the total economy.

Source: Author’s analysis of unpublished total economy data from Bureau of Labor Statistics, Labor Productivity and Costs program and Bureau of Economic Analysis, National Income and Product Accounts public data series

THE BOTTOM (high school graduates):

This graph highlights the growing disparity between wages paid and productivity for different educational levels (which we will use as proxies for societal classes). There are a number of explanations for this decoupling. One explanation is the decline of labor union participation due to regulatory changes and pressure from globalization. Another explanation is that as technology has advanced, it has become and increasingly important factor of production; businesses are opting to spend a larger portion of their revenues on machinery as opposed to workers.

This Monday I observed a roundtable at the U.N.– “The Threat of Growing Inequalities”–where one of the speakers raised this point. Taking home a “smaller piece of the pie”, those at the bottom are able to buy less political influence, which leads to weakened labor rights and neglected falling real minimum wages. Economic forces enable those at the top to rig to laws in their favor, further exacerbating inequality–this is the political economy explanation of rising inequality. This explanation hits on another divisive element of contemporary American society, the different legal system experienced based on ones wealth.

Whatever the reason (or as is often the case in real-world economic analysis, combination of reasons), this phenomenon obviously contributes to increasing inequality. How bad is inequality today? The Stanford Center for the Study of Poverty and Inequality has 20 graphs which tell much of the story, while Politifact has compiled a number of inequality related “fact-checks”.

It is heartening to see grassroots minimum-wage movements emerge, spanning many industries (and worldwide, many countries), led by people who are willing to take a stand through collective action. These people are willing to risk the wrath of vengeful corporate executives for economic justice. However, it will take a concerted effort by well intended politicians, independent media outlets (I try to do my part), and progressive judges / competent public defenders to capitalize on this grassroots activism if meaningful progress is to be made on the inequality front.

THE TOP (“the .1%” is not represented in the graph above):

What is going on at the bottom of the economic pyramid is only part of the inequality story. The meteoric rise of top earners incomes increases inequality; economic growth is important, but how evenly it is distributed also matters. Again here we see a decoupling of wages and productivity in the other direction  (much greater compensation than productivity; in fact, one could argue short-sighted investments result in negative productivity for the economy as a whole, while at the sane time lead to huge rewards for those carrying them out). A micro-example of this adverse relationship, described by former derivatives trader Sam Polk, as “wealth addiction”, is highlighted in a recent NYT opinion piece:

IN my last year on Wall Street my bonus was $3.6 million — and I was angry because it wasn’t big enough. I was 30 years old, had no children to raise, no debts to pay, no philanthropic goal in mind. I wanted more money for exactly the same reason an alcoholic needs another drink: I was addicted.

I’d always looked enviously at the people who earned more than I did; now, for the first time, I was embarrassed for them, and for me. I made in a single year more than my mom made her whole life. I knew that wasn’t fair; that wasn’t right. Yes, I was sharp, good with numbers. I had marketable talents. But in the end I didn’t really do anything. I was a derivatives trader, and it occurred to me the world would hardly change at all if credit derivatives ceased to exist. Not so nurse practitioners. What had seemed normal now seemed deeply distorted.

DESPITE my realizations, it was incredibly difficult to leave. I was terrified of running out of money and of forgoing future bonuses. More than anything, I was afraid that five or 10 years down the road, I’d feel like an idiot for walking away from my one chance to be really important. What made it harder was that people thought I was crazy for thinking about leaving. In 2010, in a final paroxysm of my withering addiction, I demanded $8 million instead of $3.6 million. My bosses said they’d raise my bonus if I agreed to stay several more years. Instead, I walked away.

The first year was really hard. I went through what I can only describe as withdrawal — waking up at nights panicked about running out of money, scouring the headlines to see which of my old co-workers had gotten promoted. Over time it got easier — I started to realize that I had enough money, and if I needed to make more, I could. But my wealth addiction still hasn’t gone completely away. Sometimes I still buy lottery tickets.

Wealth addiction was described by the late sociologist and playwright Philip Slater in a 1980 book, but addiction researchers have paid the concept little attention. Like alcoholics driving drunk, wealth addiction imperils everyone. Wealth addicts are, more than anybody, specifically responsible for the ever widening rift that is tearing apart our once great country. Wealth addicts are responsible for the vast and toxic disparity between the rich and the poor and the annihilation of the middle class. Only a wealth addict would feel justified in receiving $14 million in compensation — including an $8.5 million bonus — as the McDonald’s C.E.O., Don Thompson, did in 2012, while his company then published a brochure for its work force on how to survive on their low wages. Only a wealth addict would earn hundreds of millions as a hedge-fund manager, and then lobby to maintain a tax loophole that gave him a lower tax rate than his secretary.

I see Wall Street’s mantra — “We’re smarter and work harder than everyone else, so we deserve all this money” — for what it is: the rationalization of addicts. From a distance I can see what I couldn’t see then — that Wall Street is a toxic culture that encourages the grandiosity of people who are desperately trying to feel powerful.

I was lucky. My experience with drugs and alcohol allowed me to recognize my pursuit of wealth as an addiction. The years of work I did with my counselor helped me heal the parts of myself that felt damaged and inadequate, so that I had enough of a core sense of self to walk away.

Dozens of different types of 12-step support groups — including Clutterers Anonymous and On-Line Gamers Anonymous — exist to help addicts of various types, yet there is no Wealth Addicts Anonymous. Why not? Because our culture supports and even lauds the addiction. Look at the magazine covers in any newsstand, plastered with the faces of celebrities and C.E.O.’s; the super-rich are our cultural gods. I hope we all confront our part in enabling wealth addicts to exert so much influence over our country.

This is a powerful piece, an inside voice admitting that derivatives traders “don’t really do anything”, and that an insatiable “wealth addiction” (and the political clout it buys) drives a widening income gap in this country. The idea that much investment “doesn’t really do anything”, that it is speculative rather than true investment, is not a new concept. In fact, the concept was laid out eloquently by John Maynard Keynes in “The General Theory of Employment, Interest, and Money“:

It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” 

This was written in 1936 in the context of post-Great Depression financial regulation, long before technological changes such as the internet and mass-deregulation created a risk-seeking “too-big-to-fail” financial sector which nearly destroyed the global economy in 2008. One can imagine what Keynes would have to say about the financial sector–and the inadequate regulatory response to the Great Recession–we experience today!

The top his risen due with the help of financial deregulation, enabling a “wealth addiction” by canonizing those selfish (or at best ignorant) enough to pursue such ends. This, coupled with the bottoming out of the lower end of the economic pyramid, leads to gross inequality. Inequality distorts our legal and political system, which leads to self-perpetuating social immobility; those at the top stay at the top (and continue rising), while those at the bottom stay at the bottom (an inter-generational poverty trap).

But how could we let this happen to America, once a “beacon of hope”? Wouldn’t our democratic system have stopped this from happening?

THE MIDDLE (bachelors and graduate degree earners):

It is indeed perplexing how we got into this mess, given America’s democratic system. Part of the explanation is that we canonize the rich–we want to be them, we don’t want to regulate them. We also vilify the poor–they are lazy, undeserving, and are responsible for the majority of anti-social behavior (crime, drug use, etc.). “We” here is the middle class, the last faction of American society where social mobility and meritocracy exists (to a certain extent).

Middle class families can afford the necessities needed for “equality of opportunity”, even if they cannot afford great luxuries. They earn college degrees and go on to make living wages. These workers still see a connection between productivity and compensation. An income of $50,000/yr is probably related to the amount you produce. Perform well and there is a promotion in it for you; you may even “make it to the top”!

To paraphrase John Steinbeck: “Socialism never took root in America because the poor see themselves not as an exploited proletariat, but as temporarily embarrassed millionaires”

Those at the top receive more than they produce, so why complain (however they do get defensive anytime someone proposes a common sense regulation)? Those in the middle earn roughly what they produce, and have a reasonable belief they will make it to the top; you don’t want to regulate what you one day aspire to be! Those at the bottom–well fuck em’ they’re lazy drug users!

How have those at the top succeeded at winning the PR war on income inequality? The best explanation I have heard comes from Matt Taibbi’s book “Griftopia”. In this book, he tells a story of local level governance which is overrun by regulations (he uses an example of a bureaucracy ramming affordable housing down a communities throat). Knowing that middle-class people experience over-regulation at the local level, those at the top seize on this “big-government” narrative to drum up support for financial deregulation; they create a narrative of “the poor banker trying to earn a buck”.

This narrative resonates with the middle-class worker who experiences the aforementioned local government over-regulation. It is reinforced by media commentary, which is often a pawn of those at the top (another tool, like political clout, enabled by surplus wealth).  Furthermore, this narrative also vilifies financial regulation as a something which stifles economic growth / cost jobs / lead to higher consumer finance costs (and in this economy, we simply cant afford it!), even though economic theory and common sense suggest that inequality stifles consumption, job creation, and economic growth.

Of course this is a false equality; federal (and international) financial sector regulation and local / state government regulation are unrelated (local governance may well be over-regulated in some instances, but the financial sector is undeniably under-regulated). But unless you have studied the way the government works (which most people haven’t), you have no idea you are being fed horseshit; you hear the word “regulation” and cry bloody murder. Because local governance is often intervening on behalf of lower class citizens, this creates a rift between the middle and lower class, while the real culprits are laughing all the way to the bank (quite literally–they tend to work at banks).

If this sounds like class warfare, that’s because America is experiencing class warfare.

This post relied heavily on generalizations, there are undoubtedly people in each class of society who do not fit into these generalizations. But in general these descriptions hold (that’s why they’re called generalizations).

This post focused on America; globally the inequality problem is much worse. According to a just-released Oxfam report, the richest 85 people in the world control the same amount of wealth as the bottom 3.5 billion (that’s nearly half the global population!). Recently, UNDP chief Helen Clark spoke about the link between inequality, poverty, and standard of living. Least developed countries experience different problems (extreme poverty, authoritarian / incompetent governance, lack of access to credit, armed conflict, etc.), but these problems manifest themselves in similar ways (poverty, inequality, power imbalances).

The whole world must confront and stop enabling “wealth addiction”, if we hope to realize sustainable human development in the 21st century. We must try, through regulation, taxation, and incentives, to restore the productivity-to-earnings relationship. As inequality becomes more of a “mainstream” issue (it has recently been emphasized by, among others, Barack Obama and Pope John Francis), we can expect to see a larger portion of society begin to champion pro-poor causes.


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Economic Outlook: (Hopefully Learning) Lessons From Japan

Japanese economic policy, named “Abeconomics” after Japan’s Prime Minister Shinzo Abe, offers a natural experiment from which the U.S. can draw lessons. There is a much more obvious natural experiment for the U.S., which is U.S. economic policy, but those against “Quantitative Easing” are never short on reasons for why QE hasn’t debased the dollar / led to soaring interest rates on U.S. bonds (but soon will ahhtheskyisfallingmoralhazard!!!!!). Perhaps Japan’s experience, which is further removed from the U.S., can allow us to be more objective in our analysis.

The basis for expansionary monetary policy is due to “liquidity trap” macroeconomics. When the Fed cut’s interest rates near zero, non-traditional means of using monetary policy are the only policy choice left to stimulate aggregate demand and reduce unemployment (as far as monetary policy goes, fiscal policy is another story to be addressed shortly).

Both the U.S. and Japan have greatly increased the supply of money in attempt to revive the economy. QE in the U.S. has basically quadrupled the Feds holdings since 2008, while Abeconomics has doubled Bank of Japan’s (BoJs) holdings. In the U.S., the dollar has remained strong despite QE. In Japan, the Yen has slid in value (and this is a desired result, to increase export competitiveness):

“Normally a weakening exchange rate might be taken as a sign of decline. The yen has fallen nearly 14 percent against the dollar this year, and no currency has fallen more except the Venezuelan bolívar.

In Japan’s case, it is a sign that the policies put in place by Mr. Abe and Haruhiko Kuroda, chairman of the Bank of Japan, are starting to work. A weaker yen makes Japanese exports more competitive around the world.”

The U.S. probably benefit from a slightly weaker dollar, making exports more competitive which could help revive U.S. manufacturing and renewable energy industries (among others). I believe the USD role as primary international reserve currency (60% of international holdings) are keeping the dollar strong despite QE. Foreign holders do not want to see the value of their reserves go down, so the dollar continues to be the safe-haven for investments despite unprecedented monetary stimulus.

How effective have these policies been? U.S. unemployment has dropped to 7.5%, although underemployment and people dropping out of the labor market may be producing a rate that doesn’t capture the stagnation in the job market in the U.S. Japanese unemployment sits at 4.1%, a rate that for the U.S. would currently constitute an economic pipe-dream.

Japan certainly has its issues, but it is not letting doomsayers dictate its economic policy. Despite much higher gross government debt to GDP (Japan has roughly 235% debt to GDP ratio, while the U.S. is at about 107%) Japan is pursuing fiscal stimulus. Abeconomics includes a 2-2.5% of GDP stimulus plan for Japan. Compare that with the fiscal contraction in the U.S.

So the U.S. and Japanese economic policies give us a natural experiment. Both are advanced countries with highly skilled labor forces and strong financial markets. Both are pursuing monetary expansion. One of the countries, despite a much higher debt-to-GDP ratio, is also pursuing fiscal stimulus, while the other is pursuing fiscal contraction. Granted Japan went through years if not decades of stagnant growth before flipping the script to “Abeconomics”. The U.S. is “only” 5 years removed from the Great Recession. Do we really need to wait decades before we pursue policy that we know will stimulate the economy and reduce unemployment / the output gap?

As Keynes said, “In the long run, we’re all dead”. It is not enough to say give it time and things will get better. Peoples skills and confidence in their abilities are deteriorating in the U.S.. The output gap is large and growing, and spending on safety-net policies will not decrease until unemployment goes down (hence “automatic stabilizers”). Hopefully Japan’s successes will inspire confidence in fiscal stimulus; if a country with twice as high of a debt-to-GDP ratio (and an unemployment rate almost half as low) can benefit from fiscal stimulus, surely the U.S. can as well.