Wednesday, April 23, 2014

The Neo-Fisherite Rebellion



Over the last three years, a quiet rebellion seems to have sprung up in macroeconomic circles. So far, it's limited to a few whispers, a couple of papers, and the odd blog post or dinner speech, but it represents a striking break from conventional thinking. And despite my best efforts, I find myself unable to convince myself that it's wrong. The rebellious idea - which I've decided to call "Neo-Fisherite" - is that low interest rates cause deflation, and high interest rates cause inflation.

First, the basic idea. The Fisher Relation says that nominal interest rates are the sum of real interest rates and inflation:

R = r + i

That's not an assumption, that's just a definition (actually it's an approximation, but close enough). What I call the "Neo-Fisherite" assumption is that in the long term, r (the real interest rate) goes back to some equilibrium value, regardless of what the Fed does. So if the Fed holds R (the nominal interest rate) low for long enough, eventually inflation has to fall. This is exactly the opposite of the "monetarist" conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

The opening shot of the Neo-Fisherite rebellion was fired by Minneapolis Fed President Narayana Kocherlakota, in a speech in 2010:
The fed funds rate is roughly the sum of two components: the real, net-of-inflation, return on safe short-term investments and anticipated inflation. Monetary policy does affect the real return on safe investments over short periods of time. But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run. 
Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent. 
To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. (emphasis mine)
This sparked a furious backlash in the blogs (see here, here, and here for just a few examples). Especially note the detailed critiques by Andy Harless and Brad DeLong.

Following that controversy, Kocherlakota famously converted to a more conventional monetarist position and began arguing for more QE and higher inflation (raising the interesting, but almost certainly fantastical, possibility that his conversion is a deep-cover operation and he really still thinks "easy" monetary policy will be deflationary!).

But others emerged to pick up the banner of rebellion.

The second outbreak of the rebellion came when Steve Williamson wrote a paper in which QE is deflationary. This touched off possibly the most entertaining and explosive debate in the history of the macroeconomics blogosphere. "Monetarist"-leaning bloggers like Scott Sumner and Nick Rowe teamed up with "Keynesian"-type bloggers like Brad DeLong and Paul Krugman to assail Williamson's idea, while a few mavericks like Tyler Cowen, David Andolfatto, and me came cautiously to Williamson's defense (without believing in his model per se). I have no idea how much of a splash the paper made within academia itself, but that would be interesting to know.

Anyway, unlike Kocherlakota, Williamson has stuck to his guns. Last December, he wrote a blog post suggesting that Paul Volcker whipped inflation in the early 80s not by raising interest rates in the short term, but by lowering them in the long term. In February he wrote that "there's a clear Fisher relation in the data" for both Japan and the U.S., posting this graph:



The graph shows a positive contemporaneous correlation between inflation and interest rates (which monetarists, of course, would claim is evidence that interest rates are lowered in response to deflationary shocks).

In a recent "debate" with Mark Thoma (who took a fairly conventional monetarist view), Williamson again reiterated the Neo-Fisherite idea.

Last December, Williamson's revolt got some heavyweight support when it was joined by John Cochrane:
I've been following with interest the rumblings of economists playing with an amazing idea -- what if we have the sign wrong on monetary policy? Could it be that raising the interest rate raises inflation, and not the other way around? 
Conventional wisdom says no, of course: raising interest rates lowers inflation in the short run and and only raises inflation in a very long run if at all. 
The data don't scream such a negative relation. Both the secular trend and the business cycle pattern show a decent positive association of interest rates with inflation, culminating in our current period of inflation slowly drifting down despite the Fed's $3 trillion dollars worth of QE. 
Cochrane proceeds to write down a reduced-form model in which a long period of low interest rates causes inflation to jump up for a short while but then trend downward in the long run. He concludes cautiously:
Obviously this is not the last word. But, it's interesting how easy it is to get positive inflation out of an interest rate rise in this simple new-Keynesian model with price stickiness. 
So, to sum up, the world is different. Lessons learned in the past do not necessarily apply to the interest on ample excess reserves world to which we are (I hope!) headed. The mechanisms that prescribe a negative response of inflation to interest rate increases are a lot more tenuous than you might have thought. Given the downward drift in inflation, it's an idea that's worth playing with. 
I don't "believe" it yet (I hate that word -- there are models and evidence, not "beliefs" -- but this is the web, and it's easy for the fire-breathing bloggers of the left to jump on this sort of playfulness and write "my God, that moron Cochrane 'believes' monetary policy signs are wrong" -- so one has to clarify this sort of thing.) We need to explore the question in a much wider variety of models.
About a month ago, Cochrane followed up with a simple structural model that includes the Fed and the Treasury, and gets the same results. He also notes how normal monetary policy deals with the Fisher Relation:
Nominal rate = real rate plus expected inflation. Tradition says though that you temporarily steer the wrong way. First lower the nominal rate, then inflation picks up, then deftly raise the nominal rate to match inflation. If you instead raise rates and then just sit there waiting for inflation to catch up all sorts of unstable things happen...But maybe not.
Just a few days ago, Williamson evaluated Lars Svensson's policy advice from a Neo-Fisherite point of view, summing up the core of the rebellion quite well:
For simplicity, think about a world with perfect certainty. In the long run, standard asset pricing gives us the Fisher relation, which is 
R = r + i, 
where R is the short-term nominal interest rate, r is the real interest rate, and i is the inflation rate...Therefore, in the long run, if R is targeted at its lower bound by the central bank, 
i = - r - t 
So, if we think that r is invariant to monetary policy in the long run, then if the central bank pegs the nominal interest rate at its lower bound, and central bank liabilities are taxed, this will make long-run inflation lower.
(Note that the Neo-Fisherite idea is NOT that a fall in interest rates causes the price level to jump up and then drift back down to its original level. If the Neo-Fisherites are right, holding interest rates at low levels for a long time will cause a long-term deflationary trend that will eventually push the price level lower than if interest rates had been kept at the old, higher level.)

So why do I find myself unable to convince myself that the Neo-Fisherite idea is wrong? Well, like Cochrane, I don't really "believe" in any of these specific models (or any others). But two things make me unwilling to discount the Neo-Fisherites. The first is a thought experiment, and the second is the evidence.

The thought experiment is this: Suppose there was no government debt, and the Fed raised nominal interest rates to 20% and held them there forever. What would happen to real rates? Well, they wouldn't rise to 20% forever, because there's just no way that our society can physically, technologically deliver a 20% riskless rate of return to bondholders. Eventually, one of two things would have to happen: either 1) the Fed's control over the nominal interest rate would break down, or 2) inflation would rise (the Neo-Fisherite result). If the Fed can't control the nominal interest rate, then our standard models of monetary policy all break down, and we have to think about the microeconomics of money demand, which is hard to do. But the only alternative would be the Neo-Fisherite result.

As for the evidence, the U.S. case is more interesting to me than the case of Japan. In Japan, population growth is negative and Total Factor Productivity is stagnant, raising the obvious possibility of a Larry Summers-style "secular stagnation", where interest rates look low but are in fact high. But in the United States, productivity and population both continue to grow at a reasonable clip, so while "secular stagnation" seems possible, it would require some more stuff in the basic model that I haven't seen yet. Meanwhile, QE, while it produces slight jumps in inflation expectations whenever a policy change is announced or an asset purchase is made, has overall coincided with a downward drift in inflation. Monetarists will say that this is because of expectations that the Fed's asset purchases won't be permanent, and of course we can't rule that out. We can't really rule anything out in macro, even serious academic macro, much less the "eyeball-it-and-see-what-you-think" approach taken on the blogs (and in much of the private sector).

But what I'm saying is, there seems as of yet no obvious reason for me to write off the Neo-Fisherite idea. And - as Cochrane and Williamson have both shown - it's possible to write down models where the idea works. The structural models so far all rely on rather odd and rigid fiscal policy rules, so the microfoundations are still kind of crazy. But I see no reason why those models are substantially crazier than any of the more mainstream, monetarist-type (or RBC-type) models. So for now, count me on the side of the Neo-Fisherite rebels, just because I think the idea is neat, and potentially very important, and I want to see where it leads.

Because the idea is very important. Everything the Fed does, pretty much, is based on the idea that the longer you hold interest rates at low levels, the "easier"- i.e. the more pro-growth and inflationary - your monetary policy is. The Neo-Fisherite idea doesn't just discount the effectiveness of monetary policy(like RBC models do, or like the MMT people do) - it stands that whole monetary policy universe on its head. If the Neo-Fisherites are right, then not only is the Fed massively confused about what it's doing, but much of the private sector may be reacting in the wrong way to monetary policy shifts.

Anyway, blog debates are fun, but I'm even more interested to see if Neo-Fisherite papers are starting to appear in the academic literature in increasing numbers. If they do, that means the rebellion can no longer be written off. (On this note, see updates below...)


Updates

Specifically, what I'd be interested to see is for someone to find some microfoundations for the Neo-Fisherite result that don't depend on fiscal policy reaction functions.

Blogger Edward Lambert of Angry Bear declares his support for the Neo-Fisherites.

Someone on Twitter points me to a recent paper by Stephanie Schmitt-Grohe and Martin Uribe in which a Neo-Fisherite result holds. The driving force behind the model is a form of animal spirits. That's interesting, because when I was thinking of what kind of microfoundation other than a weird fiscal policy rule might give a Neo-Fisherite result, I thought this kind of behavioral explanation might do the trick...so it's cool to see my intuition confirmed. Here's a Simon Wren-Lewis blog post about that paper.

Monday, April 21, 2014

Sol Invictus



There is a lot of buzz about the effort by the Koch brothers and assorted conservative groups to end "net metering" for solar power. Kevin Drum and Paul Krugman think that it's mainly about conservative tribalism - conservatives have identified solar as something liberal, so they fight it on ideological grounds. Personally, I suspect that the current fight against net metering is mainly economic - utility companies stand to lose their government-protected monopolies if rooftop solar takes over, and of course the Kochs make their billions from the fossil fuel industry.

Anyway, the first thing to realize is that even if net metering gets killed (and if it does, it will only be in red states), it's not the end for solar. It's a slight delay. With costs continuing to plummet, net metering is only important in the short term; in a few years, we won't be talking about this. And in those states that do kill net metering, the main thing that (temporarily) replaces solar will be natural gas, not coal. With U.S. carbon emissions from electricity generation already falling, the main danger for the Earth's climate is China, which is doing its own thing policy-wise. Net metering may be important for the next few years of Koch Industries profits, but it's not a factor in whether or not the planet gets fried. So don't worry! Or at least, don't worry more than you were already worrying.

But anyway, Drum and Krugman do have a point, which is that lots of conservatives are fighting against solar instead of embracing it, simply because of tribal animus. Back in the 70s and 80s, solar was a hippie dream, and the only way it was happening was through heavy government subsidy and regulation. Meanwhile, conservatives had their own dream, nuclear, which was ready to go, and which could only be held back through government intervention. Which it was. The nuclear dream died because nuclear scared people. The solar dream lived on, and eventually - after decades of heroic technological advancement - it prevailed. Solar is the Dream That Won, and nuclear is, as The Economist puts it, the Dream That Failed. Conservatives are still mad about that.

They shouldn't be. Solar is a libertarian dream. The utility companies that states like Oklahoma are scrambling to protect are cozy government-protected monopolies (though eventually they too will survive by switching to solar). Rooftop solar offers a chance for independent homeowners to free themselves from reliance on a collectivist system. And solar is a triumph of human ingenuity, the kind of advance that Julian Simon believed would always save us from "limits to growth" - in the long run, oil and coal and gas will run out, but cheap solar will sustain capitalism. 

So it's time for conservatives to put aside their anti-solar animus and embrace the technology. Guys, don't let yourself turn into shills for industrial policy to add a few years to the business models of the fossil fuel barons. You are better than that.

Saturday, April 19, 2014

Not a summary of economics




Today both Alex Tabarrok and Ezra Klein posted this list of economics "lessons" given by Tom Sargent (a strong contender for "smartest living economist") at a 2007 graduation speech in Berkeley. Ezra calls it "everything you need to know about economics", and Alex says the list "summarizes economics", but this is quite a bit of overhype. What Sargent actually says is: "Here is a short list of valuable lessons that our beautiful subject teaches." Sargent isn't summarizing the findings of econ; he's telling the Berkeley grads some things he thinks they need to take away from the subject.

So what does Sargent think Berkeley grads need to know? Let's go through the list and see.
1. Many things that are desirable are not feasible.
This is the basic idea of all of econ. But I think Sargent has a special reason for reiterating it.
2. Individuals and communities face trade-offs.
Implied by #1, but in a speech this short I think we can forgive Sargent this slight verbosity.
3. Other people have more information about their abilities, their efforts, and their preferences than you do.
Asymmetric information is of course very important in econ, but I also think Sargent has a special reason for mentioning it in the list.
4. Everyone responds to incentives, including people you want to help. That is why social safety nets don't always end up working as intended.
Here we start to see a policy implication emerge from the list, as Sargent cautions against social safety nets.
5. There are tradeoffs between equality and efficiency.
Actually, this is not true in general! The Second Welfare Theorem shows how under certain conditions, there is no tradeoff at all. So why does Sargent say that such tradeoffs exist? Probably because - and here I'm putting words in Sargent's mouth - he thinks that the kinds of policies Berkeley grads will want to try will involve equality-efficiency tradeoffs. What kind of policies are those? Well, #4 gives a clue: social safety nets. 
6. In an equilibrium of a game or an economy, people are satisfied with their choices. That is why it is difficult for well meaning outsiders to change things for better or worse.
This is also a caution against government intervention in the economy. A theme is beginning to emerge.
7. In the future, you too will respond to incentives. That is why there are some promises that you'd like to make but can't. No one will believe those promises because they know that later it will not be in your interest to deliver. The lesson here is this: before you make a promise, think about whether you will want to keep it if and when your circumstances change. This is how you earn a reputation.
This just sounds like general "good life advice" for young people, and it doesn't fit with the theme of the other "lessons", so let's skip it and move on to #8.
8. Governments and voters respond to incentives too. That is why governments sometimes default on loans and other promises that they have made.
Personally I don't think economics has learned much at all about the incentives of government voters (why the heck do voters vote anyway, when their vote will never change an election outcome?!), but Sargent's point here is to caution against the use of government to try to solve the problems of the world. So this fits with #6, 5, 4, 3, 2, and 1.

By this time we can sort of see why Sargent might have put #1, 2, and 3 on the list, above and beyond the fact that they are important foundational principles of economics. By discussing tradeoffs, he's saying "You might want to use government to help people, but there will be costs." By discussing asymmetric information, he's also saying "Other people know what's best for them better than you do, so if you try to help them with government policy, you might end up hurting them instead." 

It's all shaping up to be one big caution against well-meaning government intervention in the economy by do-gooding liberals concerned about promoting equality and helping the poor.
9. It is feasible for one generation to shift costs to subsequent ones. That is what national government debts and the U.S. social security system do (but not the social security system of Singapore).
Actually, this is only true up to a point - there is a cap on the amount of real costs that can be shifted to future generations by one currently living generation, even if there is no cap on the amount of government debt. But again, Sargent's point is that attempts at government intervention in the economy have more costs than their proponents may realize.
10. When a government spends, its citizens eventually pay, either today or tomorrow, either through explicit taxes or implicit ones like inflation.
I'm not quite certain this is completely true, since countries can default on their debt, but close enough. Anyway, it definitely fits with the theme of all of the previous "lessons" except #7.
11. Most people want other people to pay for public goods and government transfers (especially transfers to themselves).
This definitely fits with the theme.
12. Because market prices aggregate traders' information, it is difficult to forecast stock prices and interest rates and exchange rates.
This is good life advice, but it does not obviously fit the theme (unless Sargent is thinking of govt. intervention to pop asset bubbles).

So 10 out of Sargent's 12 "lessons" are cautions against trying to use government to promote equality or help people. It's not hard to see why Sargent - himself a Clintonite sort of Democrat - might emphasize this point to a bunch of Berkeley grads. Berkeley is a famously liberal school (and was even more so when Sargent went there), and thus its graduates seem more likely than other people to be overzealous in wielding the government as a tool of human welfare.

Fair enough. If I were giving a graduation speech to students at Tokyo University, I'd tell them much the same thing (speaking of which, hey Tokyo University administrators, my schedule is wide open!).

But I think that when this kind of list is put forth as a "summary of economics", it does a disservice to the profession. It reinforces the notion that econ is basically a form of political advocacy, and that it's main value-add is to innoculate us against communism. That may have been true to some degree back in the 1960s, but nowadays ideological capitalism-cheerleading is not a big part of what professional economists do (or good ones, anyway). Econ has become a much more technocratic field, and new theories and discoveries have made the question of "government vs. markets" a much less simple one, even as communism has become much less of a political threat. Sargent, of course, knows that, and is just playing to a very particular audience of what he takes to be starry-eyed, wet-behind-the-ears, do-gooding Berkeley hippies. But it would be nice if bloggers did not hype lists like this as "everything you need to know about economics".

Thursday, April 17, 2014

Does inflation make you poorer?


A lot of people think that inflation makes them poorer. I hear this all the time. It makes sense, right?

You might think: "Hmm, if my income stays the same, and prices go up (inflation), then I can't buy as much, so my real purchasing power has gone down. I'm poorer!"

And then you might think: "Actually, no matter what happens to my salary, I can buy more if prices are lower. So inflation always makes me poorer, no matter what."

Are you one of the people who thinks this? Then let's take this idea, and run with it, and see where it gets us. First, go to the BLS' inflation calculator, and enter a starting year of 1980 and an amount of $100, then hit "calculate". I did that, and I got a number of $286.76. That means that it would take $286.76 in 2014 to buy what you could buy with only $100 in 1980. In other words, the total inflation from 1980 to 2014 was 186.76%!

So imagine if there had been zero inflation from 1980 to now. Does that mean that you'd be 186.76% richer now than you are? That would be a pretty good deal, eh? You'd probably have a bigger house, at least one more car, and plenty of money in the bank!

In fact, it wouldn't just be you, right? All of America would be richer! The logic that "inflation decreases purchasing power" applies equally to each and every person, right? So if there had been 0% inflation since 1980, everyone in America would have a bigger house, another car, and would be taking nicer vacations.

OK, and it gets better. If inflation decreases your purchasing power, then deflation increases it. It makes sense, right? Deflation means prices go down. Lower prices mean you can buy more stuff. Duh. What could be simpler?

So if we only had deflation, we'd be getting much richer every year. The more prices went down, the more stuff we could buy. With 20% deflation, in a few years we'd all be living like kings, and with 90% deflation, our money would dectuple in purchasing power every year! In no time, we'd all have yachts, private jets, and yearly vacations to Europe and Japan. Right?

No?

Wait, something's wrong here. This doesn't seem possible. But how can you escape this conclusion? If inflation decreases your purchasing power, then deflation increases it. That's definitely true, since deflation is just negative inflation. If prices go down, you can buy more stuff. But how on Earth could deflation create all those yachts and private jets out of thin air? It couldn't, could it?

So maybe there's a flaw in your thinking. Maybe inflation doesn't really make you poorer. How could that make sense? How could rising prices not reduce the amount of stuff you can buy?

Well, there is an answer, but I want you to think of it yourself. I'll just give you a hint: Whenever you buy something, the money you spend is someone else's income...

Wednesday, April 16, 2014

Guest Post: Still confused about high-frequency trading? Yes.



Noah's note: This is a guest post by Zachary David, an HFT practitioner. You can follow him on Twitter here. My view of HFT is not quite as benign as his, but that's probably to be expected. I haven't seen many actual practitioners in the big media discussion about HFT, so I thought I'd get one to offer his own perspective.  


I’ve felt like a popular boy lately. In the five years I’ve been developer and researcher at a small trading firm, my family and friends mostly thought I just look at numbers, write code, and play with computers all day; they thought mostly correctly. But Michael Lewis’ recent indictment of high-frequency trading (HFT) changed all that. Now the mystique of “the black box” pervades the blogosphere and news media. I’m often asked for my thoughts about so-and-so’s piece or if regulation is going to kill my job. The discerning readers of Noahpinion wont be surprised when I say that most reporting on this topic falls somewhere between incomplete and wrong.

Today Evan Soltas published an introduction to high-frequency trading on Ezra Klein’s new Vox Media: Confused about high-frequency trading? Here’s a guide. But rather than a guide to HFT, it’s only a guide to the narrow set of topics made popular by Lewis’ book — which pertain only to US equities are not representative of the whole field. While this critique could easily be applied to most of the recent HFT coverage, Mr. Soltas is a very clear writer and that makes it easy to do a point-by-point analysis. Each of the subject headings below corresponds to the respective heading in the Vox piece.

(As I preface all of my pieces: there is a non-zero probability that I err. My focus as a developer has been primarily in futures and currency markets. While currencies are fragmented similar to US equities, there are specific nuances and regulations of which I do not have experience)

What is high-frequency trading?

 ... High-frequency trading is a kind of market activity that moves in less than one millisecond to spot and take advantage of an opportunity to buy or sell. It happens through trading algorithms, programs that determine how to trade based on fast-moving market data. ...

In this section we learn that HFT is faster than blinking, what type of market activity it analyzes, and a type of trade it might make. But we don't get a precise definition of what it is. Allow me.

high-frequency trading: the ability to quickly execute trades and manage order activity.

This is a broad definition because the field is broad. Loosely, the three main categories of automated trading strategies are (1) latency arbitrage, (2) market making, and (3) statistical arbitrage. There are many algorithmic firms employing many different strategies that fall into some combination of the above. However, it is important to note that none of these strategies are risk free and thus arbitrage, by the economic definition, is a misnomer. Unfortunately, Mr. Lewis has pigeonholed the entire industry into number one. And number one is very boring.

(This piece is going to be too long already. So I wont get to talk about the cool fun stuff like market making and non-latency sensitive stat arb. Perhaps another time)

Is high-frequency trading growing?

Not anymore, according to most data. High-frequency trading came into vogue during the 2000s, but after many traders entered the market, profits are way down, and there seems to be slightly less high-frequency trading than there used to be ...











Here Soltas conflates the decline in firm profits with the incidence of HFT itself. This is odd because in economic terms, a perfectly competitive market implies that long term profits will be zero. This is exactly what we would expect to see as competition increases.

Generally, academic research pertaining to HFT firms uses the SEC (2010) definition:

HFT firm: market participants that end the day with close to zero inventories, frequently submit and cancel limit orders, use co-location facilities and highly efficient algorithms, and have short holding periods.

While this is a good definition for HFT-only firms, the declining costs of co-located servers, declining costs of latency-based solutions from software and hardware manufacturers, and the increase in the amount of open source projects has broadened the ability for any firm to do HFT-style execution. The industry magazine Automated Trader frequently covers the fast execution algorithms which have allowed firms to get into large positions with minimal impact on market prices — meaning less opportunities for other firms to capitalize on. (Last I heard, the market rate for a custom high-frequency platform is $2-4 million)

So yes, high-frequency trading is growing even if HFT-only firm profits are decreasing.

How does high-frequency trading make money?

... When the traders see CalPERS place a bid for Apple shares on the tech-heavy Nasdaq exchange, they quickly buy shares on other exchanges, inferring that CalPERS' orders are coming down the wires. Then the high-frequency traders sell the Apple shares back to CalPERS at a higher price than they paid for them a millisecond ago. This "electronic front-running" happens because the high-frequency traders have an advantage in terms of speed, and because "the stock market" doesn't really exist — what exists are many stock exchanges in a trading network. ... 
... The third exploits the network structure of markets, and the fact that they don't all adjust instantly to changes in price. If high-frequency traders can figure out where a stock price will be in the next millisecond before other investors can get a quote, that's a huge advantage they can use for profit.

Yes and no. Yes, that is roughly the trade Mr. Lewis describes in his book. But the reality is a bit more nuanced. First, I think it's unlikely that CalPERS has a Market Participant Identification (MPID) on the NASDAQ OMX, so these traders wouldn't identify the orders as belonging to CalPERS (from their website it looks like they conduct their trading through various brokers).

More importantly, neither of those trades are risk free. In the first case, firms are making bets that someone is trying to get into a large position and will pay whatever price is offered. In the second, they are betting that the price change they witnessed on one exchange is actually where the market is going to be. 
Here's an example:

two different markets trading the same stock
Imagine these are the order books (i.e. the sets of bids and offers by price and size) for the same stock on two different markets. The HFT firm sees someone place a buy order for 2 on Market A at 16127 (making that price the new best bid with a quantity of 1). So the HFT firm does the same on Market B. Now in order to profit from that movement, they have to be able to sell it at a higher price. If someone else comes in and starts selling, forcing the price downward, the HFT firm will lose money on that bet.

Can high-frequency trading cause stock-market crashes?

The high-frequency trading algorithms simply move too fast for humans to intervene with better judgment. When stocks drop, the trading programs may decide to stop trading, withdrawing liquidity from the market, or they may add to the sell-off.
This supposes that humans do have better judgement. But market crashes have happened long before the existence of HFT. In a previous post, I noted that even completely automated firms have people, called operations or “ops”, who monitor the overall health of the systems to make sure they are functioning as desired. When something out of the ordinary happens, they have to quickly figure out whether or not to turn off certain algorithms. No one flips the switch and shuts their eyes (except some people working night desk, *cough* *cough*).

That wouldn't surprise many people who remember what happened to the stock market on May 6, 2010 at 2:45 p.m. — the "Flash Crash," in which U.S. stocks fell 9 percent and then recovered in the course of a few minutes. Shares in companies like Accenture, a management consultancy, fell from $40 a share to a penny.

Oh the good ole Flash Crash. Amid all of the phenomenology reports and finger pointing, it's easy to forget the general conditions surrounding the event. There was massive political uncertainty and the markets were already volatile. All morning, CNBC had a picture-in-picture box of the riots in Greece. Further, it's a bit disingenuous to say share prices fell to a penny. All that implies is that there were no orders in the order book — very little trading actually took place at the low prices. During an equivalent panic in the days of floor traders, no one would raise a hand to trade.

What caused the overloading, Nanex argues, was "quote stuffing" — high-frequency traders that sent in a blizzard of orders to buy and sell at the same time, only to cancel those orders milliseconds later before they went through.

I'm highly skeptical of Nanex's data and methodologies. Like all of their claims, the "quote stuffing" scenario has never been validated. Recent data suggests Nanex's research is fraudulent. Analysis that comes from them should not be treated like peer-reviewed research.

Are there other possible problems with high-frequency trading?

1) Much high-frequency trading exploits data before it is public for an advantage.
Until last summer, the data firm Thomson Reuters, for example, sold to elite investors the right to see an important economic statistic, the University of Michigan's consumer confidence survey, five minutes earlier than the rest of the market. An "even-more elite" group of high-frequency trading clients could purchase an extra 500 millisecond head start.

Important economic statistics are released on regularly scheduled dates and times. Market participants know these well in advance. If a firm conducts trading that is sensitive to an economic number, the firm appropriately removes bids and offers from the market, and possibly closes its position, prior to the number's release. There's very little advantage to be had.

2) Some strategies in high-frequency trading, such as "pinging" and "spoofing," are unethical or illegal.
"Spoofing" is a strategy, ostensibly banned in 2010, in which high-frequency traders send in orders with the idea of trying to confuse, or "spoof," other traders - and especially other trading algorithms - into thinking that demand to buy or sell a stock is coming. If the other traders fall for it, the algorithm quickly reverses course to take the side of the trade it actually wanted. There's evidence that this is what trading algorithms sending in bizarre orders, as they did during the Flash Crash, might be up to.

Again, I need to reiterate the fact that these are all unverified claims from a very likely fraudulent researcher.

What are some ways we could curb high-frequency trading?


I wont use Noahpinion as a soapbox to discuss why all of the proposed ideas are awful, or the endless amount of unintended consequences that comes with any idea "to redesign the way markets work."

But I will say Finem Respice — look to the end. There are many electronic markets in the world that trade under many different sets of rules. We should seek solutions that are already in use in real markets. The currency exchange EBS has successfully experimented with several ideas. First, after they increased the minimum price increment (tick size) of several currency pairs, they noticed more liquidity at every price level. More recently, they've introduced latency floors which randomize a queue of incoming messages in several millisecond buckets. That has also been a success and they are expanding it to all of their products.

Thank You


Thank you Noahpinion readers! (and thank you Noah) I appreciate the opportunity to talk about my job a little bit before it becomes socially cold for another 5 years. And unlike my blog, people actually read this one. So I am greatly looking forward to the excellent commentary that typically accompanies a Noah post.

Tuesday, April 15, 2014

Book Review: Flash Boys



OK, I promised a review of Michael Lewis' Flash Boys, and here it is.

Flash Boys is an excellent book. It's fun and readable. It gives readers a window into how the stock market really works, and the kind of people who work there. It explains a lot about a very important issue that finance is facing.

For example, Lewis explains how a lot of the things that high-frequency traders are doing are just ways to game an SEC regulation, "Reg NMS", that came into effect in 2007. If this regulation were changed, a lot of the things HFT is doing would no longer make money. (Since gaming regulations is probably not a very socially valuable activity, a lot of financial economists have been calling for this regulation to be changed to create "batch auctions" every second or so; sadly, Lewis does not discuss this proposed solution.)

Also, Lewis gives a great explanation of how large banks use "dark pools", which were created to be a sort of refuge from HFTs, to rip off clients by selling them out to HFTs. Because the clients don't know the rules of the pools, and because they trust the big banks (yes, even after 2008), the clients lose money. In fact, I wish Lewis had shone more light on the dark pool issue in the first half of the book.

Finally, Lewis does a great job of exposing the injustice committed by Goldman Sachs against programmer Sergey Aleynikov. This actually had little to do with HFT, but was a classic tale of the evil that is callously committed by large bureaucracies where everyone is looking out for their own interests instead of trying to do the right thing.

So you should definitely read Flash Boys. But when you do, keep in mind two things that I think Lewis leaves out.

The first thing Lewis leaves out actually strengthens his case against HFT. Lewis, who tells a tale of bad guys ripping off good guys, glosses over the massive waste represented by the bad guys' own effort! At some point, it's clear that more speed is unnecessary for the efficient functioning of financial markets. There's no reason why prices need to adjust in a millisecond instead of a second. All the effort that HFTs spend on making this happen - all the math geniuses, and the supercomputers, and the hundreds of miles of fiber-optic cable - are valuable resources that could probably be put to much more productive use elsewhere in the economy. This has been pointed out by bloggers like David Glasner and Paul Krugman, and is based on a famous paper by Jack Hirshleifer, which you should read. A tale of social waste is not as exciting as a tale of plucky good guys rebelling against nefarious evil geniuses, but from an economist's perspective it's a big problem. The Death Star, if you think about it, was a massive waste of engineering talent.

The second thing Lewis leaves out is the other side of the story. All throughout Flash Boys, the victims of the HFTs - "investors" - are portrayed as good guys, just doing their jobs. The investors just want to trade, we're told, and the HFTs are unwanted middlemen who stand between the investors and stop them from trading. But who are these "investors"? Why are they doing all this "trading" in the first place?

Lewis' answer is that the investors are investing money on behalf of you and me - pension fund managers, for example, or mutual fund managers. But why should that require a lot of trading? Your pension manager is not Warren Buffett - he is not going to beat the market year after year. What he should do is to put your retirement money into a nice diversified basket of assets - ETFs, index funds, and the like - and just let it sit there for decades, maybe rebalancing it once a year or so. If he does that, the tiny amount that he gets front-run by HFTs at the beginning and end of those decades is going to make precisely zilch of a difference to your retirement account. But if instead, he trades and trades and trades enough to get substantially ripped off by HFTs, chances were that he was just playing the old sucker-and-be-suckered game that Michael Lewis wrote about in Liar's Poker.

In which case, he should be fired and replaced by a cat.

I'm actually not kidding. In 2012, the UK Observer held a stock-picking contest between professional investment managers - the good guys of Flash Boys - and a house cat named Orlando. The cat won. This result is, of course, supported by a long line of academic research into the unimpressive returns of professional money managers. As much as a quarter of your retirement account is being sucked away by the massive fees of money managers who, on average, are worse randomness. And this has been true since long before HFT existed.

In other words, HFT acts as a tax on trading, but much of that trading is hurting your mom and dad's retirement accounts in the first place - the "investors" who are the unambiguous good guys in Flash Boys are not so unambiguous in real life. In fact, if HFTs prompt pension funds to shift to passive management (or to "patient capital" investing that improves corporate governance), that could A) improve the efficiency of the financial sector, and B) boost returns for you and your mom and dad. In fact, there are signs that this is already happening! Led by California's massive CALPERS, big pension funds are shifting more and more money into ETFs, index funds, and the like.

Might we have HFT to thank for this sensible, rational shift? That's hard to say, but I think Michael Lewis should have at least mentioned the possibility in Flash Boys. Instead, I think he gives the "investors" and their "trading" a free pass.

So anyway, keep these omissions in mind when you read the book. But do read it. It's one of the most important popular books on modern finance, and - along with Scott Patterson's The Quants - is one of the first to introduce people to the brave, weird new world of electronic trading.

Monday, April 14, 2014

R vs. g



In his new book, Thomas Piketty argues that R, the rate of return on capital (which is different than the safe interest rate "r") is greater than g, the rate of economic growth, and that this fact can be expected to continue into the indefinite future, resulting in an ever-rising capital share of income and an ever-falling labor share. The big question is whether R really will be greater than g into the foreseeable future.

It occurs to me that this is just the "robots vs. globalization" argument all over again. 

The "robots" argument basically says: "Labor" is just the flow income from renting out one specific type of capital, i.e. human capital. If technology continues to make more and more obsolete, then the value of human capital will fall as a percentage of total capital, and thus labor's share of income will continue to fall toward zero. That's the scenario I considered in this Atlantic article a while back. This thesis is supported by the research of Loukas Karabarbounis and Brent Neiman, and is often labeled the "rise of the robots" in econ blog discussions.

The "globalization" argument basically says: In 1973, when the world finally began re-globalizing after the period of restricted trade brought about by the world wars, there was a lot of labor with very little capital, in China and India and Southeast Asia and Latin America and Africa and the communist bloc. Capital was scarce, and was highly concentrated in rich countries. After trade barriers started falling, all that labor was dumped on global markets, resulting in a global labor glut and capital shortage, raising the return to capital and decreasing the return to labor. That imbalance will eventually right itself, but only after enough time has passed. This thesis is supported by the research of Michael Elsby et al.

These explanations aren't mutually exclusive, of course. But in terms of policy, if the "rise of the robots" is the biggest factor, we need to think about all kinds of difficult policy decisions and welfare arguments. But if globalization is the main reason for R>g over the last 4 decades, then all we can do - and all we should do - is wait for the big wave to end.

Which is why strikes me as a little weird that conservative-leaning economists seem to want to embrace the "robots" argument, while liberal-leaning economists seem to want to embrace the "globalization" argument. If globalization is at fault, then even trade barriers will avail us little, since we trade in a global marketplace; all we can do is wait until the poor countries fill up with capital, and labor's share bounces back. That is an outcome that conservatives would favor. But if robots are to blame, then Piketty is right, and labor's share will never bounce back...leaving some kind of radical redistribution as the only option for preventing mass human misery. That is not an outcome that conservatives would favor.

Friday, April 11, 2014

Japanese toilets are something you should consider buying



I have a new article out in The Week about how America should be importing more of Japan's latest and greatest inventions:
The question of adoption of foreign technology is key to the Big Question of development economics — namely, why some societies grow fabulously rich while others remain desperately poor... 
I've lived in Japan for a total of about three years, and in the summer I usually go back. So I've had a lot of contact with Japanese technology. And let me tell you — they have some things we would really like, if we would only bring them to our shores. 
The biggest example is the amazing Japanese toilet. These so-called "washlets" are famous for washing your butt with a jet of warm water. But that's not their only important feature. For another thing, the seats are heated. Have you ever sat on a heated toilet seat? It is an experience not to be missed. Imagine a heated car seat on a cold day, and then imagine that without pants. Also, the toilet flushes at the touch of a button, and the button is on a control panel near your hand — no more having to reach behind you to pull a lever! 
But Americans do not have Japanese toilets... 
We've grown used to the idea that everything good is invented in America. If it wasn't invented here, it must not be worth having, we tell ourselves... 
There are other examples, besides just Japanese toilets. Japanese saran wrap, for example, makes American saran wrap look like the bad joke that it is. The Japanese version tears cleanly, doesn't stick to itself unless you want it to (how do they do that?!), and is strong and durable.
The article is obviously a little tongue-in-cheek, since toilets are not that big a deal in the grand scheme, and since America is in general relatively good about importing foreign technology (arguably better than Japan). But relatively good does not mean good enough, and it's important for us to keep our edge. Also, Japanese toilets are really great, and you should try one.

Wednesday, April 09, 2014

Some more ways that racism is hurting black Americans



Jonathan Chait has a long essay about race and the Obama presidency. I think he goes way too easy on conservatives, who seem to believe that the 1964 Civil Rights Act represented the end of American racism, and that the personal dislike and distrust of black people that is still fairly common in America somehow doesn't count as "racism". To me, it seems clear that this widespread "personal racism" has serious negative effects on the well-being of American black people.

How, you ask? Well of course there are the obvious and much-repeated examples of hiring discrimination, housing discrimination, and legal discrimination. People go back and forth on how much of these exist. I think that they're probably substantial, but I won't rehash those old arguments here. Instead, I want to suggest some additional ways that racism may be hurting black people.

1. Business networking. In the world of jobs and work and business, human networks are incredibly important. There's a huge amount of research on this, so much that it's almost too much effort to decide which links to post - see here, or here, or here or here, or anywhere. It's a well-known fact: friends and acquaintances are hugely important for getting a job, getting a promotion, getting a raise, and starting a successful business. The value of these connections is called "network capital" or "social capital".

And racism, of course, inhibits black people from forming human networks. When white (or Asian, or Hispanic) people don't see black people as worthy of friendship, trust, and frequent socialization, it makes it much harder for black people to succeed in the business world, legal discrimination or no.

This is different from the problem of workplace discrimination. That problem could, in theory, be solved if whites made a big effort to treat blacks fairly in hiring, salary, and promotion decisions. But the network capital problem will not be solved merely by fairness. It can only be solved by actual friendships between individual black and white people.


2. Neighborhood isolation. In an excellent article in Slate, Jamelle Bouie recently explained how many American black people, even after escaping poor neighborhoods, are pulled back to these neighborhoods, causing all kinds of negative outcomes. Why does this happen? Well, housing discrimination is one reason, but it's obviously more than that - the NFL player that Bouie describes could hardly have found it impossible to get a house in a rich white neighborhood. There must be other forces that make black people reluctant to leave poor, violent neighborhoods behind.

One obvious force is personal racism on the part of white people (and Asians, Hispancs, etc. - I'm going to stop writing this caveat now, and just say "white people"). If I were a black person who grew up poor or lower-middle-class, and I were contemplating becoming an upper-middle-class person, I would probably think twice. Why? Because I'd worry that an undercurrent of subtle, tacit, and unstated disdain, distrust, and dislike would permeate my new social set. I wouldn't want to give up my family and friends to hang out with a bunch of people who looked down on me because of my race. I'd choose to live around people who accepted me at a basic level, even if that entailed big risks and costs.

Look, in real life I'm Jewish, and if I lived in a country where half the upper middle class people were anti-Semitic, I'd think twice before hanging out with the upper middle class. I just would.


3. Personal violence. It's a fact that black communities in America are exceptionally violent, even after accounting for the effects of poverty. Why? One reason that strikes me as extremely likely to be a piece of the puzzle is police discrimination. Racist police - or even just the specter of racist police! - can be a powerful disincentive to use the police for protection, and motivate black people to rely on personal violence for their own defense.

It's pretty simple. If a guy in my neighborhood were threatening me, the first thing I'd do would be to pick up the phone and call the cops. I believe the cops would help me. But if I were black, I think I'd be very worried that the cops would just arrest me, or would simply fail to do anything about the problem because they just don't care about keeping black people safe. So I would not call the police. I would instead try to scare away the people who were threatening me. I'd get a gun. I'd get a gang of friends to watch my back. Maybe I'd even spray a few bullets into the guy's house, to teach him I meant business and was not a person to be f***ed with.

Yes, I really would do this, especially if I was poor and could not simply move away. It's not a "culture of violence", it's just plain old rationality. When I lived in Japan, many college-educated white people - who would call the cops in a second if threatened in Canada or Australia or the UK or wherever they came from - would just laugh if someone suggested calling the cops. They assumed that Japanese cops would discriminate against them, or would simply throw them in jail, if called.

(Note that violence in black communities declined a lot in the 1990s. If my theory is right, then "community policing" strategies, and the increasing racial diversity of the police in black neighborhoods, might have had a lot to do with that.)


What all of these problems add up to is this: To really help black Americans (and other minorities that are hurt by racism), it is not enough to make them nominally equal under the law. And it is not even enough for white people to act in a fair and unbiased manner toward black people. Respect is important, but mere distant, cold respect is not going to be enough. What needs to happen is for white and black people to actually be friends and hang out with each other on a regular basis. "Black America" can no longer continue to exist as a separate, foreign mini-nation within the American nation, because separate is inherently unequal. Real integration is the only real answer. Fortunately, I think attitudes are changing among the younger generation of Americans, but powerful people - political leaders, the media, churches, etc. - need to do their part.

Monday, April 07, 2014

The foxy Fed



A few days ago, the Fed released its workhorse model of the macroeconomy - the FRB/US model - to the public. The model had been only semi-private before, since the Fed would send it to interested researchers, and revealed some information about it to the general public. But now the model is fully public. How should we interpret that action?

Why didn't the Fed fully reveal FRB/US model before now? It always seemed to me that it was basically because of - for lack of a better word - embarrassment. Academic macroeconomists haven't used or studied this type of model in decades (having abandoned everything else in favor of DSGE). In 2010, Chris Sims appeared to call models like FRB/US "something close to a spreadsheet". Since most Fed employees are drawn from the same pool of people as academic macro (and interact with academic macroeconomists quite frequently), the fact that they use something like FRB/US must have seemed a bit awkward. In fact, I've heard academic macroeconomists make fun of FRB/US a number of times.

So if my guess is right, the Fed's publication of FRB/US indicates that whatever embarrassment existed is now essentially gone. That is kind of interesting.

After all, FRB/US flies in the face of two key developments in academic macro. Since FRB/US has a huge number of parameters, all of which are assumed to be structural, it is a lot harder for this model to pass the intuitive test known as the "Lucas Critique". Basically, more "structural" parameters = more assumptions = more chance to get some of the assumptions wrong = easier for any given economist to wrinkle his nose at the model.

Second, FRB/US does not force its users to use Rational Expectations (which the Fed more aptly calls "Model Consistent Expectations" or "MCE"). The model has an option that allows you to use it with MCE. But it also has an option to allow you to use it with non-model-consistent expectations. That flies in the face of what Robert Lucas told economists to do, and what most academic macroeconomists do in fact do.

(Also, FRB/US uses more heterogeneity than most academic DSGE-type models use.)

Lucas and his followers (and "his followers" include almost 100% of academic macroeconomists working after 1980, to a greater or lesser degree) hoped and expected that DSGE models, which have a relatively small number of parameters and generally only consider the MCE case, would fully replace models like FRB/US at central banks. But that has not happened, despite decades of arguments by academics. The Fed and other central banks do indeed use DSGE models, but they continue to use things like FRB/US as well. Where academic macro is hedgehoggy, central banks are stubbornly foxy.

And I say "stubbornly" because instead of becoming more and more shy about their continued deviation from academia, the Fed now seems to be getting more bold about it. In their notes on the public release of FRB/US, they very explicitly show how the model is used not just for unconditional forecasting, but for policy analysis - exactly the thing that Robert Lucas told us that we shouldn't do with this kind of model.

That's my (non-insider) takeaway from the public release of FRB/US - the Fed seems less embarrassed about its continued split with academic macro.

(Note: I'm definitely not calling the Fed cowards for not releasing FRB/US before now; in fact, the opposite. It takes lots of guts to keep using a diverse array of models when some of the world's smartest hedgehogs are yelling at you to use only one kind! Instead, I think it's the academics who might want to pause and think about why even central banks, their main audience, aren't totally sold on their approach even after more than three decades...)

Update: Steve Williamson has more. He's not a fan of FRB/US, but he agrees with me that the main takeaway from its continued existence is that the Fed has not fully bought into the ideas of Robert Lucas.

Saturday, April 05, 2014

No one really knows if HFT is good or bad



Like every other human in the known Universe, I'm currently reading Michael Lewis' Flash Boys. But I've been thinking about HFT for quite a while, because Stony Brook has a lot of people who study it for a living (including some people who have done it for a living at Renaissance and other top firms). So even though I'm only halfway through the book - and I'll write a review when I finish it - I have some thoughts on the topic.

Basically, no one knows if HFT is good or bad. There are two reasons for this. The first is that no one really knows what HFT does to markets. The second is that no one really knows what is good or bad for markets.

Why don't we know what HFT does? Well, one reason is that there are a lot of different HFT strategies. Some HFTs could be pure market-makers, just gobbling up bid-ask spreads. Some could be "front-runners", looking for signals of large institutional trades and trading in between the chunks of these trades (this is the strategy Lewis spends a lot of time discussing). There are other common ones (like latency arbitrage, Twitter mining, high-frequency statistical arbitrage etc.). No one has the data to know how much of each of these is being done at any given time.

But a lot of HFTs simply don't know what their strategy really is. They hunt for patterns in prices or orders, find a pattern that seems to work, and trade on it until it stops making money. They don't have any idea why the pattern exists. Sometimes it only exists for a few seconds. In fact, if they stop to gather enough information about the pattern to figure out why it's there, it often disappears! Actually, there are deep mathematical (information-theoretical) reasons to suspect that lots of HFT opportunities can only be exploited by those who are willing to remain forever ignorant about the reason those opportunities exist. It's mind-bending (and incredibly interesting).

Needless to say, we have no idea what this latter type of HFT does to the market, because even its users don't know what it is! But even for the simpler strategies - market-making, front-running, etc. - we don't really know how they impact markets. This is because all of these strategies involve the phenomenon of asymmetric information. Most of our finance theories - the kind where you get nice clean results, like factor models or CAPM-type models - don't involve asymmetric information. Once you add it in, stuff gets complex and weird, fast. If you ever think you understand how financial markets work, go read Asset Pricing Under Asymmetric Information by Markus Brunnermeier, and you will be convinced otherwise.

Do market-makers increase or decrease liquidity? Do front-runners increase or decrease it? What about informational efficiency of prices? What about volatility and other forms of risk, at various time scales? What about total trading costs? Good luck answering any of these questions. Actually, Stony Brook people are working on some of these, as are researchers at a number of other universities, but they are huge questions, and our data sets are incredibly limited (data is expensive, and a lot of stuff, like identities of traders, just isn't recorded). And keep in mind, even if we did know how each of these strategies affected various market outcomes, that wouldn't necessarily tell us how the whole ecosystem of those strategies affects markets - after all, they interact with each other, and these interactions may change as the strategies themselves evolve, or as the number and wealth of the people using each strategy changes. 

Confused yet? OK, it gets worse. Because even if we did know how HFT affects markets, we don't really know if it's good or bad on balance. For example, HFT defenders often say HFT provides "liquidity". Is liquidity good for markets? How much is liquidity worth, are there different kinds of liquidity, and does it matter when the liquidity comes? If I have a bunch of totally random trading, that certainly makes markets liquid, but is that a good thing? Actually, maybe yes! In lots of models of markets, you need random, money-losing "liquidity traders" in order to overcome the adverse selection problem, thus inducing informed traders to trade, and getting them to reveal their information. But HFTs don't lose money, they make money - is their liquidity provision worth the cost?

To know that, even if we knew the impact of HFTs on informational quality of prices, we'd have to know the economic value of informational efficiency. Suppose the true worth of GE stock. according to the best information humanity has available, is $100. Suppose the price is $100.20. How bad is that? How much is it worth, in economic terms, to push the price from $100.20 to $100.00? Is it worth $0.20 per share? It depends on how GE's stock price affects the company's investment decisions. To know that, we need an economic model of corporate decision-making. We have many of these, but we don't have one over-arching one that we know works in all circumstances. Corporations are way more complicated than what you read in your intro corporate finance textbook!

(And this is all without thinking about weird things like behavioral effects of the humans who interact with HFTs...)

To sum up: There is very, very little that we know abouthttp://streetwiseprofessor.com/?p=8340 HFTs. We have incomplete data, incomplete understanding of the nature of HFT strategies, incomplete understanding about the interactions between ecosystems of strategies, incomplete theories of markets under asymmetric information, and incomplete understanding of the economic value of liquidity and informational efficiency.

So what the heck do we do?? Obviously we need a lot more research, but in the meantime, why not enlist the market itself to help give us some more info? If we legalize and facilitate a number of kinds of alternate kinds of stock exchanges where HFT has a much harder time - e.g. dark pools, batch-auction exchanges, etc. - we can learn a lot (though not nearly all we need to learn) about the overall impact of HFT (and other algorithmic trading!).

Like I said, I haven't finished Flash Boys (and I'll write a review when I do), but my early impression is that Lewis presents a very oversimplified picture of how HFT works - but in plumping for alternate types of exchanges, he gets the solution broadly right.


Updates
Here's a similar post by Craig Pirrong, who shares my uncertainty about the costs and benefits of liquidity and informational efficiency, but who is slightly more confident about the net effects of HFT on informational efficiency.

David Glasner has a great post on the topic as well. The biggest cost of HFT is probably the resources that are wasted on "information tournaments". I'm setting up a lab experiment about this very topic, in fact. This problem was pointed out in a famous 1971 paper by Jack Hirshleifer.

Thursday, April 03, 2014

How should Charles Koch use his power?



"It's a very dangerous thing to do exactly what you want"
- The Flaming Lips

One of the most startling moments of my life came at a conference earlier this year, when a tenured macroeconomics prof at a good school, whom I had never met, walked up to me and said: "Hey, I agree with a lot of the things you write about macroeconomics. What do you think we macroeconomists ought to be doing?" More than ever before, it sank in that people might care about, listen to, and be influenced by things I say. I know this sounds a little silly, but I had never really believed that before. Blogging felt like a way to have a fun discussion with smart, nerdy people like Brad DeLong and Tyler Cowen. But when enough people start reading you, you become a "thought leader", whether you meant to or not. At that point you basically have three choices: 1) shut up, 2) confidently push on, or 3) try to moderate what you say.

It's not an easy decision. If you think the Marketplace of Ideas is more or less efficient, then it doesn't matter how loud you shout or how many readers you have, society is going to weigh your arguments on the merits, so you might as well say whatever you feel like saying. Or if you think you're facing an implacable, dishonest opposition, then maybe you should make your message stronger to balance out their power - a sort of "dialectical" approach. Or maybe you think you've found the One True Way, and so it makes sense to fight tooth and nail. I don't really think any of these things, so I've decided to moderate my tone on macroeconomics-related issues ever since I talked to that professor at the conference. Not to say things I don't believe, but to tone it down, insert more caveats, and give a more accurate picture of what I really think instead of just blogging my most controversial (i.e. fun) ideas.

Now, I'm a guy with only a tiny amount of power, so I'm not too worried. A more famous writer like Paul Krugman or Michael Lewis has more. But some people have much, much, much more. For example, Charles and David Koch, the famous Koch brothers.

Together, Charles and David Koch have about 80 billion dollars of wealth. Compare that to Bill Gates, with $77B, and you see that if they were one person, the Kochs would be the richest person in the world...and they act as one for political purposes. If John D. Rockefeller were a comic-book superhero who got split into two people, he'd be the Koch Brothers.

This huge amount of wealth gives the Kochs enormous power to affect politics, if they choose to do so. And they do choose to do so - a lot. "Political activities of the Koch Brothers" has its own Wikipedia page. For the last two years, Koch money has been very important for the Republican party. In some political races, the Kochs outspend all other Republican donors combined. In addition, the Kochs have been extremely active in funding academic departments whose political tenor agrees with their own beliefs. And they have spent lots of money to set up think tanks - including the Mercatus Center, which provides supplemental employment to several of my favorite econ bloggers (for which I suppose I should thank them) - and to influence other think tanks.

Why do the Kochs do this? Why do they think their perspective is so much more important and valid than the perspectives of all the people who have less money and power than they do?

Well, they might believe that all their spending doesn't really influence the political process that much - that money doesn't translate into power. And they might have so much money that they don't feel the need to save it. So it all might just be for fun. But I highly doubt this.

Alternatively, they might believe that there are powerful negative forces in American society, and that these negative forces are unscrupulous and unrestrained in their tactics, and that in order to balance out the "bad guys", the Kochs must pull no punches. Finally, the Kochs might just believe that they understand the One True Way, and that the masses of people who disagree with them are simply misguided.

Reading Charles Koch's recent op-ed in the Wall Street Journal, I'd guess it's a combination of those latter two. Koch is very confident in his view of what is right and good, and he thinks that the people opposing him are unscrupulous and unrestrained:
[T]he fundamental concepts of dignity, respect, equality before the law and personal freedom are under attack...That's why, if we want to restore a free society and create greater well-being and opportunity for all Americans, we have no choice but to fight for those principles... 
Instead of encouraging free and open debate, collectivists strive to discredit and intimidate opponents. They engage in character assassination...Such tactics are the antithesis of what is required for a free society—and a telltale sign that the collectivists do not have good answers... 
Instead of fostering a system that enables people to help themselves, America is now saddled with a system that destroys value, raises costs, hinders innovation and relegates millions of citizens to a life of poverty, dependency and hopelessness... 
If more businesses (and elected officials) were to embrace a vision of creating real value for people in a principled way, our nation would be far better off—not just today, but for generations to come. I'm dedicated to fighting for that vision. I'm convinced most Americans believe it's worth fighting for, too.
Obviously, if America has elected "collectivist" politicians, it means that many, many Americans support "collectivism". Charles Koch thinks it's worth using his own tremendous personal power to singlehandedly balance out the power of a huge number of the people who disagree with him. He thinks this is OK because he believes so strongly in his cause, and because he thinks his rhetorical opponents use dirty tactics.

But if I were Charles Koch, I wouldn't be so sure of these things.

First of all, why do so many people disagree with Koch's ideas? There are certainly times in history when the mass of people was gravely, horribly wrong. But those times are rare. So if the majority is wrong, they're probably only moderately wrong. This is not a reason for Koch to moderate his views. But it is a reason for him to reconsider his policy of outspending the multitudes of his opponents.

Second of all, Koch should consider that his perception of the unscrupulous ways of the "collectivists" might be mistaken. There seems to be a bit of a tendency for certain rich old men to see themselves as being in more danger than they really are - for another example, witness Tom Perkins. Charles Koch should consider whether part of his perception of vicious tactics by the "collectivists" is just a persecution complex.

A big part of the reason that the Kochs are so reviled is that they have lots of power. Power magnifies the degree to which we don't like people who disagree with us. Charles Koch, with his $40 billion, can exercise a voice in politics that is far louder than the voice of any of the people who disagree with him. And with David Koch totally on his side with another $40 billion, there's basically two of him. That scares many people, and it strikes many others as unfair - why should another guy's voice be thousands of times more powerful than my own?

The Kochs have freedom of speech, so the only check on their use of money for political purposes is their own conscience and sense of responsibility. But those can be powerful checks. Notice that most of the super-rich don't shell out hundreds of millions of dollars on politics. Bill Gates doesn't. Warren Buffett doesn't, despite the fact that he obviously cares about issues. Larry Ellison doesn't. The Waltons do a little bit, but not nearly so much as the Kochs. Sheldon Adelson does, but his reasons are...more cynical. George Soros is the only real rival to the Kochs in terms of individual political spending, though he has only about a quarter of their wealth.

So it seems to me that most super-rich people are more skeptical than the Kochs about the correctness of their views, the badness of those who disagree, and/or the fairness of outspending hundreds of thousands of normal, non-rich individuals. If I were super-rich, I think I'd be more like Buffett or Gates or Rockefeller, and less like the Kochs.

(I do hope they keep supporting econ bloggers, however.)

Tuesday, April 01, 2014

A Marshall Plan for the Culture War


I have an article in the Atlantic, basically saying that now that we liberals have won the Culture War, it's time to reach out to conservatives to repair American families and promote work ethic. Excerpts:
Any time you win a great victory after years or decades of bitter struggle, there is the temptation to pillage the lands of the conquered enemy. This is always a mistake... 
The reason we need to reach out to conservatives is simple—there are a lot of them, and they are our countrymen. America is not going to be healthy unless conservative America is healthy. And America is not going to be a fully effective nation-state until conservative America feels completely included in the new liberal America that is now emerging... 
It’s time to reach out to conservatives on the issue of family stability. It’s becoming clear that traditional family gender roles—the idea that the man should be able to be the sole breadwinner—are not sustainable in the modern economic environment...The better way is what Richard Reeves, in a landmark article in The Atlantic, calls “High Investment Parenting.” When families focus on the kids, instead of on maintaining traditional gender roles, it turns out to be a lot easier to keep the family together...But how can we liberals help spread high-investment, gender-equal parenting to working-class, conservative America?...We need to make common cause with conservatives like W. Bradford Wilcox... 
We also need to reach out to conservatives on the issue of work. Many conservatives—like Kevin Williamson, Michael Strain, James Pethokoukis, and Ron Unz—have woken up to the fact that in a purely laissez-faire economy, lots of people get left behind in ways that are ultimately unhealthy to the nation.

Saturday, March 29, 2014

"Land of the brave" no more?



I really like this Megan McArdle piece about risk-taking:
If you can’t try something new in 10th grade, when can you? If you can’t afford to risk anything less than perfection at the age of 15, then for heaven’s sake, when is going to be the right time?... 
Now is when this kid should be learning to dream big dreams and dare greatly. Now is when she should be making mistakes and figuring out how to recover from them. Instead, we’re telling one of our best and brightest to focus all her talent on coloring within the lines... 
Now, more than ever, we view a college degree as an absolute prerequisite for a minimally decent life. And if we’re in the upper middle class, it has to be a degree from an elite school...To keep their kids from falling off the side, [parents are] pushing them harder than ever.
Is American risk-taking really decreasing? Well, it's hard to say. Despite the popularity of Silicon Valley startups in the news, the rate of new business formation has fallen steadily since the 80s. Americans are less likely to try to switch jobs than before. Discount rates implied by stock prices haven't fallen much, but I'm not sure that tells us a lot.

But anyway, let's assume it's true, and that America has on the whole become a more timid nation. Why might this be happening?

1. No social safety net. America has less of a social safety net than most rich European and Anglophone countries. Especially since welfare reform in 1996, economic failure has dire consequences. If your business or risky career path falls through, you'll have no health insurance (well, at least til Obamacare kicks in), and you could even find yourself on the street. Jacob Hacker calls this the Great Risk Shift.

2. Income inequality + income stagnation + social preferences. The big runup in inequality since 2000 has mostly been about the top 0.1%. But in the 1980s - when the rate of new business formation started to fall - there was a much broader increase in inequality. The middle class spread out, and that raises the penalty of failure. If you don't break into that $100k-and-up income bracket, you'll be stuck in $30k service-sector-land. Add to that the fact that incomes for the lower part of the distribution have flatlined since 1980, while incomes for the top brackets have soared; a career failure means, more than ever, that you'll be much poorer than your peers.

3. Labor market segmentation. In America, if you're unemployed for longer than six months, you have a much worse chance of getting a job Also, the college wage premium has increased - if you don't go to a decent school, good luck getting a decent job. This is a weaker version of what has happened in Japan. It seems like both college and the duration of unemployment have become important signaling devices. Fall off the "success" wagon, and good luck getting back on.


These three explanations don't involve any increase in Americans' risk aversion; they simply mean that risks have increased. But what if risk aversion is increasing too? I can think of a couple reasons for this:

4. High-Investment Parenting. America's upper-middle-class has largely adopted a parenting strategy that Richard Reeves calls "High-Investment Parenting". With relatively low fertility rates among the upper middle class, this kind of parenting strategy makes sense. But it could mean that parents are going out of their way to discourage their precious kids to take risks.

5. The Internet. I noticed something odd recently. Japanese people are traveling to America less, and when you ask them why, they often cite violence as the reason, even though violence in America has declined dramatically in the last two decades. But thanks to the internet, there's a lot more information available about the violence that does exist, and by the availability heuristic, this will tend to make people more worried about it. In the same way, Americans may be more acutely aware of the real consequences of failure, thanks to the internet, and this may be scaring them.


So the question is, what do we do to encourage Americans to take more risks? Well, the internet is here to stay, and High-Investment Parenting seems like a very good thing overall. So the best way to boost risk-taking seems to be to decrease the downside risks of failure - by establishing a social safety net (including universal health care), and by doing whatever we can to fight labor market segmentation (I'll admit I'm not sure how to do that, but there must be ways). It's a lot easier to be the "land of the brave" when you've got a whole army behind you.