Mercury Rising 鳯女

Politics, life, and other things that matter

Not water: fire next time

Posted by Charles II on July 9, 2011

FT has a series of interesting articles/video on market risks from fraud and market failure.

1. Increasingly, brokers have the responsibility for policing fraud, since the exchanges do not know what regulatory area the client is in. Many brokers, of course, are completely unequipped to do this, and their only backup are the regulators. You know. The regulators that were completely caught by surprise by the mortgage crisis, Bernie Madoff, etc.

2. There has been limited progress toward regulating derivatives. Foreign exchanges are claiming that the US rules of the long-delayed and much-sabotaged Dodd-Frank are too strict, which of course is the opposite of the truth. Since the US Congress is in the hands of the Four Horsemen of the Apocalypse (my phrase, not the FT’s), there’s no way to get amendments of Dodd-Frank through without risking wrecking the whole thing. This gives plenty of room for financial interests who want to continue reckless practices to quibble about things and prevent any global implementation.

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3. High frequency trading, widely blamed for last year’s flash crash, continues as a threat to market stability. I think it is a threat to market profitability. The reason is this: If I buy a stock at $1 and sell it to you for $2, then I make a profit of $1, less transaction costs. The high-frequency traders say, in essence, that their activities do not influence the prices of stocks, that since they trade on little price squiggles, they don’t affect the equilibrium. But some thought reveals that this must be incorrect. Let’s suppose that there was a little price squiggle to $2.01. The high frequency trader bought at $2, and sold at $2.01. They didn’t reduce my profit. Unless one believes that stocks can go to infinite price, they did reduce the profit potential of the person who bought it. And this is before consideration of transaction costs (broker’s fees, taxes, and recordkeeping costs), which inevitably reduce profit potential even further.

Explaining this in detail still eludes me, but I understand why the HFT argument that they don’t affect price is wrong through a physical analogy. It is like saying that the force of a wave is not reduced by cross-currents within it. But conservation of energy says that the total energy of motions within a wave must either be directed forward or in some other direction. Cet. par., motion not in the forward direction subtract from the force of the wave. The analogy hinges on conservation of energy being comparable to equilibrium price. But, since the only way that high frequency traders can not reduce the profit potential is to sell at a loss. Believing that investment banks lose money is less sensible than believing in fairies.

4. From MarketWatch, Brett Arends explains why there is likely to be an even greater financial crisis next time. Some of the complaints are somewhat hysterical. For example, “U.S. nonfinancial corporations overall are now deeply in debt, to the tune of $7.3 trillion.” Well, yes. But it’s debt at extremely low interest rates, they aren’t spending the cash, and corporate balance sheets are for the most part in excellent condition. So, this is mostly a non-issue. The main concern is that the real economy is not doing very well. Economists call this the output gap–the difference between how much GDP you could be producing and how much you are producing.

US GDP output gap

According to CBPP, every year we are producing $820B of wealth less than we are able to do–and have been since the crash. This is adding up to Trillions with a T of dollars of wealth poured down the drain. While some of that was inevitable once the housing bubble got going, the slow growth policies adopted by conservatives in the White House, Congress, and the states mean that they are sentencing us to continuing impoverishment as a nation.

Arends misses the leverage that matters: margin accounts, for example. He also doesn’t mention the growing risk that if there’s a debt limit crisis and interest rates spike, it will raise borrowing costs for the US government and further waste our growth potential. But it’s a useful read.

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