Krugman Versus Keynes

Remember Paul Krugman? You know, the guy who thinks we’re so deep in a liquidity trap that pretty much all spending is good spending, even if it’s socially wasteful?

Well, here’s something odd. That very same Paul Krugman is outraged to the core by expenditures on fiberoptic cables to support high frequency trading — expenditures that I happen to agree represent a giant social waste.

“We’re giving huge sums to the financial industry for little or nothing in return”, gripes the very same Krugman who thought it was a swell idea to stimulate the economy through hundreds of billions in government spending, whether or not we got anything in return.

It’s true that Keynesian economists have reasons to believe that wasteful spending is sometimes good. But honest Keynesian economists tend to acknowledge that those reasons apply equally well to both private and public spending.

Krugman’s view, apparently, is that, at least in the current climate, wasteful spending is good as long as you’re spending taxpayer’s money, but bad if you’re spending your own money. That’s not Keynesianism. It’s just crankiness.

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121 Responses to “Krugman Versus Keynes”


  1. 1 1 RJ

    I don’t think you’re being fair.

    We’re giving huge sums to the financial industry for little or nothing in return”, gripes the very same Krugman who thought it was a swell idea to stimulate the economy through hundreds of billions in government spending, whether or not we got anything in return.

    Krugman’s view, apparently, is that, at least in the current climate, wasteful spending is good as long as you’re spending taxpayer’s money, but bad if you’re spending your own money.

    No, the issue involved taxpayer supported resources, hence the reference to meetings with county boards and state highway commissions in the Forbes article, and how it is benefiting an industry that Krugman and others believe offer society little to no value for the great costs it imposes.

    Nor has he stated all spending is equal and referenced Keynes coalmine hypothetical here. (Notice the emphasis between “wholly” and “partially” wasteful.) He also mentioned numerous times that there are other preferable forms of spending to others.

  2. 2 2 Greg

    I was just about to post basically what RJ posted. I’d just add that, even if you believe all spending is good, you can still believe some forms of spending are better than others. For instance, what could the cost of that fiber optic cable done for our aging power grid instead?

  3. 3 3 Kevin Erdmann

    I call shenanigans on RJ and Greg. I don’t see anything in the Forbes article about public spending. Those meetings are probably about purchasing right-of-way along pre-existing public corridors – private money paid to public and private land owners. Krugman’s “huge sums” are in reference to the amount of private production that comes from the finance industry.

    This is “The People’s Romance” combined with anti-Wall Street posturing. The double standard is so stark. Here we have people who will defend all sorts of public spending, including war-making, because of some sort of “multiplier” or positive externality. It’s worth building a global military empire because we get GPS, etc.

    Then we have private individuals using their own capital to build actual, honest-to-goodness infrastructure. It’s a damned fiber optics line from Chicago to New York, for Pete’s sake – state of the art I am sure. But, since they dare to intend to dispense of its use through private means, well then, it’s just a big old waste.

    They just built the best fiber optic connection current technology could provide! Let’s just accept all the BS about HFT. Even if those are the witches you’re hunting, how hard is it to imagine that somebody you aren’t interested in tarring might actually find that fiber optic line useful at some point?

    Somebody just went to a hell of a lot of trouble building the best communications channel they could possibly build between two important economic centers. Infrastructure, I think they call it. Show me a country that would celebrate this. That would probably be a dynamic, successful country.

  4. 4 4 Advo

    It’s not only that the money is wasted, the money is spent to enable the flashies to collect rents.

    Plus, I have no problem on the one hand to acknowledge the truth of what Keynes stated – any spending, even if it is wasteful, is good for a depressed economy – while at the same time deploring wasteful spending nevertheless.
    Plus, this kind of wasteful spending goes on without regard to the situation of the economy.

    Just because you’re a Keynesian doesn’t mean you have to qualify criticism of wasteful spending with the proviso that such waste would be beneficial under certain economic circumstances.

  5. 5 5 Steve Landsburg

    I briefly appended a note to the original post acknowledging RJ’s point, but on second thought I’ve deleted it. I think Kevin Erdmann is right that we’re not talking about substantial public spending here. Certainly when Krugman refers to hundreds of billions of wasted dollars, he’s not talking about the resources coughed up by county boards; he’s talking overwhelmingly about private investments.

  6. 6 6 Greg

    Kevin – I touched on your point. I think there are better uses for our billions, within the realm of infrastructure spending, than fiber optic cable. But that’s not what I came here to defend. I stand by my claim that, in general, one should be free to decry “good” policy when it comes at the expense of “better” policy. Conservative economists do it all the time.

  7. 7 7 Gabe

    Krugman likes public spending, as long as it’s what he wanted to spend our money on. I don’t think this is even a matter of whether the money was spent on a HFT fiber optic line or a new bridge. No matter what the investment is, it’s been done with stolen money and is subject to the vultures on K Street. If we are assuming that the we need public spending, then we can get into a debate concerning our preferences for what type of infrastructure serves the greatest good. But why are we assuming this? And why is Krugman, a man who is nothing more than a pundit (albeit an intelligent one) such a frequent point of discussion on this blog? Arguing how much value is added by an industry is what fascists do, so that they can plan society accordingly. Or we can let the market determine a thing or two and allow crony, inefficient firms to fail. I recognize that from a practical standpoint, this post is completely useless. But I hate to see the debate devolve into “I think the money should go to X instead of Y”. Let’s not write with the pretense of knowledge.

  8. 8 8 RJ

    Kevin-Worrying about direct spending from the government misses the point entirely, nor was it something I addressed. You’re too focused on explicit costs and not implicit costs. The article quotes one of the investors admitting that “Not everyone wants a fiber optics tunnel in rural Ohio.” Those rights-of-way along pre-existing corridors, which were taxpayer supported in the first place, could have been used for something else that would have resulted in greater social benefits instead of going to the few elite.

    Even still, the point of my post was that Landsburg wasn’t being fair in his criticism against Krugman’s views of spending, and I thought an earlier post of Krugman’s referencing Keyne’s coalmine hypothetical was a good example to show where he’s coming from. There are others too.

  9. 9 9 RJ

    Oh, and one more thing.

    Certainly when Krugman refers to hundreds of billions of wasted dollars, he’s not talking about the resources coughed up by county boards; he’s talking overwhelmingly about private investments.

    He didn’t say hundreds of billions of dollars, he said hundreds of millions of dollars for the fiber optic line. That difference is significant. The only time he mentioned “billions of dollars wasted” was in the context of what the financial industry as an aggregate wastes annually, referenced by Thomas Philippon’s paper. It seems to me the whole piece merely expressed concern that society is allocating scarce resources to inefficient industries that benefit the few; personally, I don’t see anything wrong with criticizing private spending that comes at a great cost to society.

  10. 10 10 Steve Landsburg

    RJ:

    I don’t see anything wrong with criticizing private spending that comes at a great cost to society.

    Neither do I. Nor do I see anything wrong with criticizing public spending that comes at a great cost to society. Krugman, however, will cheerfully tell you that all such critics are motivated only by the vilest of intentions.

  11. 11 11 Gabe

    Steve Landsburg is funded by the Koch brothers. It’s the only explanation for holding dissenting views.

  12. 12 12 Daniel

    You simplify Krugman’s stance beyond recognition to make your point. Krugman opens his article with a comparison of a tunnel that would have created a new route to relieve some of the heavy traffic to/from NYC and helped 100′s of thousands of people in their commute time everyday with a fiber optic cable that allows oh so very slightly faster arbitrage corrections. The point is that we as a nation are apparently too broke to do something that has such an obvious net benefit to society, but have all the money in the world to correct arbitrage 3/10′s of a millisecond faster. He’s making an allocation of resources argument, not an overall spending argument.

    Krugman does believe that doing something useless is better than doing nothing when we’re constrained by a liquidity trap, but as RJ and Greg have pointed out, that doesn’t preclude him from making comparisons between the actions that we could take. And in this case, Krugman is making a point that allocation to the financial industry (a very special form of private spending) in excesses that make it worth for them to spend money on shaving 3/10′s of a milliseconds off of arbitrage time is worth less than spending money on nothing (digging holes or what not), since it allows more money as a fraction of GDP to be funneled towards the financial industry which he is claiming already has too large of a fraction of GDP. He also probably believes that allocating higher fractions of GDP to the financial sector makes liquidity traps more likely to occur, and thus it makes perfect logical sense that he’d in this case argue against private spending to decrease the likelihood of depressions.

    Why are you so obsessed with Krugman btw, it seems that you criticize him even when it doesn’t make sense to include him in the post (e.g. your last post). It just always seems like you have some personal vendetta against him. Did he steal your candy when you were kids or something?

  13. 13 13 Daniel

    “Neither do I. Nor do I see anything wrong with criticizing public spending that comes at a great cost to society. Krugman, however, will cheerfully tell you that all such critics are motivated only by the vilest of intentions.”

    This isn’t really a fair criticism of Krugman. He would only say that those that are motivated by the vilest of intentions are those that seek to lower spending overall since spending by the public sector in this case does not replace spending by the private sector because of the underutilized labor, etc. So if someone would like to propose spending money in the public sector more efficiently while keeping spending the same or increasing it, I don’t think he’d have any problems with that and be fine with criticizing specific aspects of the public sector in this case.

  14. 14 14 Kevin Erdmann

    RJ & Daniel,

    It seems like you are treating the use of right of ways as if they are at capacity so that the placement of this line is a zero sum game yet at the same time you are treating the HFT industry as if new investment has no effect on the existing competitors.

    Reality seems 180 degrees from this. The private investors are paying public and private landowners for right of way that creates negligible limits on other potential lines, so this is purely a transfer from these private interests to the land holders. And, the profits from the use of this line will come almost wholly at the expense of other HFTs.

  15. 15 15 Patrick R. Sullivan

    If Krugman REALLY wants the spending on ‘infrastructure’ that will benefit large numbers of people, there’s a simple way to get it. Look up ‘Millau viaduct’ (and that was done by French Communists!).

    Sheesh, he’s a Nobel prize winning economist with a column in the NY Times, and he can’t propose an actual solution–building tunnels and bridges as business ventures (the way NYC got its first subway).

  16. 16 16 Daniel

    @ Kevin Erdmann,

    You make a good point that if the HFT line does not lead to a higher concentration of wealth in the financial industry than it would have the same result as paying someone to dig and fill in holes. So you’ve convinced me that if the line really doesn’t change the allocation of resources, and it really has negligible effect on other’s use of this same passage ways than it would have the same stimulative effect of digging and filling in holes. Although I’m not sure that HFT is a zero sum game for the financial industry, I admit that I’m not really sure. I still think it was a good example for the excesses of the financial industry and doesn’t really hurt the rest of Krugman’s argument (that the financial industry is becoming over bloated for whatever reason).

    @Patrick R. Sullivan,

    Interesting example. I agree that it would be good if the government made more deals like this. However I’m not sure it’s always possible, especially during a financial downturn to get a private company on board with this financing scheme for every needed infrastructure project.

  17. 17 17 enoriverbend

    Apropos of Greg’s comment “Krugman likes public spending, as long as it’s what he wanted to spend our money on. ”

    Krugman has recently accepted a job devoted to studying income inequality… a job which pays $25000/month. No word yet on whether cognitive dissonance has caused Paul to give up his column.

    This is with City University of New York, which is publicly funded via the state and city.

  18. 18 18 Kevin Erdmann

    Daniel,
    It’s like digging a hole and filling it with a state of the art fiber optic line. It would take a lot of biased, ugly, binary assumptions about the line’s builders and it’s lifetime usage to completely annul the value of that.

  19. 19 19 cqaq

    I agree, stimulus money would have been better spent (in part) by having the gov build the network. And then building a faster one…

    The build can be seen as a tax on Wall Street to fund infrastructure for main street. Wall Street’s going to use the bandwidth, and was willing to pay a premium for low-latency bandwidth. Someone built it, Wall Street funded it — and moved off of other fiber assets, thus lowering their costs — and eventually they’ll move on to something else. What will be left in the wake is more fiber laid.

    As you point out, this was all private spending. Making arguments about what else society could have gotten out of the labor even more absurd — unless, of course, one believes there should be no free market. It’s one thing for people to be incensed about wasteful gov spending — because they feel it’s THEIR money — quite another to be incensed by free exchanges between third parties.

    I do find it amusing that people can get riled up about the “waste” of building something like this (I have times almost felt this too) but give barely any thought to the wastefulness of the complexity of the US tax code.

  20. 20 20 Richard Fam

    Economic McCarthyism?

  21. 21 21 Daniel

    Kevin erdmann

    Who are the HF traders serving by reducing arbitrage by 3/10′s of a second or are you saying the line will have alternative uses over it’s lifespan? This is not a rhetorical question. I really want to know the answer.

  22. 22 22 Kevin Erdmann

    Daniel,

    Of course there will be alternative uses. Do we even know if 100% of the initial bandwidth will be used just for HFT?

    And, HFT is an easy target, but the discussions surrounding Michael Lewis’ new book make it clear that this is a complex issue. And, every corner of modern life is a complex mixture of utilitarian production, competitive redundancies, status signaling, etc. It just strikes me as banal to paint a picture of the economy that only focuses on that issue with regard to a specific economic function, and to say that every dollar that goes to it, from the ditch diggers, to the quant programmers, to the night janitor at the headquarters building, is 100% waste – that these people, engaged in a complex endeavor embedded in an even more complex system of transactions – starting with the first dollar they claim as income, are just a waste of resources.

    A government edict to dig holes and fill them in is not so complex that it can’t be called wasteful. I think the confidence with which this fiber optic line is being called entirely wasteful far exceeds the ability to honestly call it such.

  23. 23 23 Daniel

    @Kevin Erdmann,

    I admit that I’m not really sure about other uses for the fiber optic cable line. I definitely don’t think Krugman thinks that all of finance is wasteful, just that it’s taking an increasing fraction of GDP and dampening growth in the rest of the economy. There is some evidence that when financial sectors become too bloated it increases the probability of financial crisis that create a abnormally long depressions.

  24. 24 24 RJ

    It seems like you are treating the use of right of ways as if they are at capacity so that the placement of this line is a zero sum game yet at the same time you are treating the HFT industry as if new investment has no effect on the existing competitors.

    Don’t ‘speculate’ on things I haven’t said. I merely said this line, relative what it could have existed in place, is wasteful.

    Reality seems 180 degrees from this. The private investors are paying public and private landowners for right of way that creates negligible limits on other potential lines, so this is purely a transfer from these private interests to the land holders.

    That doesn’t mean it’s optimal or that it’s wanted by the public. And where are you getting that it creates ‘negligible limits’ on other potential lines?

    And, the profits from the use of this line will come almost wholly at the expense of other HFTs.

    ^Nope, not if it’s rent-seeking.

  25. 25 25 Henri Hein

    I find this kind of thing downright funny. Krugman — and, by corollary, Daniel and RJ — wants me to believe, only on his say-so, that he can see the value of this fiber-optics project better than Barksdale and Spivey. It’s a laughable proposition. I don’t know much about HFT, but it’s safe to assume that Barksdale and Spivey, who are investors by trade and have spent considerable time and money on this project, knows a great deal more about its value than Krugman does.

  26. 26 26 Steve Landsburg

    Krugman — and, by corollary, Daniel and RJ — wants me to believe, only on his say-so, that he can see the value of this fiber-optics project better than Barksdale and Spivey.

    Henri Hein: No, I don’t think that’s fair to Krugman. What he wants you to believe is that the value of the project to Barksdale and Spivey diverges dramatically from its social value. That’s not only a respectable position; it is, I think, a correct one.

  27. 27 27 Henri Hein

    I still don’t understand how we can know this. Comparing the social value of a rail line vs. a fiber-optics cable requires an intricate knowledge of both the transportation industry and the HFT industry that I suspect Krugman does not have. I don’t see how we can say a priori one is better than the other, and I don’t see how we can calculate the difference without a massive amount of data that is simply not available. It seems like I’m missing something.

  28. 28 28 Kevin Erdmann

    RJ,
    So, it’s your belief that this will have no effect on the profits of existing HFTs, but that it will now be significantly more difficult for someone to snake a pipe through the hinterlands of Pennsylvania because this line used Pennsylvania all up?

  29. 29 29 RJ

    It seems like I’m missing something.

    Aside from reading comprehension and an understanding of how to properly use “corollary”?

    Snark aside…

    So, it’s your belief that this will have no effect on the profits of existing HFTs,

    No.

    but that it will now be significantly more difficult for someone to snake a pipe through the hinterlands of Pennsylvania because this line used Pennsylvania all up?

    That could be one possibility, but it’s not the only way waste occurs (nor does capacity have to be maxed out for the matter).

  30. 30 30 RJ

    And I’ll repeat it again because throwing a question back at me to avoid a question I asked earlier gets irritating, Kevin, where are you getting that it creates ‘negligible limits’ on other potential lines?

  31. 31 31 Henri Hein

    Corollary: something that naturally follows (Definition 2a in Merriam-Webster).

    Since you and Daniel defends the Krugman position above, I took it to naturally follow that you also want me to believe the proposition. Was that hard to comprehend?

  32. 32 32 RJ

    Since you and Daniel defends the Krugman position above, I took it to naturally follow that you also want me to believe the proposition. Was that hard to comprehend?

    Excellent, you can cite a secondary definition that’s vague enough for you to attempt to stretch it. Now cite the word “non sequitur” after you read what I initially posted (hint, it was actually a criticism of a criticism).

  33. 33 33 Henri Hein

    RJ: I read your post #1, and in it, you say “[the project] is benefiting an industry that Krugman and others believe offer society little to no value for the great costs it imposes” [sic]

    If you did not mean to defend Krugman’s position by that, maybe you should clarify, rather than engage in semantic obfuscations.

    You have not begun to address the knowledge problem, which was my main point. So I will see your non-sequitur and raise with an ad hominem.

  34. 34 34 Steve Landsburg

    Henri Hein:

    HFT is (as far as I can tell) socially wasteful for exactly the same reason that robbery is socially wasteful: It consumes resources without producing anything of value.

    What do you imagine is the social value of executing a trade .03 seconds faster than it would otherwise have been executed?

  35. 35 35 Kevin Erdmann

    Steve,
    I’m surprised to hear you say with such confidence that the fiber optic line adds no value, even if it is used only for hft. This is a complex interaction. There are a lot of things going on regarding liquidity and a sort of algorithmic market making. After reading the responses of some hft people to Michael Lewis’s book, I think to say anything absolute about this is a little bold.

  36. 36 36 cqac

    It consumes resources without producing anything of value.
    The same could be said of economists. :) And has.

    As to the social value of executing a trade 0.000001s (=1us) faster:

    (1) What does the timescale matter? Why not ask what’s the value in executing 1 hour faster? Possibly because it would be wasting people’s time to wait around trying to figure out if they could do a deal. But then the same might be said of the 1us question. People have encoded their procedures (or part of their procedures) for determining fair value into algorithms. Rather than sit on the phone chatting, they let their algorithms go out and interact. You get feedback and information when someone chats with you, they get feedback when something occurs in the market. The faster the turnaround time, the more information disseminated per second, the more efficient the whole process. Thus freeing up human capacity to do something other than appear on CNBC in a funny-colored jacket standing on the stock-exchange floor.

    (2) Competition drives innovation. There are residual benefits from all of this activity. Research into building better hardware, in telecommunications and in other layers. While some might say, “those people could’ve built that anyhow”, I would ask who would have funded it and how would they have chosen what to work on? Hobbyists work on being faster, better, etc. because it’s cool, but they drive even harder on the problem when there’s a buyer for their services.

    (3) Do you dislike Bitcoin? People building custom ASICS for mining. Is there a different answer for the social value for that activity? I could provide a similar answer, but I’m curious if you have your own and why it wouldn’t apply to HFT as well?

    (4) Are you concerned with ad placement on the internet? People fiercely competing to make algorithms run faster and better just so they can be sure to get their ad placement bid in on time after crunching through the user profile data for the page view.

    (5) The absurdity of the grand utility arguments – that we all have the same assessment of utility (value). When you claim something produces nothing of value, that’s a highly subjective statement. Do you believe that the definition of what constitutes robbery is an equally subjective assessment? Who gets to decide what creates value and what doesn’t? If someone sits in a sensory deprivation chamber for an hour doing absolutely nothing, are they robbing you because they aren’t creating something of value, but are using up resources (their time)?

  37. 37 37 Twofer

    I’ve not read the Michael Lewis book yet (I believe that I could make a credible case that he is America’s best story teller right now – and I mean that in the positive sense), but I’ve had the opportunity to listen to a couple of interviews with him about it.

    What I gather Lewis is telling us in the book is two things. First, its the story of the rise of intermediaries in the market, how transactions are not directly between buyer and seller, they go through intermediaries that we have no way of knowing about. The value of the .03 seconds is that the intermediary can front run the trades as well as other forms of predation (basically trade with information about tomorrows price today which in the computer world is what .03 second advantage allows you to do) and always win — as born by the fact that intermediaries that do this are posting a profit every single day which basically means they are trading with no risk — something the rest of us don’t get to do. That money comes out of our pockets (presuming we use brokers, have retirement accounts etc.)

    The second thing Lewis seems to be saying, and I think this is in line with Krugman, is that there is a very bad set of Wall Street incentives that leads to these kinds of investments (e.g. in human time, not computer time, front running is not legal — for what I hope are obvious reasons). Others have already commented about the rising share of GDP that the financial sector and the issues it causes.

    Personally, I think we should be mad about what this investment allows a few people to do at the expense of the rest of us. It is also worth noting that after publication of Lewis’s book, several investigations into HFT have been announced.

    To the person above who suggested a market based solution to the issue of HFT, that is what Lewis suggests too. His book, as I understand it is also a story of an attempt to do just that.

  38. 38 38 Steve Landsburg

    cqac:

    1) What does the timescale matter? Why not ask what’s the value in executing 1 hour faster? Possibly because it would be wasting people’s time to wait around trying to figure out if they could do a deal. But then the same might be said of the 1us question.

    Except that a) saving a millisecond is clearly less valuable than saving an hour and b) far more importantly, we have *absolutely no theory* that predicts that the private and social values of these saved milliseconds coincide.

    2) Competition drives innovation. There are residual benefits from all of this activity. Absolutely. There are also residual costs. Again, we have *absolutely no theory* that suggests that the private costs/benefits coincide with the social costs/benefits.

    3) Do you dislike Bitcoin? People building custom ASICS for mining. I like Bitcoin a lot. But there’s no doubt that Bitcoin *mining* is pretty much socially worthless, and that it’s part of the downside of Bitcoin, not the upside.

    4) Are you concerned with ad placement on the internet? People fiercely competing to make algorithms run faster and better just so they can be sure to get their ad placement bid in on time after crunching through the user profile data for the page view. It seems likely to me that there’s a lot of social waste there, but I haven’t thought this one through carefully enough to be sure.

    5) The absurdity of the grand utility arguments – that we all have the same assessment of utility (value). Absolutely nobody ever claimed any such thing, and if you think that that’s what the argument rests on, then you’ve entirely failed too understand the argument.

    6) If someone sits in a sensory deprivation chamber for an hour doing absolutely nothing, are they robbing you because they aren’t creating something of value, but are using up resources (their time)? Of course not. Why would you suggest such a silly thing?

  39. 39 39 RJ

    Henri:

    Clarifying the context of someone’s argument or views is not the same as defending/agreeing with the content. I criticized Landsburg’s post by stating that he wasn’t being fair to Krugman’s position and referenced Krugman’s often espoused views on spending.

    What you did was initially come off as a douche and made a straw man out of what Daniel, Krugman, and I said, as well as their implications. Given that you’ve shown the least understanding of the subject being discussed, you might want to follow the example of several other posters here and show a bit more humility.

    So no, I do not intend to address any of your points. Mocking you seems like a better use of time.

  40. 40 40 Methinks

    We’re “giving” the financial industry huge sums? We are, but the “giving” Krugnuts is referring to is called “investment”. That’s not “giving” by any definition and you should know better than to pander to hogwash.

    Further, Krugnuts has no clue what he’s talking about. He doesn’t know a thing about financial markets or how the various parts of the financial industry – particularly liquidity provision in financial markets – works.

    Look, the reason people keep investing in HFT shops and other liquidity providers (like, say, myself) is that we make a profit by competing with each other to provide bids and offers to any investors who would like to exit or enter positions. Our competition gives you better execution, reduces transactions costs, volatility (and, no, our activities do not change the vol associated with changes in the security’s valuation. Don’t get mixed up about which vol we’re talking about) and, ultimately, reduces the cost of capital for companies seeking to fund new projects. So, if that’s a social waste, then I guess I don’t know what’s a social good.

    further, if liquidity provision is a social waste, then please do tell me why I’m making money doing it since I can’t force a single person to trade with me. All I – and any liquidity provider – can do is post our markets. If nobody wants to trade on those markets, they don’t have to. Obviously, someone finds my activity valuable then? Well, apart from ivory tower academics who insist on passing judgement on things they don’t understand.

  41. 41 41 Patrick R. Sullivan

    ‘I’m not sure it’s always possible, especially during a financial downturn to get a private company on board with this financing scheme for every needed infrastructure project.’

    For those for which it isn’t possible, there’s a clear message there, no?

    One of the best takedowns of Michael Lewis is here;

    http://scottlocklin.wordpress.com/

    The post title is ‘Michael Lewis: shilling for the buyside’

    ‘Old fashioned sell side guys have obsolete jobs. Their jobs are to find liquidity for “buy side” customers buying into or liquidating a large position. Katsuyama’s anger at the idea that “the market is rigged” seems the simple rage of a man who has been assigned a task he is not qualified for. There are tales of he and his team wasting hundreds of thousands in RBC money executing bad trades to see what happens. They seemed shocked, shocked, that the market would move away from their ham-fisted dumpings of huge blocks of shares to someone else’s routing system.’

    Just for a taste.

  42. 42 42 Patrick R. Sullivan

    Then there is Manoj Narang;

    http://www.institutionalinvestor.com/Article/3328158/Channel/199225/A-Much-Needed-HFT-Primer-for-Flash-Boys-Author-Michael-Lewis.html

    Who does a good job explaining how increased speed has reduced the costs of trading, and thus the profit PER TRADE. Pretty much like everywhere else where faster exchange has been introduced.

  43. 43 43 Henri Hein

    Steve Landsburg:

    Our assumptions were different, then. I confess I know practically nothing about HFT. Its defenders say that the increase in price signaling due to the higher number of trades in any given time segment contributes information, and thus, more rational equities pricing. I find that plausible and have no information to evaluate for or against that.

    I used to think that the whole derivatives sub-segment was a waste. Once I learned more about its origin and purpose, I gained respect for what it adds, by moving risk from people that cannot afford it to people that can. Now I’m hesitant to pass judgment on investment mechanisms I don’t understand.

  44. 44 44 Methinks

    “What he wants you to believe is that the value of the project to Barksdale and Spivey diverges dramatically from its social value. That’s not only a respectable position; it is, I think, a correct one.”

    “HFT is (as far as I can tell) socially wasteful for exactly the same reason that robbery is socially wasteful: It consumes resources without producing anything of value.”

    So, basically, what you’re saying is that there’s no social value to lower execution costs, lower volatility and lower cost of capital? Wonderful. I have your books and I wouldn’t have pegged you for saying something so inane. Or do you not realize that what you’re saying is inane because you don’t actually know anything about trading in general and liquidity provision and HFT specifically? In which case, you should probably dial it back a bit. A lot, actually.

    You know what robbery is? The “good old days”. Days I’m old enough to remember. Days when the decidedly un-HFT floor crowds regularly colluded and raped customer orders. Days when you needed a floor broker in your employ to ensure anything approaching reasonable execution. Days when the specialist could freeze the book (do you even know the consequences of freezing the book? I’m guessing you don’t).

    “What do you imagine is the social value of executing a trade .03 seconds faster than it would otherwise have been executed?”

    What you describe is better liquidity. Liquidity is efficiency. What about efficiency in an economy is offensive to you?

    Consider that the 0.03 second improvement is just the latest iteration of improvements in a long process of improvements that have together monstrously improved efficiency in the financial markets. I remember the days when you had to wait over a minute to get executed and a lot can happen in 60 seconds (time during which you are at the mercy of the floor crowd for that 60 seconds). This is efficiency that (once again) results in lower vol, lower transactions costs and lower cost of capital. It boggles my mind that an economist would see no value in a marginal improvement.

    Remembering the floor crowd days, I struggle to understand how you can call a completely voluntary act – the willingness to transact with someone at the price they want or better the price for them – “robbery”. Are you serious? To call it “robbery” is to display inexcusable ignorance and arrogance on your part.

    But, I’m arguing against interest. Please, by all means, kill the HFT guys. Though like all market makers, we employ algorithms (at the command of the SEC, incidentally, so good luck killing that), we are not an HFT shop. There’s nothing I’d love more than for you and your lot to outlaw HFT so that liquidity falls, spreads widen and I make even more money. Liquidity providers, like all dealers, make money on the spread. The wider the spread you have to cross, the more money I make. Go for it. It’s your funeral.

  45. 45 45 Daniel

    @Methinks,

    This is only aligning markets in New York and Chicago by 3/10′s of a millisecond faster, not all trades. And I don’t think anyone would argue that a 1 minute would be ideal for markets but where do we draw the line between a useful reduction in time rather than a prisoner’s dilemma between HFT firms?

    And is there any evidence that HFT creates a noticeable benefit to the economy as a whole rather than just the HFT firms? Has there been a panel study of countries that looked at % change in GDP in the year before and the year after implementing HFT. Even then it’d be hard to pin down the effects because implementation of HFT is naturally correlated with an advancing economy. This is minimal amount of evidence that would be needed to convince economists that HFT has a positive impact on the economy as a whole rather than the whole of the financial sector or even more specifically HFT firms at the expense of other financial firms.

  46. 46 46 Methinks

    @Daniel

    …not all trades

    Not on all trades? Well, then it’s useless. Just like any product that isn’t affordable or available to everyone is totally useless.

    but where do we draw the line between a useful reduction in time…

    “we” don’t draw any lines anywhere. Customers (investors looking to manage their positions) draw the lines. You don’t get a vote in any trade to which you are not a party. Where do we draw the line at how quickly your local supermarket restocks milk?

    “And is there any evidence that HFT creates a noticeable benefit to the economy as a whole rather than just the HFT firms?”

    Yes, there is. Firs of all, HFT firms – like all liquidity providers – benefit from volatility, wide bid/ask spreads and less timely execution. The very fact that bid/asks are bettered by fractions of a penny and marginal improvements in executions are counted in milliseconds tells you exactly how razor-thin the margins are and how low volatility is. Do you think that razor-thin margins are better for the supplier rather than the customer? If so you’ll have to explain that to me. Also, you’ll have to explain why you think that lower risk for the customers damages customers and benefits the supplier of that lowered risk when higher volatility (risk to the customer) benefits the supplier.

    Has there been a panel study of countries that looked at % change in GDP in the year before and the year after implementing HFT.

    Has there been a panel study of countries looking at the % change in GDP (a stupid measure of economic progress as their ever was anyway, but I digress) before and after increased competition in clothing stores, grocery stores, shoe stores, computer manufacturers, service providers, etc? NO??? Then how do we know innovation and competition in any industry is beneficial?

    HFT exits because of increased competition in the market. There is no magic in financial markets. Like all markets, financial markets benefit from competition. Yet, I’ve seen economist after economist (real ones like Landsburg and Caplan, not the hacks masquerading as economists like Krugnuts) make completely idiotic (sorry, boys. Truth hurts) arguments that competition in financial markets should be reduced. Please someone explain to me the magic by which competition, which is widely acknowledged to benefit every single market, actually fails to produce the beneficial effects in the financial markets? That is the argument that Landsburg (let alone Daniel) is essentially making. I’m deeply confused by this.

    This is minimal amount of evidence that would be needed to convince economists that HFT has a positive impact on the economy as a whole rather than the whole of the financial sector or even more specifically HFT firms at the expense of other financial firms.

    Let me explain to you how competition works: more competitive firms which provide customers with better products and services ALWAYS benefit at the expense of their slower, less efficient and less effective competition. That’s “creative destruction”, my dear. That’s why you drive a car and not a horse and buggy.

    I don’t know what you don’t like or what isn’t obvious to you about the benefit to the entire economy of lower transactions costs, lower risk and lower cost of capital, but all of those things are very well documented. If you don’t believe me, just take a look at the spreads and volatility in medium to low liquidity securities (where HFT doesn’t operate) and check out their cost of capital.

  47. 47 47 Methinks

    As long as we’re at it, though, has anyone done a panel study on the benefit of more economists and more competition among economists to GDP? Any at all? Can we just assume that economists in general and more economists specifically are completely useless and are perhaps even socially destructive until such a panel study proves their benefit beyond a reasonable doubt? Let’s introduce Certificates of Need in every industry. Until someone with zero understanding of an industry, let alone specific knowledge, decides something is beneficial nobody can start a new firm. That’ll be great.

  48. 48 48 Daniel

    @Methinks,

    “Please someone explain to me the magic by which competition, which is widely acknowledged to benefit every single market, actually fails to produce the beneficial effects in the financial markets?”

    Not always. Sometimes increased competition just shifts around the allocation of resources wastefully. When two well known companies enter an advertising war for similar products, it essentially just shifts around market share without tangibly benefiting either firm or the consumer. See prisoner’s dilemma.

  49. 49 49 Methinks

    And yet, Daniel, there are lots of HFT firms. Because of their competition to provide bids and offers spreads have tightened and executions are better, so we know the consumer has benefited from HFT. Your theoretical argument does not apply. Before you attack HFT you first have to figure out what it is. I’ve seen no evidence that its detractors have any idea what’s actually going on before they trot out strong opinions about how things oughta be changed.

  50. 50 50 Methinks

    As long as you brought up the head-to-head battle between giant companies, Vanguard and Fidelity are locked in such a battle. The result is that management fees (paid by the customer) have plummeted (but not all at once). Oh woe is us, right? Sadly, Landsburg’s argument is that unless every marginal improvement is huge it’s not worth the investment. In fact, it’s “robbery” (???? Still trying to figure out how he got there). That’s not an argument based on evidence. That’s just the grumbling of a person whose only exposure to trading is occasional trades in a small retail account from a laptop on his kitchen table. It’s also equivalent to arguing that competition in clothing manufacturing is useless if every marginal improvement in retail price isn’t huge by some random person’s arbitrary standard. In fact, it’s robbery!

  51. 51 51 David J

    Someone just needs to convince Krugman that the lizard-person conspiracy theories are true and that these high-frequency trading firms are actually made up of invading space alien lizards. Then it’ll all be fine.

  52. 52 52 Daniel

    @Methinks,

    So then let’s get into the specific arguments against HFT and you can tell me why specifically the critics are wrong. I do want to learn more about it and your obviously more knowledgeable than I on the topic. We’ll go one argument at a time so that it’ll be minimal time input on both of our parts. What about the critics argument that HFT trades ahead of mutual fund rebalancing, and thus slowly draining money away from other mutual fund holders to HFT firms. This aspect of HFT strikes me as at best a zero sum game in favor of the HFT firms. What about this specific critique is either incorrect or overblown?

  53. 53 53 Daniel

    @Methinks 50,

    You were saying that competition always leads to a better off market. I was giving you a specific example where it doesn’t. I think that most of the time competition leads to a better off market, but that in specific markets for particular reasons the opposite can be true. So evidence of competition can not be used exclusively as evidence for a better market. You provided another example, which is well taken, still doesn’t change the point that competition doesn’t necessarily in all circumstances lead to a better market overall.

  54. 54 54 Steve Landsburg

    Methinks:

    I’m very glad to have you here, and hoping to learn from your experience and knowledge about financial markets. You’re welcome to disagree with me (or with anyone) and you’re welcome to express your disagreement forcefully. I find it entirely plausible that you could end up changing my mind. However:

    Landsburg’s argument is that unless every marginal improvement is huge it’s not worth the investment.

    What you’re not welcome to do is to make up ridiculous arguments out of whole cloth and attribute them to other people (in this case me). Forcefulness is welcome. Dishonesty will get you banned.

  55. 55 55 Patrick R. Sullivan

    That’s it, Steve? No responses to Methinks’ numerous specific arguments?

    You’re looking like Charlie Brown flat on his back on the pitcher’s mound right now.

  56. 56 56 Patrick R. Sullivan

    ‘Sometimes increased competition just shifts around the allocation of resources wastefully.’

    You know that how?

  57. 57 57 Patrick R. Sullivan

    Btw, hyperbole–what Methinks has indulged in at times–has been known as a legitimate rhetorical device for thousands of years. Seneca said of it that it, “asserts the incredible in order to arrive at the credible”

  58. 58 58 bigjeff5

    @Patrick
    Give Steve a little credit – he did say this:
    “I find it entirely plausible that you could end up changing my mind.”

    I take that to mean he’s going to review what he knows about HFT, and delve deeper into what he doesn’t know about HFT and trading practices in general, and come out with a more well-founded position on the matter. That’s the responsible thing to do when you realize there is more information out there than you knew about. Doggedly defending a belief held with incomplete information is not responsible, nor is completely changing your opinion just because someone made a good argument.

    For myself it has shifted me to the position that it is definitely not obvious that HFT does more harm than good, and that small improvements in speed have zero social benefit.

    The best example of direct harm I have heard of was the “Flash Crash” of May 6, 2010. Billions lost, but recovered within minutes. The total waste was on the order of millions – not a lot, relatively speaking. Also, while the official cause was the HFT systems, other independent investigations have disagreed. So even then, there is at least a little doubt that HFT actually caused volatility in the market, and in the general case it has been a significant stabilizer.

    That’s probably as far as my interest in HFT will take my personal analysis of the situation.

  59. 59 59 Daniel

    @patrick,

    In that same post I gave a specific theoretical situation where that would be the case. I remember my game theory book using the tobacco industry and the ban on advertising leading to higher profits as a specific example of this in the real world but have not done the research myself to confirm.

  60. 60 60 Methinks

    Whole cloth, Steve? I don’t think so. Not only do I generally have a lot of respect for you (hence my disappointment!), but I don’t enjoy wasting my time being dishonest (building armies of straw men). It’s possible I misunderstood you, but I didn’t make anything up simply to malign you. This is what I based my analysis on:

    HFT is (as far as I can tell) socially wasteful for exactly the same reason that robbery is socially wasteful: It consumes resources without producing anything of value.

    What do you imagine is the social value of executing a trade .03 seconds faster than it would otherwise have been executed?

    Here’s my logic: I assumed that you understood that an execution time of, say, an hour would be quite costly because long execution times increase risk. Risk ultimately increases cost of capital and innovations that reduce cost of capital are most certainly socially valuable. Since I assumed that you would see the value of reducing execution times because they do have social value, when you said “What do you imagine is the social value of executing a trade .03 seconds faster than it would otherwise have been executed?” you found no social value purely because of the small size of the latest incremental improvement.

    Thus it is perfectly reasonable to read you as having made that argument though you may not have been aware or intended to make it because you don’t know enough about finance – specifically how trade execution ultimately impacts the wider economy. If you stand by your argument that a small improvement has no social value then I ask that you please explain why marginal improvements have no social value because that is not the economics I learned.

    I’m always pretty forceful – although I try to refrain from likening people to thieves and their activity to robbery until I understand the topic better -, but I do try to be fair. Ban me if you wish, but dishonest I was not.

  61. 61 61 Methinks

    @Daniel,

    No problem. I’m in as long as time allows because I don’t have an endless supply of it and some of the answers really do take a lot more explaining than you might imagine. I – and a couple of actual HFT traders – answered a lot of these questions on marginal revolution a couple of weeks ago, so I may end up referring you to those comment sections.

    A major risk of market making (indeed, trading) is adverse selection. Informed customers can reduce us to ashes quickly. For time immemorial liquidity providers have tried to suss out informed order flow in order to avoid being trampled (not hyperbole!) by it (we avoid this by moving our market in response). This is not unique to HFT by any means. Informed customers hate this because it makes it harder to profit from information as market makers move the price closer to the fair value before informed customers can fully profit from the information. This reaction on the part of market makers also effectively disseminates the information to the wider public – and that is most definitely of social value. In effect, by refusing to dumbly allow informed customers to adversely select against them, there’s better price discovery and instead of only the mutual fund benefitting from that information, everyone benefits. HFT shops do exactly this, only with faster and cooler computers. Ask yourself this: why are informed traders entitled to benefit at the expense of market makers, small uninformed retail traders and less informed institutional traders?

    There is absolutely nothing wrong with reading order flow. We were all taught to read order flow before we were allowed to execute a single order. It’s not unethical because market makers (including HFT) only see the orders after they are made public. No market maker has any privileged information about an order. The importance of seeing order flow and moving your market in response is so vital that all market makers seek to locate closer to the exchange and are obsessed with speed for that reason. In the old days, we were IN the exchanges. Now, we all (including my firm, which is not technically considered HFT) locate our servers at the exchange. What’s the difference?

    What would be unethical is your executing broker trading ahead of the trade you entrusted it to execute. Your executing broker knows who you are, what positions you hold and possibly a lot of information about your trading. Most importantly, your executing broker has a fiduciary duty to you, in part for those reasons. A guy posting bids and asks on the exchange has no duty to fall on his sword so that you can benefit from information not yet priced into the security. if he reads you correctly, he has the right to move out of the way and by doing so cheapening the cost of information to the entire market.

    So, what you describe as a cost is actually a benefit to the entire market. Cheaper information, faster price discovery and more trading occurring at the continuous fair value of the security is most definitely a benefit to the market.

  62. 62 62 Methinks

    @Daniel,

    I answered a different popular talking point against HFT (a sign of my age. I wasn’t wearing my glasses and was thrown by the “mutual fund” bit when I read your question and didn’t realize you meant index rebalancing. Sorry. But, hey, we knocked that one out too so one less to go).

    So, rebalancing can be handled in a lot of different ways. The most common way index rebalancing happens is that the fund announces via press release well in advance which securities will be exiting and entering. It is a well known fact that index funds that rebalance on a single day do so at the close (the order is specifically called “market on close”). HFT has no special information. They read the same press releases you do. If you wanted to you could buy the stock in the market and offer it to the index fund at the close on rebalancing day.

    In fact, because so many people crowd into the trade, it’s unlikely to be profitable. The price of an entering stock jumps dramatically upon announcement of its future inclusion in an index and then everyone lines up to offer the stock at the close of the market on rebalancing day. In fact, it’s pretty amusing to watch the tidal wave of offers awaiting the index fund as the market heads for the close. As a result of the competition to sell to the index fund, the price of the security the fund is seeking to buy often FALLS right at the close and index fund gets the better of the HFT guys and every other sucker because there are more shares offered to the fund than the fund is looking to buy. So, the activity of HFT (and the whole market’s reaction, more broadly) is not the thing that is detrimental to index fund rebalancing. Liquidity providers are often on the losing end of that trade.

    Yet, academic studies show that these rebalancings are not beneficial to index funds. They lose to them on net. However, this is because when the announcement is made, the stock jumps sharply and even with the tsunami of offers, the fund ends up buying the stocks at higher prices (and selling at lower prices) than they would sans announcement. Why do index funds still make these announcements? Because it’s in their rules. They have to. Why do they have these rules? That’s a good question, but not my wheelhouse. I’m no mutual fund expert, but my unfortunately intimate experience with regulators informs me that they are probably forced to make announcements by the regulator. As far as I can tell, some index funds appear to have the discretion to do the necessary trades to rebalance over a longer time period, thus reducing the negative effects of showing their hand. That’s much much smarter. However, the point is that it’s the funds themselves (or the regulators) via stupid rules that hurt index fund, not HFT or any other market participant.

  63. 63 63 Methinks

    @bigjeff5 (gotta love that name!)

    The best example of direct harm I have heard of was the “Flash Crash” of May 6, 2010. Billions lost, but recovered within minutes. The total waste was on the order of millions – not a lot, relatively speaking. Also, while the official cause was the HFT systems, other independent investigations have disagreed.

    I disagree that the cause was HFT. I remember the flash crash well. The market was completely broken. Data feeds necessary to run algorithms – and indeed to inform manual trading – went haywire. These technical glitches are sometimes going to happen in an electronic market (I argue that the risk of the occasional glitch is worth the benefit of electronic markets, but that’s another conversation). When something like that happens, leaving your algos on is basically suicide – I point to Knight as an example of what can happen to you very quickly if your altos go crazy. The safest thing to do is turn off all your algorithms and step away until the glitches are fixed.

    Not only HFT but all official market makers (Designated Market Makers) turned off their algos. As a DMM, we were forced to provide a two-sided market at all times, but we all turned off our algos as well leaving only our stub quotes in (for instance: $0.01 at something like $150 for a $30 stock, 100 up). The exchange later called to let us know that the $0.01 trades were going to be busted and we didn’t even realize the stub bids were hit out. That’s how insane it was.

    Since HFT is the new scapegoat, they got blamed for not being willing to go bankrupt in the face of technical glitches they did not cause. In fact, they simply refused to take more risk than they would be compensated for – as all good decision makers would.

    In response, the SEC forced all DMM’s (which the vast majority of HFTs are not, by the way) to post a continuous wide, but much narrower market than stub quotes around the most recent trading range. The SEC sold it to the public as a way to ensure a bid or offer in a panic. That’s not what’s going to happen because the algos necessary to post those markets are very fast (hey! The SEC compelled all stock DMMs to be HFT. Good luck killing it now!) and will simply move down with the stock price without a single trade being executed on our markets. But, at least the SEC “did something” that Nanex can now spend hours making a fuss over.

  64. 64 64 Methinks

    @Daniel,

    I’m skipping around a bit, but re this:

    You provided another example, which is well taken, still doesn’t change the point that competition doesn’t necessarily in all circumstances lead to a better market overall.

    You seem to be rather overly attached to waxing theory when reality is right before you. What is theoretically possible is totally irrelevant in this argument. We have before us not a theoretical situation but a real world situation. In this real world situation, increased competition has provided real, measurable benefits (even if you yourself cannot adequately measure them) to consumers at the expense of less efficient competitors. Waxing philosophical about theoretical possibilities on this matter is only interesting at unfortunate dinner party conversation among academics so starved for interesting diversions that they are unable to secure dinner invitations to more interesting soirees.

  65. 65 65 Daniel

    @Methinks,

    Thanks, I think I’ve learned a lot about HFT today. I’ll head over to marginal revolution to find out more.

  66. 66 66 Steve Landsburg

    Methinks: Thank you for your reply.

    Your misunderstanding of my position was this:

    Landsburg’s argument is that unless every marginal improvement is huge it’s not worth the investment.

    A correct statement would have been this:

    Landsburg’s argument is that unless a marginal improvement is worth more than its marginal cost it is best not undertaken”.

    Now (and none of this is controversial among policy analysts):

    1) At the margin, the *private* value of an improvement must be equal to its *private* cost (where “private” means “felt by the decisionmaker”), because if the private value were less than the private cost, the improvement would not be undertaken, and if the private value were less than the private cost, the private decisionmaker wouldn’t have stopped there.

    2) The social value of an improvement is equal to its private value plus its external value (where “external” means “felt by someone other than the decisionmaker”). The social cost of an improvement is equal to its private cost plus its external cost.

    3) Because (at the margin) the private value is equal to the private cost, it follows that the social value exceeds the social cost if and only if the external value exceeds the external cost. Therefore, to determine whether the improvement is socially desirable, we can ignore private costs and benefits and focus only on those that are external.

    4) External effects that come through small price changes can be ignored, because, for example, a small price increase benefits sellers to exactly the same degree that it hurts buyers, so the cost and benefit cancel out. We call those effects *pecuniary*.

    5) Therefore we can focus our attention entirely on effects that are external and non-pecuniary.

    6) The reason robbery is bad is because it has substantial external non-pecuniary costs, with no offsetting external non-pecuniary benefits.

    Now: When I look at HFC, I see substantial external non-pecuniary costs — namely, *your* investment in high-speed transmission lines diminishes the value of *my* investment in high-speed transmission lines. That effect is external (you are the decisionmaker, but the cost falls on me) and it is non-pecuniary (I am hurt not by a change in the price of something I’m looking to sell on a competitive market, but by a substantial fall in the value of an asset.)

    I do not see the offsetting external non-pecuniary benefit. That is, perhaps, where you can educate me. But it’s not enough to demonstrate an external non-pecuniary benefit; there also has to be some reason to believe that the external non-pecuniary benefit suffices to outweigh the external non-pecuniary cost.

    Therefore, the *argument* against HFC is the same as the argument against robbery: Substantial external non-pecuniary costs. That doesn’t make HFC the moral equivalent of robbery or any of the other things you seem to be suggesting I said. It does mean that the reason we would like to see robbery curtailed appears to apply equally well to HFC. If that reasoning is correct, then we should want to see HFC curtailed.

    It does not follow that we want to see it curtailed through regulation, because we might believe — and in particular, *I* might believe — that empowering regulators is an act fraught with the potential for bad (external, non-pecuniary) consequences, and we might prefer to live with one evil rather than combat it with a greater one. But that’s quite irrelevant to the question of whether or not HFC is an evil.

    (And I use the word “evil” here not in a moral sense, but in a policy-analysis sense — i.e. to mean something that we’d want to curtail if there were a practical way to do it without causing even greater harm of some other sort.)

    I hope this clarifies what I was saying, and if you’re still confused, I hope you’ll ask for more clarification before perpetrating another inaccurate paraphrase.

    I do appreciate your presence here. I have not yet read your couple of most recent posts. But when I do later tonight, the main thing I’ll be looking for is: “Where is the positive non-pecuniary externality, and why should we believe that it outweighs the negative?”

  67. 67 67 BC

    Re: #66. On (1), even if the marginal private benefit of the last “unit” of HFT equals its marginal private cost, the total private benefit of (the earlier “units” of) HFT could vastly exceed its total private cost, correct? (Also, if there are limits to how much HFT one can “consume”, then even the marginal private benefit could exceed marginal cost.) So, based purely on its private benefits and costs, the social value of HFT could be very high, provided it imposes very few external costs, i.e., it is not necessary that HFT provide *any* external value whatsoever for its social value to exceed its social costs, correct? The analogy here would be that you could buy a bagel with your own money, which you really enjoy but which benefits no one else, and as long as there are no external costs, that bagel has a net positive social value.

    So, the question then is, does HFT impose non-pecuniary negative external costs? I don’t understand Steve’s argument that it does. How does one person’s construction of a high-speed transmission line diminish Steve’s investment in another high-speed transmission line? How is the HFT line different from any other private communication line that others build for non-HFT purposes, i.e., did HFT receive some sort of subsidy or favored treatment? If not, wasn’t the cost of the transmission line fully internalized?

    In terms of external benefits, I think that active traders and arbitrageurs in general provide tremendous external benefits, namely that the rest of us don’t need to invest any resources ourselves to determine “fair” prices of anything. To the extent that we believe that markets are efficient, we can just sit back, let the arbitrageurs fight each other, and piggyback on their efforts by buying index funds, the market portfolio, etc. at pretty much random times (no market timing necessary) with very little, if any, sacrifice in returns. All of this benefit is external — there is no way for the arbitrageurs to charge us for their research services, technology development, etc. The value of these services might be estimated as the difference between active and passive management fees times the total assets invested passively. For HFT in particular, one might fairly wonder whether the additional fraction of a second in market efficiency is all that externally valuable. However, unless there is some external cost that I’m missing, we are basically getting the external benefit for free anyways.

  68. 68 68 Methinks

    @BC

    I completely agree and I will add that it is the activity of the arbitrageurs competing with each other that increases the efficiency of the market. As one of my former bosses put it, “If markets were always efficient in the short-term we’d make no money, and if the markets were not efficient in the long-term we’d make no money”. Moreover, market makers duking it out reduces transactions costs so that you have to give up less of your return in transactions costs than you otherwise would. Market making profits continue to decline and that decline implies a trend of increasing efficiency in the market.

  69. 69 69 Methinks

    @Steve Landsburg,

    I’m going to divide my reply into two posts because part of my response will be a bit of housekeeping and not central to the argument.

    First of all, thank you for your response and for clearing things up. Your reply was very helpful and clarified your position.

    Second, while I’m fine with the use of evil and the analogy to robbery now that you’ve explained it, I still think you are simply wrong. BC makes a very good case and I will add to that in the next comment. However, I ask you to please seriously consider refraining from saying such things in the future because there are mobs of people who literally believe that HFT is populated by evil thieving monsters who rob them and belong in jail. These people will point to your quotes and scream that “even free market economist Steve Landsburg agrees with us that these HFT guys are evil thieves”. They write their political representatives and, spotting an opportunity to extract more bribes and spend a bit more time grand-standing, these politicians then rattle the cages of the SEC. All of this serves to increase the probability of more very bad regulation which will be written by the most politically-connected HFT shops so that who gets to engage in this activity is determined by political fiat. Please, don’t unintentionally feed the rioting mob.

    Landsburg’s argument is that unless a marginal improvement is worth more than its marginal cost it is best not undertaken”.

    Right, but then what Landsburg is saying is that he has already determined that the cost outweighs the benefit based on absolutely no evidence. You even confess to being unable to see the benefits and then proceed to assume that if you can’t see the benefits they don’t exist, which is not an argument you’d accept from anyone else because it’s ridiculous. As BC points out, you don’t seem to have a handle on the marginal costs, let alone the benefits. So, it’s quite extraordinary that you would be so sure of yourself. Basically, this paraphrasing is equally as bad as mine and it is, in fact, saying the same thing using different words.

  70. 70 70 Methinks

    <i*your* investment in high-speed transmission lines diminishes the value of *my* investment in high-speed transmission lines.

    Like BC, I don’t see how my running a high-speed transmission line to trade diminishes the value of a transmission line you use to run a hospital. I suppose you could argue that my competitors’ older and slower lines are now worth less, but why are my competitors entitled to the preservation of the value of their assets?

    <i4) External effects that come through small price changes can be ignored, because, for example, a small price increase benefits sellers to exactly the same degree that it hurts buyers, so the cost and benefit cancel out. We call those effects *pecuniary*.

    This is where the bulk of your error lies. The effects are NOT small and they are NOT a wash (in this case) between liquidity providers and liquidity takers.

    An improvement in the speed of execution benefits both liquidity providers and liquidity takers. It’s not a wash.

    The benefit to liquidity takers is obvious: their risk is reduced. Their order spends less time on the book and is less likely to be adversely selected. When the risk of investment is reduced, investors can reduce their required rate of return, which then reduces cost of capital.

    The benefit to market makers (HFT accounts for roughly 70% of that activity in equities presently) may be less obvious to you. If market making algos can move fractions of a second faster they too can reduce adverse selection and the reduction of this risk allows them to offer more liquidity because the cost of supplying it is reduced. The markets become thicker and deeper (more liquid) and that then additionally reduces the risk for all participants.

    Further, because these algos are faster, better and cheaper than human traders (each algo can replace several expensive traders and the support staff necessary to employ them), trader headcount has been falling. That means that a very valuable resource has been freed up to pursue other ventures.

    So, it is not a wash at all. Everyone wins. And while BC is correct that we (market makers) are unable to force you to pay the full price of our research, investment and pricing models or even prevent you free-riding by leaning on our market without doing any of the work, that benefit exists with or without HFT specifically. However, the more competition, the greater the benefit.

    Ah, but the increment is so small! Yes, this increment may seem small to you, but it is repeated over more than a billion trades per day. A 0.03 second faster execution on a billion shares (a ridiculously conservative estimate) is equivalent to a 3 second improvement on ten million shares daily. Every day. Every year. From now on. That’s a huge improvement.

    Further, if history is a guide, the 0.03 second improvement is unlikely to be the only improvement resulting from the original investment. It’s likely only the first in a series of permanent improvements.

    So, the benefit you brush of as *pecuniary* is anything but. I suspect that the paper to which Patrick R. Sullivan links says that, but I’ve been too busy running my mouth on your blog to look at it yet. The benefits to the larger economy are diffuse and, I suspect, difficult to quantify and therefore more difficult for you to see for the same reason that the cost of industry subsidy is difficult for taxpayers to feel. It could be extra pennies, but in the pockets of hundreds of millions of people in America alone.

    I fully understand that it’s still possible that the marginal improvement is outweighed by the marginal cost, but it is not probable. In fact, it’s highly improbable. While the externalized benefit is very easy to see, I confess that, like BC, I also fail to see where the cost has been externalized at all.

  71. 71 71 Methinks

    My apologies. I apparently failed somewhere in my attempt to you HTML tags in the above post, making it confusing to read. I’ll repost here and cross my fingers that I don’t repeat my failure.

    *your* investment in high-speed transmission lines diminishes the value of *my* investment in high-speed transmission lines.

    Like BC, I don’t see how my running a high-speed transmission line to trade diminishes the value of a transmission line you use to run a hospital. I suppose you could argue that my competitors’ older and slower lines are now worth less, but why are my competitors entitled to the preservation of the value of their assets?

    4) External effects that come through small price changes can be ignored, because, for example, a small price increase benefits sellers to exactly the same degree that it hurts buyers, so the cost and benefit cancel out. We call those effects *pecuniary*.

    This is where the bulk of your error lies. The effects are NOT small and they are NOT a wash (in this case) between liquidity providers and liquidity takers.

    An improvement in the speed of execution benefits both liquidity providers and liquidity takers. It’s not a wash.

    The benefit to liquidity takers is obvious: their risk is reduced. Their order spends less time on the book and is less likely to be adversely selected. When the risk of investment is reduced, investors can reduce their required rate of return, which then reduces cost of capital.

    The benefit to market makers (HFT accounts for roughly 70% of that activity in equities presently) may be less obvious to you. If market making algos can move fractions of a second faster they too can reduce adverse selection and the reduction of this risk allows them to offer more liquidity because the cost of supplying it is reduced. The markets become thicker and deeper (more liquid) and that then additionally reduces the risk for all participants.

    Further, because these algos are faster, better and cheaper than human traders (each algo can replace several expensive traders and the support staff necessary to employ them), trader headcount has been falling. That means that a very valuable resource has been freed up to pursue other ventures.

    So, it is not a wash at all. Everyone wins. And while BC is correct that we (market makers) are unable to force you to pay the full price of our research, investment and pricing models or even prevent you free-riding by leaning on our market without doing any of the work, that benefit exists with or without HFT specifically. However, the more competition, the greater the benefit.

    Ah, but the increment is so small! Yes, this increment may seem small to you, but it is repeated over more than a billion trades per day. A 0.03 second faster execution on a billion shares (a ridiculously conservative estimate) is equivalent to a 3 second improvement on ten million shares daily. Every day. Every year. From now on. That’s a huge improvement.

    Further, if history is a guide, the 0.03 second improvement is unlikely to be the only improvement resulting from the original investment. It’s likely only the first in a series of permanent improvements.

    So, the benefit you brush of as *pecuniary* is anything but. I suspect that the paper to which Patrick R. Sullivan links says that, but I’ve been too busy running my mouth on your blog to look at it yet. The benefits to the larger economy are diffuse and, I suspect, difficult to quantify and therefore more difficult for you to see for the same reason that the cost of industry subsidy is difficult for taxpayers to feel. It could be extra pennies, but in the pockets of hundreds of millions of people in America alone.

    I fully understand that it’s still possible that the marginal improvement is outweighed by the marginal cost, but it is not probable. In fact, it’s highly improbable. While the externalized benefit is very easy to see, I confess that, like BC, I also fail to see where the cost has been externalized at all.

  72. 72 72 Seth

    “When I look at HFC, I see substantial external non-pecuniary costs — namely, *your* investment in high-speed transmission lines diminishes the value of *my* investment in high-speed transmission lines.” -SL

    That doesn’t seem to hold if your investment in high-speed transmission lines doesn’t provide the benefit she is looking to get out of her investment in high-speed transmission lines.

    Even if it does diminish your investment, how do we know where do you draw the line for any creative destructive investment?

  73. 73 73 RJ

    Trying to be just a spectator, but…

    Seth:

    Even if it does diminish your investment, how do we know where do you draw the line for any creative destructive investment?

    This…

    But it’s not enough to demonstrate an external non-pecuniary benefit; there also has to be some reason to believe that the external non-pecuniary benefit suffices to outweigh the external non-pecuniary cost.

    E-Readers diminish the value of paper books and the overall value of bookstores, an external cost, however the gains in time spent not having to go to the bookstore, buy a large bookshelf to hold a great library, etc. outweigh the costs.

  74. 74 74 Methinks

    RJ,

    I don’t think Landsburg convincingly argued that there are external costs of the sort and size he’s claiming and he completely ignores the enormous benefits – assuming that none exist because he can’t see them. I don’t think that if Steve Landsburg were presented with such an argument that he would find it compelling. I find it no less compelling coming from Landsburg than from a lesser man.

  75. 75 75 gbalella

    ““Please someone explain to me the magic by which competition, which is widely acknowledged to benefit every single market, actually fails to produce the beneficial effects in the financial markets?””

    Yes the competition for sub-sub-sub-prime loans and the competition for turning them into MBS and more complex financial products was sooooo productive…

  76. 76 76 Gabe

    @gbalella

    You can thank our policy makers for:
    1) Providing banks with reason to believe they would be bailed out if the sh*t hit the fan
    2) Providing incentives for owning homes (writing off interest payments)
    3) Keeping long term interest rates artificially low by making the secondary mortgage market more liquid then it would have been without the existence of Fanny or Freddie
    4)Forcing banks to lower lending standards in order to prevent “redlining” and other “discriminatory lending behavior”
    5) Keeping short term interest rates artificially low with bad monetary policy

  77. 77 77 Gabe

    Competition in a competitive market is beneficial. Competition in a market with distorted prices can be detrimental.

  78. 78 78 Steve Landsburg

    How does one person’s construction of a high-speed transmission line diminish Steve’s investment in another high-speed transmission line?

    Because there’s a big return to being the fastest trader, so if your line is marginally faster than mine, it drives the value of mine way down.

  79. 79 79 Steve Landsburg

    Methinks:

    Right, but then what Landsburg is saying is that he has already determined that the cost outweighs the benefit based on absolutely no evidence.

    Actually, it’s you who seem to have already determined that the benefit outweighs the cost based on absolutely no evidence. My mind, by contrast, is open.

  80. 80 80 Steve Landsburg

    Seth:

    Even if it does diminish your investment, how do we know where do you draw the line for any creative destructive investment?

    That’s what economic theory is for. Theory tells us, for example, that under very broad and general hypotheses, competitive market outcomes tend to maximize welfare. Here’s a case where those hypotheses don’t apply, so the general theory isn’t very helpful.

    Fortunately, theory often draws the line for us. Unfortunately, sometimes it doesn’t. When it doesn’t, all we can do is look at specifics.

  81. 81 81 Steve Landsburg

    Methinks:

    The benefit to liquidity takers is obvious: their risk is reduced. Their order spends less time on the book and is less likely to be adversely selected. When the risk of investment is reduced, investors can reduce their required rate of return, which then reduces cost of capital.

    1) How on EARTH is that external?

    2) Even if it WERE external, we would have, at best, you pointing to an external benefit and me pointing to an external cost. How do we know which one is bigger?

  82. 82 82 BC

    #78. I think we have to distinguish between accounting costs and economic costs. I have always understood economic costs to be opportunity costs: benefits given up.

    So, if the HFT line inhibits Steve’s ability to get the benefit of transmitting data through his own line, then that would indeed be an (external) economic cost. However, if Steve’s data transmission benefits are not inhibited and the HFT line merely changes his preferences/utility such that he no longer values such benefits, then I don’t think that qualifies as an economic cost. Steve is not giving up any benefits as a result of the HFT line. It could impose an accounting cost: Steve might have to write down the value of the asset and report that depreciation to his shareholders. (Steve might also regret having incurred the sunk costs to build his now-obsolete line, but sunk costs are not part of marginal costs of course.)

    Consider an apple farmer that plants an orchard because he believes that consumers really like apples. After some time, consumer tastes change and no one wants to buy apples anymore. Obviously, the apple orchard could drop in value, creating an accounting cost. However, would we say that consumers’ taste changes imposed an external economic cost on the apple farmer? I wouldn’t think so, but if we would, then I think there are myriad now-obsolete businesses that would be able to legitimately petition government to try to recoup these alleged external costs that have arisen over the years due to constantly changing consumer tastes.

    It seems to me that there is a difference between an asset devaluation that arises from change in demand vs. one that arises from a change in (that asset’s ability to produce) supply. I always thought of cost as more of a supply-side concept rather than a demand-side concept.

  83. 83 83 Steve Landsburg

    BC: Your analogy fails first because the principles of welfare economics do not allow us to cost-benefit-analyze the effect of a change in tastes. The entire theoretical setup forces us to take tastes as given.

    Be that as it may, it does seem to me that yes, we should view a change in consumer tastes as an unfortunate thing. People like apples, so apple orchards are set up. Then people decide they like oranges, so the apple orchards come down and orange orchards go up. If tastes had not changed, consumers would have been just as happy continuing to eat apples an a lot of expenses would have been avoided. That observation is irrelevant to policy, because we view tastes as something that policy can’t change.

    But the building of fiberoptic cables is something that policy can change.

    As for your analysis of costs: The relevant economic cost is not the diminishment in value of the old cable; it’s the resource cost of building the new one. If, after the expenditure of all those resources, the world as a whole is not significantly richer than before (because wealth has been transferred from the old cable owners to the new cable owners without any significant change in total wealth), then those resources are wasted.

    We can often *measure* that cost by looking at the reduction in value of the old cable, and we often do that without being explicit about why we’re doing it. But the reason we’re doing it is not that we’re inappropriately counting sunk costs, or mistaking accounting costs for economic costs; it’s because theory tells us that this is a good way to estimate the real cost of the resources being devoted to building the new cable.

  84. 84 84 Methinks

    1) How on EARTH is that external?

    How is reducing the cost of capital for firms as a by-product of additional NOT external?

    2) Even if it WERE external, we would have, at best, you pointing to an external benefit and me pointing to an external cost. How do we know which one is bigger?

    A useful first step would be for you to produce an actual example of an external cost. So far, while I have pointed to concrete benefits, you talk about some potential unspecified costs.

    Actually, it’s you who seem to have already determined that the benefit outweighs the cost based on absolutely no evidence. My mind, by contrast, is open.

    Now who’s concocting ridiculous arguments out of whole cloth and attributing them to other people? I from the start pointed to specific benefits – benefits you apparently knew nothing about – and I said very clearly that while it was possible that the costs outweigh those benefits, I found it unlikely for xyz reasons.

    You, on the other hand started off with “robbery” and “evil”, entirely certain that the costs outweighed any benefits without an ounce of supporting evidence. And you refuse to address my specific examples, choosing instead to complain about which one of us is more open-minded. Which mind is open?

  85. 85 85 Steve Landsburg

    Methinks: I pointed, from the beginning to a specific external cost: If I build a cable that shaves .003 seconds off a trading time, it substantially diminishes the value of your cable that shaves .004 seconds off the same trading time.

    So that’s the external cost you have to beat.

    But based on some quick back-of-the-envelope calculations I just did, I no longer think it’s plausible you can do this. I’ll post those calculations tomorrow morning.

  86. 86 86 Methinks

    As for your analysis of costs: The relevant economic cost is not the diminishment in value of the old cable; it’s the resource cost of building the new one. If, after the expenditure of all those resources, the world as a whole is not significantly richer than before (because wealth has been transferred from the old cable owners to the new cable owners without any significant change in total wealth), then those resources are wasted.

    Cool. Since there are two sides – the cost and the benefit – why not now turn your attention to the benefit and see if the benefit doesn’t outweigh the cost? Why are you over-focused on one side of the equation?

    Also confusing: This kind of waste in a competitive market is not unique to investment in trading technology. It happens in every industry. Why single out HFT traders to nail to the cross (hey, gimme a break. It’s Easter)?

    Why not have a policy that forces everyone who wants to invest in anything to prove to some government body (for that’s what it will be) that their investment is not wasteful before they are allowed to deploy their own capital? I’m sure funding that extremely efficient government department won’t be wasteful at all. At least we can assume a priori that policy-makers and government workers will be able to very efficiently and cost-effectively guard against social waste! After all, efficiency and preservation of social value is what government is known for the world over.

  87. 87 87 Methinks

    If I build a cable that shaves .003 seconds off a trading time, it substantially diminishes the value of your cable that shaves .004 seconds off the same trading time.

    I think you must mean my cable shaves a maximum .002 seconds of the EXECUTION time.

    I eagerly await the numbers. But, if your conclusion is correct, you’re then going to have to explain why I’m still in business and why my margins are large while my cables are significantly slower than HFT’s. You’re also going to have to explain why – in light of our hugely devalued assets – there are still thousands of liquidity providers, including many HFT shops competing with each other head-to-head.

    I strongly suspect that you assign too much importance to speed alone. Speed is not the only margin on which we compete. In fact, determining fair value and building pricing models is rather difficult and also incredibly important. Additional speed possessed by someone who does a worse job of valuing securities or whose algorithms are not as good is all but useless.

  88. 88 88 Methinks

    Also, Steve, I’m sort of still holding on the hope that you’ll address the BENEFITS of increased execution speed to SOCIETY. You have completely ignored any and all benefits and that is just mind-boggling.

  89. 89 89 Steve Landsburg

    Methinks: My estimation of the benefits will be up tomorrow morning.

  90. 90 90 Daniel

    @Methinks,

    Maybe I’m not up to speed, but didn’t Steve point to the external cost of the other firms still using the slower lines? I thought that was a pretty clear example of an external cost? If whenever one HFT firm creates a newer, faster line, the other HFT firms also have to build a newer faster line to stay competitive, that very much is an external cost to those firms. You said something about them not seeing why they’re entitled to their prior investment, but that is irrelevant to determining whether something is an external cost. Whether or not someone is “entitled” is not involved in determining whether something is an external cost. If someone not involved in the transaction of building another faster line is harmed in anyway, that’s an external cost.

  91. 91 91 Patrick R. Sullivan

    ‘Why not have a policy that forces everyone who wants to invest in anything to prove to some government body (for that’s what it will be) that their investment is not wasteful before they are allowed to deploy their own capital?’

    In fact, a prominent economic historian (Paul David) once proposed exactly that;

    ‘One thing that public policy could do is to try to delay the market from committing to the future inextricably, before enough information has been obtained about the likely technical or organizational and legal implications, of an early, precedent-setting decision.

    ‘In other words, preserving open options for a longer period than impatient market agents would wish is the generic wisdom that history has to offer to public policy makers….’

    His pal Brian Arthur expressed the same sentiment in Scientific American;

    ‘Steering an economy with positive feedbacks so that it chooses the best of its many possible equilibrium states requires good fortune and good timing—a feel for the moments at which beneficial change from one pattern to another is most possible.

    ‘Theory can help us identify these states and times. And it can guide us in applying the right amount of effort (not too little but not too much) to dislodge locked-in structures.’

  92. 92 92 Methinks

    @Steve,

    Awesome. I Look forward to it.

    @Daniel,

    I’m not arguing that competitors don’t impose costs on each other, but merely pointing out that they do, while mildly interesting, is useless.

    At the Cafe Steve is arguing that the fastest HFT trader reaps all or most of the rewards. Yet, there are other margins on which we compete and they are at least as important as speed (which is important, but not exclusively even in very high speed trading). And there are parts of the market where HFT’s speed is totally useless.

    For instance, we chose not to take our firm in that direction. We don’t compete on speed at all and we don’t need to because we operate in a segment of the market where speed is not very important. We specialize in providing liquidity in extremely illiquid securities of all sorts (including stocks) and this is a segment of the market in which all of the lightening speed of HFT is pretty useless. In our segment of the market, our firm, though small compared to large HFT shops, is a very large competitor and possibly the most profitable competitor in our space. The reason for this is not our expenditure on technology (which is comparatively tiny) but an innovation (which is obviously proprietary) in hedging. We have significantly reduced the risk of providing liquidity and so we can provide more liquidity to a segment of the market that lacks it most and are able to “strip away” (as Steve put it) less innovative competitors’ profits.

    So here’s my question: Why is my ability to “strip away” my competitor’s profits okay but an HFT’s ability to “strip away” their competitor’s profits not okay? A priori. We both achieve the same end – we both reduce transactions costs, volatility and aid in faster price discovery. It’s entirely possible that I provide more benefit relative to the cost I impose (on the other hand, I may not), but since HFT operates in very liquid securities where margins are tighter but volumes are much larger, it’s not crazy to assume that even very small incremental improvements in speed, spread or whatever is also a net positive. For society. Especially in light of the blinding speed with which the cost of technology is falling (I mean, the cost of building the same line is likely to be lower for the second guy than it was for the first). Yet, we start with the position that this cannot be so. That implies a lot of bias and little real analysis.

  93. 93 93 Methinks

    @Patrick

    Why am I not surprised? In fact, everyone should bloody well get permission to major in certain subjects in school or enter certain professions. God knows we could do with fewer expensive axe-grinding degrees.

  94. 94 94 BC

    Ok, I am a little confused now. In #83, Steve says that, “The relevant economic cost is not the diminishment in value of the old cable.” I (think I) agree with that: that’s not an external cost. In #85 though, Steve appears to say that diminishment of old cable value is an external cost. I’ll set that aside though.

    In #83, Steve says, “If, after the expenditure of all those resources, the world as a whole is not significantly richer than before (because wealth has been transferred from the old cable owners to the new cable owners without any significant change in total wealth), then those resources are wasted.” Maybe, this is the source of confusion. I don’t think that the only effect of the new cable is to transfer wealth from the old cable owners to new. That would ignore the liquidity-provision function of HFT, which is presumably the reason any of them make money to begin with.

    Suppose, Steve is the incumbent HFT with the 4-ms line. The rest of the world pays him $0.01/share each day for providing liquidity to trade 100M shares of stock. That must be the benefit, for example, from crossing bid-ask spread to trade with him immediately instead of waiting. If the world valued that liquidity at less than 0.01/share, they would wait to trade instead. (For example, instead of buying stock at Steve’s asking price, they would wait for a lower asking price to come along.) Total benefit = $1M/day. Steve’s marginal cost of providing such liquidity must also be 0.01/share, by #66-1: Steve provides liquidity up to the point where price of liquidity equals marginal cost.

    A newcomer builds a 3-ms line that allows such newcomer to provide liquidity at lower marginal cost (including the cost of the line). For example, the faster speed reduces risk of holding positions because the newcomer can respond to events more quickly. Thus, bid-offer spreads narrow so that liquidity now costs only 0.0075/share. Essentially, the supply curve for liquidity shifts down and to the right. From above, the public values the first 100M shares of liquidity at 1M but only pays the newcomer HFT $750k, so they are already 250k better off. In addition, because liquidity is now cheaper, the public “consumes” more of it by trading more. We move down the demand curve for liquidity until the public values the last share of liquidity at newcomer’s marginal cost of 0.0075/share. Total social benefit of liquidity is some number greater than 1M and exceeds the marginal social cost of providing such liquidity.

    In short, the analysis here for a new HFT low-cost provider of liquidity would not seem to be any different from a new low-cost provider of any other good. What is different about HFT?

  95. 95 95 James Hanley

    The small college where I teach is along the path of this high speed data network. When completed it will afford us better connectivity at a lower price. This benefits more than just the financial sevtor.

  96. 96 96 Methinks

    You know, in the past (when spreads were so wide you could drive a truck through them, market makers were minting money at the expense of customers and nobody was complaining), you actually had to own a seat on the exchange to achieve what we now achieve by locating our servers at the exchange. We also had to pay other fees in order to be located at the exchange.

    Those seats went for millions of dollars and there was a limited supply. Also, physical exchanges favored large men, not small women, because you had to be seen and heard to trade. Electronic markets eliminated that handicap. Anyone can get a direct line for about $1,000 per month while skipping the $2,000 monthly fee for the pleasure of being regulated along with the regulatory burden of constant scrutiny and the monthly filing of FOCUS reports, etc. While the cost to compete has dropped precipitously, the liquidity provided (predictably) is much better.

    So, here are my questions:

    Why is it perfectly fine to impose millions of dollars of costs on your competitors in order to gain a speed advantage but not thousands? I assure you that the benefits society got from locals at the exchange were far fewer than the benefits from HFT.

    Why is it perfectly fine for electronic markets to destroy the value of a local’s expensive seat, but not fine to diminish the value of a competitor’s fiber optics line?

    When did creative destruction become a social cost? The fact that a small benefit to the consumer causes a large loss to a competitor is not a social cost.

  97. 97 97 Steve Landsburg

    Methinks:

    The fact that a small benefit to the consumer causes a large loss to a competitor is not a social cost.

    In other words, you don’t understand what a social cost is.

  98. 98 98 Rob Rawlings

    “But the building of fiberoptic cables is something that policy can change.” (#83).

    Suppose that orange growers find a way to make orange’s more attractive to consumers than apples even though underlying tastes remain the same. This will have an external cost to apple growers. Should we consider using policy to control orange-growing technology ?

  99. 99 99 Methinks

    Well, Steve, one of us doesn’t.

    BTW, in anticipating your math I suddenly realized that you’ve muddled the issue (and I’ve helped muddle the issue) so badly that your calculation isn’t likely to produce anything meaningful.

    Shall I post my attempt to unmuddle the issue here or will you do another post for your calculations?

  100. 100 100 Steve Landsburg

    Suppose that orange growers find a way to make orange’s more attractive to consumers than apples even though underlying tastes remain the same. This will have an external cost to apple growers. Should we consider using policy to control orange-growing technology ?

    Well, you might be able to come up with some assumptions under which the answer would be yes, but I don’t offhand see any plausible assumptions that would yield that result. What did you have in mind?

  101. 101 101 Rob Rawlings

    #100

    Suppose there is a fruit market and you sell more by getting your fruit there first.

    The apple grower develops a fast fruit truck technology , starts to sell more apples , and spends a lot of money investing in his orchard to expand capacity.

    Then the orange grower develops an even faster truck that renders the apples growers investments useless.

    Some people might make a case for banning the use of high speed trucks to bring fruit to market quickly. Society would be better off as we would have the same qty of fruit and the resources used for the fast fruit trucks would be used for something else.

    I don’t think this would be good case though as if people didn’t value “early” fruit highly enough then a third fruit grower who didn’t invest in high speed fruit truck technology would out compete them both by simply offering cheaper fruit slightly later.

  102. 102 102 Steve Landsburg

    Rob Rawlings: Your example makes no sense to me. Are you envisioning a single truck that can serve a substantial fraction of the fruit market?

  103. 103 103 Rob Rawlings

    The general idea was that fruit growers could invest in high-speed trucks in order to get to market faster.

    To describe it more fully:

    It’s an island that grows 2 type of fruit. The fruit is sold early every morning at a fruit market. The buyers go there before going to work and will often buy the first fruit to arrive in order to save time. The island is quite small and one large high-speed truck could bring all of the daily fruit from one of the farms to the market. The farms are opposite sides of the market so they will each need their own truck.

  104. 104 104 Steve Landsburg

    Rob Rawlings:

    If one truck can supply the entire market, and if the marginal cost of growing fruit is (probably implausibly) low, then your example should work.

  105. 105 105 JohnW

    This discussion seems like a perfect example of why many people consider economists to be useless. Methinks and others provide many useful facts and practical analysis of the real world, and the economist blogger drones on about ivory tower social costs.

  106. 106 106 Phil

    I organize a ditch-digging and ditch-filling competition at my club, and put up a $500 prize for the winner. I get exactly $501 worth of pleasure watching it, regardless of the skill of the competitors.

    The membership goes out and practices. Their only motivation is the prize — they don’t particularly like ditch-digging. All ten competitors are equally skilled. They each invest $50 (opportunity cost and annoyance value) worth of practice, and all ten wind up again equally skilled on competition day.

    The $500 the members spent on practice is clearly a social cost, right? There was zero total benefit from all that work.

    Even only one of the ten practices, his practice is still a social cost. All it did was transfer existing resources from the other nine people to him. The sum of everyone’s utility is still the same as if he hadn’t practiced at all.

    The same thing is true if they each invest $1 in practice, instead of $50.

    I may not have that right — I may not be understanding social cost correctly. But if I am … aren’t the new cables the same thing as the ditch practice?

  107. 107 107 Steve Landsburg

    Phil:

    I organize a ditch-digging and ditch-filling competition at my club, and put up a $500 prize for the winner. I get exactly $501 worth of pleasure watching it, regardless of the skill of the competitors.

    The membership goes out and practices. Their only motivation is the prize — they don’t particularly like ditch-digging. All ten competitors are equally skilled. They each invest $50 (opportunity cost and annoyance value) worth of practice, and all ten wind up again equally skilled on competition day.

    The $500 the members spent on practice is clearly a social cost, right? There was zero total benefit from all that work.

    Even only one of the ten practices, his practice is still a social cost. All it did was transfer existing resources from the other nine people to him. The sum of everyone’s utility is still the same as if he hadn’t practiced at all.

    This is exactly correct, except insofar as all that practice leads to a better show for you. Even if does, though, there’s still no reason to think that we’re going to get the optimal amount of practice.

  108. 108 108 Phil

    Thanks!

    P.S. That’s why I specified it’s the same pleasure regardless of the skill of the competitors. :)

  109. 109 109 nivedita

    @Methinks, I’m not really an expert in HFT or a professional economist, but I think part of your disagreement with Steve comes from conflating HFT in general with the specific instance of constructing high-speed data links between market centers.

    To put some arbitrary numbers on this to give a concrete example, if there exists a link between New York and Chicago that provides $100mm of benefits, when considering a proposal to build another link that will cost $80mm and provide $120mm in benefits, this is a no-brainer to a private investor regardless of what happens to the value of the existing link. But from society’s point of view, if the new link will make the existing one obsolete and worthless, it makes no sense to spend $80mm to get $20mm of incremental benefit.

    This argument however is very particular to data links, where you can expect high capital investment requirements to create barriers to entry. They can be expected to be natural monopolies, like the power distribution system or the highway system. This argues for regulating them in some fashion to try to align private cost/benefit with societal cost/benefit — the flip side to this argument is that the original link might never have gotten built by private investors even if it was beneficial to society on net, because if a new one got built six months after they invested, they wouldn’t be able to recover their original investment (on the third hand, the economics of the new one are impacted by similar considerations, so it’s less likely to be built etc). Analyzing this seems pretty hard.

    However, other instances of HFT (like colocation) as you point out are not very expensive and do not present significant barriers to entry, so one would expect normal competitive market dynamics to hold, aligning private incentives with society’s incentives.

  110. 110 110 Phil

    Are there many other investments like this with negative social value? Other than robbery, Dr. Landsburg’s example, I can’t think of any others.

    It seems I should look for a “winner take all” transaction where the prize already exists. Oh, right, the Oklahoma Land Rush … I think that’s another example from a Landsburg book.

    Are there more?

  111. 111 111 nivedita

    I think you could also argue that a substantial part of HFT is dedicated to diffusing information quickly between markets, and society could have avoided a good deal of this if the equity markets didn’t have so many different trading venues to begin with. Is the benefit of having multiple venues as opposed to one venue (as much of the futures markets have) worth the cost?

    Steve, isn’t it also true that if you kept out competing data links because they weren’t economical from a societal point of view, but failed to properly regulate the single data link, it would lead to the existing data link being priced higher than marginal cost and being underutilized?

  112. 112 112 nivedita

    Phil, doesn’t your example describe much of the professional sports industry :)

  113. 113 113 Steve Landsburg

    Phil:

    Are there more?

    Gold mining is the classic example — it’s imperfect because some gold has socially valuable uses, but most gold is used as a store of wealth and therefore each nugget you dig out of the ground diminishes the value of existing gold, making its net social value essentially zero.

    Sports tournaments. Competition to write the best operating system. Competition to be the world’s most popular comedian. Et cetera.

    The fact of the matter is that competition often yields imperfect outcomes. That’s what makes the invisible hand theorem — the fact that, given the right assumptions on cost curves, competition yields perfectly efficient outcomes — so awesome.

  114. 114 114 nivedita

    This argument can also be applied I think to patents and copyrights — I think Steve had a post a few months back on copyrights where a slightly better novel cost society more than the incremental benefit.

    Or for the drug industry, where patents give the incentive to develop a drug in the first place, to get some comfort that the investment will be recovered for successful drugs. But this in turn incentivizes competitors to develop slightly better products that can be patented and take the market away from the original — net result: small benefit to society from improved drug, large cost for R&D/testing of new drug.

  115. 115 115 Phil

    Ah, gold mining, I like that one!! Thank you.

  116. 116 116 Phil

    The “new drug that’s only a tiny, tiny bit better than the old drug” example works for me too.

  117. 117 117 cqac

    Seconding much of what Methinks says.

    Back to (1)

    Except that a) saving a millisecond is clearly less valuable than saving an hour and b) far more importantly, we have *absolutely no theory* that predicts that the private and social values of these saved milliseconds coincide.

    You’re mixing up who is saving what amount of time. If I were to take an algorithm that performs a desired computation in 2ms and then improve it to compute in only 1ms, you cannot from that alone claim I am only saving 1ms of human labor. Maybe that’s not what you’re saying, but it certainly sounds like it, since I distinguished saving 1 hour of a person’s time from 1us of a computer’s time. Computers have a hard time doing some things that people do efficiently, they need more feedback, more samples, more trials to start figuring out what’s going on. Having algorithms interact through executing against one another rapidly and frequently feels different than how people would do something, but that’s precisely because the speed at which the computer can perform some tasks is much, much faster than the speed the human can perform them. And, the way in which the computer figures out what’s happening, or “gets a read on the market”, or a “feel for the market”, is by interacting with it, not by talking to some guy. Arguably, this is much fairer, everything happens out in the open, there are no private conversations on the floor, and no tips from your broker.
    If humans could write sales tickets as efficiently as computers and could run around as fast, they would likely have evolved into executing many more trades per day and trading in much smaller lot sizes on average, for the exact same reason that the computers do. If the cost of doing so is low enough, it makes sense.

    As for the claim of having “absolutely no theory”, I agree with Methinks. The idea of free markets seems like enough.

    And if you are looking for evidence that much of this competition is good, I suggest listening to more impartial observers, like Cliff Asness. Someone who cares a LOT about execution costs, but has no direct stake in the HFT area.
    As an aside, things have NEVER been better for the retail investor. If you don’t know what a 606 or 605 report is, go look them up. Retail investors get MUCH better execution than anyone else, especially if they’re willing to advertise that they’re retail and thus aren’t trying to make 0.3cents on their trade, they’re just looking for liquidity. So most of the HFT scare-story going on is incredibly hypocritical, trying to scare individual retail customers into thinking that HFT is “trading ahead” of them. That’s non-sense.

  118. 118 118 cqac

    Twofer:

    What I gather Lewis is telling us in the book is two things. First, its the story of the rise of intermediaries in the market…

    It sounds as though you are unfamiliar with the markets. There are almost always intermediaries. And the number of intermediaries 10-20 years ago was probably as large or larger than today for an individual.

    One of the hypocrisies of Lewis’s book, and something I haven’t heard talked about on the news shows, is the absence of commentary about Katsuyama’s role and salary. Katsuyama is an intermediary. He wasn’t trading proprietarily, he was agreeing to do executions on behalf of someone else. IIRC, his salary was 1.5M. And he did a bad job. Why do I say he did a bad job? His job, the whole reason he’s supposed to be paid this 1.5M is because he is supposed to be the expert on equity market structure, and is supposed to know how to get his customers good execution prices. He failed. If he hadn’t, you wouldn’t have a story, you would’ve had someone who had attracted more customers to his services because he would have been doing a better job than others.
    In these days of attacking anyone who makes more than X,Y, or Z thinks they should, and with the zealous attacks on anyone making large amounts on wall street, I’m surprised people are willing to see Katsuyama as some David against the Goliath of HFT. It’s the other way around, and we are all a little bit better off for it. Some Katsuyamas are going to stay in Wall Street, and others are going to go do something else of benefit to society (they usually aren’t quitters or slackers, they can find something else to do).

  119. 119 119 cqac


    I like Bitcoin a lot. But there’s no doubt that Bitcoin *mining* is pretty much socially worthless, and that it’s part of the downside of Bitcoin, not the upside.

    If there was no mining, or no cost to the transactions, do you think Bitcoin would work? I do not.

  120. 120 120 cqac

    6) If someone sits in a sensory deprivation chamber for an hour doing absolutely nothing, are they robbing you because they aren’t creating something of value, but are using up resources (their time)?


    Of course not. Why would you suggest such a silly thing?

    Some might call it hyperbole, I just think of it as trying to get to the root of the apparent disagreement.

    So it’s clear, what one person chooses to do with their own time, cannot be considered robbery simply because they arguably could have been doing something else with their time that would have had *benefit to society* or some *social value*.

    Now let’s go to Phil’s ditch-digging example. I will assume that when you said, “This is exactly correct,” you are including reference to Phil’s claim that this is just like the HFT issue with building better transmission lines. I will infer that this means it’s not the natural resources you are primarily concerned with in the construction, it’s the time and labor of the people involved.

    So, who is committing robbery in Phil’s example? A bunch of people all did things with their own time and money, of their own free will, and clearly did not impede anyone else from doing whatever it was they wanted to do. We could have said we have 11 people go into an isolation chamber and shuffle some bills around amongst themselves. If there’s no social cost for sitting in the isolation chamber, it seems hard to argue there’s one here?

    I think Methinks and I probably believe you are vastly underpricing the societal cost of trying to theorize about how best to run the world, when we know that as imperfect as it may be, the best way to have things improve is to have people competing and trying to figure out how to do things more efficiently to please others. The place where regulations and theorizing a bit can help most is when things get stuck and artificial monopolies or monopsonies crop up and competition gets stifled. Unfortunately, those regulations themselves tend to become an unfortunate way for the regulators to profit (by having insider knowledge of the “correct” interpretation of exceptionally opaque regulations).

  121. 121 121 Steve Landsburg

    cqac:

    We could have said we have 11 people go into an isolation chamber and shuffle some bills around amongst themselves. If there’s no social cost for sitting in the isolation chamber, it seems hard to argue there’s one here?

    If you really think it’s costless to sit in an isolation chamber for an hour, then why aren’t you doing it?

    You are welcome to post thoughtful disagreements, but please don’t continue to post arrant nonsense. Stop, reread your posts, and take a minute to ask if they make even a lick of sense.

  1. 1 The Costs and Benefits of Competition
  2. 2 Competition, Rent-Seeking, and High-Frequency Trading
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