Sunday, December 06, 2009

Are financial speculations really "harmful human activities"?

It is worrisome when not one but two eminent economists denounced financial speculation as "harmful human activities" in the short space of 2 weeks. (See Paul Krugman's column here and Robert Frank's here.) It is more worrisome when their proposed cure to this evil is to apply a financial transaction tax to all financial transactions.

Granted, you can always find this or that situation when financial speculation did cause harm. Maybe speculation did cause the housing bubble. Maybe speculation did cause an energy price bubble. In the same vein, you can also argue that driving is a harmful human activity because cars did cause a few horrific traffic accidents.

No, we can't focus on a few catastrophes if we were to argue that financial speculation is harmful. We have to focus on whether it is harmful on average. And on this point, I haven't seen our eminent economists present any scientific evidence. On the other hand, as an ex-physicist and an Einstein-devotee, I can imagine some  thought experiments (or gedankenexperiment as Einstein would call them), where I can illustrate how the absence of financial speculation can clearly be detrimental to the interests of the much-beloved long-term investors. To make a point, a gedankenexperiment is usually constructed so that the conditions are extreme and unrealistic. So here I will assume that the financial transaction tax is so onerous that no hedge funds and other short-term traders exist anymore.

Gedankenexperiment A: Ms. Smith just received a bonus from her job and would like to buy one of her favorite stocks in her retirement account. Unfortunately, on the day she placed her order, a major mutual fund was rebalancing its portfolio and had also decided to shift assets into that stock. In the absence of hedge funds and other speculators selling or even shorting this stock, the price of that stock went up 40% from the day before. Not knowing that the cause of this spike was a temporary liquidity squeeze, and afraid that she would have to pay even more in the future, Ms. Smith paid the ask price and bought the stock that day. A week later, the stock price fell 45% from the peak after the mutual fund buying subsided. Ms. Smith was mortified.

Gedankenexperiment B: Mr. Smith decided that the stock market is much too volatile (due to the lack of speculators!) and opted to invest his savings into mutual funds instead. He took a look at his favorite mutual fund's performance, and unfortunately, its recent performance seemed to be quite a few notches below its historical average. The fund manager explained on her website that since her fund derived its superior performance from rapidly liquidating holdings in companies that announced poor earnings, the absence of liquidity in the stock market often forced her to sell into an abyss. Disgusted, Mr. Smith opted to keep his savings in his savings account.

Of course, our economists will say that the tax is not so onerous that it will deprive the market of all speculators (only the bad ones!?). But has anyone studied if we impose 1 unit of tax, how many units of liquidity in the marketplace will be drained, and in turn, how many additional units of transaction costs (which include implicit costs due to the increased volatility of securities) would be borne by an average investor, who may not have the luxury of submitting a limit order and waiting for the order to be filled?


Jez Liberty said...

Thanks for bringing these pieces to the attention of your readers. I dont think I had heard about them before...

And this is worrisome for people like me setting out to start developing automated trading systems (although some long term systems do exist- where hopefully tax would have marginal impact)

I think the arguments are pretty poor... Would we have run such crazy markets without the Greenspan/Bernanke Puts and reckless monetary policies of the Fed?? I think abolishing them would be better solution (utopia though...)

PS: I like your examples - they illustrate the point pretty clearly

Peter said...

I don't understand why you are both complaining about the lack of "scientific experiments" on this subject while simultaneously trying to make your point with some made-up scenarios. Calling them gedankenexperiments doesn't magically make them scientific.

We could argue back and forth making up endless quaint hypothetical counterexamples involving Mr and Ms Smith, but I'm pretty sure that wouldn't settle anything. I'd rather look at the evidence . . . and the giant experiment otherwise known as our modern economy provides plenty to suggest that something needs to change. Financial transaction taxes could act as a damping factor that prevent wild oscillations in the economy. Maybe they're worth a try.

Matt said...

I don't think Ernie is saying that his thought experiments prove that financial speculations are beneficial to mankind. But he's just trying to show the other side of the coin; and while Ernie doesn't provide scientific proof, neither did Krugman. Krugman simply asserts that the liquidity that short-term traders provide to the market is "socally useless." Ernie provides two counterexamples to show that this liquidity is not necessarily useless. And I guess Krugman wants to ban all activities that he deems "not socially useful?"

And Krugman's and Frank's argument that speculators cause any bubbles is not particularly compelling. And that they caused the current mess, precipitated by the housing bubble, is ludicrous. Right, speculators are the ones who kept interest rates at historically low rates for many years. Speculators are the ones who relaxed lending standards and let any warm body buy a house. Speculators bundled these loans together, somehow got them rated highly by Moody's, and sold them to people who didn't quite understand what they were doing. Give me a break.

Unknown said...

It's not speculation that caused the bubble. It's the leverage used for that speculation.

Anonymous said...

Ernie I'm not sure I follow the two scenarios.
In experiment A, why would the mutual fund buy so deep into the book, in this long-term-investment-only-world, if they don't think the stock is worth that price? If they do and they're right, that means if Ms Smith is willing to wait long enough (she is supposed to, after all), the stock should bounce back to the exceed the high price they pay, shouldn't it?
Likewise in experiment B, either the mutual fund should hold on to the stock to sit through the short squeeze, or the mutual fund shouldn't have used the strategy in the first place. The mutual fund should derive its earnings from either being able to execute rapidly enough (in your scenario it's not), or sell the stock earlier by correctly predicting (on average) the poor earnings. It seems Mr Smith should just conclude that this particular mutual fund is a poor one.

As for the study on the effect of transaction tax on liquidity... I seem to have seen a lot of papers on SSRN about this in the past.

Anonymous said...

Please: lets not dignify with reasoning what is pure and simply a confiscation, another "stick it up to the rich ! !"

Anonymous said...

Don't worry about Paul Krugman. He's a dead wood in the economics profession. He's now an activist.

Anonymous said...

There is one good thing about the proposed tax. You can trade futures on its probability of passing.

Ernie Chan said...

I disagree with your suggestion that financial transaction tax will necessarily dampen volatility in the market. In my view, reduced liquidity in the markets will increase, not decrease, volatility.

Traders such as George Soros make large bets on the market but hold them for multiple days. They are unlikely to be deterred by a small financial transaction tax.

Traders who trade at high frequency and who provide intraday liquidity will be the ones hurt most. But these short-term traders were not the ones who caused the myriad financial disasters in the past.

In my view, this tax is barking up the wrong tree.


Ernie Chan said...

Just like any investment decisions, the mutual fund in both scenarios may or may not be right to buy/sell the stock at that price, and the stock price may or may not go up/down in the long-term. However, what we are concerned with is transaction cost. Clearly, Ms. Smith (and the mutual fund that Mr. Smith is considering) has paid far higher transaction costs than she otherwise would, if the market is more liquid and less volatile.

Clearly, there are studies on the effect of transaction tax on liquidity, but I haven't seen any of these eminent economists cite their conclusions in making their "socially-desirable" conclusions! I think the onus is on those who want to change the current system to cite the research, not those of us who prefer the status quo!

JohnLeM said...

Concerning this post, I would like to point out an intermediary position, that could match everybody's concerns.

I started (I am mathematician, former quant and business analyst) in September 2008 a Research program, proposing in January 2009 to cleverly tax trades. Clever means: if no speculative pression (no bubble risk), no need to tax. However, if there is a risk of bublle inflation, then regulators could trigger an asymetrical tax.

Results and links to my works can be found summarized at my blog: (I am not active at present time over the topic, I did not succeed in finding a sponsor to fund this project !)

Todd M said...

Has anyone considered the "unintended consequences" that a tax like this would have? To start would they impose this tax on market makers? If so spreads would explode so that every transaction would now incorporate this tax. If not, the worst offenders in this debacle would be allowed to trade tax free! Seems a bit crazy to me. Lets say the tax imposes a fee of .25%, spreads would widen .5% or market makers would lose .25% on each transaction. This means that investors who presumably would be buying at the ask and selling at the bid would lose 1% per dollar traded. Compare this to real returns on equities that have averaged 6-7% annually. That is almost 15% of my annual equity returns assuming annual turnover. Then consider what they would do to bonds where real returns are frequently much lower.

When an investor's forward looking cash flows are reduced they will do the only rational thing they can; they will ask for more. Average holding periods these days are measured in months not years so the tax is even more onerous than it initially appears. But the tax is not the same on everyone. Stocks and bonds would drop almost as much tax would remove from annual returns - it would depend on the overall composition of the remaining investors and for foreigners IT WOULD BE DOUBLE! Who needs the Chinese, the Saudis the Japanese, not us... Even more comical is that this tax would not discourage leveraged buyouts but would discourage market making! Isn't this exactly the OPPOSITE of what people today are trying to achieve - that is, lower leverage, a maintenance of orderly markets and positive overall returns? This tax would also increase the cost of capital for all firms (both their debt and equity) as well as for the government (assuming primary dealers are taxed). Since the cost of capital for a lightly levered firm is in the neighborhood of 6.5% and the average ROIC for all firms over time is 9%, can you imagine the number of projects and jobs that would be killed by just a 1% increase in the cost of capital for all firms?

I asked Bob Frank this at a Cornell event specifically noting the impact on spreads and the follow-on effects on WACC and he dismissed them as inconsequential. I would love to see a study done that would examine what would happen if a foreign buyer 1. Exchanged their currency for dollars - Taxed 1x 2. Bought a financial instrument - Taxed 2x. 3. Sold that financial instrument Taxed 3x. and 4. Swapped for their domestic currency. Taxed 4x. How would their preferences change? Wouldn't they want more bang for their buck and using derivatives more frequently (Puts/Calls/CDS) and aren't these precisely the types of levered and in some cases anti-social instruments we are trying to move people away from?
I don't know but it is something that should be seriously considered and studied.