But all trading is, in some sense, a stupid thing for people to devote their energies to. Just moving around stocks and money between people is a mostly-pointless activity in itself; if you buy my shares of Facebook stock no new investment happens, no new factories are built, no new diseases are cured. Each individual trade looks pointless from a social perspective. But the ability to buy and sell stocks efficiently makes it easier for new companies to raise money. The trades are mostly pointless, but the system of trading is valuable.
Incidentally, most people think that we do spend too many resources on this whole trading business. There's a wonderful recent paper by Thomas Philippon of NYU, who points out that, while the income of the financial industry has grown from ~5% to ~8% of the American economy since 1980, the value it provides, in terms of liquidity services and financing of businesses, has not grown nearly as fast. As he puts it, the "cost of financial intermediation" has actually gone up.
high-frequency trading has been genuinely wonderful for small investors like you and me. We might not be particularly clever, but when we put in an order to buy this or sell that, the order gets filled immediately. We pay almost nothing in trading costs — just a few pounds, normally. And we get the very best price in the market: something called NBBO, for “national best bid/offer”. If you look at all the prices being quoted on all of the stock exchanges in the country, we get the lowest price of all if we’re buying, and the highest price of all if we’re selling.
That wasn’t true ten years ago.
The role of the ﬁnance industry is to produce, trade and settle ﬁnancial contracts that can be used to pool funds, share risks, transfer resources, produce information and provide incentives. Financial intermediaries are compensated for providing these services. The income received by these intermediaries measures the cost of ﬁnancial intermediation. This income is the sum of all spreads and fees paid by non-ﬁnancial agents to ﬁnancial intermediaries, and it is also the sum of all proﬁts and wages in the ﬁnance industry. The ﬁrst contribution of the paper is empirical.
I show that the income of ﬁnancial intermediaries as a share of GDP varies a lot over time. The income share grows from 2% to 6% from 1870 to 1930. It shrinks to less than 4% in 1950, grows slowly to 5% in 1980, and then increases rapidly to more than 8% in 2010. This ﬁnding is robust to alternative measures, e.g., excluding net exports of ﬁnancial services, or scaling by services instead of GDP.
After observing these large historical changes in the ﬁnance income share, it is natural to ask the following questions: Is ﬁnance a normal good? Should we expect ﬁnance to grow with income per capita? How do productivity growth in the non ﬁnancial sector or technological progress in intermediation aﬀect the size of the ﬁnance industry?
To answer these questions, I introduce ﬁnancial services for ﬁrms and households in the neoclassical growth model. This is the second contribution of the paper. Under the assumption of homogenous monitoring (a natural assumptions for monitoring and screening technologies), the model predicts no income eﬀect (i.e., no mechanical tendency for the ﬁnance income share to grow with per-capita GDP). The intuition for this result is simple. As borrowers become more productive, the value of monitoring increases even though the monitoring technology itself does not change. Since the opportunity cost of being a banker is the wage in the non-ﬁnancial sector, and since this wage is proportional to aggregate productivity, the income share of ﬁnance remains constant on the balanced growth path. I test this hypothesis and ﬁnd that it holds well.
There's a wonderful recent paper by Thomas Philippon of NYU, who points out that, while the income of the financial industry has grown from ~5% to ~8% of the American economy since 1980, the value it provides, in terms of liquidity services and financing of businesses, has not grown nearly as fast. As he puts it, the "cost of financial intermediation" has actually gone up since the 1970s, unlike most industries where increasing use of technology has lowered costs. High frequency trading may be a part of this, but it's unlikely to be the main part; it is a symptom of the excessive dedication of resources to trading, rather than a cause.
The more obvious problem with exchanges run by computers is that computers don’t have any common sense. We saw this on the 6th of May, 2010 — the day of the so-called “flash crash”, when in a matter of a couple of minutes the US stock market plunged hundreds of points for no particular reason, and some stocks traded at a price of just one cent. It was sheer luck that the crash happened just before 3pm, rather than just before 4pm, and that as a result there was time for the market to recover before the closing bell. If there hadn’t been, then Asian markets would have sold off as well, and then European markets, and hundreds of billions of pounds of value would have been destroyed, just because of a trading glitch which started on something called the e-mini contract in Chicago.
« Older Whenever a new Bond film is released, the promotio... | Korean robot prepares salad... Newer »
This thread has been archived and is closed to new comments
Buy a Shirt