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How Financial Speculation Can Help America

Some good paragraphs from Professor Krugman:

But speculation based on information not available to the public at large is a very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back in 1971, such speculation often combines “private profitability” with “social uselessness.”

It’s hard to imagine a better illustration than high-frequency trading. The stock market is supposed to allocate capital to its most productive uses, for example by helping companies with good ideas raise money. But it’s hard to see how traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve that social function.

What about Mr. Hall? The Times report suggests that he makes money mainly by outsmarting other investors, rather than by directing resources to where they’re needed. Again, it’s hard to see the social value of what he does.

And there’s a good case that such activities are actually harmful. For example, high-frequency trading probably degrades the stock market’s function, because it’s a kind of tax on investors who lack access to those superfast computers — which means that the money Goldman spends on those computers has a negative effect on national wealth. As the great Stanford economist Kenneth Arrow put it in 1973, speculation based on private information imposes a “double social loss”: it uses up resources and undermines markets.

Not all market activity is useful market activity. This is not useful market activity. It's parasitic market activity. And therein lies an opportunity. The government needs more in the way of revenue if it's going to continue to fund important basic services. But we don't want to tax things we want more of right now, like work. We want to tax things we don't want more of, like high-speed financial speculation. This sort of speculation might not be good for the market, but since firms find it profitable to do, and estimates are that a small financial transactions tax could raise $100 billion a year, its existence might yet prove good for the country.

By Ezra Klein  |  August 3, 2009; 11:39 AM ET
Categories:  Financial Regulation , Solutions , Taxes  
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Comments

This is off base, I think. High frrequency trading has benefits like added liquiidty and better price discovery.

Further, the idea that these people are parasitic assumes that that they are successful leaches. Hardly a tenable assumption, I’d argue. High frequency trading is capital at risk. To the extent that these people are even professionals, they don’t stand a chance against the big houses that can and do move markets with their orders. When they place losing trades they could be actually adding social value.

Posted by: fatinspanish | August 3, 2009 11:54 AM | Report abuse

I fail to see how the chance of failing at high frequency trading adds social value. The majority of high frequency trading is done by the big financial firms -- not individual investors. People are not making decisions -- computers are.

Basically fatinspanish is putting together as many poorly-spelled buzzword-laden phrases he's cribbed off of financial sites to sound like he knows something. He does not. Paul Krugman may not always be right (in fact he is frequently wrong), but he's right on this one.

The only problem is that transaction taxes like what Ezra describes would not lessen the amount of high frequency trading -- it would eliminate it entirely. From my understanding the amount of money made PER TRADE is very small - cents or fractions of a cent. It is the volume of trades that makes money. I understand that that would not necessarily be seen as an issue -- but as a revenue stream it is exceedingly poor. If the disincentive works, you have no revenue coming from it!

Posted by: jjhare | August 3, 2009 12:42 PM | Report abuse

So how often is often enough in financial trading? Once a day? Should we stop people from using their PCs, since that's a tax on people who don't have them? What about the telephone? Does the telephone have a net negative effect on national wealth?

"But it’s hard to see how traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve that social function."

Newspaper and web pundits criticizing the social uselessness of others can only be described as irony.

Posted by: tomtildrum | August 3, 2009 1:10 PM | Report abuse

I'm not an expert on this (I don't think anyone is) but the "efficient allocation of capital" argument is disingenuous. My understanding is the owner of the computer (like GS)gets to "see" the price of a stock a fraction of a second before anyone else, and can then choose to fill the order and pocket a few pennies on the difference. Do it often enough and pennies add up to millions of dollars. (What could possibly go wrong?)

The thing is, the money is coming out of someone's hide - either the buyer or the seller. It's one thing to charge a commission to fill the trade - you are providing a service. These trades are not providing a service. The super-fast computer inserts itself in the middle of the trade.

Imo it's a way connected people can make money without doing anything productive.

Posted by: luko | August 3, 2009 2:02 PM | Report abuse

(This may count as hijacking my colleague's comments thread; OTOH, I have blogged about this before: http://voices.washingtonpost.com/fasterforward/2009/03/tax_prep_software_must_die.html .)

One thing Ezra and the authors of the CEPR study don't mention is that a financial-transactions tax could be a lot simpler than our current method of discouraging high-frequency trading: the higher tax rate applied to short-term capital gains. (To judge from my last set of 11099-DIVs, there are actually three different capital-gains rates, but my head exploded when I tried to understand them all.) Today, you or, more likely, your broker need to keep long-term records of your activity to decide which rate applies to which slice of your holdings. With an FTT, that goes away; like a sales tax, you pay at the time of purchase, after which you can forget about it.

So if an FTT would replace the different capital-gains rates--which is not clear from the proposals on the table here--then I'd be 100 percent in favor of it. If nothing else, think of all the interview sections it would eliminate in TurboTax.

- RP

Posted by: robpegoraro | August 3, 2009 3:14 PM | Report abuse

jjhare, by all means, please continue to invest in your 401(k) AND misunderstand high-frequency trading. I think that will work out really, really well for you in the long run.

Oh and BTW, did you rebalance yet this quarter?

Posted by: fatinspanish | August 3, 2009 6:56 PM | Report abuse

The idea of taxing activities that are socially harmful but not enough so as to make them illegal is a good one that is not used enough. Let's do it so as to provide a correction to the current incentive structure. Added bonus: more revenue for the government.

Posted by: politicaleconomist | August 4, 2009 4:30 PM | Report abuse

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