Over the weekend Paul Krugman gave us the rather tired story that all of this growth in modern finance hasn't actually done very much for us average guys in the street. In more detail, that the Spread Networks fibreoptic line from Chicago to New York doesn't make much economic sense, and that the growth of the financial industry as a whole just seems to be more going to the financiers and not very much of benefit going to us.
This is, how shall we put this, a less than accurate description of what has been going on. I wouldn't argue that the Spread Networks story is of any particular huge benefit to us but I would that it is symptomatic of the rise of high frequency trading which has been of huge benefit to us all. And the analysis that leads to modern finance producing not much of interest seems rather unperceptive, ignoring as it does the entire subject of pensions. Something which, as we might expect given increasing lifespans in the past 6 or 7 decades, has grown as a portion of the economy.
Even as one tunnel was being canceled, however, another was nearing completion, as Spread Networks finished boring its way through the Allegheny Mountains of Pennsylvania. Spread’s tunnel was not, however, intended to carry passengers, or even freight; it was for a fiber-optic cable that would shave three milliseconds — three-thousandths of a second — off communication time between the futures markets of Chicago and the stock markets of New York. And the fact that this tunnel was built while the rail tunnel wasn’t tells you a lot about what’s wrong with America today.
Who cares about three milliseconds? The answer is, high-frequency traders, who make money by buying or selling stock a tiny fraction of a second faster than other players.
That tunnel cost several hundred million dollars: was that all a waste? As I say, I'm not particularly going to defend that one project, but I will defend HFT of which that project is a part. For, as you can see here, something has been happening to trading costs over the past 30 years. The bid/ask spread, the tick, has fallen from 0.2% of the value of a trade down to 0.002%, a reduction of two orders of magnitude. And that tick is the fee that we investors pay to be able to buy and sell on the markets, the difference between what we can buy at and sell at.
To give some sort of idea as to the size of this, consider that the NYSE daily turnover is of the order of $100 billion to $200 billion (depends upon the year). And let's take that $200 billion as being the turnover of all US equity markets (it ain't, it's much too small, but let's run with it) and then say that there are 200 trading days in a year. So, 200 by $200 billion gives us an annual turnover of $40 trillion in the stock markets. That sounds about right as the stock markets are at least an order of magnitude smaller than the foreign exchange markets, at $4 to $5 trillion per trading day. Don't take these numbers as being accurate, they're only ballpark.
And all investors collectively (for that's what the average means) were paying 0.2% in the tick or spread only 20 years ago. Or $80 billion collectively. Now we're all, collectively again, paying only one hundredth of that, or $800 million. Now not all of that reduction in costs comes to us, retail investors. But given the role that our pension funds have in Wall Street we do indirectly get a goodly proportion of those savings. And note, those savings appear to be around $78,200 million which is, however you want to look at it, a fair old chunk of change.
We also know what it is that has led to a goodly portion of that collapse of the spread: the very HFT that everyone is raging about. More trading is the same as saying more liquidity. More liquidity is the same as saying smaller ticks or spreads. At which point we can start to have some sense of proportion about those three hundred million dollars spent on the Spread cable. No, we're not going to try and claim that this one cable had anything more than the most marginal effect on that $79,200 million savings to the rest of us. But the whole system of HFT, of which that fibreoptic cable is a part, has very definitely had a significant role in that saving.
And that then is where we have benefited. For, if we're honest about it, we're just absolutely delighted if people spend a few hundred million of their own money, to make their own profit, the side effect of which is the rest of us save some tens of billions a year as a result. Sounds like quite a bargain in fact.
Krugman also goes on to point to the following:
And that’s part of a much broader picture, in which society is devoting an ever-growing share of its resources to financial wheeling and dealing, while getting little or nothing in return.
How much waste are we talking about? A paper by Thomas Philippon of New York University puts it at several hundred billion dollars a year.
Mr. Philippon starts with the familiar observation that finance has grown much faster than the economy as a whole. Specifically, the share of G.D.P. accruing to bankers, traders, and so on has nearly doubled since 1980, when we started dismantling the system of financial regulation created as a response to the Great Depression.
What are we getting in return for all that money? Not much, as far as anyone can tell. Mr. Philippon shows that the financial industry has grown much faster than either the flow of savings it channels or the assets it manages.
And having read the paper mentioned (here) I would have to say that I'm less than convinced. I looked specifically for the word "pension" in it and he seems not to mention it at all. Which is really something of a pity. This is from Emmanuel Saez:
There's been, as you can see, a certain increase in pensions saving over the time period he's studying. From some pittance of GDP to some 100% or so. And from the Saez paper this is only fully funded defined benefit pensions: so that pension section doesn't include our own 401 (k) and IRA savings, because those are defined contribution, not defined benefit. Defined benefit pensions are almost exclusively those provided for us by our employers. The other sectors of financial wealth haven't changed all that much, entirely correct as this paper by Philippon says. But pensions savings have changed remarkably. And yes, pensions savings are indeed normally counted as part of the financial sector.
In effect, Philippon's paper has simply failed to notice some $18 to $20 trillion that the financial system now manages to make sure we can afford Ex-Lax in our old age, the money that we hope to use to make sure we don't go meat shopping in the cat food aisle. And an analysis of the costs and benefits of the financial system that fails to note that much money might not be the very best guide to the overall net benefits.
I'm afraid I'm not impressed here, not impressed at all. We know very well that there have been benefits both from HFT and also from the growth of the financial sector. It might well be worth having an argument about whether those benefits are worth what we're currently paying (hey, I hate hedge fund managers just as much as the next rational person) but we do actually have to try and work out what the benefits have been, not just glibly assume that here haven't been any at all.
