One of these days I may finally understand what was the problem we were trying to solve with all these increasingly complicated financial thingamajigs. And what exactly is the benefit we derive from them.
Not betting on it, though.
P.S. Looking for something simple, e.g. "If you have derivative trading, your GDP will be 5% larger, and the gain is spread across the population in proportion to income." The kind of things you have for engine efficiency, or compiler optimization ...
If I'm a big company, like Delta, I want to make sure my profits are based on my efficiency at my core business, like operating an airline, not some random thing like the fluctuations of oil prices. So, I'd like to buy a contract that insures me against high oil prices. To pay for that insurance contract, I'd sell a contract that gives away my excess profits that might accrue if oil fell. These contracts are derivatives of oil, not oil itself.
A healthy derivatives market helps businesses focus on producing useful things for society. Every human should buy health insurance. Every big business should buy commodities and currency insurance (they don't call it that).
An unhealthy derivatives market encourages business to gamble rather than produce. GE Capital, before it got shut down, was at one point a bigger business than the rest of GE.
Just FYI, GE Capital didn't get shut down. Some of it was sold off, but it was mostly spun off into a separate company: synchrony financial. But yes, because it was overshadowing the engineering core of GE.
I upvoted you because I don't understand the benefit of quant funds either.
With short selling, derivatives and high frequency trading, I can at least see the argument for increased liquidity and so forth... But how does society benefit when leading AI research minds spend their time building gambling models that try to predict the sentiment of other gamblers?
At the same time, I recognize that forcing any such social logic onto research is a slippery slope towards Soviet-style government-stunted research. So I guess I'll rather have machines gambling trillions of dollars.
It is – and similar things have been for the last decades– a waste of a generations' brightest minds in a high-stakes, zero-sum game with no benefit whatsoever for society.
It's a distinctively American quality to feel dirty for having these doubts and associating them with the Soviet system. Free markets often create perverse incentives, races to the bottom etc. and it's the genuine role of governments to counteract these: Outlaw it, tax it, or – what may be enough in these cases – make absolutely sure those standing to profit from these activities also bear the full brunt of their failures.
Not sure if anywhere else are public finances already quite as intertwined-with/invested-in "the cowboy Wall St financial system" if you will, as the American ones. All these current and incoming pensioners.. all the numerous social insurance schemes.. all these bonds that must be sold to same (effectively, behind the schematics) to fund current-day budgets.. remember the formers' contributions have already been "spent" (into "assets") and at collection time the entire scheme will have to remain just as fluidly operational as it was before. These quants and funds etc are not just managing some nobles' / oil sheikhs' / super-rich moneys after all --- perhaps not even primarily, in absolute numbers! This makes any and all regulations and reforms forever a major challenge in "realpolitik" terms.
Markets are only zero-sum on a transactional level, in isolation. Yes for every buyer there's a seller and for every winner over some time scale, there's a loser.
But in the broader context of the entire real world, a well-functioning market is valuable in itself. It enables people to transfer risk inexpensively, instantly, automatically, and at fair prices. This competitive pricing mechanism also provides valuable signals to the real economy so people can invest in areas that need it.
Imagine a market with 4 participants:
-A farmer who grows corn and wants to lock-in a price for next year's harvest so he can invest in a new tractor and refurbishing his grain elevator.
-A baker who wants to lock-in his price for his corn purchases next year so he can invest in new ovens for his plant.
-A speculator who monitors price trends and takes risk intermediating between buyers and sellers.
-An exchange that provides a meeting place for these parties.
On Monday, the farmer places his orders with the exchange to sell his 2018 corn harvest. The baker is on vacation until the next day, so the farmer can't transact. However, the speculator knows bakers tend to buy corn around this time of year, so he buys the contracts from the farmer at a slight discount. The exchange also takes a fee from the farmer, and from the speculator.
The farmer goes off to the tractor dealer, and gets to work refurbishing his grain elevator.
On Tuesday, the baker comes to the exchange. No farmers are around, just the speculators who bought from them yesterday. Today is a lucky day for the speculators who can now sell to the bakers at a slight premium. Sometimes they misread the market and take losses instead. Again, the exchange takes a fee from the baker, and from the speculators.
The baker is comfortable funding purchases of his new ovens, knowing that he isn't at risk of corn prices rising next year, which would cut into his profit margins and make his plant unprofitable.
So far, the exchange has made money for providing a meeting place, and the speculator has made money for matching up buyers and sellers who arrive at different times. The farmer and baker each lost a bit of money by trading against the speculator--his profits are their losses, and vice-versa when he's wrong.
2018 rolls around. The cost of corn has risen due to import tariffs. The baker made money on the contracts and the farmer lost an equal amount. The exchange and speculator each made some money. Transactionally, this is actually a negative-sum game, because the exchange makes money no matter what, but it let everyone involved focus on their particular business and insulated them from risks they didn't want to bear.
I wasn't denying that– it's quite obvious that capitalism and its market-mechanisms are the best form of organising an economy. At least among those that we know.
The criticism was directed at the ever-expanding high end of financial markets where it seems to me the benefits it produces in the "real world" are marginal at best and in no way proportional to the money earned in the sector and the brain capacity it utilises. Some deep learning outfit with 200 quants basically putting pressure on the "speculator" in the scenario you sketched out, that may or may not create some small marginal improvement in the market, but could also just serve to better capture any residual utility the farmer and baker may have had from participating in the first place.
When push comes to shove these things determine the allocation of resources in society. How many people does a company making spoons gets to hire or should we put more of them on webforum moderation ? Same for cars/glass/shoes/...
The idea is that letting algorithms decide will result in better/more productive allocation of resources, which will result in more and better everything.
Of course, is that reality ? I would point out, however, that stock markets resource allocations are far better than royalty/governments allocating resources.
> When push comes to shove these things determine the allocation of resources in society.
John Bogle, founder of Vanguard and renowned investor, seems to disagree with you: "The stock market has nothing—n-o-t-h-i-n-g—to do with the allocation of capital. All it means is that if you’re buying General Motors stock, say, someone else is selling it to you. Capital isn’t allocated—the ownership just changes. I may be an investor, you may be a speculator. But no capital goes anywhere. This is basically a closed system. You have new IPOs and whatnot, but they’re very small compared to this vast thing we call a market, which is now around $24 trillion. The allocation of capital? That’s just nonsense."
I think you are mixing up the concept of a market economy with a specific kind of market, the "stock" market.
That sounds like an exaggeration in order to make an unrelated point.
Why would people sell equity in their company except for cash, and why would you pay cash for ownership in a company except for the stream of income it represents and the secondary market for that ownership?
How come people decided it is illegal to trade ivory from an elephant killed a couple hundred years ago? Was it made illegal to possess child pornography that was already created only because it is morally toxic, or does said consumption also induce demand for additional victims?
Even though debt markets have a lot more to do with day to day financing of corporations, equity markets have a great influence on terms. Furthermore, the unavoidable importance of secondary markets for debt and their derivatives can be understood by considering the importance of secondary markets with respect to prices of homes, automobiles, or any other large consumer purchases.
I didn't mean to imply that stock markets were not important, just that "allocating resources" in the sense that parent meant, e.g. "How many people does a company making spoons gets to hire or should we put more of them on webforum moderation ?", being its primary purpose seems like a stretch (except for the occasional new IPO / stockholders' meeting). If anything, venture capital and as you mentioned, debt markets are closer to this idea of allocating resources.
My main point really was that the examples parent gave seemed much closer to examples of market economics in general and would hold true, with or without stock markets.
I can see the limitations in equating stock price directly with GM retooling a factory for a new model year, but it is a far more accurate depiction of what is going on, even if a little abstract, than to say that they have nothing to do with each other and even spelling it out letter by letter. Saying that it is basically a closed system is even more bizarre.
John Bogle is either clearly incorrect, or the quotation may be taken out of context and may be unrelated (I don't know); however, the price that the seller sells at is usually not the price that he originally bought at. This difference, specifically the change in dollar value for the same object being sold, is how capital enters and leaves that system. Note that this is specifically about money-capital, and not capital based on other resources -- so if Bogle was talking about some other kind of value, he could easily be correct; although from that quotation alone, it really looks like he's talking about stock-trading money, and even values the market at $24T, so... I'm guessing he just didn't think it all the way through.
> The idea is that letting algorithms decide will result in better/more productive allocation of resources
Is it? I thought the idea behind HFT was to make a shedload of money for the firms with the most effective algorithms. To be clear, I have no problem with that, and I'm not close to the industry. But it would surprise me to hear that those in it conceive of themselves as optimizing social resource allocation, rather than, say, setting themselves up to retire at thirty with all the money they'll ever need.
There isn't just one argument. The liquidity argument is focused on why would we allow HFT, instead of limiting transactions to traditional investors only.
The algorithms talked about here are not HFT algorithms, but investment algorithms. Things like "if it's down for 3 days in a row, allocate 5% in the stock" type programs, written using machine learning. They generally will not change orders rapidly. They are about more efficient/effective investment, and the argument I gave is more focused on what the function of a stock market and investing is.
Because these algorithms are much more like traditional investors than HFT.
Can't you say that about any profession, especially other forms of middlemen? Does it really matter if your grocer's motivation is having a nice house and good schools for his kids vs. feeding people and providing a market for farmers?
Yes. A grocer with illicit intent can poison the food that they serve because some God told them to do it. We need to ensure that they both are sane and correctly motivated. This isn't simply about providing welfare for people; it also concerns the identification of malicious intent and the avoidance of harm. There may be a few professions where this doesn't matter, but by and large I'd say an individuals motivation for choosing a profession does really matter (especially with middlemen).
The investment side of that equation is tiny compared to the demand side of that equation. GM's stock has very little to do with GM's actions. Much like the most profitable approach when a companies tax rate is 10% is effectively the same approach as when there tax rate is 20%.
GM's stock price has very much to do with GM's actions. GM can do countless things which will impact its equity value.
Also, changing the effective|marginal tax rate by 50% has material implications on your business model and capital structure, e.g. debt (and tax shields).
10% to 20% is a 100% increase not a 50% increase. Now sure, paperwork changes, but the price of your widget or the layout of the factory etc don't really care about the taxes outside of extreme cases.
Anyway, profitable companies like GM can issue stock to raise capital or buy back stock. Buybacks don't really depend on the stock price as it's not an investment it's another form of dividend. Issuing stock is an inefficient way to raise capital better to issue bonds or not issue dividends.
Now sure, there are second order effects of stock price such as stock options. But again +/- 10% to stock price on a given day does not do much.
PS: Consider Microsoft if the tax rate where to increase to say 40% what would they change?
...and 20 to 10 is 50%. I chose the smaller % as it's still substantial.
For your widget company, it does matter! ;-) What widgets you make, your price, your price relative to competition, market share protection, pricing power, where you build your factory, PP&E decisions, and more all depend on your tax rates. I promise, and want to compete against firms that overlook these parameters.
For GM, you're overlooking other (mis)management decisions that will show up in the share price.
Right now, MSFT is facing just such an issue re: re-patriating money from overseas. If there were a one time foreign tax holiday as floated by Obama, MSFT would choose very different decisions than the status quo in terms of buy backs and R&D spend. In terms of operations changing, I guarantee they'd re-think their debt and their product mix within their 3 reporting segments. Some products wouldn't be profitable enough to sell if the profit margin shifted 2-3%.
I don't nessisarily disagree with you examples. But, I think you are misssing the forest for the trees.
I have had several successful CEO's all tell me to ignore taxes. That does not mean you install or don't install solar panels based on tax breaks. It can be very important, but it's generally premature optimization. Further, it's not the top tax rate that is important it's differential tax rates aka A @X or B @ less than X.
MSFT's re-patriating money is a good problem to have. They may see a tax holiday in the next administration or they may not. But again, it's getting to that point is the issue.
Microsoft (and other international companies) go to great lengths to optimize and defer taxes into the future. As the US already has among the highest corporate tax rates in the world not much would change as all international revenue is being held overseas anyhow. There would be changes in how they allocate their resources but only a CFO might be able to tell you what those would be.
Because it's a static, well-known, open problem on which to focus research and public attention, and then that work can be generalized onto something useful.
A more efficient engine might be as good a metaphor as many others. Five percent, equivalent to about a quarter percent faster growth over 20 years isn't a bad starting point either, depending on just how constrained the simplified capital markets would be. The increased friction that would be created by simplifying financial instruments across the board would probably facilitate a lot of rent extraction for people working in finance, but only up to a point, since the less efficient allocation of resources would also eventually leave a smaller pot for them to extract their share.
Like an engine, generalizations about quantities of reagents and thermodynamics aren't going to be violated by the real world, yet the engineers designing engines will understand the dynamics of low level interactions that are unexpected by someone with only a top level view. That is, in general more funding and more instruments that fine tune allocations of resources and risk really do accelerate growth. And yet, the details within the financial industry that can pervert incentives or corrupt signals do undermine some of the gains in funding efficiencies that are to be had. Given a fixed amount of design work a simpler engine might be more reliable than a complex one, but it won't be as efficient as one with more features and sufficient engineering to make them reliable.
> The increased friction that would be created by simplifying financial instruments across the board would probably facilitate a lot of rent extraction for people working in finance
You can have rent extraction through complexity as well as through friction. It's not obvious to me that a more complex, deregulated system is more efficient than a regulated, simpler system. I know that is the dichotomy that is usually talked about - a balance between efficiency and morality, but the sort of marginal increases in GDP we're talking about could easily be wiped out by other factors, for instance complexity that the clients can't understand, and greater instability in the general economy.
I agree that regulation is an important part of controlling information asymmetries, obfuscation of risks etc, and that regulation can mean better signals and be more efficient than only relying on the reputation of institutions.
What I was saying though, is that a blunt approach of declaring that financial instruments can only have some specific measure of complexity would eventually limit the resources available to new projects and businesses. The tangent about rent extraction was a distracting and motivated by my suspicion that a lot of people simply resent incomes in the finance industry, and want to see them make less money regardless of net impact on the economy. However, just as a baker counter intuitively makes more when the price of flour increases, less fine-tuned and efficient financial markets could ultimately make more money for the people working in finance.
I think that there is a belief that complex financial instruments inefficiently insert extra steps into the flow of finance and extract rent from those manufactured inefficiencies. Yet, a better reading is that they circumvent some inefficiency elsewhere in the financial system, and the people who implement that gain in efficiency are able to extract a little of the decreased waste until they too are circumvented.
If the quant programs duplicate a manager's strategies it will be useful. The manager may have forgotten some steps in making a good decision. The programs also will be helpful if you change the markets, like from US to Saudi. The programs can identify the differences in legislation, etc. that may cause your strategy to fail and you don't need to completely reformulate strategy which was successful.
Not betting on it, though.
P.S. Looking for something simple, e.g. "If you have derivative trading, your GDP will be 5% larger, and the gain is spread across the population in proportion to income." The kind of things you have for engine efficiency, or compiler optimization ...