Financial Regulation

Robert Waldmann

Just to post about something other than health care reform, I will type my vague thoughts on financial regulation after the jump. Much is similar to stuff I posted when financial regulation was the hot topic.

I want to take a long look at financiar regulation starting with generalities very far from possible regulations. My focus will be on the academic debate and what it might have to do with policy. I think policy makers ignore academic finance economists, and I think that is the way it should be, but I don’t.

So my obsession is why do many commentators assume that high trading volume (which they call liquidity) is a good thing, while I think it’s a bad thing. This is clearly related to policy, since the point of a Tobin tax is to reduce trading volume. Without going that far, arguments are often made that some regulation is bad because it would reduce trading volume, even if that is not the aim.

I think to understand the mutual incomprehension, one has to understand two very different views of financial markets.

First there is the view of the non expert. Here, I think, “speculation” is often used as a pejorative term. The view is that buying with the aim of selling soon at a profit is socially destructive. Practiononers use the word “trading” or the phrase “active trading” to avoid the negative connotations of “speculation.”

Part of hostility towards speculation is the sense that finance is a zero sum game so if speculators make money they are hurting others. Another part is the conviction that speculation drives prices away from fundamental values causing bubbles and crashes. The two views are logically inconsistent, since the second criticism asserts that speculation reduces total wealth. I think disapproval of the motives of speculators leads to the sense that it is harmful. The idea that people often do socially useful things for selfish reasons remains strange and suspect.

So, the conclusion is that speculation (that is active trading) is bad and maybe it should be punished with a tax on transactions (Tobin tax). At least, the argument that a regulation is bad because it would reduce trading volume is considered absurd.

On the other hand, there is the view of the majority of experts (here I mean the view held by the majority of experts in say 1987, since then many have changed theri minds). Here the claim is that active trading by sophisticated agents drive prices towards fundamental values, that is the prices that would occur if markets were perfectly efficient. It is assumed that something puts a gap between prices and fundamental values (for example the fundamental value changes or for another people drive down a price because they are selling because they need cash or for a third there are mysterious irrational noise traders).

There are also agents who are assumed to trade optimally given transactions costs. Thus the lower are transactions costs the closer are prices to fundamental values. Also these agents might have to invest in gathering information which they will do only if they can profit and so it is important that they can buy or sell a lot without affecting the price much so the market had better be thick.

Such agents are socially useful as prices equal to fundamental values sent optimal signals to the real economy about where to allocate capital.

Regular readers of this blog will know that I think the non experts are totally right and the experts are totally wrong. So I have to ask how could experts be wrong ?

First there is the matter of self interest. Experts include active traders who are claiming that things that are good for them are good for the world. Second there is vanity — active traders tend to overestimate their skill and the skill of active traders in general. Third, I think there is just the assumption that active trading is just what one does if one is a trader.

In my view a whole lot of active trading is pure gambling where huge positions of different active traders net out.

The next question is “If they are so dumb, why are they rich ?” The fact is that traders have obtained huge amounts of money and that not all of it was at the expense of the US Treasury in the lates bailout. I think the key fact is that investment banks have divisions which are very like casinos — that is while the market is a bit like a casino, investment banks are more like casinos. They get huge amounts of money from gamblers by convincing them to bet against the odds.

I think the core competency of an investment bank — that which hedge funds can’t do just as well — is to convince unsophisticated traders who would be best off buying and holding the market to buy overpriced assets, sell underpriced assets, and pay fees. It is a fact that the highly paid star employees of investment banks include traders *and* salesmen. It’s also true that investment banks own account and the rest of the worlds holdings are uhm different. I suppose there is some way of arguing that it isn’t a huge scam, but I have no idea what that argument might be.

Now I can perfectly well understand why the owners of a casino want high trading volume, that is lots of betting. I can’t understand why policy makers who try to restrict gambling in casinos feel they should encourage high trading volume in financial markets.

Now it seems to me that the relationship between trading volume and market efficiency is an empirical question. One sure can’t answer it assuming markets are always efficient. It also seems to me that market volatility almost has to be a good estimate of market inefficiency. Basically it is impossible to argue that fundamental values change anything like as much as asset prices. I think it is clear that higher trading volume is associated with higher price volatility. The data seem to correspond very much to the non experts view and not at all to the experts view (recall dated summer 1987).