Written by Robert P. Murphy
University of Rochester economist Steve Landsburg is an extremely sharp thinker who is always worth reading–even when he’s wrong, as I think he (mostly) is when it comes to so-called “high frequency trading” (HFT). But before I jump into my criticism of his latest post, let me praise a great zinger Landsburg launched at the Keynesians in an earlier blog entry.
Reading guys like Paul Krugman rail against the socially useless financial sector, Landsburg raised an excellent question: Haven’t Keynesians like Krugman for years been lecturing us on the desirability of even pointless investment spending when the economy is stuck in a “liquidity trap”? And yet, I don’t remember Krugman or any other Keynesian thanking their lucky stars that traders had built a $300 million fiber optic cable between Chicago and New York just when–according to their own analysis–there were large multipliers on investment spending. The project actually started in March 2009 and “soon had 125 construction crews working at once.” The timing couldn’t have been more perfect. Talk about stimulus!
And remember, Krugman has been arguing that even a bogus alien invasion threat would be good. So even if, down the road, he still thought the financial sector absorbed too much of the economy without producing something socially useful, he should still be telling us how many extra jobs that fiber optic cable produced during the critical liquidity trap years.
Now that I’ve given Lansburg his due for pointing out this failure of Keynesians to take their own views seriously, I must move on to his seemingly error-based critique of HFT. Since Landsburg is far more mathematically skilled than I am, I hesitate to bring up this point, but I really do think he just botched it. Anyway, here’s an excerpt from Landsburg’s latest post, in which he blasts HFT as grossly inefficient:
Spread Networks recently spent $300 million to build a fiberoptic cable that will let Wall Street traders shave .003 seconds off their execution times.
What’s the social value of that cable? If you can shave .003 seconds off the time it takes to execute a trade, how much good have you done the world?
Clearly, the full value of the cable resides in its ability to get things done faster. So start with a vast overestimate: Suppose the entire economy is on hold waiting for that trade to be completed. Then, thanks to the cable, we can all get on with our lives .003 seconds sooner and produce an extra .003 seconds worth of output.
In a $15-trillion-a-year economy, that comes to about $1500.
If we assume, more realistically, that just 1/1000 of the economy is hanging fire waiting for this one trade, the social contribution of a .003-second speedup is roughly $1.50. I’m confident it’s even more realistic to replace that 1/1000 with 1/1,000,000 . That gets us down to about an eighth of a cent.
But chances are you’d be willing to pay a hell of a lot more than an eighth of a cent for that extra speed, which is why Spread Networks is willing to pour $300 million into this thing, and why, quite generally, we should expect there to be more invested in such projects than they return in social value.
Now as people in the comments were quick to point out, Landsburg appears to have made an enormous mistake in his calculation: He has computed (an upper bound on) the social value of speeding up one transaction. But the term is high frequency trading. After all, no firm would spend $300 million just to speed up one transaction.
Using Landsburg’s technique, then, we should take that “social benefit” of 1/8 of a penny, and multiply it by how many trades the HFT operation will execute in a year. If the operation executes at least 240 billion such trades per year, then it passes the very cost/benefit test Landsburg set up for it. Well, Wikipedia says HFT accounted for about half of all stock exchange volume in 2012, and this CNN article says the volume was about 6.8 billion shares per day (during the first 10 days of 2012). That means after 71 trading days, we hit the threshold.
Now to be fair, we should only be counting the number of trades that the firm(s) using the specific $300 million fiber optic cable are executing in a year, not the total number of HFT trades. And there are other costs besides the initial $300 million outlay. On the other hand, I’m not sure why Landsburg only plugs in the U.S. economy as the baseline; surely financial markets around the world benefit from the benefits (whatever they might be) of HFT occurring on Wall Street. The U.S. accounts for about a quarter of world GDP, meaning that Landsburg arguably needs to multiply his estimate of the social benefits of HFT by a factor of four.
Yet if Landsburg’s analysis of the social benefits and costs of HFT is seriously flawed, his conclusion is even more troublesome:
There remains the question: If HFT is socially destructive (as I now think it clearly is), what should be done about it? Outlawing, directly regulating, or taxing it seems like a nightmare to me for multiple reasons, including the implausibility of effective enforcement and my general reluctance to cede power to regulators who all too often wield that power in unanticipated and obnoxious ways.
But here, perhaps, is an easy fix: What if trades were executed anywhere between 0 and 1 second after they were submitted, with the delay chosen randomly? On average, we’d slow everything down by half a second. At the same time, we’d pretty effectively destroy the value of a .003 second head start, and Spread Networks might start looking for an investment that could actually enrich the world — perhaps an orange grove.
Even if we concede the Pigovian framework upon which Landsburg bases his critique of HFT–whereas I would have preferred a more Hayekian approach in which stock speculation serves a useful social function by helping to coordinate economic activity–his policy recommendation doesn’t follow at all.
After all, if Steve Landsburg (and Paul Krugman, etc.) are smart enough to see that “arms races” are destructive, then why can’t the people running the rich hedge funds and stock exchanges see it too? The owners of professional sports teams have “salary caps” and other such devices, why can’t we give the people in the financial markets the time and freedom to figure this one out for themselves?
I definitely agree that during the last few decades, the financial sector has been causing gross harms (if not net harms) to the rest of the economy, but that is because of government intervention, particularly in the form of central banking and then more recently the bailouts. Yet this type of argument (though he probably agrees with me) isn’t at all what Landsburg has done in his recent analysis of HFT.
It is depressing when even a champion of free markets and outside-of-the-box thinking like Steve Landsburg so readily turns to deliberate handicaps on the flow of information. Especially when I’m pretty sure his calculation justifying the move is off by a factor of several hundred billion.
Robert P. Murphy is the author of The Politically Incorrect Guide to Capitalism, and has written for Mises.org, LewRockwell.com, and EconLib. He has taught at Hillsdale College and is currently a Senior Economist for the Institute for Energy Research. He lives in Nashville.