Should Old Acquaintance Be Forgot

Although I started this blog more than eight years ago, it lay largely dormant for most of this period and this has been my first full calendar year of (somewhat) regular posting. The experience has been consistently rewarding but occasionally exhausting. As the year draws to a close I'd like to acknowledge my debt to a few of the individuals whose writing I have enjoyed and learned from over the past twelve months, and to reflect upon some of the main ideas that have been explored in these pages.

Macroeconomic Resilience began the year as an anonymous blog but was subsequently revealed to be the creation of Ashwin Parameswaran, whose ecological perspective on behavior and markets is very close to my own. Every post of his is worth reading in full, but there is one on the trade-off between resilience and stability that remains an absolute favorite of mine.

Steve Randy Waldman's posts on interfluidity are generally so compelling and self-contained that there is usually very little left to add. I have been especially appreciative of a sequence of recent posts in which he argues that technocratic arguments, regardless of their merits, are unlikely to be persuasive if they are not consonant with our moral intuitions. It is the neglect of this important point that has so many commentators wondering why a policy that allegedly saved the financial system from collapse at negligible cost to the taxpayer is so deeply unpopular.

Along similar lines, Yves Smith on naked capitalism has been relentless in her criticism of TARP (and the unseemly self-congratulation of its architects) on the grounds that superior alternatives were available at the time. While there is plenty of room for debate on these points, it's a conversation that must be had, and one that has to consider the impact of the policy on the distribution of financial practices, as well as the outrage generated when moral intuitions are offended. It is essential that Yves (and her guests) continue to challenge the emerging academic consensus on the policy. 

One of the defining events of the year for me was the flash crash of May 6. Contrary to initial media reports, this was not the result of a fat finger or computer glitch -- it was the consequence of interacting trading strategies, most of which involved algorithmically implemented rapid responses to incoming market data for very short holding periods. In understanding the mechanics of the crash I benefited from comments posted by RT Leuchtkafer in response to an SEC concept release. One of these was published three weeks before the crash and turned out to be remarkably prescient. 

Viewed in isolation, the crash might be considered fairly inconsequential, and a recurrence could probably be prevented by implementing rule changes such as trading halts followed by call auctions. But the crash ought not to be viewed in isolation. Like the proverbial canary in a coalmine, it's importance lies in what it reveals about the manner in which trading strategies interact to produce major departures of prices from fundamentals from time to time. These more routine departures take longer to build and correct, are difficult to identify in real time, and leave their mark in the form of value and momentum effects, volatility clustering, and the fat tails of return distributions.

This view of speculative asset markets as a behavioral ecosystem in which the composition of stategies is a key determinant of market stability has also been advanced by David Merkel on The Aleph Blog. David's sequence of posts on what he calls "the rules" is well worth reading, and it was in response to his tenth rule that I wrote my first post on trading strategies and market efficiency. That was just a couple of weeks before the flash crash occurred and brought these ideas suddenly to life.

I am convinced that the non-fundamental volatility induced by the trading process has major effects on portfolio choice, risk-bearing, capital allocation, job creation and economic growth. Some possible mechanisms through which such effects can arise have been explored by David Weild and Edward Kim, and I thank David for bringing this work to my attention. I am also grateful to Terry Flanagan of Markets Media Magazine for an invitation to attend their Global Markets Summit where I witnessed a fascinating and combative debate on the broader economic effects of exchange-traded funds. 

On the issue of market efficiency I have tangled with Scott Sumner on multiple occasions. But his anniversary post on The Money Illusion really struck a chord with me. Scott has a talent for making complex ideas intelligible, and an ability to maintain a clear distinction between a model and the empirical phenomenon that it is designed to explain. His vision of the economy is coherent and he is a formidable intellectual adversary. His post made me even more optimistic about the ability of blogs to shape economic discourse in constructive ways.

My window to the world of economics and finance blogs is Economist's View. Mark Thoma somehow manages to be both comprehensive and highly selective in his choice of links, virtually all of which are worth following. But more importantly, his site is a wonderful clearinghouse for open debate on economic methodology, especially in relation to macroeconomics. His post on the dynamics of learning (featuring a video presentation by George Evans) was especially memorable, as was Brad DeLong's diagrammatic discussion of the topic.

Despite the recent flowering of behavioral and experimental economics, I believe that the level of methodological homogeneity in our profession is stifling. But the time may finally be ripe for the introduction of agent-based computational models into mainstream discourse. A problem with simulation-based approaches is that there are no commonly accepted criteria on the basis of which the robustness of any given set of results may be evaluated. This will change once there is an outstanding article in a leading journal that sets a standard that others can then adopt. Where will it come from? Based on my reading of ongoing work by Geanakoplos and Farmer, I suspect that it may emerge from this recently funded initiative at the Santa Fe Institute. That would be nice to see.

Although my posts here have dealt largely with economics and finance, I also have a deep personal interest in social identity and group inequality, especially in the American context. On this set of issues I have found no voice more incisive than that of Ta-Nehisi Coates, whose freshness of perspective and formidable powers of expression I find breathtaking. His post on Robert E. Lee was one of several spectacular pieces this year, and prompted me to respond with my own thoughts on cultural ancestry. Related themes have been explored in a series of fascinating dialogues between Glenn Loury and John McWhorter.

Finally, I am thankful for the numerous extraordinary comments that have been left here, many by individuals who manage superb blogs of their own. Joao Farinha on economic development, Barkley Rosser on bubbles and agent-based models, Kid Dynamite on the flash crash, Economics of Contempt on TARP, Nick Rowe on learning, Adam P on equilibrium, Andrew Gelman on dynamic graphs, 123 on exchange traded funds, Andrew Oh-Willeke on private equity and cultural founder effects, and JKH on maturity diversification come immediately to mind, but there are many, many others.

I could go on, in a futile attempt to acknowledge all those who have influenced me and taken the time and trouble to  respond either in comments here or on their own blogs. But this post has to end before the calendar year does, and this seems as good a time to stop as any.

A very Happy New Year to you all.

Perspectives on Exchange-Traded Funds

Are exchange-traded funds good or bad for the market?

That was the title of a lively and interesting session at Markets Media's third annual Global Markets Summit last Thursday. The session was organized as an old-fashioned debate between two teams. On one side were David Weild and Harold Bradley (joined later by Robert Litan on video), who argued that heavily traded funds composed of relatively illiquid small-cap stocks were responsible, in part, for the sharp decline in initial public offerings over the past decade, with devastating consequences for capital formation and job creation.

Responding to these claims were Bruce Lavine, Adam Patti and Robert Holderith, all representing major sponsors of funds (WisdomTree, IndexIQ and EGShares respectively). The sponsors argued that they are marketing a product that is vastly superior to the traditional open-end fund, provides investors with significant liquidity, transparency and tax advantages, and is rapidly gaining market share precisely because of these benefits. From their perspective, it makes as little sense to blame exchange-traded funds for declining initial public offerings and the sluggish rate of job creation as it does to blame them for hurricanes or influenza epidemics.

So who is right?

Bradley and Litan have previously argued their position in a lengthy and data-filled report, and Wield has testified on the issue before the joint CFTC-SEC committee on emerging regulatory issues. Their argument, in a nutshell, is this: The prices of thinly traded stocks can become much more volatile as a result of inclusion in a heavily traded fund as a consequence of the creation and redemption mechanism. For instance, a rise in the price of shares in the fund relative to net asset value induces authorized participants to create new shares while simultaneously buying all underlying securities regardless of the relation between their current prices and any assessment of fundamental value. Similarly a fall in the fund price relative to net asset value can trigger simultaneous sales of a broad range of securities, resulting in significant price declines for relatively illiquid stocks. This process results not only in greater volatility but also in a sharply increased correlation of returns on individual stocks. The scope for risk-reduction through diversification is accordingly reduced, which in turn influences the asset allocation decisions of long term investors. The result is a reduction in the flow of capital to the smaller, more innovative segments of the market, with predictably dire consequences for job creation.

The sponsors do not deny the possibility of these effects, but argue that any mispricing in the markets for individual stocks represents a profit opportunity for alert fundamental traders, and that this should prevent prolonged or major departures of prices from fundamentals. But this is too sanguine an assessment. Fundamental research is costly and its profitability depends not only on the scale of mispricing that is uncovered but also on the size of the positions that can be taken in order to profit from it. Furthermore, since a significant proportion of trades are driven by the arbitrage activities of authorized participants, mispricing need not be quickly or reliably corrected. Both illiquidity and high volatility serve as a deterrent to fundamental research in such markets.

The problem, in other words, is real. But what I find puzzling about Bradley's position on this issue is that he seems unable (or unwilling) to recognize that precisely the same effects can be generated by high-frequency trading. As was apparent in an earlier session at the conference, he remains among the most vocal and fervent defenders of the new market makers. His justification for this is that spreads have declined dramatically, lowering the costs of trading for all market participants, including long term investors.

There is no doubt the costs of trading are a fraction of what they used to be, but a single-minded focus on spreads misses the big picture. It is worth bringing to mind John Bogle's wise words:

It is the iron law of the markets, the undefiable rules of arithmetic: Gross return in the market, less the costs of financial intermediation, equals the net return actually delivered to market participants.  

If spreads and costs per trade decline, but holding periods shrink to such a degree that overall trading expenditures rise (due to significantly increased volume), the net return to long term investors as a group must fall. Furthermore, if increases in volatility and correlation induce shifts in asset allocation that have the effect of reducing financing for small companies with high growth potential, then even gross returns could decline.

I have been arguing for a while now that the stability of an asset market depends on the composition of trading strategies and, in particular, that one needs a large enough share of information trading to ensure that prices track fundamentals reasonably well. But changes in technology and regulation have allowed technical strategies to proliferate, and high frequency trading is a significant part of this phenomenon. The predictable result is a secular increase in asset price volatity and an increased frequency of bubbles and crashes.

The flash crash of May 6 was just a symptom of this. Viewed in isolation, it was a minor event: prices fell (or rose, in some cases) to patently absurd levels, then snapped back within a matter of minutes. But the crash was the canary in the proverbial coal mine -- it was important precisely because it made visible what is ordinarily concealed from view. Departures of prices from fundamentals are routine events that, especially on the upside, are not quickly corrected. Some of the proposed responses to the crash that were favored at the conference -- such as trading halts followed by call auctions -- are cosmetic changes. They will have the effect of silencing the canary while doing nothing to lower toxicity in the mine.

It is the unremarkable, invisible, gradually accumulating departures of prices from fundamentals that are the real problem. These show up in the magnitude and clustering of asset price volatility and, through their effects on the composition of portfolios, leave their mark on the path of capital allocation, employment, and economic growth.

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I am grateful to Terry Flanagan of Markets Media Magazine for the invitation to attend the summit.

I would also like to mention that the Kauffman report contains a number of assertions with which I disagree. For instance, Bradley and Litan endorse the claims of Bogan, Connor and Bogan that an exchange-traded fund with significant short interest could collapse with some investors unable to redeem their shares. This has been refuted very effectively by Steve Waldman in his comments on the Bogan post, and by Kid Dynamite. It is unfortunate that most responses to the report have focused on this dubious claim, rather than the more legitimate arguments that are advanced there.

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Update (12/11). David Weild writes in to say:

I think we are seeing capital leave the microcap markets for a variety of reasons including:

• Loss of liquidity providers
• Emergence of ETFs (they don't buy IPOs and most don't buy follow-on offerings)
• Indexing displacing fundamental investing (again, when this occurs, the funds stop investing in IPOs)
• Loss of the retail broker as a stock seller.

If you don't have access to sufficient capital then capital formation, innovation and economic growth will suffer. That is clearly where we are.

I have also heard from someone who was once active in convincing the SEC to expand approval of ETF applications (and prefers to remain anonymous). He asserts that "the effects now being debated were certainly not an anticipated consequence. I can't remember a single conversation externally or internally at the SEC about whether the creation and redemption mechanism would increase correlations."

In hindsight it seems obvious that returns would become more highly correlated, but the fact that it was completely unanticipated at the time illustrates the enormous challenge of regulatory adaptation to financial innovation.

Building a Computational Model of the Crisis

A team of four researchers affiliated with the Santa Fe Institute has secured a grant from the Institute for New Economic Thinking to fund the development of an agent-based computational model of the financial crisis. The model will explicitly consider "housing and mortgage markets, banks and other financial institutions, securitization processes and hedge fund investors, manufacturing and service firms, and regulatory agencies," with the goal of discovering "the essential elements needed to reproduce the crisis, while investigating alternative policies that may have reduced its intensity and strategies for recovery."

It's an interesting and multidisciplinary group, composed of Doyne Farmer, John Geanakoplos, Peter Howitt and Robert Axtell. Genakoplos and Howitt are two of the most creative economists around, and I have discussed the work of the former on leverage and the latter on learning in earlier posts. Axtell is the co-author (with Joshua Epstein) of a fascinating book called Growing Artificial Societies, in which they develop an elaborate computational model of the interaction between a renewable resource base and the human population that depends on it. The model reproduces spatial patterns of resource depletion and recovery as well as population growth, migration and decline. Farmer is a physicist by training but has been working on finance for as long as I can remember. I discussed some of his work in an earlier post making a case for greater methodological pluralism in economics in general, and agent-based modeling in particular.

The team is looking for a graduate student or postdoctoral fellow to join them for a couple of years. For a young researcher interested in finance, the microfoundations of macroeconomics, and the agent-based computational methodology, this could be a fantastic opportunity.

Global Health and Wealth over Two Centuries

Here is a story in four minutes of remarkable divergence followed by rapid convergence in health and wealth across nations over the past two centuries (h/t David Kurtz)

Where the entire world was clustered in 1810 only sub-Saharan Africa remains. But even here there are profound stirrings of change.

I suspect that someday soon animations such as this will replace the soporific tables and charts than now appear as motivating evidence in economic papers.

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Update (12/6). Pinkovskiy and Sala-i-Martin argue that over the past decade and a half, the nations of sub-Saharan Africa have experienced a dramatic and broad-based decline in poverty and inequality (h/t Mark Thoma):

African poverty reduction has been extremely general. Poverty fell for both landlocked and coastal countries, for mineral-rich and mineral-poor countries, for countries with favourable and unfavourable agriculture, for countries with different colonisers, and for countries with varying degrees of exposure to the African slave trade. The benefits of growth were so widely distributed that African inequality actually fell substantially...

It has often been suggested that geography and history matter significantly for the ability of Third World, and especially African, countries to grow and reduce poverty... Since these factors are permanent (and cannot be changed with good policy), they imply that some parts of Africa may be at a persistent growth disadvantage relative to others.

Yet... the African poverty decline has taken place ubiquitously, in countries that were slighted as well as in those that were favoured by geography and history. For every breakdown... the poverty rates for countries on either side of the breakdown tend to converge, with the disadvantaged countries reducing poverty significantly to catch up to the advantaged ones. Neither geographical nor historical disadvantages seem to be insurmountable obstacles to poverty reduction... even the most blighted parts of the poorest continent can set themselves firmly on the trend of limiting and even eradicating poverty within the space of a decade.

This is consistent with recent observations by Shanta Devarajan, Ngozi Okonjo-Iweala, and even the much-maligned Gordon Brown.

I have argued in a couple of earlier posts that sub-Saharan Africa may have entered what might be called a zone of uncertainty in which optimistic growth expectations can become self-fulfilling:

History can matter for long periods of time (for instance in occupational inheritance or the patrilineal descent of surnames) and then cease to constrain our choices in any significant way. Once reliable correlations can break down suddenly and completely; history is full of such twists and turns. As far as African prosperity is concerned, I believe that a discontinuity of this kind is inevitable if not imminent.