Mystery Economic Theater 2010

[ewmayer]

Latest issue of The Atlantic has a great article on HFT:

Monsters in the Market: In today’s exchanges, strong programs prey on weak ones, humans are hard to find, and the SEC struggles to keep up

On the third floor of Citigroup’s Manhattan headquarters, at the far end of a trading floor overlooking the Hudson River, Young Kang, Citi’s global head of algorithmic products, leans over a terminal and monitors the progress of a canny and powerful beast named Dagger. Bred and trained in secret by Citi’s financial engineers, Dagger can stalk through more than 20 markets, public and otherwise—hunting for anomalies, buying and selling, prowling through mountains of historical data—all at the behest of Citi’s clients. Amid the trading-floor din, Dagger fulfills its duties in flickering silence, with a speed and acuity no human can match.

“It’s self-learning,” Kang says. “The numbers keep updating, the strategy keeps adjusting itself. It gets smarter.”

And it makes a lot of money. Algorithms like Dagger can exploit the smallest inefficiencies in the market. They can parse trades in millionths of a second. Some species can detect other algos embarking on predictable trading strategies, and ruthlessly adjust their techniques. They’re growing ever more complex, subtle, and sophisticated. And as they become more popular, they’re creating some serious headaches for regulators.

By some estimates, algorithms now trigger 70 percent of all trades in U.S. equities. The speed and volume of everyday trading have propelled the market into a new and esoteric dimension, and rendered traders in the pits largely obsolete. Average daily share volume on the New York Stock Exchange increased by 181 percent between 2005 and 2009, while the time required to execute a trade on its electronic systems dropped to 650 microseconds.

Such changes have a lot of people worried, including the Securities and Exchange Commission. It released a wide-ranging paper earlier this year seeking suggestions on how to restructure the entire equity market, and created a Division of Risk, Strategy, and Financial Innovation in part to help monitor new technologies. A market collapse in early May—in which automated-trading systems exacerbated a sell-off that drove the Dow down more than 900 points in less than an hour, before it quickly recovered—gave two worries new public salience: that the proprietors of these algos may not be in full control of their creations, and that the strategies they pursue are, in some cases, fundamentally warping the financial markets.

My Comment: Of course "fundamentally warping the financial markets" is only a problem if the warping is occurring in a direction other than the one decreed by governments and central banks keen to lure burned retail investors back into the equity markets so the operators thereof can once again collect their skim, their "bezzle", in the words of Galbraith the elder. [Note that while HFT is a great driver of volume, the exchanges make relatively money from it, due to e.g. "liquidity provider rebates" they offer to the biggest HFTers.] Being an algorist by profession but also a yearner for open, transparent markets, I feel a curious combination of fascination and disgust on reading this sort of stuff.


Tax, jobs bill blocked in Senate: A Democratic bill to extend jobless benefits and raise taxes on investment fund managers failed a key vote in the Senate on Thursday, dealing a blow to President Barack Obama's push to boost the economy.

The bill would have extended popular business tax breaks, stopped a 21 percent Medicare pay cut for doctors treating elderly patients and extended extra Medicaid money to cash-strapped states. Democratic leaders failed to muster the 60 votes needed to overcome solid Republican opposition to the bill, which would have added about $55 billion to the deficit over 10 years. The Senate voted 56-40 against the measure.

The defeat sent Democratic leaders back to the negotiating table to try to win support from a few moderate Republicans.

"We're not going to give up," said Democratic Leader Harry Reid. It was unclear when the Senate would take up the measure again.

Senate Finance Committee Chairman Max Baucus said that "everything would be on the table" in an effort to try to win support from at least a few Republicans.

Republican opponents argued that the bill would add billions to an already bloated $1.4 trillion budget deficit. Democratic leaders had scaled back the bill from a version that failed a test vote earlier this week. That version would have added about $80 billion to the deficit over 10 years.

The Senate earlier in the day had rejected a Republican alternative that would have been paid for by across-the-board spending cuts for non-defense programs and freezing pay for federal workers.

My Comment: Having seen the sovereign-debt crisis burning its way across Europe [And Japan, and much of Latin America,and Dubai, and Ukraine...], an increasing numbers of politicians on both sides of the aisle in DC are becoming very leery of the borrow-and-spend-our-way-out-of-a-crisis-caused-by-too-much-debt Keynesian approach espoused by most of the economic establishment [which seems to fail to grasp that not all recessions are created equal] ... this is gonna get very interesting when it becomes obvious that the economy has slipped back into recession and the hue and cry for "Stimulus part deux", "QE 2" and perhaps even "Son of Tarp" becomes a clamor. The UK appears to have embraced the necessity of harsh austerity:

Budget 2010: The days of spend now and pay back later are over. Later is now

If we are to be hauled back from the brink of ruin, the Conservative-led Coalition will need to introduce something far more radical than short-term nifty housekeeping. Its goal must be nothing less than the recalibration of a collective mindset. Those who want it all, demand it now, and expect to pay later – or, better still, hope that someone else will – have run out of road. For the Dick Turpin generation, next stop is York Assizes. The game is up.

According to Dr Tim Morgan of Tullett Prebon, a City broking firm: "Western societies have been succumbing to a psychology which decrees that tomorrow doesn't matter, at least until it arrives… An excessively relaxed attitude to debt is the real problem, applying pretty equally to governments, businesses and individuals… Borrowing means over-consuming now at the expense of under-consuming later. Welcome to 'later'."

My Comment: ...but it seems likely we here in the the-normal-rules-don`t-apply-to-us-because-we`re-special-the-self-procalimed-greatest-country-on-esrth-dammit US will be the last of the major economies to learn the needed lesson,especially as long as acolytes of Keynesian dogma like Paul Krugman [who is currently vacationing/hobnobbing in Europe] still hold sway in the highest corridors of power:

That ’30s Feeling

Suddenly, creating jobs is out, inflicting pain is in. Condemning deficits and refusing to help a still-struggling economy has become the new fashion everywhere, including the United States, where 52 senators voted against extending aid to the unemployed despite the highest rate of long-term joblessness since the 1930s.

Many economists, myself included, regard this turn to austerity as a huge mistake. It raises memories of 1937, when F.D.R.’s premature attempt to balance the budget helped plunge a recovering economy back into severe recession. And here in Germany, a few scholars see parallels to the policies of Heinrich Brüning, the chancellor from 1930 to 1932, whose devotion to financial orthodoxy ended up sealing the doom of the Weimar Republic.

My Comment: This frequent assertion-as-fact of the Keynesians that "the economy was recovering" in the late 30s until evil deficit hawks torpedoed it needs to be debunked. Then as now, the assertion rests chiefly on GDP figures, which were only printing positive due to massive government deficit spending. [The spending gets counted toward GDP but the incurred debt does not get subtracted - ain`t government-sanctioned Ponzi accounting great?] Then as now, there was no evidence of a real recovery based on robust and sustained private-sector jobs creation ... until WW2 came along and completely reshuffled the board.

And excuse my ignorance, but I was laboring under the apparent misconception that Weimar`s doom was sealed by an unsustainable socioeconomic status quo and hyperinflatioanry currency collapse resulting from rampant money-printing [Keynesian stimulus run wild, if you will] whose root cause was an unpayable debt load imposed on Germany by the victors of WWI [and which was exacerbated by a continuing blockade of imports and exports by the allies even after the treaty of Versailles came into effect], coupled with continued and often violent political, social and labor unrest in 1920s Germany. As if Brüning really had any control of what was by then inevitable...

[ewmayer]

Even former chief bubblehead [now trying hard to redeem himself and avoid official Ash Heap of History status] Alan Greenspan is deeply worried about the US sovereign debt situation:

Greenspan Says U.S. Debt Near Limit, Is at Risk of Rise in Long-Term Rates: Former Federal Reserve Chairman Alan Greenspan said the U.S. may soon face higher borrowing costs on its swelling debt and called for a “tectonic shift” in fiscal policy to contain borrowing.

“Perceptions of a large U.S. borrowing capacity are misleading,” and current long-term bond yields are masking America’s debt challenge, Greenspan wrote in an opinion piece posted on the Wall Street Journal’s website. “Long-term rate increases can emerge with unexpected suddenness,” such as the 4 percentage point surge over four months in 1979-80, he said.

Greenspan rebutted “misplaced” concern that reducing the deficit would put the economic recovery in danger, entering a debate among global policy makers about how quickly to exit from stimulus measures adopted during the financial crisis. U.S. Treasury Secretary Timothy F. Geithner said this month that while fiscal tightening is needed over the “medium term,” governments must reinforce the recovery in private demand.

“The United States, and most of the rest of the developed world, is in need of a tectonic shift in fiscal policy,” said Greenspan, 84, who served at the Fed’s helm from 1987 to 2006. “Incremental change will not be adequate.”

Rein in Debt

Pressure on capital markets would also be eased if the U.S. government “contained” the sale of Treasuries, he wrote.

“The federal government is currently saddled with commitments for the next three decades that it will be unable to meet in real terms,” Greenspan said. The “very severity of the pending crisis and growing analogies to Greece set the stage for a serious response.”

My Comment: As has been happening with distressing regularity since he left the Fed and started sounding sensible from time to time, I find myself agreeing with the Maestro. I mailed links to the Krugman and Greenspan articles to several of my favorite bloggers (Mish, Barry, Denninger, ZH), along with my commentary as above - Mish picked up on it and wrote a nice comparative-analysis piece, which concludes with a comment I for once hope is wrong:

Krugman is on the wrong side of this debate while Greenspan is mostly right. However, no one will pay any heed to the now discredited Greenspan who ironically was worshiped for all the things he got wrong and ignored the few times he ever said anything that made any sense.

The ZeroHedgers pronounce themselves similarly befuddled, gobsmacked and generally discombobulated to hear the Maestro talking so sensibly:

Goblin Emeritus Says America's Spending Days Are Over

If there is one person in this world who has less credibility than the Goblin in chief, Ben Bernanke, it has got to be the Goblin emeritus, or the man who spawned the monetary policy that will eventually destroy the world. Which is why when we read Alan Greenspan's Op-ed in the WSJ, we cringed, as we actually agree with pretty much most of what he is saying.

[xilman]

Originally Posted by ewmayer

My Comment: Having seen the sovereign-debt crisis burning its way across Europe [And Japan, and much of Latin America,and Dubai, and Ukraine...]

I was under the impression that Ukraine is in Europe. Has it recently been moved out of Europe into, presumably, Asia?

Paul

[ewmayer]

Originally Posted by xilman

I was under the impression that Ukraine is in Europe. Has it recently been moved out of Europe into, presumably, Asia?

Paul

My Old-European brain still considers Eastern Europe (especially the far-eastern-European former Soviet republics and satellite states) as quasi-separate from Western Europe ... please don't mention my geopolitically-incorrect slip to the girlfriend [Yulia T ... what can I say, I simply could not resist those Princess-Leia-style Danish-pastries she wears on her head], she'd have me in the proverbial bad-cossack doghouse for weeks if she learned of my faux pas.

[cheesehead]

Originally Posted by ewmayer

Greenspan's statement oddly omits to point out that the U.S. Treasury, under then-new chairman Paul Volcker, was at that time beginning a deliberate campaign of tightening money supplies in order to restrain wage-price inflation. That surge was not "unexpected" (except by those who paid no attention to Fed actions), but instead was a foreseeable but unavoidable part of the Fed's then-new strategy for restraining wage-price inflation.

Greenspan undoubtedly finds it convenient, as do many conservatives, to characterize historic events from that period in such a way as to avoid giving any credit to Volcker (plus, whenever possible, to portray President Carter negatively).

[Fusion_power]

Did you ever try to "push" a string?

The world wide economy has many parallels with a pan of boiling water. There are eddies, uplifts, downdrafts, and swirls in maddening patterns... or are they random?

My gut instinct is that spending more than your income is going to cause problems at some point when the bills come due. The longer the debt accumulates, the worse the final accounting with be. Volcker was combating runaway inflation by raising interest rates. The treatment was 100% successful but the patient almost died. Now we have very low inflation, very high unemployment, and the U.S. economy is like a man stretched out over a pit of crocodiles waiting for someone to cut the rope.

Greenspan is NOT a dummy. Give him some credit. He made a crucial mistake... or two... or three in blowing asset bubbles by maintaining low interest rates. The price we pay for these bubbles is the current depression. He is still correct that the debt burden is approaching a level that can't be sustained.

Note of interest. Fannie Mae and Freddie Mac are essentially nationalized and accumulating debt at a prodigious pace. I fail to see how they are going to do anything other than become a progressively larger hole into which we pump money. My issue with them is the trash they are buying. It amounts to paying top dollar for seriously flawed assets.

DarJones

[cheesehead]

Originally Posted by Fusion_power

Did you ever try to "push" a string?

To what do you refer?

My gut instinct is that spending more than your income is going to cause problems at some point when the bills come due.

Of course. But conservative think tanks decided in the mid-to-late 1970s that the short-term political gains were worth it. (Not that that's the only short-sightedness that politicians have ever demonstrated!! )

The longer the debt accumulates, the worse the final accounting with be. Volcker was combating runaway inflation by raising interest rates. The treatment was 100% successful but the patient almost died.

"the patient almost died"? We had a recession, but it was hardly a nation-killer, and I don't see how it, as a side-effect of the Volcker strategy, was avoidable anyway, once so many years had passed with unsuccessful inflation-fighting efforts.

Exactly how was inflation, then (late 1970s), to be stopped without restricting money growth or raising interest rates? (Note that no other 1960s-1970s attempted plan succeeded.)

Now we have very low inflation, very high unemployment, and the U.S. economy is like a man stretched out over a pit of crocodiles waiting for someone to cut the rope.

Your juxtaposition of that statement immediately after the previous one makes it look like you're claiming that our current economic problems and high unemployment were a consequence of the Volcker plan. Please correct that misleading impression if such was not your intent.

He is still correct that the debt burden is approaching a level that can't be sustained.

Then why did the GOP knowingly start pushing it up (other than because of political greed and willingness to prey upon the average voter's weak grasp on national economics, that is)?

National debt at start of Reagan's term - $1 trillion

Reagan added $2 trillion.

Bush Sr. added $1 trillion.

Clinton added $2 trillion -- but he changed the trend, ending with surpluses.

Bush Jr. added $4 trillion.

The GOP has deliberately and knowingly (though not admitting it) been steering our national debt upward since 1980, for the purpose of its "Starve the Beast" plan (which also had other objectives).

[R.D. Silverman]

Originally Posted by ewmayer

And it makes a lot of money. Algorithms like Dagger can exploit the smallest inefficiencies in the market. They can parse trades in millionths of a second. Some species can detect other algos embarking on predictable trading strategies, and ruthlessly adjust their techniques. They’re growing ever more complex, subtle, and sophisticated. And as they become more popular, they’re creating some serious headaches for regulators.


...

So now we can kiss goodbye the last pretext that Business Schools
might have for teaching their so-called "efficient market" theories.

These computer programs exploit information changes much faster than
they can spread to the entire market. Therefore, information is NOT
equally available to all participants.

[garo]

Barry Ritholtz does a very nice take-down of Greenspan. There is a lot more and the entire article is worth reading.

Greenspan is an economist to blithely ignore, as his commentary contains almost nothing of value other than its status as a contrary indicator. Before we get into the details of his deficit commentary, I must highlight this sentence: “The financial crisis, triggered by the unexpected default of Lehman Brothers in September 2008, created a collapse in global demand that engendered a high degree of deflationary slack in our economy.”
No, Alan, the financial crisis was not triggered by Lehman’s collapse. You are getting the causation exactly backwards: The crisis is what triggered LEH’s collapse. Further, the fall of Lehman was hardly “unexpected.” Whether you want to look at stock price before the collapse, spreads on its debt, David Einhorn’s forensic accounting (he was short LEH) or our own quantitative analysis (we were short LEH), there were plenty of warnings about Lehman’s collapse. It was only unexpected by those whose ideological beliefs blinded them to reality. (Remind you of anyone?)
Moving onto his discussion about the deficit, the hypocrisy leaps out in nearly every paragraph. Any Greenspan related discussion of current deficits must begin with his specific role in helping to create them.
Not, understand one thing: I pay my share of taxes, and they are not insubstantial. Thus, I am in favor of properly funded tax cuts – meaning, reductions in taxes that are paid for with a matching reduction in spending. But Not Greenie . . . When the Bush White House proposed a trillion dollars in unfunded tax cuts in 2001, and again in 2003, Greenspan publicly endorsed them. (Why a sitting FOMC chair got involved in the politics of tax legislation, as his support of privatizing Social Security, is best saved for another day).

Barry is also firmly against the deficit chicken-hawks who had no problems increasing the deficit to give massive tax cuts to the rich and engage in two wars of choice but now are suddenly panicked over deficits.

In Why plans for early fiscal tightening carry global risks, Martin Wolf of the Financial Times demonstrates yet again why he is the most savvy columnist writing on that side of the pond.
He looks at the foolishness of the Austerians, the name Mark Thoma has given to the newly converted deficit chickenhawks.
Wolf:
“Yet again, we hear the cry of the old economic religion: repent before it is too late; the wages of fiscal sin is death. But is it already time to retrench? I doubt it. At least, we must recognise the risks: delayed retrenchment poses the danger of inflation and even default; premature retrenchment threatens recession and even deflation, as I argued last week. Having barely survived the biggest financial meltdown in history, we need to appreciate that these downside risks are serious . . .

[garo]

Originally Posted by Fusion_power

Greenspan is NOT a dummy. Give him some credit. He made a crucial mistake... or two... or three in blowing asset bubbles by maintaining low interest rates. The price we pay for these bubbles is the current depression. He is still correct that the debt burden is approaching a level that can't be sustained.

He is an utter and total dummy and deserves no credit whatsoever except for being the creator in large part of the mess the US economy finds itself in today. Read the Ritholz take-down in full along with the Greenspan myths article he links to.

[ewmayer]

Originally Posted by R.D. Silverman

So now we can kiss goodbye the last pretext that Business Schools
might have for teaching their so-called "efficient market" theories.

These computer programs exploit information changes much faster than
they can spread to the entire market. Therefore, information is NOT
equally available to all participants.

It`s even worse than that - Denninger explains, and calls for HFT to be banned:

Solving the HFT Dilemma

Now more than a month beyond the "flash crash", and having seen the "gun the market" games of the HFT boys for more than two years, it is time to call "full stop" to this arms race.

The markets are supposed to be a place where capital is formed and price discovered. Neither is served, and much damage is done, by sending false signals of liquidity in the marketplace, as HFT proved during the "flash crash."

Second, and at least equally-important, the HFT "algos" are severely-distorting the price discovery mechanism.
...
High-frequency trading has come to be 70% or more of the volume on US markets, and not one bit of it provides a social good. Indeed, it is a social evil, in that the skimming must, by definition, come from those who are participating in the market to either invest or raise capital. It cannot be otherwise, since an exchange is incapable of manufacturing anything of value itself.

In addition, this false liquidity signal - that is, alleged "depth" in the market that does not exist, as for every share of stock that is intended to execute there are thirty that are not - leads people to believe they can buy or sell in volumes that cannot actually be filled. This in turn leads to circumstances like the "Flash Crash" where sellers come in and poof - all the buyers instantly disappear!

My Comment: KD makes a good case that the "price sniffing" practices employed by the HFT algos are in fact illegal under the SEC`s own ;longstanding anti-market-manipulation rules ... a good read [as are most of KD`s pieces which are not foam-at-the-mouth rants ... problem is, he is too prone to the latter].


Similarly to Barry Ritholtz [see garo`s post above] Robert Reich calls Alan Greenspan a hypocrite for suddenly turnng deficit hawk [see link in my post of last Friday]:

My Father and Alan Greenspan

Contrary to Greenspan, today’s debt is not being driven by new spending initiatives. It’s being driven by policies that Greenspan himself bears major responsibility for.

Greenspan supported George W. Bush’s gigantic tax cut in 2001 (that went mostly to the rich), and uttered no warnings about W’s subsequent spending frenzy on the military and a Medicare drug benefit (corporate welfare for Big Pharma) — all of which contributed massively to today’s debt. Greenspan also lowered short-term interest rates to zero in 2002 but refused to monitor what Wall Street was doing with all this free money. Years before that, he urged Congress to repeal the Glass-Steagall Act and he opposed oversight of derivative trading. All this contributed to Wall Street’s implosion in 2008 that led to massive bailout, and a huge contraction of the economy that required the stimulus package. These account for most of the rest of today’s debt.

If there’s a single American more responsible for today’s “federal debt explosion” than Alan Greenspan, I don’t know him.

My Comment: However, Reich`s analogy with the depression-and-WW2-driven debt accumulated under FDR ["we paid that off no problemo"] is misguided - we don't want to [and can't] repeat the economic conditions prevailing after WW2, out modern economy - driven by offshoring and global wage arbitrage as it is - ensures that most of the GDP boost resulting from the economist-sought recovery in consumer spending will be accompanied by a large balance-of-trade deficit since "over there" is where most of the "real stuff" we use gets made these days, and there is no imminent second baby boom which will lead to a huge multidecadal consumer-demand and GDP-growth explosion which will magically deflate [in relative terms] our federal debt. Oh, and lastly: Reich seems to have missed the fact that his dollar ain`t worth what his daddy`s was. There a hint about how part of the government debt got "paid" there.

In other words, Greenspan may be a huge hypocrite on the deficit issue, but that doesn't make him automatically wrong - it just means everything he says should be taken with a very large proverbial grain of salt, and an effort to winnow any underlying truth from the self-serving spin, causality-misrepresentation and obfuscation.