Month: May 2011

Do our intuitions about deadweight loss break down at very small scales?

by  Tyler Cowen in

I’ve been thinking about high-frequency trading again.  Some of the issues surrounding HFT may come from whether our intuitions break down at very small scales.

Take the ordinary arbitrage of bananas.  If one banana sells for $1 and another for $2, no one worries that the arbitrageurs, who push the two prices together, are wasting social resources.  We need the right price signal in place and the elimination of deadweight loss is not in general “too small” to be happy about.

But at tiny enough scales, we stop being able to see why the correct price is the “better” price, from a social point of view.  Think of the marginal HFT act as bringing the correct price a millisecond earlier, so quickly that no human outside the process notices, much less changes an investment decision on the basis of the better price coming more quickly.  (Will we ever use equally fast computers to make non-financial, real investment decisions in equally small shreds of time?  Would that boost the case for HFT?  Is HFT “too early to the party”?  If so, does it get credit for starting the party and eventually accelerating the reactions on the real investment side?)

HFT also lowers liquidity risk in many cases (it is easier to resell a holding, especially for long-term investors, as day churners can get caught in the froth), and thereby improving the steady-state market price, again especially for long-term investors.  That too could improve investment decisions, even if the improvement in the price is small in absolute terms.

Some decisions based on prices have to rely on very particular thresholds.  If no tiny price change stands a chance of triggering that threshold, we encounter the absurdity of there being no threshold at all.  We fall into the paradoxes of the intransitivity of indifference and you end up with too many small grains of sugar in your coffee.

So maybe a tiny price improvement, across a very small area of the price space, carries a small chance of prompting a very large corrective adjustment, with a comparably large social gain.  Yet we never know when we are seeing the adjustment.  The smaller the scale of the price improvement, the less frequently the real economy gains come, but in expected value terms those gains remain large relative to the resources used for arbitrage, just as in the bananas case.  It’s not obvious why operating on a smaller scale of price changes should change this familiar logic.  Is the key difference of smaller scales, combined with lumpy real economy adjustments, a greater infrequency of benefit but intact expected gains?

In this model the HFTers labor, perhaps blind to their own virtues, and bring one big grand social benefit, invisibly, every now and then.  Occasionally, for real investors, their trades help the market cross a threshold which matters.

I am reminded of vegetarians.  Say you stop eating chickens.  You are small relative to the market.  Does your behavior ever prompt the supermarket to order a smaller number of chickens based on a changed inventory count?  Or are all the small rebellions simply lost in a broader froth?

What is the mean expected time that HFT must run before it triggers a threshold significant for the real economy?

Aren’t the rent-seeking costs of HFT near zero?  Long-term investors do not have to buy and sell into the possible froth.  HFTers thus “tax” the traders who were previously the quickest to respond, discourage their trading, and push the rent-seeking costs of those traders out of the picture.  More fast computers, fewer carrier pigeons.  Are there models in which total rent-seeking costs can fall, as a result of HFT?  Does it depend on whether fast computers or pigeons are more subject to production economies of scale?

Opportunity cost

by  Tyler Cowen in

I then wrote to a number of well-known philosophers, asking each of them if they would supervise a course-by-mail, consisting of my writing letters to them about their work, getting responses from them, and ultimately providing comments on a paper I wrote. Nancy Cartwright, Lynne Rudder Baker and Nathan Oaklander agreed to do this for me. They were all extremely generous with their time, and I owe all three of them, along with Quentin, an enormous debt.

That is from LA Paul, who has since become a very accomplished philosopher.  How many economists would help out in the same way?  Hat tip goes to Kieran Healy.

*1493*

by  Tyler Cowen in

1491: New Revelations of the Americas Before Columbus, by Charles C. Mann, is one of my favorite books ever, in any field.  And now there is a “sequel,” namely 1493: Uncovering the New World Columbus Created, due out in August.  Excerpt:

Incredibly, the Basque-Vicuña war had almost no effect on the flow of silver.  Even as Basques and Vicuñas fought in the streets, they cooperated on mining and refining the silver, then shipping it from Potosi.  The last was a huge task.  One account describes how a single shipment of 7,771 bars left the city in 1549, four years after the lode’s discovery.  Each bar was about 99 percent silver and weighed more than eighty pounds.  All were stamped with serial numbers by the foundry and marked with the owner’s stamp, the foundry stamp, and the taxman’s stamp. By the time the assayer individually certified its purity with his stamp, the bar looked as if it had been graffiti-tagged by a demented numerologist.  Each llama could carry only three or four bars.  (Mules are bigger than llamas, but need more water and are less surefooted.)  The shipment required more than two thousand of the beasts.  They were watched by more than a thousand Indian guards who in turn were watched by squads of Spanish pistoleros.

Is 1493 as good as 1491?  That’s hard to say, but I can report this.  I am spellbound reading it, it will be one of the best books of this year, and, although I know this area somewhat, I am learning fascinating information on literally every page.  Mann stresses how much it mattered to suddenly be living in the “Homogenocene,” where Asia, Europe, and the New World suddenly started becoming more alike.  Mexico City had the world’s first Chinatown and was the first global city.  The discussion of the importance of the potato, and in general New World agriculture, surpasses previous accounts and he explains the importance of knowing how to make chuño.

I have an irrational fondness for this sentence of Mann’s:

The First World War distracted governments from the task of monitoring insect movements.

Definitely recommended.  By the way, here is Mann’s piece on soil erosion and the economics of dirt.  Here is Mann’s home page.  Journalists, if anyone is crying out to be the subject of a fascinating profile, it is Charles C. Mann.

The wisdom of Josh Barro

by  Tyler Cowen in

Unfortunately, it’s also possible (as many other voices on Wall Street are warning) that a default would permanently raise Treasury spreads, drive investors to find alternative safe havens, cause a double-dip recession, and unleash various other evils. So, if they are willing to create the possibility of a default, Republicans in Congress are willing to expose America to severe downside risk.

It’s important to step back and consider the stakes here. Republicans say it is important, above all else, to rein in federal government spending. But the risk with excessive spending is not that government will literally become unaffordable or that we will be unable to service our debts. The United States has tremendous available fiscal capacity, as demonstrated by significantly higher tax burdens in most other first-world countries. The real risk of elevated spending is that we’ll adopt a permanently higher level of taxation.

That is a risk, but not a catastrophic one. While there is a link between government spending and economic growth, it is not as strong as conservatives like to believe. For example, Mueller and Stratmann find that a one percentage point rise in government spending as a share of GDP will tend to reduce annual GDP growth by a bit under one-twentieth of a percentage point. If we take Simpson-Bowles as an example of the sort of deficit deal that might be achieved in the medium term without the need to flirt with a bond default, then we’re talking about a difference of one to two points of GDP in government spending compared to an all-Republican plan.

There is also nothing special about government spending as a share of GDP as opposed to other determinants of economic growth, such as rule of law, freedom of contract, immigration policy, free trade and the structure of the tax code—not to mention policies on infrastructure, land use and education. Basically, we could make up a sub-0.1 percentage point hit to long term GDP growth with policy improvements elsewhere.

Which is to say, it does not make sense to create a risk that U.S. Treasuries will be dislodged as the world’s safe-haven investment as a strategy to shift the size of government by a percentage point of GDP or two. Winning this fight is not so important that it makes sense to throw caution to the wind, but that is what Republicans in Congress appear willing to do. The gamble looks even worse when you consider that a debt-limit-impasse-gone-wrong would not necessarily lead to Republicans getting their way on the long-term fiscal adjustment.

The full post is here.

Star Children: Return to Home

by  Alex Tabarrok in

DARPA, believe it or not, has a request for information on what they call the 100 YEAR STARSHIP™ STUDY.

Neither the vagaries of the modern fiscal cycle, nor net-present-value calculations over reasonably foreseeable futures, have lent themselves to the kinds of century-long patronage and persistence needed to definitively transform mankind into a space-faring species.

The 100 Year Starship™ Study is a project seeded by DARPA to develop a viable and sustainable model for persistent, long-term, private-sector investment into the myriad of disciplines needed to make long-distance space travel practicable and feasible….

We are seeking ideas for an organization, business model and approach appropriate for a self-sustaining investment vehicle. The respondent must focus on flexible yet robust mechanisms by which an endowment can be created and sustained, wholly devoid of government subsidy or control, and by which worthwhile undertakings—in the sciences, engineering, humanities, or the arts—may be awarded in pursuit of the vision of interstellar flight….

Responses should describe the:

• Organizational structure;
• Governance mechanism;
• Investment strategy and criteria; and
• Business model for long-term self-sustainment.

The best model we have of such an organization is a religion. Business organizations such as the Hudson’s Bay Company have occasionally lasted hundreds of years but more by accident than by design. Universities have lasted hundreds of years, although often with government support and vague missions. A few foundations have lasted for a long period of time but often with big mission changes.

Many religions, however, have maintained themselves more or less intact for over a thousand years. Even in the modern age, new religions appear to be quite capable of forming and maintaining themselves for long periods of time. Mormonism has been on-going for nearly two centuries, the Unification Church and Scientology (n.b. started by a science-fiction writer) have been on-going for over half a century. A religion with a million or so adherents can easily last for hundreds of years while generating substantial revenues and while maintaining focus.

Humanity was born of the stars, our very atoms forged in the heart of a million suns. It is in the stars that we lost travelers will find our true home and our true destiny. The twinkling lights of the yawning sky gently call to us each night to return to the place of our birth. We must answer that call. Star-children, return to home.

(See what I mean? This could work. )

Hat tip: Daniel Kuehn.

Further evidence that it’s not just about wage stickiness

by  Tyler Cowen in

Employment rates for new college graduates have fallen sharply in the last two years, as have starting salaries for those who can find work. What’s more, only half of the jobs landed by these new graduates even require a college degree, reviving debates about whether higher education is “worth it” after all.

That is from Catherine Rampell.  As I like to say, wage stickiness is for the workers you’ve already hired, not for the new ones.  And yet employment for the new workers is not running smoothly, so how can it all be about wage stickiness?  That said, this is also circumstantial evidence that low employment rates are in part about wage stickiness.  If wages are falling for new hires, it is probably the case that for many currently employed workers real wages need to fall as well, and that often happens only with some resistance.

What else is driving lower employment for recent college graduates?  Some of them are quite willing to simply not work for a while.  Others fear that low-track jobs will hurt their future careers and so they wait rather than starting as a garbageman.  What else?

*The Declaration of Independents*

by  Tyler Cowen in

The authors are the renowned Nick Gillespie and Matt Welch and the subtitle is How Libertarian Politics Can Fix What’s Wrong with America.

This book is a excellent 2011 statement of what libertarianism should be, though I would say the title is more descriptive of the content than is the subtitle.  It’s well written throughout, smart to focus on the areas where libertarianism is strongest, and remarkably for an “ideological” book it never ventures into the absurd or makes indefensible claims.

It stresses government as a dysfunctional institution which forces too much bundling, too little choice, and too little real accountability.  It explains why the dynamics of political power are so difficult to avoid.  It recognizes the numerous ways in which we are freer than in times past and it stresses the cultural dimensions of both recent progress and libertarian thought.  It reads like a book which is much smarter for having read blogs written by people of opposing points of view (just my speculation).

Is the book libertarian or liberaltarian?  There’s never quite a recipe for how government might, say, shrink to a much smaller share of gdp.  The section on health care stresses that health care is not the major determinant of health and that government policy has driven cost inflation.  I am never sure how much the latter claim is true.  They call for more choice in the hands of consumers, but the details are murky.  They call, correctly, for insurance and provider deregulation.  There is a call, correctly, for more competition and portable, non-job-attached health insurance policies.  But can all that, combined, lead us to dismantle Medicare and Medicaid and still somehow deal with the “people dying in the streets” problem?  That case is not made, nor am I sure how much the authors wish to make it.  I am also not so sure that current political markets are a crumbling duopoly; we will see.

This is the up-to-date statement of libertarianism.  Not warmed-over right-wing politics, but real, true-blooded libertarianism in the sense of loving liberty and wanting to find a new path toward human flourishing.