Next year the innovative swimming suits that are causing world records to fall at rapid pace will be banned.  Michael Mandel wonders if this is the beginning of the counterrevolution against technological progress and Tyler argues “essentially on innovation we’re seeing a flipping of the burden of proof and I don’t think it is possible to easily fine-tune that flipping in a way to capture good innovations and rule out bad ones.”  Believe it or not, Mandel really was talking about swimsuits.   Tyler, however, was talking about high speed trading but is there much difference between the two?  I don’t think so.

High-tech swimming suits and trading systems are primarily about distribution not efficiency.  A small increase in speed over one’s rivals has a large effect on who wins the race but no effect on whether the race is won and only a small effect on how quickly the race is won.  We get too much investment in innovations with big influences on distribution and small (or even negative) improvements in efficiency and not enough investment in innovations that improve efficiency without much influencing distribution (i.e. innovations in goods with big positive externalities).

One difference between swimsuits and trading systems is that the former are regulated by FINA, the federation that administers international competition in aquatic sports.  We have some hope that a group like FINA can internalize the major externalities both because it encompasses the primary players in the market and because externalities outside of the market are likely to be small (swimming rules are unlikely to cause non-swimmers many problems.)  Thus, FINAs rules on swimsuits have some claim to efficiency.  Note that we see similar “anti-innovation” rules in many other sports such as car racing.  NASCAR, for example, does not allow stock cars to use fuel injectors even though this innovation is now standard on production cars.

NASDAQ (and the other exchanges) are the logical equivalent to NASCAR and FINA in that they can internalize the externalities among the primary players.  Thus, if the exchanges were to regulate various high-speed trading strategies I wouldn’t have any problems with that.

But would exchange regulation go far enough?  Unfortunately we have learned that the exchanges don’t internalize systemic risk.  Trading rules can cause non-traders many problems.  As a result, I think there is a case to be made for greater regulation than the exchanges would provide.  There is good reason to be skeptical about regulation in general but since this product, “financial innovation,” is primarily about distribution I’m less worried about regulation in finance than in fields where innovation is more closely tied to efficiency.

Here is a good survey of some of the debates, plus Paul Krugman mentions the topic in his column today.  Here's my earlier post but I'd like to add or reiterate a few points:

1. On one hand, critics wish to charge that there is little or no advantage to having prices move more quickly to reflect new information.  On the other hand, some of these same critics charge that short-run volatility of prices — assuming this is in fact the result of HFT (and that is not proven) — creates social costs.  That's not quite a contradiction but it is an odd mix of views about the relevance of the short run.

2. I haven't seen a good estimate, or for that matter a bad estimate, of the social loss involved from investing resources in HFT.  Even if the practice has no gain, I suspect the loss is small.  It's the symbolic nature of the issue which excites people — bailed-out elites doing fancy things with powerful computers in a non-egalitarian manner — rather than the belief that it is a policy priority.  Even if you think HFT is bad, on an actual list of bad policies or practices in our world, would it be in the top million?  Mostly it's a canvas on which to paint complaints about the continuing political and economic power of finance, but we shouldn't let that skew our judgment of the practice itself.

3. There is no argument to date, and probably no argument period, that HFT can lead to financial insolvency or collapse on a major scale.  The cost, if there is one, is that the associated trading strategies bring a temporary collapse of asset prices for some period of time (how long?) or perhaps greater ongoing price volatility, or uncertainty about order execution, in the short run.

When I read that HFT may give markets "a new, currently unknown set of emergent properties" I think buying opportunity.

4. Research by Hans Stoll indicated that program trading was not in fact an instrumental culprit behind Black Monday in 1987, yet media coverage of HFT seems to be indicating that it was.  Many of the HFT debates echo themes from the earlier program trading debates from the late 1980s but in fact program trading did not turn out to be a major problem.  We have been down this path before and it turned out there was much less there than the critics thought at the time.

5. The more I read these debates, the more nervous I get about the idea of a financial products safety commission.  Essentially on innovation we're seeing a flipping of the burden of proof and I don't think it is possible to easily fine-tune that flipping in a way to capture good innovations and rule out bad ones.  We should still follow the rule of regulating practices shown to be harmful or likely to be harmful.

Here is my latest column, on the monetary proposals of Scott Sumner.  You probably know Sumner from his blog TheMoneyIllusion and in my view he has become possibly the most astute commentator on monetary policy at this time.  Excerpt:

The Fed has already taken some unconventional monetary measures to
stimulate the economy, but they haven’t been entirely effective.
Professor Sumner says the central bank needs to take a different
approach: it should make a credible commitment to spurring and
maintaining a higher level of inflation, promising to use newly created
money to buy many kinds of financial assets if necessary. And it should
even pay negative interest on bank reserves, as the Swedish central
bank has started to do. In essence, negative interest rates are a
penalty placed on banks that sit on their money instead of lending it.

Much
to the chagrin of Professor Sumner, the Fed has been practicing the
opposite policy recently, by paying positive interest on bank reserves
– essentially, inducing banks to hoard money.

The Fed’s balance
sheet need not swell to accomplish these aims. Once people believe that
inflation is coming, they will be willing to spend more money.

In
other words, if the Fed announces a sufficient willingness to undergo
extreme measures to create price inflation, it may not actually have to
do so. Professor Sumner’s views differ from the monetarism of Milton Friedman by emphasizing expectations rather than any particular measure of the money supply.

There are more excellent posts on Scott's blog than I am able to link to.  Read through it all, if you have any interest in these topics. 

One thing I learned from a systematic reread of Sumner is that he isn't quite the advocate of quantitative easing that I had thought.  All things considered, he seems to favor QE over doing nothing, but he also thinks that a truly credible commitment to future inflation can get us there without much painful-for-the-Fed's-balance-sheet QE being required.

While I think there is a very good chance Sumner is correct, my reread of his blog also gave me a better sense of, if he is wrong, why he is wrong or maybe incomplete is a better word.

In very general terms, think of our government, or central bank, as being able to do some good things by creating credibility, the rule of law being one example.  In this particular case the Fed could use its credibility to guarantee two to three percent price inflation annually or more exactly some target for nominal GDP growth.

One point is that bureaucracies tend to hoard credibility rather than to spend it.  That still could mean Sumner's advice is correct and this is simply why the Fed doesn't follow it.  There is, however, a deeper worry.  One possibility is that a weakened Fed cannot today precommit to delivering on two to three percent.  Let's say that Congress gets upset along the way, for whatever reason.  The Fed has then put its credibility on the line, including for the longer future, and that credibility is utterly refuted.  Ouch.  More technically, combine the two ideas of self-fulfilling prophecies and nested games.

Maybe the Fed is too risk-averse but there's also the possibility that the Fed is prudent in its unwillingness to stick its neck out.  Maybe the Fed has credibility only as long as it doesn't try to spend it (try modeling that).  This would bring us into the literature on creative ambiguity and signaling.

Another possibility is that, instead of Congress intervening, markets simply don't respond.  Sumner's theory makes sense to me, but how certain can we be?  The Fed again is putting a lot of longer-term credibility on the line.  Maybe the best the Fed can do is a kind of "inch-along" promise, which probably won't be very effective, as we are observing.

Perhaps the key question is just how credible a central bank can be, relative to its (possibly unjustified) risk aversion.

I now read Sumner much more as a "theorist of credibility," and thus as an implicit game theorist, than I used to.