Reining in the Speculators
Thousands of people trade trillions of dollars' worth of stocks, bonds, currencies, commodities, and derivatives every second of every breathing moment.
When you stop and think about it, exactly why should that happen? Does the value of I.B.M. actually change from minute to minute? Is someone always in the process of discovering something truly new and valuable about Exxon Mobil or the supply of the world's crude?
The answer, of course, is no, which is why there is a lingering sense, even among professional investors, that something about the whole process is basically no different from gambling. In times of crisis, this feeling moves from the back of the mind to the gut, where it festers. Politicians and populists attack speculative traders as parasites, blaming them for whatever crisis happens to be upon us. During the Asian financial crisis of the late 1990s, the Malaysian prime minister called George Soros a "moron" and attacked hedge fund currency traders.
In our moment of drama, the bugles have sounded to start the hunt for the market manipulators. With food and fuel costs soaring, Senator Joe Lieberman absurdly proposed barring pension funds and university endowments from investing in agricultural and energy commodities. Panicked by the plummeting shares of banks and brokerages, the Securities and Exchange Commission is trying to chase down rumors in the marketplace. The S.E.C. and Britain's regulator, the Financial Services Authority, have both introduced measures that attempt to curtail the activities of some short-sellers, the most vilified of all speculators, citing the dubious potential for "abuse."
These efforts come as no surprise. But they are misguided. It's better, not worse, for people and institutions to diversify their holdings into different asset classes, such as commodities. Financial markets do suffer from an endemic shortcoming, but it's not rumor mongering or manipulation by dark, powerful forces. It's myopia. Short-termism is the problem.
Trading in every capital market has grown wildly in recent years, and whole new markets, like those for derivatives, have exploded. Stocks change hands more frequently than ever. On the New York Stock Exchange, turnover hit a high of 143 percent in 1928, meaning the value of the entire market traded almost one-and-a-half times. Then turnover plummeted, staying below 20 percent from 1938 to 1975. Since then, according to a study by Dartmouth economist Kenneth French, the chart looks like the one for California home prices, pre-implosion. It rose to 59 percent in 1990 and in 2007 hit 215 percent.
Hedge funds account for much of this: They cycled through 36 percent of their positions during the first quarter of 2008, according to Goldman Sachs. But the supposedly staid mutual fund managers are not much better. Morningstar estimates their turnover rates are 93 percent a year. Even activist investors, who claim to have companies' long-term interests at heart, hold shares for a median period of only one year, according to a recent study led by Duke University's Alon Brav.
Market hyperactivity has been so enduring that hardly anyone notices, but the fact remains: The long-term investor is practically extinct.
Though volume increases every year, intelligence doesn't. Short-termism and noise distort company decisionmaking, and managements are forced to try and please investors who want to jump in and out of stocks with little friction.
Which brings us to what may be a very controversial solution to all this, an old idea that can be new again: a tax on short-termism. We should have a small transaction tax on all financial trades. The more you trade, the more you pay.
Short-term trading has a social cost. Getting a piece of information a few minutes early and trading on it doesn't create any value; it simply redistributes value. It may even damage the economy. Nobel Prize-winning economist Joseph Stiglitz illustrated this in the late 1980s with this example: Say $100 bills are put at the feet of a group of naturally lethargic people, who pick up the money at their leisure. Then an energetic person comes along and decides to run around the lazy folk and pick up the $100 bills. This forces people to sprint for their money, using more energy to achieve the same result. "They are unambiguously worse off," Stiglitz wrote.
Acolytes of market fundamentalism argue that active markets help prices do a better job of reflecting the true value of assets. Yet during a stretch when trading was at a peak, we experienced two of the greatest bubbles in the history of the world-the late-1990s tech bubble and this decade's housing and credit bubble. If anyone still believes that financial markets are getting prices right, I've got a C.D.O.-squared made up of mezzanine tranches backed by subprime-mortgage debt that I'd like to sell you.
Thanks to the credit crisis, there is a wide consensus that the U.S. needs more and different financial regulation to deal with built-up excesses. The Federal Reserve is lending to investment banks and will likely bring them under its regulatory umbrella. The S.E.C., hopelessly emasculated during the Bush-Cox regime and recently mired in its pursuit of rumormongers, will need revamping.
Regulatory reform is necessary, but regulation has its limits. It's arbitrary. So along with new and better regulation, we should introduce a tax on trading. In the 1970s, James Tobin, another economist who would go on to win the Nobel Prize, championed a levy on speculative currency trading, which became known as a Tobin tax.
But we should tax all transactions, based on the value of the asset being traded. Dean Baker, an economist for the left-leaning Center for Economic Policy Research, argues that a small tax (say 0.25 percent, though it would vary depending on the asset) be levied whenever a financial instrument-a share, mortgage securities, a credit derivative-passes from one owner to the next. Trades wouldn't be legal unless the tax had been paid.
This isn't so unthinkable. After all, we already pass judgment on whether we should encourage long-term holding through the tax structure. We have capital gains taxes that fall more heavily on short-term gains than long-term ones.
At the margin, such a tax would hinder short-term speculation. For long-term holders, the impact would be small, diminishing in significance over time. Those investing on fundamentals would be almost untouched. But the tax would slow down the two groups that are doing little to help the markets. The first is made up of traders who erroneously think they can beat the market but in fact are just responding to noise. They read charts and measure momentum; they don't care about fundamentals. The second group is made up of those who gather the "little crumbs," in the words of Sherman McCoy's wife in The Bonfire of the Vanities. These are the brilliant quantitative hedge funds that have computer programs executing countless trades every second. The world would benefit from the shrinking of these two groups.
One category of passive, ignorant investors wouldn't be harmed, and that's okay. These are the index investors in 401(k)s and retirement accounts. Yes, they contribute to distortions. They ignore fundamentals and are price-agnostic. But they are long-term holders. It's only the index speculators slinging around exchange-traded funds who would feel the weight.
Transaction taxes, which exist in many markets abroad, have attracted surprising fans. In the late 1980s, prominent young economists embraced the idea. It's no coincidence that this occurred in the aftermath of the horrific stock market crash of 1987. Lawrence Summers, who would become Bill Clinton's Treasury secretary, co-authored a sheepishly titled paper, "When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax." These days, of course, our problem is not that capital markets work too well, making the case for a transaction tax even stronger.
Stiglitz championed the transaction-tax idea in 1989. He was only slightly less apologetic, lest the profession fear for his sanity. "As an economist, I begin with a general suspicion against narrowly based taxes," he began. But he overcame that reservation, arguing that such a tax would make the stock market more efficient and reduce price volatility. It's a tax that's meant to correct behavior, as described by the English economist Arthur Pigou. Why should we tax casino gambling but not options trading?
Such a tax could make the markets better. Financial markets raise capital for new enterprises. They help people exchange assets and information. But just because there is higher volume doesn't mean these trades are expressing more views. Instead, all that is happening is that the bandwagon is speeding up. The faster it goes, the more people want to get on. Noise traders drive out the fundamental investors. During the tech bubble, famous value investors like Julian Robertson were forced out of the market at the top. "If we think people in the market are looking at what other people are doing, it's totally plausible that the more people there are, the further you are getting from the right prices," says Baker.
I won't pretend that the tax idea is much in vogue today. When I asked Summers about transaction taxes, he replied that he has rethought his position from two decades earlier: "I have become convinced that in the world of today, because of globalization, derivatives, and other institutional changes, it is probably not realistic to collect significant revenue from turnover taxes. I also have become more convinced than I was years ago of the importance of maintaining liquidity."
If such a levy did get any traction in Washington, the usual suspects would rise with a passel of objections. They would say the tax would stifle innovation and efficiency. But to let those words stand as descriptions of what has been happening in markets lately is to concede the debate. Experimentation would be a better word than innovation to describe what the Wall Street firms have been doing.
Put that way, there are obviously limits to what we should permit the math geniuses to try in the petri dishes of the capital markets. "Financial innovation has been treated almost as an end in and of itself," says Baker, one of the few economists not to have given up on the transaction tax. "I was always suspicious, but I'm even more so now. These people"-those math geniuses-"had no idea what they were doing."
Opponents will also argue that a speculation tax will lead to distortions and hurt the U.S.'s position as the leader in global capital markets. But the U.S. isn't powerless in international negotiations. And London is headed for some measure of greater regulation too. Working in concert, the U.S. and Britain could implement such a tax.
As for Summers' concern about liquidity, clearly trading has dried up in certain markets in the past year, sending the value of some assets down dramatically. But the cause was short-term thinking at financial firms. They thought they would always have markets to sell into, that the arenas of mortgage securitization or auction-rate securities or structured finance would never disappear. If the markets had been dominated by more diligent, long-term traders, such firms would have had to become more cautious about what they sold.
The crisis in the markets requires some radical rethinking. Of course, no government regulation or tax structure will be able to prevent fraud, greed, stupidity, and short-sightedness. But the prevailing political and economic ideology of the past 25 years has been to discount the propensity of markets to encourage these tendencies. Indeed, proponents have argued that markets prevented such behavior and were marvelously self-healing.
It has become clear that the opposite is true. Markets tend toward excess and run amok if unchecked. A tax that nudges markets toward becoming more rational and less frenzied would be a good start.
And raising revenue for a deficit-ridden government from people who can afford it would be a nice little bonus.Visit Portfolio.com for the latest business news and opinion, executive profiles and careers. Portfolio.com© 2007 Condé Nast Inc. All rights reserved.