This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org/archives/2014/0514orr.html
This article is from the
May/June 2014 issue.
at a 30% discount.
The Big Casino
How to Rein in Stock-Market Speculation
Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
—John Maynard Keynes (1936)
On April 13, Flash Boys, by business writer Michael Lewis, opened at number one on the New York TImes best-seller list. Reviews of the book had appeared on the front page of every major business publication in the United States and most major mainstream news outlets, both in print and on the web. The book explains how new technological advances in stock-market trading have given an unfair advantage to some wealthy traders and have allowed them to make billions of dollars at the expense of everyone else in the market.
Lewis’ books are always highly readable. He conveys technical detail by couching it in a story with heroes and villains. In this case the villains are high-frequency traders. The hero is Brad Katsuyama, an employee of the Royal Bank of Canada, who unraveled a mystery that even some of the biggest brokerage houses did not understand. Over the course of two years, Katsuyama was able to discover how high-frequency traders “front-run” others—exploiting differences of just milliseconds in computer-network communication times. Katsuyama is the hero because he created a new stock exchange to thwart the villains.
Flashboys and “Investor” Outrage
Gamblers at a blackjack table know they will occasionally lose. But if they see a player who can take his bets off the table if he is losing and can take part of every pot as well, they will be very upset. This is why Michael Lewis’ book Flash Boys: A Wall Street Revolt, which describes how high-frequency traders are able to “front-run” the market, has raised such a furor in the business press. Gamblers like playing the game, but not if the game is rigged. When they finally find out how it is rigged they will protest loudly.
On April 3, in reaction to the revelations in Flash Boys, brokerage-firm founder Charles R. “Chuck” Schwab issued a statement calling high-speed trading a “growing cancer” that threatens to destroy faith in the fairness of the markets. Schwab pointed out that while the total number of trades stayed relatively flat from 2007 to 2013, the number of trade inquires rose from 50,000 per second to 300,000 per second! He called this “an explosion of head-fake ephemeral orders” designed to “skim pennies off the public markets by the billions.” He claimed that “high-frequency trading isn’t providing more efficient, liquid markets,” but rather it is “picking the pockets of legitimate market participants.” He pointed out that some high-frequency traders claim to be profitable on over 99% of their trading days, a statistical impossibility unless the game is rigged.
High-speed trading is only one of the many forms of front-running. Another can occur in what are called “dark pools.” Dark pools occur when trades are carried out entirely within a single bank, brokerage firm or hedge fund. A bank or brokerage may have a large institutional financial institution, such as a pension fund, that wants to sell a large block of a particular stock. Bidding such a large sale on a public exchange is likely to “move the market,” because the depth of the market will be transparent. If the bank or brokerage can arrange for a trade with a group of other clients that want to buy that particular stock, the buyers and seller can negotiate a price without the public market being aware of the transaction. The bank or brokerage could also decide to buy part of the block using their own proprietary funds. When the transaction is finally recorded, the market may move. It is here that the bank can use the information from the “dark transaction” and use their propriety funds to make a 100% accurate bet on the movement of the price. This is part of the reason the Volker Rule proposes to restrict banks from proprietary trading.
Lewis writes, “The trouble with the stock market—with all of the public and private exchanges—was that they were fantastically gameable, and had been gamed: first by clever guys in small shops, and then by prop[rietary] traders who moved inside the big Wall Street banks.” Both Lewis and Schwab see the game as rigged, but they both still cling to the idea that if it were not rigged, it would efficiently channel capital to productive investment. Given that not a single dollar from any trade on the secondary markets goes into productive investment, this refusal to see the stock market as nothing more than a big casino is incredibly self-serving.
The bottom line is that modern electronic trading does not necessarily make financial markets more efficient or provide increased liquidity. Rather it sets up a situation of “haves” and “have-nots.” The “haves” can use their existing wealth to build high-speed trading systems and other forms of front-running. They will use these systems to strip wealth from the “have-nots.” While this is often a case of the “richest” stealing from the “rich but less rich,” it is also draining wealth from pension funds and defined-contribution savings plans, such as 401(k)s. The ongoing allocation of resources to maintaining an edge in the market drains those resources from more productive uses in the real economy. It also makes the financial markets more unstable.
Charles Schwab suggests that all of these practices should be made illegal. But history teaches us that “entrepreneurs” will always find a way around rules. A better solution would be to make this part of a speculation reduction tax package. Since the average profit from front-running by high-speed traders is less than 0.1%, a tax of 0.1% on every order and cancellation should greatly reduce the practice. Placing a speculation reduction tax of 0.5% on every stock trade, whether it occurs in a public market or in dark pools, would greatly increase the stability and fairness of financial markets.
In his book, Lewis provides details on how high-frequency trading works and how it affects other traders. But he glosses over a much more fundamental aspect of stock markets. “Building a stock market,” Katsuyama says, “is like building a casino.” This is a truth that has been recognized forever—at least by anyone whose income did not depend on ignoring it. Every night on the evening news we hear something like this: “In economic news, the Dow is up by 1.5%, the S&P is up by 1.2% and the NASDAQ is down by 0.3%, based on blah, blah, blah.” Reporting these numbers so prominently and giving a supposed link to the events of the day gives the impression that the stock market plays a central role in moving the economy forward and that everyone has a stake in these daily changes.
In fact, the movement of these stock indices on a day-to-day basis has very little to do with the actual economy and the stock market has almost no positive impact on the lives of most Americans. Fewer than half of American families own a single share of stock, and only about a third own shares totaling more than $5000. The stock market is the realm of the elite, and for the past several decades has had a negative impact on the real economy. The problem with the stock market is not just that the casino game has been rigged to favor some gamblers—more fundamentally, the problem is the existence of the casino in the first place.
Who Really Are the “Investors”?
Economic textbooks tell us that financial markets play an important role in the economy, linking saving to investment. Some individuals have more income than they currently want to spend, so they engage in saving. Other individuals need money to engage in investment. “Investment” in this context means the creation of new, physically productive resources. If a firm builds a new factory, installs new machines, or buys new software to do its accounting, that is investment. When students spend time and money to acquire new skills that make them more productive, that is investment. So when a bank takes people’s savings and lends it to the owner of a restaurant to buy a new stove, the bank plays an important economic role. Savers can get their money back if they need it in the future, because loans get repaid and other savers are putting new money into the bank. When you put money in the bank you receive interest. This is your reward for saving and giving the bank the use of your money. But you are not engaging in investment. The person who borrows the money and puts it to productive use is the investor. When you put money in the bank, you are a saver, not an investor.
Corporations can bypass banks and gain access to financial capital by issuing stock. When a company issues new shares of stock, the money raised from the sale can be used to engage in productive investment. The issuing of new shares is called an “initial public offering,” or IPO. IPOs are not done on stock exchanges. They are handled by investment banks. These IPOs transfer savings to firms and the firms can use the money for real investment. If these investments are successful, GDP will rise as consumers gain access to new products, the firm will grow and become more profitable, and the price of their shares will rise, which provides savers a long-term capital gain as a return on their saving. This usually occurs over an extended period of time.
No one would buy a share of stock if they could not get their money back when they needed it. The useful role of the stock exchanges, what we call the “stock market,” is to provide “liquidity.” One individual who has money to save today can buy a share of stock from someone who needs to get their past savings back. The role of brokers is to provide this liquidity. Brokers must be able to accurately assess the quantity and prices of stocks available in order to bring buyers and sellers together. Anything that makes this information more accurate will make the markets more liquid and “efficient,” but anything that makes the information less accurate makes the market less liquid and less efficient. This is the problem Lewis addresses.
The words we use to describe things matter. Investors are usually seen as contributing to the economy because they hire workers to build new factories, new machines, and other productive assets, and these assets can make the real economy more productive. Workers create the assets, and the investors are given the credit. On the other hand, gamblers and speculators are usually seen as frivolous and destructive.
The biggest propaganda coup of the 20th century was convincing the media and the general public to call the speculators on the New York Stock Exchange (NYSE) “investors.” They did it by blurring the positive role of the stock market with the speculative role. If you buy a share of Pacific Gas and Electric (PG&E) on the stock exchange, you will get a quarterly dividend payment, just like the interest you get from the money you put in a bank. But PG&E does not get any new money to use for actual investment. The price you pay for the stock goes to the previous owner of the stock, not the company. Buying stock on the NYSE is not investing, but rather seeking a return on saving. But unlike saving at a bank, this saving involves a risk and is a form of speculation.
On Dec. 31, 2013, the Dow Jones Industrial Average hit a new record high of 16,577. The media cheered this result and proclaimed that happy days are here again. Yet that same day, they reported that income inequality is continuing to increase, median family income is still 9% below what it was at the start of the recession, and the index of consumer sentiment is still 25% below pre-recession levels. Millions of people are still unemployed and Congress let long-term unemployment benefits expire. It appears that all of this suffering on Main Street is good for the stock market.
That day, NYSE market volume was 735 million shares, and another 1.34 billion shares were traded on the NASDAQ. It was a slow day because of the holidays. More than $200 billion changed hands, yet not a penny of all this money went to a corporation for use as productive investment. The biggest casino in the world is located at the corner of Wall Street and Broad Street in New York City. Calling the players on the NYSE “investors” completely changes our understanding of the role they play. Consider rewording some recent Wall Street Journal stories: “Gamblers bet big on new Genentech drug,” or “Speculators made 73% in one day buying Twitter’s IPO in the morning and reselling later in the day to suckers caught up in the excitement.” The Wall Street Journal does occasionally tell us the truth when they report on the “bets” made by “players” on the NYSE. Speculators betting that the price of a share will rise want to buy it and those betting that the price will fall want to sell it. If there are more buyers than sellers, the price will rise, regardless of anything that is happening in the real economy. Reporting a record high for the NYSE has about as much importance as reporting a record amount of gambling in Las Vegas. Except the gambling on the NYSE can have a much larger negative impact on the real economy.
Big Gambling Does Big Damage
The reason why the volume on the NYSE is so high is because speculators engage in high- frequency trading. An analyst predicts that, based on breaking news, the price of a particular stock may go up. If s/he can be the first to buy the stock before the price goes up, s/he can sell it a few minutes later (or even fractions of a second later) and make a profit. This is why brokerage houses now rely on “program trading.” Computers can see price differentials and make trades much faster than humans can. Brokerage firms need to have the fastest possible computers and the fastest network connections because milliseconds matter. By 2010, this type of high-frequency (or “quant”) trading made up 70% of the bloated stock trading volume.
How to Rein in the Gambling
Between 1970 and 1986, the financial sector never accounted for more than 16% of corporate profits. By the 2000s, on the eve of the financial crisis, it received more than 41% of all corporate profits. Finance has become a massive drain of resources away from the real, productive economy and has made the overall economy more unstable.
Salaries are a payment for work, while capital gains are a payment just for being wealthy enough to own an asset that goes up in price. The three-minute trade described above results in a capital gain of half a million dollars. A salary of $500,000 would be taxed as ordinary income at a rate of 39.6%, but capital gains are taxed at only 20%. Taxing those who work at a higher rate than those who speculate is an insult to working people.
These sorts of trades are often carried out by “hedge fund” managers. These managers do engage in what some might call work, but their work is similar to the work of the dealer at a casino, except that it pays much better. They help speculators gamble at the Big Casino. They often increase a company’s stock price by buying a controlling share in the company, and replacing the managers with ones who are willing to lay off workers and drive down the wages of those who remain. The bonuses given to financial-sector managers are often much larger than their base salaries. These bonuses often take the form of “carried interest,” which is a mechanism for redefining salaries—which would otherwise be taxed at the 39.6% ordinary-income rate—as long-term capital gains, to be taxed at 20%. These two special tax breaks are how Warren Buffett and Mitt Romney end up paying a smaller percentage of their incomes in taxes than their secretaries do. It is time to insist that capital gains should be taxed at the same rate as ordinary income.
Payments to corporate executives and financial-sector employees represent more than half of the income growth to the top 1% of the income distribution since the start of the recovery in 2008. Bills to eliminate the special treatment for capital gains and to put a cap on executive bonuses have been introduced repeatedly in Congress, but financial-sector lobbying and campaign contributions have blocked their passage.
While eliminating special tax breaks for the financial elite would help reduce income inequality and generate revenue to fund essential government projects, it is not enough to stabilize the financial sector. Canada’s banking sector is more highly concentrated than the U.S. banking sector, yet Canada weathered the financial crisis much better because finance had not been deregulated as it had been in the United States. Future financial-sector stability will only be possible with the recreation of a 21st-century version of the Glass-Steagall Act. This new act must recreate the firewall between commercial banks that service the real economy and securities firms involved in financial speculation—as existed between the 1930s and, despite significant erosions, the 1990s. Tighter regulations must be put on all financial institutions, including the new kinds that have grown up since the 1980s, which are often referred to as “shadow banks” (see Rachel Keeler, “Tax Havens and the Financial Crisis,” D&S, May/June 2009). But Congress also needs to rescind the Gramm-Leach-Bliley Act (1999)—which swept away the remaining elements of Glass-Steagall—and adopt regulations to restrain the creation of increasingly arcane financial derivatives. Regulated derivatives served the housing market very well from 1935 to the 1980s. Unregulated derivatives helped to create the financial collapse that began in 2007.
While none of these are likely given the current political composition of Congress and the new era of unrestrained corporate campaign contributions, in the short term the Obama administration could rigorously enforce the financial reform laws already on the books. That includes writing stronger rules to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010).
Another example is the Volker Rule. This rule seeks to prevent “proprietary trading” by banks and brokerage firms. Propriety trading gives these firms the possibility of “front-running” their clients in much the same way as high- frequency traders. Yet since the passage of Dodd-Frank, the Volker Rule has been watered down, largely due to lobbying by financial interests.
The Obama administration could also hold financial institutions and their leaders accountable when they break the law. This would require criminal prosecution of corporate executives and not just the slap-on-the-wrist penalties being imposed on financial institutions. Whether the Obama administration has the will or courage to do any of this is an open question.
If a speculator buys a share of stock for $100 and sells it three minutes later for $100.50, s/he makes a return of 50 cents, or 0.5%. If s/he buys a million shares, s/he makes half a million dollars for three minutes of “work.” But the “work” was done by a computer program and the speculator has done nothing to make the economy more productive, to create jobs, or to increase GDP. All the speculator has done is to bring a large pile of money to the table at the casino. S/he has redistributed money from one person at the table to another, and for this, the Wall Street Journal calls the speculator an “investor.” Speculators can use their winnings to hire the best and brightest minds to give them an edge at the table, and they will pay them well. We are told how important it is to get students into STEM fields (science, technology, engineering and math). Yet government funding for these fields is being cut and jobs prospects are uncertain. Stock market speculation diverts the best and brightest minds away from solving real problems facing the world. Instead they are writing software to “read” news feeds looking for key phrases that might indicate a change in speculators’ sentiment toward a particular stock, so that instantaneous trades can be made. They are writing algorithms to find the minutest correlations between economic indicators and changes in share prices. Landing a job at a big Wall Street firm can lead to annual bonuses in the millions of dollars. Jobs in basic scientific research and engineering cannot hope to compete. Corporate managers are rewarded with bonuses for increases in stock prices, regardless of the long-term impacts on the firm. It forces managers to focus on quarterly profits and not on long-term growth. Cutting jobs and driving down wages can increase stock prices, but this has devastating impacts on the lives of ordinary people and reduces demand for products. If the price of a company’s stock starts to fall, management can use the cash held by the company to buy back shares in order to prop up the price. This diverts resources that could have been used for productive investment into the hands of stock market speculators.
If enough of these speculators believe prices will continue to rise, they will pour more money into stocks, and share prices will rise. Speculation can be self-fulfilling and create price bubbles. The Dow Jones was up by more than 35% for the year in 2013. This run-up in stock prices had several causes. Economists tell us that stock prices should reflect expected profitability, and despite the anemic recovery, corporate profits are soaring. The share of total national income going to the owners of capital is now higher than at any point in modern U.S. history. But this is at the expense of the vast majority of the population. The share of national income going to wages and salaries continues to fall and is lower than in 1960. In the 33 years since 1980, inflation-adjusted labor productivity has gone up by 141%, while wages have stagnated, going up by only 8%.
The idea that each generation is better off than the previous one is no longer true. In the current recovery, 95% of the income gains have been taken by the top 1% of the population. The rise in stock prices is a reflection of the declining standard of living of the majority of Americans and the increasing incomes of the already wealthy. A recent Pew Center poll revealed that 64% of the population responded “no” when asked “does the U.S. offer everyone the same chance to get ahead?” The share of income going to the richest 10% is higher than at any time since 1917. It is this richest 10% that own 91% of all stocks, including 401(k) accounts and mutual funds, and 94% of other financial securities.
Some of the run-up in stock prices may reflect this rise in profit, but a larger part is the result of speculation. Since the start of the recession, the Federal Reserve has pumped almost $4 trillion into the financial markets. All of this money has to go somewhere. Banks are not lending it to businesses to engage in real investment. Some of it is being used by speculators to buy up foreclosed houses and either turn them into rentals or do minor maintenance and then “flip” them for a tidy profit (see Darwin BondGraham, “Whose Housing Recovery?” D&S, March/April 2013). This is resulting in a massive redistribution of wealth from the middle class to the top 10% of wealth holders. In some cities, this is reigniting the housing bubble. But much of the money is finding its way into the stock market and this flood of money is driving up stock prices.
When speculators are optimistic, they create bubbles. But if speculators turn pessimistic, they can also create stock market crashes. If this only affected the gamblers it would not be a problem. But as a company’s stock price falls, it may be harder for the firm to borrow from banks or the bond market to pay for day-to-day operations. If this happens to enough companies, this can crash the real economy and drive up unemployment. As stock prices fall, the retirement savings of millions of workers (who have seen their defined-benefit pensions stolen and converted into 401(k) savings accounts) will also decline. Ordinary people reap little benefit from the daily speculation on the stock market, but millions experience real losses when the bets go bad. The Big Casino does very real damage to the real economy.
Key Step Toward Taming the Casino
One way to reduce the damage would be to put a tax on this socially destructive behavior. We tax cigarettes and alcohol because of the damage they do. We tax gambling in Atlantic City at 8% and in Las Vegas at 6.25%. The sales taxes on socially useful items like shoes and computers are often more than 7%. There should also be a sales tax on the speculative buying and selling of stock.
To be sure, Wall Street lobbyists will try to scare the public into thinking that taxing speculation will somehow kill “investment” and jobs. Because unemployment is still high, anything that reduces employment growth will be seen as negative. But this tax will not reduce job creation. In fact, it is stock market speculation that does that. Between 2008 and 2013, the dollar value of shares repurchased by corporations was higher than the amount raised by IPOs. So the stock market has actually drained resources away from real investment and job creation.
In 2007, the year before the most recent collapse of a speculative bubble, $43.8 trillion in stocks changed hands on just the NYSE and the NASDAQ. That same year, only $65.1 billion was raised in IPOs. That is $673 of speculation for every $1 allocated from savers to real investors. Putting a tax on stock speculation will have almost no impact on productive investment by businesses, but it will raise much needed revenue for public investments in education and infrastructure.
What we need is a “speculation-reduction tax.” Some proponents of this type of tax call it a “financial transactions tax,” or FTT. But the tax would not be on all financial transactions, just on speculation in the stock and bond markets. Gamblers and speculators are seen as frivolous and destructive, and a tax that would restrict their behavior would be positively received. To be fully effective, the tax should be “progressive” with respect to time. If a stock is held for less than a day, the tax on the trade should be 5% of the value of the trade. The tax on a stock held for a week would be 2%; for a month, 1%; and, for a year, 0.5%. But opponents will make the case that this is too complex and too costly, so a flat-rate tax is a more feasible starting point.
Eleven European Union countries have now pledged to implement an FTT by the beginning of 2016. The rate being proposed, 0.1%, is too small to have much of an impact on speculation. The UK has had an FTT rate of 0.5% since 1986. It has not restricted the basic functioning of their stock market, but a tax of this amount makes the short-term trade described above unprofitable. Since 2009, ten different FTT bills have been introduced in the U.S. House and four in the Senate, most at a rate less than 0.5%. If a 0.5% tax were implemented in the United States, the Congressional Research Service estimates revenue generation of $164 billion to $264 billion per year, depending on the decline in speculative trading. The left-leaning Center for Economic and Policy Research (CEPR) estimates revenues will be $110 billion to $220 billion for a 0.5% tax. To really reign in speculative trading, the tax should be set at 1.0% and an additional tax of 0.1% should be charged on all cancelled orders (see sidebar, “How to Rein in the Gambling”).
If the U.S. government implements this type of speculation-reduction tax, it will reallocate much-needed resources to productive public investment and away from job-killing stock speculation. This idea, first proposed by John Maynard Keynes in 1936, is long overdue. As Dean Baker, co-director of CEPR, put it in 1994: “Government is perfectly willing to tax Las Vegas, Atlantic City and the lotteries, where working people place their bets with virtually no consequence to the country’s economic future. Why then should it not also tax the preferred gambling venue of the wealthy, especially given the serious costs their activities impose on the economic prospects of the majority?”