J. Bradford DeLong's Blog, page 2087

Paul Krugman: Misguided Narratives

Paul Krugman:

Misguided Narratives - NYTimes.com: Wolfgang Munchau has an especially good piece today about how Germany sees the eurozone crisis. The key graf:

So while the rest of us are debating how to solve Europe’s banking crisis, and become exasperated by the lack of progress, Ms Merkel is solving a crisis in a parallel universe. The German narrative is the outgrowth of a lie the country’s establishment has peddled ever since debate on the single currency started 20 years ago: that a monetary union can be sustained through a simple set of rules for monetary and fiscal policy; that financial regulation and current account imbalances do not matter. The eurozone crisis has proved this is not the case. But the conservatives cling to this old, comfortable straw. If there is a crisis, then it must be fiscal. And austerity is the answer.

Indeed. And it’s not just the Germans. It’s amazing how this whole crisis has been fiscalized; deficits, which are overwhelmingly the result of the crisis, have been retroactively deemed its cause. And at the same time, influential people around the world have seized on the idea of expansionary austerity, becoming ever more adamant about it as the alleged historical evidence has collapsed.

And where there is skewed vision, the economy perishes.

Hu Jintao Is Anxious...

Zhang Jing, Jon Kaiman, Jonathan Ansfield, and Andree Jacobs:

Chinese Security Officials Respond to Call for Protests: BEIJING — Skittish domestic security officials responded with a mass show of force across China on Sunday after anonymous calls for protesters to stage a Chinese “Jasmine Revolution” went out over social media and microblogging outlets.... The words “Jasmine Revolution,” borrowed from the successful Tunisian revolt, were blocked on sites similar to Twitter and on Internet search engines, while cellphone users were unable to send out text messages to multiple recipients. A heavy police presence was reported in several Chinese cities. In recent days, more than a dozen lawyers and rights activists have been rounded up, and scores of dissidents have reportedly been placed under varying forms of house arrest. At least two lawyers are still missing, family members and human rights advocates said Sunday.

In Beijing, a huge crowd formed outside a McDonald’s in the heart of the capital on Sunday after messages went out listing it as one of 13 protest sites across the country. It is not clear who organized the campaign, but it first appeared Thursday on Boxun, a Chinese-language Web site based in the United States, and then spread through Twitter and other microblogging services. By 2 p.m., the planned start of the protests, hundreds of police officers had swarmed the area, a major shopping district popular with tourists. At one point, the police surrounded a young man who had placed a jasmine flower on a planter outside the McDonald’s, but he was released after the clamor drew journalists and photographers.

In Shanghai, three people were detained during a skirmish in front of a Starbucks, The Associated Press reported. One post on Twitter described a heavily armed police presence on the subways of Shenzhen, and another claimed that officials at Peking University in Beijing had urged students to avoid any protests, but those reports were impossible to verify Sunday. The messages calling people to action urged protesters to shout, “We want food, we want work, we want housing, we want fairness.” ...

President Hu Jintao summoned top leaders to a special “study session” on Saturday and urged them to address festering social problems before they became threats to stability. “The overall requirements for enhancing and innovating social management are to stimulate vitality in the society and increase harmonious elements to the greatest extent, while reducing inharmonious factors to the minimum,” he told the gathering, according to Xinhua, the official news agency. Human rights advocates said they were especially concerned by the recent crackdown on rights defenders, which intensified Saturday after at least 15 well-known lawyers and activists were detained or placed under house arrest. Several of them reached by phone, including Pu Zhiqiang and Xu Zhiyong, said they were in the company of security agents and unable to talk, while many others were unreachable on Sunday evening. Two of the men, Tang Jitian and Jiang Tianyong, remain missing. Many of those subjected to house arrest had met in Beijing on Wednesday to discuss the case of Chen Guangcheng, a blind lawyer under strict house arrest in rural Shandong Province. The plight of Mr. Chen and his family gained widespread attention last week after a video he and his wife made about his arrest emerged on the Internet.

Mr. Jiang, one of the missing lawyers, was forced into an unmarked van on Saturday night, his second abduction in recent days, his wife, Jin Bianling, said by telephone. She said the police had also searched the couple’s home and confiscated his computer and briefcase. In an interview after his first detention on Wednesday, Mr. Jiang said that he was taken to a police station and assaulted.

Most of those who thronged the McDonald’s in Wangfujing, the Beijing shopping district, said they had no idea what the commotion was about. Some thought that perhaps a celebrity had slipped into the restaurant for a hamburger. But a young man, a Web page designer in his late 20s, quietly acknowledged that he was drawn by word of the protest.

Despite the absence of any real action, the man, who gave only his family name, Cui, said he was not disappointed by the outcome, in which police officers tried in vain to determine who was a potential troublemaker and who was simply a gawker. He predicted that many people, emboldened by the fact that an impromptu gathering had coalesced at all, would use social networking technology to stage similar events in the future.

“It’s very difficult to do this in China, but this is a good start,” he said. “I’m thankful to be able to participate in this moment in history.”

Liveblogging World War II: February 20, 1941

World War II Day-By-Day:

Day 539 February 20, 1941: Libya, North Africa. Africa Korps patrols make contact with British patrols for the first time in the desert, near Allied forward positions at El Agheila between Benghazi and Tripoli.

DeLong Smackdown Watch: Ethics of New York Times Reporters Edition

Cosma Shalizi writes:

Why Oh Why Can't We Have a Better Press Corps? New York Times Pulls Its Punches Story: It's true that Lichtblau and Risen are simply providing a SFW summery of Roston's story, but isn't that something of a public service?

He is referring to:

Eric Lichtblau and James Risen: Government Tries to Keep Secret What Many Consider a Fraud: Hiding Details of Dubious Deal, U.S. Invokes National Security: WASHINGTON — For eight years, government officials turned to Dennis Montgomery, a California computer programmer, for eye-popping technology that he said could catch terrorists. Now, federal officials want nothing to do with him and are going to extraordinary lengths to ensure that his dealings with Washington stay secret.... In 2009, the Air Force approved a $3 million deal for his technology, even though a contracting officer acknowledged that other agencies were skeptical about the software, according to e-mails obtained by The New York Times. Hints of fraud by Mr. Montgomery, previously raised by Bloomberg Markets and Playboy, provide a cautionary tale about the pitfalls of government contracting...

I don't think that Lichtblau and Risen have any business writing their story without saying--at its top--something like:

Our story is a very compressed and only slightly updated version of Adam Roston's Playboy story of more than a year ago here: http://www.playboy.com/articles/the-m...

The willingness of reporters for major newspapers and magazines to take the work of others and regurgitate it in summarized form while providing no clues to where it came from or where readers should go to learn more continues to amaze me.

Higher-Order Insanity from the Volokh Conspiracy

Ilya Somin is unhappy:

Brad DeLong Misrepresents My Position on Libertarianism and Asteroid Defense | FavStocks: n a recent post, I expressed my disagreement with co-blogger Sasha Volokh’s view that libertarianism condemns government funding of asteroid defense, pointing out that most prominent libertarian thinkers also disagree with him. Through selective quotation, Brad DeLong tries to make it seem like I endorsed Sasha’s position. He does so by quoting the part of the post where I explained why I don’t think Sasha’s position is ridiculous or “insane”...

I deny this. I did not write that Somin endorses Sasha Volokh's view that taxing people to pay for asteroid defense is immoral. Somin's insanity is, rather, a second-order insanity--the insanity of taking first-order insane claims to be questions about which reasonable people can disagree.

So: for the record: I nowhere claim that Ilya Somin agrees with Sasha Volokh's bizarre and insane claim that it is immoral to tax people to pay for asteroid defense.

I nowhere quote Ilya Somin out of context. I quote him--accurately and in context--as claiming that Sasha Volokh's position is a serious one with which reasonable people can agree or disagree.

I simply don't happen to think that Sasha Volokh's position is one with which reasonable people can agree or disagree.

And I don't think that the claim that Sasha Volokh's position is reasonable is itself a reasonable claim.

And, for that matter, I don't think that Ilya Somin's claim that Immanuel Kant's claim that you have a moral duty not to lie to insane ax murderers about the whereabouts of their would-be victim is a reasonable claim is a reasonable claim.

Now if he wants to argue that he is not insane--that the claim that the claim that Immanuel Kant's claim that you have a moral duty not to lie to insane ax murderers about the whereabouts of their would-be victims is a reasonable claim is a reasonable claim is itself a reasonable claim--I would be happy to listen to him.

But I cannot imagine how he would make such an argument. In Kant's case the trolley of moral philosophy has run off its tracks and over the cliffs of insanity. And attempts to argue that it has not are simply higher orders of insanity.

Can you?

Brad DeLong

Mark Thoma: How Convincing Is the Case for Free Trade?

Mark Thoma sends us to Uwe Reinhardt:

In his recent commentary, Professor Mankiw explained the gains from trade even more simply than is done in textbooks. Your driveway is covered in deep snow. Its removal is worth $40 to you. The boy next door, currently engrossed with a game on his Xbox, would give up the game and shovel your driveway for any payment exceeding $20. So if you pay him $30 to shovel your driveway, you will both be better off by $10. Overall social welfare is unambiguously enhanced.... As far as economists are concerned, how can anyone argue with that?...

Now let us think again about... manufactured scarves.... [M]any Americans might balk at the lower-priced scarf if it were offered not by an American but by a low-cost manufacturer in Shanghai or Bangladesh. This nationalist sentiment sets many noneconomists apart from most economists. In their work, economists are typically are not nationalistic. National boundaries mean little to them.... I say most economists, because here and there one can find some who do seem to worry about how fellow Americans fare in the matter of free trade.... Alan Blinder wrote:

I’m a free trader down to my toes. Always have been. Yet lately, I’m being treated as a heretic by many of my fellow economists. Why? Because I have stuck my neck out and predicted that the offshoring of service jobs from rich countries such as the United States to poor countries such as India may pose major problems for tens of millions of American workers over the coming decades. In fact, I think offshoring may be the biggest political issue in economics for a generation. When I say this, many of my fellow free traders react with a mixture of disbelief, pity and hostility. Blinder, have you lost your mind?... That is why I am going public with my concerns now. If we economists stubbornly insist on chanting ‘free trade is good for you’ to people who know that it is not, we will quickly become irrelevant to the public debate. Compared with that, a little apostasy should be welcome.

And Mark Thoma:

Saying that everyone could be made better off with increased international trade is not the same as people actually being made better off. There are winners and losers from increased international trade, and while I agree that the gains exceed the losses in almost all cases, the gains haven't been distributed in a way that leaves everyone, or even most everyone, better off (see, e.g., widening inequality and where the costs of these kinds of adjustments fall). When some people are made better off and others made worse off at the same time, economists cannot say it is unambiguously better or worse. If we are going to make the argument that trade is good because everyone could potentially be made better off, we should do much more than we have to ensure that this potential is realized, i.e. that the gains from trade are distributed widely across the population rather than concentrated among a smaller set of winners

Winston Churchill Liveblogs World War II: May 28, 1941

WSC:

Kirilenko et al.: "The Flash Crash: The Impact of High Frequency Trading on an Electronic Market"

Positive Feedback Trading:

SSRN-The Flash Crash: The Impact of High Frequency Trading on an Electronic Market by Andrei Kirilenko, Albert (Pete) Kyle, Mehrdad Samadi, Tugkan Tuzun

R. T. Leuchtkafer on Financial Market Ecology: Positive-Feedback Trading

RTL:

Comments of R. Leuchtkafer on 265-26: U.S. Commodity Futures Trading Commission Chief Economist Andrei Kirilenko and several co-authors published a paper called "The Flash Crash: The Impact of High Frequency Trading on an Electronic Market," to date the definitive examination of high frequency market makers. What Kirilenko reported is deeply troubling for U.S. markets, implying structural instability, crashes and liquidity crises large and small, toxic quotes and price discovery in the public markets, and the uncertainty of any order's likely effect on prices. His breakthrough paper is a decisive empirical justification for reforming how high frequency market makers operate in today's markets.... Kirilenko's study is the latest U.S. government agency report on scalpers.... Defining a "scalper" as a firm that "typically buys and sells in large quantities, expecting to hold the trade open only a very short time" and that "intends to be even as to quantities bought and sold at the close of the business day and is reluctant to carry a trade over night."...

In his autopsy of e-mini SP 500 futures trading around the May 6, 2010 Flash Crash, Kirilenko describes how these firms destabilize markets. There's a tipping point in volatile markets when, in an instant, high frequency market makers stampede to rebalance their inventories, even cascading positions from firm to firm, while prices collapse. Kirilenko calls this "hot potato" trading, but it's an interdealer panic, a market maker fratricide. His conclusions extend to any volatile episode, because, as he wrote, high frequency market makers "did not change their trading behavior during the Flash Crash."... Markets crashed when high frequency market makers hit internal inventory limits and unloaded onto the next market maker, which then hit limits and unloaded onto the next one, and so on, driving the market down by almost $1 trillion dollars in a few minutes. Kirilenko studied e-mini trading in the futures market, but the CFTC and U.S. Securities and Exchange Commission staff report on the Flash Crash showed the same behavior at work in the equities markets, doubtless from many of the same firms.

The scalper's destabilizing practices are that it can quote as it pleases and trade as aggressively as it pleases and still carry the regulatory imprimatur and privileges of a market maker.... Instead of smoothing buy and sell pressures, as market makers in the equities markets were -- in theory -- once supposed to do, scalpers exacerbate or hide from volatility, as Kirilenko discovered in the Flash Crash.... Registering as equities market makers, given valuable and unique regulatory preferences and access, cozying up with exchanges desperate for business, and then let loose on the stock markets, the scalper's business model makes the stock markets structurally unstable....

A recent study found that high frequency firms post the best price at least 50% of the time in the equities markets. The study's author and high frequency firms pounced on this as strong evidence high frequency firms contribute to price discovery, more so than any other kind of firm. The analysis and conclusion are superficial. A bid or offer has at least four dimensions. Beyond price and size, any resting bid or offer has a lifetime, and the inventory cycle or position resulting from any executed bid or offer has a lifetime. Even if it's at the best price, a bid or offer lasting a fraction of a second hasn't contributed to price discovery, and market makers use the latest technology to post and cancel thousands of bids and offers per second, even in the same stock. An executed bid or offer where the position is unwound quickly and aggressively isn't price discovery either. Kirilenko found high frequency market maker inventory or position half-lives of less than two minutes in the futures market. Some equities high frequency market makers claim as little as 11 seconds in their stocks. Market maker inventory cycles of a few seconds or minutes, enforced by aggressive trading as time or prices go against the firm, actively destabilize prices, especially so in already volatile markets.

Of a quote's four dimensions, only one has materially improved in the last 10 years. Because of decimalization, automation and deregulation, quoted spreads have improved for liquid stocks in stable markets. But quote duration is down, time-in-inventory is down, and for many stocks quote size is flat or down. This is all because, to manage costs, high frequency market maker inventory cycles are engineered down to seconds, and these firms keep their capital commitments low. High frequency firms will tell you they're like any other business except that capital is their inventory, and like any other business they make money by turning over their inventory, so they churn it as fast as they can. Frenetic trading isn't a byproduct of their strategies -- it is the strategy. The effect of all of this is that investors looking at a quote today can't predict what the quote means. They can't tell whether the quote will be there when they submit an order against it, and they can't tell when their own buying or selling will trigger a market maker's risk threshold. If they do trigger a threshold, the market maker cartwheels from liquidity supplier to liquidity demander to compete with an investor's own liquidity needs. As it cartwheels, it can shock prices. And when events align so market makers turn as a flock, as they did in the Flash Crash, they can collapse the market....

As has been said, an insight from the Flash Crash is that "volume is not liquidity." A further insight is that, batted about by scalper inventory microcycles, published quotes don't represent genuine liquidity either. A best bid today isn't a bid to own shares at a price, or even a traditional dealer or market maker's attempt to provide liquidity. As much as 50% of the time it's just a firm trying to scalp a few basis points as quickly as possible. When that scalper's bid is executed, it then becomes an unexploded competitive liquidity demand, with the timer set, as Kirilenko found, at about two minutes, or even less. These destabilizing trade practices are a fundamental structural instability behind the Flash Crash....

The equity market reforms and deregulation of the last 10 to 15 years happened for good reasons -- monopoly profits were flowing to intermediaries and exchanges, intermediaries were taking advantage of their customers, innovation was being strangled by entrenched interests -- and it was time for reform. As many of us hoped, new participants, technology and business models sprang up. Nobody wants to undo that progress. By analyzing trade and position data from the futures market, Kirilenko's breakthrough was to show how a dominant class of these business models can be disruptive, and how these models can be destabilizing enough to create systemic risk as an inherent consequence of their design. On a gross basis, these models can be checked by circuit breakers or price limits, and this is one reason price limits are standard in the futures markets. In the equities markets, these models must be checked even before they trigger circuit breakers or price limits because the equities markets are profoundly different from the futures markets. The simplest way to check these models is to put reasonable restraints and obligations on them.

A basic function of any market is to produce a quote. The scalper's toxic quotes, thousands of them a second, are a hoax on our equities markets. No one planned it. It happened as an unanticipated consequence of well-meaning reforms to a flawed system. There is no competitive solution to this problem within current regulations so long as quote price is a routing table's first regulatory imperative. Competition simply forces exchanges to publish more and faster toxic quotes, as market power continues to shift from the exchanges to the scalpers.

Finally, some have pointed out that regulation didn't work in the market break of 1987, when old-fashioned specialists and market makers shirked their responsibilities and hid from the market, and regulation won't work today. Regulation didn't stop them from shirking their responsibilities, but regulation didn't excuse them either, and regulation didn't encourage them to automate a deadlier game than hide-and-seek -- intermediaries didn't exacerbate the 1987 market break by playing market maker "hot potato," a feat unique to the Flash Crash. And the logic of "regulation didn't prevent 1987, so regulation won't work" is a civic novelty. Should we apply that logic to drunk driving, or to any other misbehavior?

Of course not. Please regulate them.

Rajiv Sethi on Financial Market Ecology: Positive-Feedback Trading

Rajiv Sethi:

Guest Post: Market Ecology « naked capitalism: The erudite and very readable RT Leuchtkafer has posted yet another comment for the Securities and Exchange Commission to digest. This one was prompted by a paper by Andrei Kirilenko, Albert Kyle, Mehrdad Samadi and Tugkan Tuzun that provides a fascinating glimpse into the kinds of trading strategies that are common in asset markets today and the manner in which they interact to determine the dynamics of asset prices.... [T]he stability of a market depends on the composition of trading strategies, which in turn evolves over time under pressure of differential performance. Since performance itself depends on market stability, and destabilizing strategies prosper most when they are rare, this process can give rise to switching regimes: the market alternates between periods of stability and instability, giving rise to empirical patterns such as fat tails and clustered volatility in asset returns.

But the underlying strategies that are at the heart of this evolutionary process are generally unobservable. Since traders have no incentive to reveal successful strategies, these can only be inferred if individual orders can be traced to specific accounts. This is what Kirilenko and his co-authors have been able to do, on the basis of “audit-trail, transaction-level data for all regular transactions in the June 2010 E-mini S&P 500 futures contract (E-mini) during May 3-6, 2010 between 8:30 a.m. CT and 3:15 p.m. CT.” While their primary concern is with the flash crash that materialized on the afternoon of the 6th, their analysis also sheds light on the composition and behavior of strategies over the period that led up to this event. Their analysis accordingly provides broader insight into the ecology of financial markets. The authors classify accounts into six categories based on patterns exhibited in their trading behavior, such as horizon length, order size, and the willingness to accumulate significant net positions.  The categories are High Frequency Traders (HFTs), Intermediaries, Fundamental Buyers, Fundamental Sellers, Opportunistic Traders and Small Traders:

[Different] categories of traders occupy quite distinct, albeit overlapping, positions in the “ecosystem” of a liquid, fully electronic market. HFTs, while very small in number, account for a large share of total transactions and trading volume. Intermediaries leave a market footprint qualitatively similar, but smaller to that of HFTs. Opportunistic Traders at times act like Intermediaries (buying a selling around a given inventory target) and at other times act like Fundamental Traders (accumulating a directional position). Some Fundamental Traders accumulate directional positions by executing many small-size orders, while others execute a few larger-size orders. Fundamental Traders which accumulate net positions by executing just a few orders look like Small Traders, while Fundamental Traders who trade a lot resemble Opportunistic Traders. In fact, it is quite possible that in order not to be taken advantage of by the market, some Fundamental Traders deliberately pursue execution strategies that make them appear as though they are Small or Opportunistic Traders. In contrast, HFTs appear to play a very distinct role in the market and do not disguise their market activity.

Based on this taxonomy, the authors examine the manner in which the strategies vary with respect.... Under normal market conditions they are net providers of liquidity but their desire to avoid significant exposure means that they can become liquidity takers very quickly and on a large scale....

From a liquidity standpoint, a passive order (either to buy or to sell) has provided visible liquidity to the market and an aggressive order has taken liquidity from the market. Aggressiveness ratio is the ratio of aggressive trade executions to total trade executions… weighted either by the number of transactions or trading volume.... HFTs and Intermediaries have aggressiveness ratios of 45.68% and 41.62%, respectively. In contrast, Fundamental Buyers and Sellers have aggressiveness ratios of 64.09% and 61.13%, respectively.

This is consistent with a view that HFTs and Intermediaries generally provide liquidity while Fundamental Traders generally take liquidity. The aggressiveness ratio of High Frequency Traders, however, is higher than what a conventional definition of passive liquidity provision would predict. Moreover, the aggressiveness ratio of HFTs is not stable over time and can spike in times of market stress as they compete for liquidity with other market participants:

During the Flash Crash, the trading behavior of HFTs, appears to have exacerbated the downward move in prices. High Frequency Traders who initially bought contracts from Fundamental Sellers, proceeded to sell contracts and compete for liquidity with Fundamental Sellers. In addition, HFTs appeared to rapidly buy and [sell] contracts from one another many times, generating a “hot potato” effect before Opportunistic or Fundamental Buyers were attracted by the rapidly falling prices to step in and take these contracts off the market.

To my mind, the most revealing findings in the paper pertain to the profitability of the various strategies, and the ability of some traders to anticipate price movements over very short horizons:

High Frequency Traders effectively predict and react to price changes... [they] are consistently profitable although they never accumulate a large net position. This does not change on May 6 as they appear to have been even more successful despite the market volatility observed on that day.... Intermediaries appear to be relatively less profitable than HFTs. During the Flash Crash, Intermediaries also appeared to have incurred significant losses... consistent with the notion that the relatively slower Intermediaries were unable to liquidate their position immediately, and were subsequently run over by the decrease in price...

HFTs appear to trade in the same direction as the contemporaneous price and prices of the past five seconds. In other words, they buy... if the immediate prices are rising. However, after about ten seconds, they appear to reverse the direction of their trading... possibly due to their speed advantage or superior ability to predict price changes, HFTs are able to buy right as the prices are about to increase… In marked contrast… Intermediaries buy when the prices are already falling and sell when the prices are already rising....

We consider Intermediaries and HFTs to be very short term investors. They do not hold positions over long periods of time and revert to their target inventory level quickly… HFTs very quickly reduce their inventories by submitting marketable orders. They also aggressively trade when prices are about to change. Over slightly longer time horizons, however, HFTs sometimes act as providers of liquidity. In contrast… unlike HFTs, Intermediaries provide liquidity over very short horizons and rebalance their portfolios over longer horizons.

What appears to have happened during the crash is that the fastest moving market makers with the most effective algorithms for short run price prediction were able to trade ahead of their slower and less effective brethren, imposing significant losses on the latter. In Leuchtkafer’s colorful language, this was a case of interdealer panic and marker maker fratricide. But regardless of how the gains or losses were distributed in this instance, the fact remains that an overwhelming share of trading activity is based short-run price forecasts rather than fundamental research. Under these conditions, how can one expect prices to track changes in the fundamental values of the income streams to which the assets give title?

Markets have always been based on a shifting balance between information augmenting and information extracting strategies, but a computational arms race coupled with changes in institutions and regulation seem to have shifted the balance markedly towards the latter. Unless the structure of incentives is altered to favor longer holding periods, I suspect that we shall continue to see major market disruptions and spikes in volatility.

This is not just a matter of academic interest. To the extent that changes in the perceived volatility of stocks gives rise to changes in asset allocations by institutional and retail investors, there will be consequences for the extent and distribution of risk-bearing, and ultimately on rates of job creation and economic growth.