Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  As important as these legal and immediate marketplace outcomes were, the results of a parallel investigation by the Securities and Exchange Commission (in cooperation with the Justice Department) had a much greater long-term impact on the structure of securities markets. In addition to levying fines against the dealers, the SEC proposed and then implemented major changes in its order handling rules for stocks traded on NASDAQ. Of special importance, the SEC required NASDAQ dealers to publicly display investor limit orders (buy orders specifying a price limit above which a purchase would not be made, or sell orders below which a sale would not be completed) between 100 and 10,000 shares (or most shares traded on NASDAQ). In addition, dealers had to notify the public of the best available prices at which they could buy and sell stocks.

  The impact of these directives was revolutionary. Opening the order book to public scrutiny gave investors, for the first time, the array of bids and asks for various stocks—simply by clicking on the web pages of NASDAQ and various electronic communications networks (ECNs), which enable investors to complete trades through the network’s computer rather than through an exchange. The new openness not only helped investors decide how to frame their offers, but it accelerated the completion of trades on ECNs, which found it easier to match crossing orders (bids and asks at identical prices). With trading migrating to ECNs, the importance of dealers and even brokers began to decline, while new completely automated exchanges that executed trades through computers, such as BATS and Direct Edge, arose to take market share away from the Big Board and even from NASDAQ. In late 2005, the once unthinkable happened: The trader-members of the NYSE voted to enable the Big Board to become a publicly held corporation, which it did in 2006. This step eventually paved the way for the NYSE to be taken over by ICE, another relative upstart.

  The automation of trading also led to its fragmentation, which was encouraged by the decimalization of stock prices—the quotation of prices in pennies rather than in fractions—that the SEC mandated in late 2000 and early 2001 as a way of reducing spreads. At smaller tick sizes, there is less volume at each price, which encourages institutional investors with large volume orders to look to multiple alternative trading venues to complete trades as a way of minimizing the impact of their orders on prices.9

  With the NYSE no longer dominant, trading now takes place in many public exchanges, as well as in dark pools—private venues owned and operated by large securities firms or other entities where offers are not publicly displayed.10 Some critics believe the fragmentation of trading reduces liquidity at any single venue and thus raises trading costs for investors. Others maintain that more competition among trading venues has led to more innovation in trading technologies, despite a number of highly publicized glitches in the public exchanges (for example, the halting of trading when Facebook went public or the ironic breakdown of BATS, one of the leading electronic exchanges, when it tried to go public itself, both in 2012).

  The automation of trading, in turn, led to two other phenomena: algorithmic and high-frequency trading. Algorithmic trading occurs when preprogrammed computers, using various market-based signals, automatically enter orders without human assistance. A special, controversial type of algo trading is high-frequency trading, the use of computers to enter rapid-fire buy and sell orders, communicated in milliseconds, thereby enabling the operators of these computers to get in the front of the line before other orders. To make this happen, high-frequency traders (HFTs) have persuaded exchanges, which have been eager for the volume and fees such rapid trading generates, to permit computers owned by high-frequency traders to be co-located with the exchange’s own computers. Some HFTs also have invested hundreds of millions of dollars to lay fiber optic cables that can communicate trade orders from distant locations essentially at the speed of light to assure trade priority. In recent years, HFTs have accounted for over half of all trading volume in U.S. equities.11

  The growth of HFTs has become a hot debate topic. Critics assert that HFTs amplify fluctuations in the market and, like runaway trains, can sometimes trigger violent, especially downward, movements in stock prices. The flash crash of May 2010—when some stock prices dropped to pennies because of massive sell orders with no one to buy—has been blamed on HFTs. In addition, some critics attack the co-location of HFT facilities with those of the exchanges as unfair to less well-heeled investors. The publication in early 2014 of Michael Lewis’s latest best-seller, Flash Boys, amplifies these arguments for a wide audience.12

  Defenders of HFTs counter with several arguments. One is that the high volumes of rapid-fire trades add liquidity to the market under normal market conditions and thus reduce spreads, which benefits individual and institutional investors alike. Unusual episodes like a flash crash can be addressed by short-term circuit breakers in which no trading is allowed—so that orders can fill up the order book like water in a sink—or even slowing it down with proposals like a securities transaction tax. As for the unfairness of colocation, HFT defenders note that NYSE members in the old days and current commodities floor traders who trade for their account had or have informational advantages by virtue of their locations. In an electronic world, locational advantages have simply moved to different players.

  The debates over HFT, algo trading, and the implications of automated trading for market structure will surely continue, and I doubt whether their resolution (if that ever happens) will be driven by a consensus among economists on these subjects, which I do not believe yet exists. The major point I would like readers to take away from this section is to realize how a seemingly obscure academic economic study led to powerful, unintended, and I believe largely desirable outcomes. Stock trading surely was going to be automated, but the decision to make orders public was clearly accelerated as a result of the government’s investigation of collusion among NASDAQ’s market makers. The resolution of the investigation armed investors with information they didn’t have before, while making it far easier for the upstart ECNs to challenge the established exchanges. In addition, the mere announcement of the investigation, followed by the Justice Department’s consent decree, saved investors billions of dollars in trading costs over the years. Economists had much to do with all these outcomes.

  As for the SEC, it has been studying what, if anything, to do about the change in structure in trading markets since at least 2010.13 In early June 2014, the SEC unveiled a sweeping set of regulatory proposals and initiatives to regulate HFT. Among the various proposals, HFTs would have to register with the Commission as broker-dealers, which would subject them to reporting requirements and potentially much greater regulatory scrutiny. The initiatives also instructed the SEC staff to develop proposals for preventing HFTs from contributing to market instability. (Good luck.)

  Economists and the Financial Crisis

  Bank-related financial crises are not a new phenomenon, in either the United States or in other countries.14 Roughly one-third of this country’s banks failed during the Great Depression.15 In the 1980s, virtually all the nation’s largest banks would have probably been insolvent if the banks’ loans to the governments of less-developed countries (LDCs) been recorded at depressed but realistic market values, rather than at their face values. During the same decade, well over 1,000 of the country’s savings and loan institutions collapsed, initially because of high funding costs at the beginning of the decade (when interest rates were well into double digits) and later because of disastrous lending and, in some cases, fraud. Later in the 1980s and into early 1990s, banks also failed at their highest rates up to that time since the Depression, largely because of excessive commercial real estate lending, especially in the Northeast.

  The financial crisis of 2007–2008 was as bad for the banking system as the Great Depression, far worse than the banking and S&L crises of the late 1980s and early 1990s. This was not because of the numbers of banks that toppled—roughly 500 over the five years from 2008 to 2012—but because of the size of some of the banks that collapsed or came
close to failure, and the fact that lending between banks essentially ground to a halt in September 2008.16 If banks wouldn’t lend to each other, how could they be expected to lend to anyone else? That question drove Treasury Secretary Henry “Hank” Paulson and Federal Reserve Chairman Ben Bernanke to do what before that crisis would have been unthinkable, especially by a Republican administration committed to free markets: Go to Congress and ask for the unprecedented sum of $700 billion to rescue the banking system. Paulson and Bernanke took this huge step because they believed without it the economy faced a real prospect of experiencing another Great Depression.

  I am not writing to defend the wisdom of what those two public servants did, along with Congress, and both Presidents Bush and Obama (although I believe that Paulson, Bernanke, and later Treasury Secretary Geithner will be praised by historians for their courage). I focus instead on what, if anything, economists had to do with the crisis. Beyond not seeing it coming (with a few notable exceptions), are they to blame in any way? And did they contribute anything good on the financial policy front in the years before the crisis for which they deserve some credit?

  I ask these questions because they are relevant to the main objective of this book, which focuses on the impact of economic ideas on business. While financial policy, whether recommended by economists or not, certainly has a clear impact on the firms or markets directly affected by it, such as banks, securities markets, and nonbank financial institutions, the policies affecting finance also indirectly have a major impact on the entire economy. Pick your metaphor: The banking system either represents the plumbing of the economy, or its circulatory system; but each one underscores the importance of a sound banking and financial system. Without confidence in finance, firms don’t invest, consumers don’t buy, and the economy collapses. So issues relating to banking crises, and how policy has reacted to and tried to prevent them, could not be more important to every business, large or small.

  How Did the Crisis Happen? A Quick and Easy Guide

  To answer the questions I just posed, it is first important to realize what got us into the financial mess. I’m not going to write a tome on this matter, since there are so many excellent analyses and accounts already published (and surely more to come). I have several favorites, as of this writing, in case you’re looking for thoughtful, interesting accounts: Alan Blinder’s After the Music Stopped, Sheila Bair’s Bull by the Horns, Gillian Tett’s Fool’s Gold, and Michael Lewis’s very popular classic, The Big Short.17 The most serious and comprehensive economic treatment of the crisis is Blinder’s (see following box). If you want to read the official version of why the crisis happened, then pick up the report of the national commission created by Congress to study the causes of the crisis.18

  Alan Blinder: A Gifted Economist Who Can Really Write

  Many of the economists I feature in this book write well, in addition to having first-rate technical chops. Alan Blinder, widely recognized as one of the world’s leading economists, is at the top of the list on both these scores.

  Blinder is a Brooklyn native, sounds like one, and is proud of it. He went to Princeton, followed with a master’s in economics at the London School of Economics, then earned his PhD at MIT. From there, he has spent most of his academic life at Princeton, writing about a broad range of subjects—monetary and fiscal policy, income distribution, the theory of price-setting, the art and science of central banking, and, most recently, financial regulation since the crisis. He is coauthor (with William Baumol) of a leading text on introductory economics, and has coauthored papers with former Federal Reserve Chairman Ben Bernanke (who also spent most of his academic life at Princeton and, at this writing, is a Distinguished Scholar at the Brookings Institution). Blinder’s recent book on the financial crisis, the highly readable After the Music Stopped, was named by the New York Times as one of the 10 best books of 2013 (over all subjects, fiction and nonfiction).

  Blinder’s talents have been put to good use in numerous influential policy positions. He was one of the first staff members that Alice Rivlin hired to work at the Congressional Budget Office. Upon President Clinton’s election he was appointed a member of the Council of Economic Advisers, and went from there to be vice-chairman of the Federal Reserve Board.

  Blinder’s great ability to explain complicated economics concepts in plain English—sometimes through the eyes of his Uncle Harry—has been recognized by the Wall Street Journal, where he has for years been the regular Democratic economist op-ed writer. He also appears frequently on television.

  Blinder has a practical business side to him, too. He cofounded both the Promontory Financial Group (a consulting company) and the Promontory Interfinancial Network (a financial services company) with former Comptroller of the Currency Eugene Ludwig. He remains active in the latter, as the firm’s vice chairman. Blinder is the highly unusual economist who has blended academic life, government service, and entrepreneurship into a remarkably successful career. Oh, and one more thing: Alan is one of the nicest, humblest individuals you will meet (not always a trait of some superstar economists, I unfortunately must admit), and always available to provide advice and counsel to others.

  If you read all these and other books on the subject, you deserve a medal; but you’re also likely to come away with your head swimming about all of the causes. In fact, Congress already had that mind-set, not only in creating the national commission but also in enacting the Dodd–Frank financial reform act to prevent future financial crises, or at least mitigate their severity. The commission was directed to study and report on almost 20 causes of the crisis. Meanwhile, Dodd–Frank became long (by some measures over 1,000 pages) and complex because multiple provisions were necessary to address the multiple causes (later identified in the commission’s report but well understood at the time Dodd–Frank was enacted). I won’t discuss the merits or drawbacks of the Act itself, a subject which also has a large and growing literature, although readers deserve to know where I stand on it: I think the Act was and remains necessary and that its detriments have been overstated, but the rules implementing the Act have turned out to be excessively complex.19

  Good economic theorists, like other social and physical scientists, are taught to apply “Occam’s Razor” (named after William of Ockham of the fourteenth century) when developing their theories: Simpler explanations of phenomena are better than those that are more complicated. In that spirit, I believe the underlying causes of the financial crisis can be reduced to two: (1) far too much subprime mortgage lending (loans to borrowers posing well-above-average risks of default) by banks and nonbank lenders and (2) excessive leverage by banks and certain nonbanks (securities firms and one large insurer, AIG) that greatly magnified the losses to financial institutions and the economy when subprime mortgages turned sour.

  Of course, it was more complicated than this, because various subfactors contributed to each of these two main causes. Subprime lending was facilitated by the packaging of such loans into securities, the massive failure of the ratings agencies to rate them properly, and excessive purchases of these securities by the two government-sponsored housing entities, Fannie Mae and Freddie Mac (which were created to buy or guarantee mortgages originated by primary lenders), and by excessive bank lending to nonbank lenders that handed out most of the subprime loans.

  Excessive leverage, meanwhile, meant that too many banks and two of the largest securities firms—Goldman Sachs and Morgan Stanley—had very thin layers of shareholder money to absorb the losses of the subprime loans or securities backed by those loans when borrowers couldn’t make their payments. By wiping out much or all of shareholders’ stakes in too many of the largest banks and securities firms, the loss of $1 trillion or so in subprime loans thus almost brought down the entire financial system. Subprime losses were aggravated by the fact that the largest banks and securities firms were funded by very short-term liabilities that were not backed by federal deposit insurance—large, uninsured deposits in the case of the
banks and overnight repurchase agreements or borrowing secured by Treasury bills, in the case of the securities firms—so when the financial institutions began to question each other’s solvency (because their own was at risk), few or none were willing to lend to each other. That’s how the financial system came close to crashing after Lehman, AIG, and Fannie Mae/Freddie Mac all failed in September 2008, and why even Republican leaders at the Treasury and the Fed, and Republican President George W. Bush, had to go hat in hand to Congress and ask for a massive government bailout to keep the financial system, and thus the entire economy, from crashing.

  The books I recommended earlier, and others, tell this frightening story in gory detail, and so there is no need for me to repeat or embellish it. Instead, I want to address an issue these books do not take up, but which I know many readers and citizens who may never read these books have asked themselves at some point: To what extent were economists responsible for either of the two causes? The short answer is: perhaps a small bit but not much more.