Why It Doesn't Matter If High-Frequency Trading Doesn't Serve A Societal Purpose

(This post originally appeared at the author’s blog)

At the end of his review on this week’s latest book on the recent economic crisis, liberal economist Bob Solow brings in this observation:

I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favourable transactions minutes or even seconds before the next most clever competitor can make a move…

Now ask yourself: can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.

This kind of reasoning has been going on for a long time, and while introspection is useful, it’s really not good for figuring out what other people should do. Some guy thinks to himself, ‘what’s the use of that?’, and decides the world would be a better place without not only that wasteful activity, but the people who actually got rewarded encouraging such frivolous activities. The world is a complex relation of people all over the world, so the fact that one guy in Boston can’t fathom how something helps the world seems rather unsurprising.

I’ll say for the record that I think Puff Daddy is a waste of resources–I have no need for him, and can’t understand his celebrity. There are many activities I not only don’t do, I judgmentally think people waste time when they do them, but I’m not so arrogant to think that really means they should do something else. It took us decades to figure out that altruism could be based on ‘enlightened’ self-interest (iterated prisoner’s dilemma, reciprocal altruism), so it’s a good idea not to throw something out merely because we haven’t figured out it’s benefit in ‘the big picture’.

A famous article in 1962 by Fisher, Griliches, and Kaysen (The Costs of Automobile Model Changes since 1949, JPE), argued that the improvements in cars from 1949 were all a waste! Using exacting logic, they noted one could have bought the same 1949 car for $700 less in 1961, and could have used that money to buy coats for the poor or some other ‘obviously’ better use (after all, 1949 car got from A to B just like the fancy 1962 ones). But, then, one could say the same thing about books: 99.99% of everything written today was said better previously by someone else. Better those people serve the poor or something more obvious than engage in frivolous or redundant work. One could go on and on, because most of the internet is frivolous (porn, games), much liesure activity pointless (football?), etc.

The only problem is with this insight is it isn’t obvious how to spend money ‘wisely’, on say obvious public goods. For example, In the 1990’s an activist Kansas City judge decided to mandate the state pay for a first class shool system. The results were typical:

Kansas City spent as much as $11,700 per pupil–more money per pupil, on a cost of living adjusted basis, than any other of the 280 largest districts in the country. The money bought higher teachers’ salaries, 15 new schools, and such amenities as an Olympic-sized swimming pool with an underwater viewing room, television and animation studios, a robotics lab, a 25-acre wildlife sanctuary, a zoo, a model United Nations with simultaneous translation capability, and field trips to Mexico and Senegal. The student-teacher ratio was 12 or 13 to 1, the lowest of any major school district in the country.

The results were dismal. Test scores did not rise; the black-white gap did not diminish; and there was less, not greater, integration

William Easterly has discussed the issues of international aid, and how over $2 Trillion dollars have basically been flushed down the toilet. So, good intentions are neither necessary (the unintended benefits of self-interest) or sufficient (charity).

I think it’s much better to let people spend their money the way they want (with a few exceptions), and equally importantly make money the way they want. It’s a good thing that American car companies, in 1962, didn’t think the 1949 model was ‘good enough’ and then spend it on something obviously of public good, like aid to Africa, or public housing. Such thinking leads to zero productivity growth, and without productivity, we can’t pay for things like, public pensions, or actually create things we find really elevating (like the Large Hadron Collider, or Al Gore’s Nobel prize winning power point presentation).

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