Felix Salmon

The problems of HFT, Joe Stiglitz edition

Felix Salmon
Apr 16, 2014 00:04 UTC

Never mind Michael Lewis. The most interesting and provocative thing to be written of late about financial innovation in general, and high-frequency trading in particular, comes from Joe Stiglitz. The Nobel prize-winning economist delivered a wonderful and fascinating speech at the Atlanta Fed’s 2014 Financial Markets Conference today; here’s a shorter version of what Stiglitz is saying.

Markets can be — and usually are — too active, and too volatile.

This is an idea which goes back to Keynes, if not earlier. Stiglitz says that in the specific area of international capital flows, “there is now a broad consensus that unfettered markets are welfare decreasing” — and certainly you won’t get much argument on that front from, say, Iceland, or Malaysia, or even Spain. As Stiglitz explains:

When countries do not impose capital controls and allow exchange rates to vary freely, this can give rise to high levels of exchange rate volatility. The consequence can be high levels of economic volatility, imposing great costs on workers and firms throughout the economy. Even if they can lay off some of the risk, there is a cost to doing so. The very existence of this volatility affects the structure of the economy and overall economic performance.

The question is: does the same logic, that traders seeking profit can ultimately cause more harm than good, apply equally to high-frequency trading, and other domestic markets? Stiglitz says yes: there’s every reason to believe that it does.

HFT is a negative-sum game.

In the algobot vs algobot world of HFT, the game is to capture profits which would otherwise have gone to someone else. Michael Lewis’s complaint is that if there weren’t any algobots at all, then those profits would have gone to real-money investors, rather than high-frequency traders, and that the algorithms are taking advantage of unfair levels of market access to rip off the rest of the participants in the stock market. But even if you’re agnostic about whether trade profits go to investors or robots, there are undeniably real-world costs to HFT — costs like drilling through Pennsylvania mountains. As a result, the net effect of the algorithms is negative: they reduce profits, for everybody, rather than increasing them.

In theory, HFT could bring with it societal benefits which more than offset all the costs involved. In practice, however, that seems unlikely. To see why, we’ll have to look at the two areas where such benefits might be found.

HFT does not improve price discovery.

Price discovery is the idea that markets create value by putting a price on certain assets. When a company’s securities rise in price, that company finds it easier to raise funds at cheaper rates. That way, capital flows to the places where it can be put to best use. Without the price-discovery mechanism of markets, society would waste more money than it does.

But is faster price discovery better than slower price discovery? Let’s say good news comes out about a company, and its share price moves as a result — does it matter how fast it moves? Is any particular purpose served to seeing the price move within a fraction of a millisecond, rather than over the course of, say, half a minute? It’s hard to think of a societal benefit to faster price discovery which is remotely commensurate with the costs involved in delivering those faster price moves.

What’s more, faster price discovery is generally associated with higher volatility, and higher volatility is in general a bad thing, from the point of view of the total benefit that an economy gets from markets.

HFT sends the rewards of price discovery to the wrong people.

Markets reward people who find out information about the real economy. Armed with that information, they can buy certain securities, sell other securities, and make money. But if robots are front-running the people with the information, says Stiglitz, then the robots “can be thought of as stealing the information rents that otherwise would have gone to those who had invested in information” — with the result that “the market will become less informative”. Prices do a very good job of reflect ignorant flows, but will do a relatively bad job of reflecting underlying fundamentals.

HFT reduces the incentive to find important information.

The less money that you can make by trading the markets, the less incentive you have to obtain the kind of information which would make you money and increase the stock of knowledge about the world. Right now, the stock market has never been better at reacting to information about short-term orders and flows. There’s a good example in Michael Lewis’s book: the president of a big hedge fund uses his online brokerage account to put in an order to buy a small ETF — and immediately the price on the Bloomberg terminal jumps, before he even hits “execute”. The price of stocks is ultra-sensitive to information about orders and flows. But that doesn’t mean the price of stocks does a great job of reflecting everything the world knows, or could theoretically find out, about any given company. Indeed, if investors think they’re just going to end up getting front-run by robots, they’re going to be less likely to do the hard and thankless work of finding out that information. As Stiglitz puts it: “HFT discourages the acquisition of information which would make the market more informative in a relevant sense.”

HFT increases the amount of information in the markets, but decreases the amount of useful information in the markets.

If markets produce a transparent view of all the bids and offers on a certain security at a certain time, that’s valuable information — both for investors and for the economy as a whole. But with the advent of HFT, they don’t. Instead, much of the activity in the stock market happens in dark pools, or never reaches any exchange at all. Today, the markets are overwhelmed with quote-stuffing. Orders are mostly fake, designed to trick rival robots, rather than being real attempts to buy or sell investments. The work involved in trying to understand what is really going on, behind all the noise, “is socially wasteful”, says Stiglitz — and results in a harmful “loss of confidence in markets”.

HFT does not improve the important type of liquidity.

If you’re a small retail investor, you have access to more stock market liquidity than ever. Whatever stock you want to buy or sell, you can do so immediately, at the best market price. But that’s not the kind of liquidity which is most valuable, societally speaking. That kind of liquidity is what you see when market makers step in with relatively patient balance sheets, willing to take a position off somebody else’s book and wait until they can find a counterparty to whom they can willingly offset it. Those market makers may or may not have been important in the past, but they’re certainly few and far between today.

HFT also reduces natural liquidity.

Let’s say I do a lot of homework on a stock, and I determine that it’s a good buy at $35 per share. So I put in a large order at $35 per share. If the stock ever drops to that price, I’ll be willing to buy there. I’m providing natural liquidity to the market at the $35 level. In the age of HFT, however, it’s silly to just post a big order and keep it there, since it’s likely that your entire order will be filled — within a blink of an eye, much faster than you can react — if and only if some information comes out which would be likely to change your fair-value calculation. As a result, you only place your order for a tiny fraction of a second yourself. And in turn, the market becomes less liquid.

It’s important to distinguish between socially useful markets and socially useless ones.

In general, just because somebody is winning and somebody else is losing, doesn’t mean that society as a whole is benefiting in any way. Stiglitz demonstrates this by talking about an umbrella:

If there is one umbrella, and there is a 50/50 chance of rain, if neither of us has any information, the price will reflect that risk. One of us will get the umbrella. If it rains, that person will be the winner. If it does not, the other person will be the winner. Ex ante, each has the same expected utility. If, now, one person finds out whether it’s going to rain, then he is always the winner: he gets the umbrella if and only if it rains. If the other person does not fully understand what is going on, he is always the loser. There is a large redistributive effect associated with the information (in particular, with the information asymmetry), but no real social benefit. And if it cost anything to gather the information, then there is a net social cost.

HFT is socially useless; indeed, most of finance does more harm than good.

As finance has taken over a greater and greater share of the economy, growth rates have slowed, volatility has risen, we’ve had a massive global financial crisis, and far too much talented human capital has found itself sucked into the financial sector rather than the real economy. Insofar as people are making massive amounts of money through short-term trading, or avoiding losses attributable to short-term volatility, those people are not making money by creating long-term value. And, says Stiglitz, “successful growth has to be based on long term investments”.

So let’s do something about it.

HFT shouldn’t be banned, but it should be discouraged. The tax system can help: a small tax on transactions, or on orders, would reduce HFT sharply. “A plausible case can be made for tapping the brakes,” concludes Stiglitz. “Less active markets can not only be safer markets, they can better serve the societal functions that they are intended to serve.”


The strategies over the supply and demand curve is now more in the hands of the robots and a little less in the company’s. The algorithm writers are now the ones doing the game playing guided of course by the companies’ forecasts and the real-money investors.

Unless there is a way to discount all these potential efficiency gains then I would leave it alone for now at least.

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Janet Yellen didn’t gaffe

Felix Salmon
Mar 21, 2014 22:20 UTC


It’s become received opinion that Janet Yellen made a “rookie gaffe” in her first press conference as Fed chair, thereby “rattling markets”. She didn’t.

According to Peter Coy, Yellen made a “substantial blunder”. John Cassidy says she “got into trouble” when she told Reuters’ Ann Saphir that the Fed would wait “something on the order of around six months” after QE ends before starting to raise rates. Clive Crook was so perturbed by the presser that he is beginning to doubt the wisdom of the Fed having any kind of forward guidance at all. Mohamed El-Erian seems inclined to agree: the markets aren’t mature enough, he says, to internalize new information without over-extrapolating (i.e., freaking out).

But here’s the thing: the market didn’t freak out. The chart above shows the benchmark US interest rate — the yield on the 10-year note. The chart gives you a reasonably good idea of what normal volatility is: last Thursday, for instance, the yield fell by a good 10bp when John Kerry made noises about imposing sanctions on Russia. And overall, the yield has stayed comfortably in a range between 2.6% and 2.8%.

What’s more, the big FOMC-related move in the 10-year bond yield happened immediately at 2pm, when the statement was released. Yellen’s “gaffe” caused barely a wobble.

So why does everybody think that Yellen blundered? The answer is simple: they were looking at the stock market (which doesn’t matter), rather than the bond market (which does). Stocks fell, briefly; not a lot, and not for long, but enough that people noticed.

Which is good! In general, Yellen should be more transparent, not less, which means that she shouldn’t be overly cautious about what she does and doesn’t say in her press conferences. Her instinct to give a straight answer to a straight question is a good one. And if Yellen’s straight talk causes a very, very small uptick in stock-market volatility — well, that might not be such a bad thing, given that stock-market volatility is pretty low at the moment and that stocks should be pretty twitchy at these levels. What’s more, we don’t want to go back to the bad old days of Alan Greenspan, where the Fed was always assumed to have failed if it did anything which caused stock prices to fall. Yellen is going to oversee a series of interest-rate rises, and it’s entirely likely that stocks will pull back when that happens. That’s no reason to criticize her.

In fact, Yellen did more than just improve the transparency of the Fed with her remarks; she also helped prepare the markets for a wider range of possible outcomes. If the Fed does end up tightening six months after QE ends, the markets might be disappointed, but the Fed would be justified in taking a “don’t say we didn’t warn you” stance. That doesn’t mean it will happen, but it does mean that Yellen is helping to prepare the markets for the inevitable uptick in uncertainty.

As I explained back in October, transparency and predictability are incompatible goals; Yellen should go for the former, rather than the latter. The Fed’s future actions are unknown, and unknowable, and Yellen needs to be open about that fact. As central banker Adam Posen told Binyamin Appelbaum, there’s going to be increased fractiousness and unpredictability on the FOMC going forwards — and that’s a good thing, a sign that the economy is getting back to normal. If Yellen is keeping the market on its toes, she’s really just giving the markets an early taste of something they’re going to be seeing a lot more of. Traders, and the media, should — must — learn to embrace that, rather than criticizing it.


The recovery has been hollow and shaky. Congress is much more concerned with its own, disparate grasping than with the fiscal health of the nation. QE was elegant monetary engineering and it worked, but it has to be paid for and the easiest way to do that is future rate hikes. Money will move in from overseas, creating a mini-chain reaction. Travelers overseas with dollars can buy two of everything. The bankers get paid and domestic manufacture suffers. It’s all a package, folks.

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The problem of Ukraine’s Russia bond

Felix Salmon
Mar 18, 2014 16:02 UTC

Now that Russia seems to have formally annexed Crimea, no one can possibly expect Ukraine to repay Russia the $3 billion it borrowed back in December. The money was given directly to kleptocratic Ukrainian president Viktor Yanukovych in order to buy his fealty; now that Yanukovych is an international pariah and Russia has seized Crimea instead, in what you might call the geopolitical equivalent of a debt-for-equity swap, Ukraine has no legitimate reason to make its payments on the loan.

But there’s a problem here: the loan was not, technically, a bilateral loan from Russia to Ukraine. Instead, it was structured as a private-sector eurobond. As Stephen Gandel says:

There are a lot of other Ukrainian eurobonds out there that look similar to the ones Russia is holding, so not paying the ones Russia is holding will have larger implications for all of Ukraine’s debt, causing prices to fall and interest rates to rise. What’s more, Russia could sell its bonds to the market… That may make a court less likely to invalidate the debt, and Ukraine less willing to do so, if it is held by a private investor, especially a non-Russian one.

This is a notorious vulture-fund move: a hedge fund buys bilateral debt from a sovereign, and then sues not as a sovereign but rather as a private-sector creditor. I can think of a few hedge funds which would be interested in Russia’s debt, if they could buy it at a discount to where the rest of Ukraine’s debt is trading. After all, to use a term you might have seen on this blog in the past, this loan is, legally, pari passu with all the rest of Ukraine’s bonded debt.

(In fact, this bond is arguably senior to the rest of Ukraine’s bonds, thanks to a very unusual provision which allows Russia to accelerate the debt if Ukraine’s GDP falls. But since there now seems to be no chance that Ukraine will pay the coupon on this bond, it’s going to be in default very soon anyhow.)

So, if Ukraine defaults on its $3 billion Russian eurobond, how can Ukraine’s allies prevent that default from having massive negative repercussions on the Ukrainian economy? Anna Gelpern has the answer: The United Kingdom, she says, should make the bonds unenforceable under English law.

Yanukovych’s good-bye bonds would not have to get bogged down in the doctrinal mess of Odious Debt precisely because they took the form of simple English-law contracts, freely tradable in the capital markets and enforceable in English courts… English courts may not have much sympathy for Russia. They may decide that invading a country, bankrupting it, and trying to collect would be too distasteful with or without Odious Debt. Supreme Court Chief Justice (and former President) William Howard Taft offered similar reasons when he refused to enforce claims by private creditors complicit in the escape of another kleptocrat in an international arbitration against Costa Rica in 1923…

To stop the debt from migrating to private hands and showing up in court, now is the time for the UK government to make the Yanukovych bonds unenforceable under English law.

If the UK parliament passes this kind of a law now, before Russia can sell its debt to a vulture fund, that would severely reduce any fund’s appetite for the bond, and therefore minimize the likelihood of the default getting litigated in London.

Gelpern adds — quite rightly — that now is also the perfect time to implement a general ban on countries selling their bilateral debt into the private markets. I’m unclear on what form such a ban would take, or how it would ever be enforced, but as a principle it’s a really good idea.

Even if the UK passes a non-enforcability law, however, the problem of the Russian bond is not going to go away for Ukraine. I’m sure there are cross-default provisions in the rest of Ukraine’s debt, which means that Ukraine’s existing bondholders are likely to be able to accelerate whenever they feel like it. Again, think vulture funds here: a small group of aggressive funds could quite easily buy up 25% of one of Ukraine’s other bond issues, and then declare the whole amount due and payable immediately. As a result, even if Russia never gets its $3 billion back, and never sells any of its bonds, the structure of the December deal could still come back to haunt Ukraine.

All of this was entirely deliberate on Russia’s part. And of course the damage that Russia caused to Ukraine by structuring its loan as a bond is pretty much nothing, compared to the damage it’s causing by seizing Crimea. But it is a reminder that wonky sovereign-debt distinctions can have real geopolitical importance. As Argentina, for one, is well aware.


First, Ukraine was essentially bankrupt in November 2013: actually, the poor state of its finances is the main reason why it asked for the credit and for gas discount. The following three months its government was paralyzed by Occupy Kiev protests; many more Ukrainians were too busy with protests or afraid of the protests to be productive. The country either was going to ask for more help, or default on its debts even without the coup d’etat / revolution / government change.

Second, though a 22 year history of dully elected kleptocracy contributed mighty to Ukrainian woes, the main reason was different. A fragile balance between voters blocks forced all governments to avoid obvious but unpopular decisions, to kick a proverbial can down the road. Wast agricultural regions are overpopulated: modern agricultural technologies cannot use so many hands. They are subsidized by industrial regions. However, the industrial regions are nothing but a huge rust belt. Whatever coal mines and plants did not close yet, it happens mostly due to a government support.

Ironically, the capture of Crimea slightly improves Ukrainian finances, because the net subsidized region used to receive more funds from the state coffers than it contributed as taxes.

As a side note, to my understanding the discussed Ukrainian bonds were issued not in UK, but in Ireland.

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The bank tax rises from the dead

Felix Salmon
Feb 26, 2014 06:05 UTC

Back in January 2010, Barack Obama — flanked by Tim Geithner, Larry Summers, and Peter Orszag — unveiled a new tax on big banks, or a “financial crisis responsibility fee”, as he liked to call it. Of course, this being Washington, the initiative never got off the ground, and was largely forgotten — until now:

The biggest U.S. banks and insurance companies would have to pay a quarterly 3.5 basis-point tax on assets exceeding $500 billion under a plan to be unveiled this week by the top Republican tax writer in Congress.

This doesn’t mean the tax is likely to actually see the light of day, of course — but the fact that it has some kind of Republican support has surely breathed new life into a proposal that most of us thought was long dead. After all, the initial proposal was designed around the idea that the tax would allow the government to be repaid for the cost of the TARP program — a goal which has now pretty much been met.

There are some interesting differences between the Obama tax of 2010 and the Dave Camp plan of 2014. The Obama tax was on liabilities; it specifically excluded deposits (which already have a sort-of tax associated with them, in the form of FDIC insurance); and it would have been levied on all financial institutions with more than $50 billion in assets. It was set at 0.15%, and was designed to raise $90 billion over ten years.

The Camp tax, by contrast, is on assets, which means that deposits sort-of get taxed twice; but that means it can also be set much lower, and the size cap be raised much higher, while still raising the same amount of money. Camp’s tax is a mere 0.035%, and is applied only to assets over half a trillion dollars. It’s designed to raise $86 billion over ten years — although, confusingly, the Bloomberg article also says that “it would raise $27 billion more over a decade than the president’s plan would”.

I like the simplicity of the Camp plan, although I would have preferred to tax liabilities rather than assets. After all, it’s not size that’s the real problem, it’s leverage, and it’s always good to give banks an incentive to raise more capital and less debt.

I like the way that it’s targeted: just ten US institutions would account for 100% of the revenues from the tax. The list in full: JPMorgan; Bank of America; Citigroup; Wells Fargo; Goldman Sachs; Morgan Stanley; GE Capital; MetLife; AIG; and Prudential. None of them need to be as big as they are, and between them they’re more than capable of coming up with $9 billion a year to help make up for the fact that they each pose a huge systemic risk to the US economy.

At heart, this is a Pigovian tax on something (too-big-to-fail financial institutions) we don’t want, and often Pigovian taxes are more effective than regulation when it comes to minimizing such things. What’s more, it’s sharp enough to hurt: JPMorgan, for instance, would have ended up paying about 15% of its 2013 net income in this one tax alone.

For exactly that reason, however, I’m still skeptical that the tax will ever actually arrive. Those ten institutions are extremely powerful, and are more than capable of persuading politicians on both sides of the aisle to vote against a tax which singles them out for pecuniary punishment. The tax was a good idea in 2010, and it’s a good idea today. But it has very little chance of ever becoming a reality.


Isn’t 3.5bp/quarter pretty much the same rate as 15bp/year?

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Is there opportunity in art history?

Felix Salmon
Feb 18, 2014 23:40 UTC

Last month, at an appearance in Wisconsin, Barack Obama made a mild dig at art history graduates like myself. “A lot of young people no longer see the trades and skilled manufacturing as a viable career,” he said, “but I promise you, folks can make a lot more potentially with skilled manufacturing or the trades than they might with an art history degree.”

It took Obama roughly 1.5 seconds to backtrack — or at least to emphasize that he loves art history. “I’m just saying,” he clarified, that “you can make a really good living and have a great career without getting a four-year college education, as long as you get the skills and training that you need.”

This is a really important point. We’re living in a world where the cost of college education is rising much faster than inflation, and saddling graduates with enormous debts which can’t even be discharged in bankruptcy. The result is that an art history degree has never been more expensive — and that you’ll be better off, in terms of total lifetime earnings, getting a vocational qualification in the trades than spending four years and a six-figure sum learning about the influence of Piero della Francesca on Jacques-Louis David.

Which is not to say that getting an art history degree is a bad idea. Virginia Postrel is the queen of this beat, and points out that even though art history graduates account for only 0.2% of adults with college degrees, a very impressive 5.9% of them are in the top 1% of incomes. In other words, someone with an art history degree is more likely to be in the top 1% than someone with a finance degree.

As Postrel says, the causation here is probably backwards, from family wealth to the decision to get a degree in art history — but still, an art history degree is nothing to sneeze at, which is possibly why Obama has apologized more formally for his remarks, in a (lovely) handwritten letter to an art history professor at UT.

I’m very sympathetic to the art historians here, and not only because that’s what I studied. The subject is almost ideal for teaching the kind of abstract-thinking skills that the next generation of graduates are going to need, in a world where a lot of number-crunching jobs are becoming rapidly automated. Studying art history means moving back and forth between words and ideas and images all the time, putting them together in novel ways while building on the work of countless smart people who came before you. I can hardly imagine a better qualification for much of the high-level knowledge work and ideation which will power the 21st Century economy.

But at the same time, the qualification is an expensive one, and (as I can tell you from my own experience, circa 1995) it’s not exactly easy to get a job as a fresh-faced graduate armed with nothing but an art history degree. The gamble is big, especially if you’re going into debt to get the degree, and frankly it’s not worth it. I wouldn’t have done it, if I had to borrow tens of thousands of dollars in order to get that degree. It’s much more sensible to pursue a vocational qualification which takes less time, costs less money, and gives you a much higher chance of getting a good job once you’ve earned it.

One of the big tasks facing the US economy is the challenge of reducing the cost of not getting a four-year degree. Not everybody can go to college, or should. The very small number of people who study art history are an elite minority; they’ll largely be fine no matter what. It’s the people who don’t go to a four-year college who need economic opportunities. And so it’s excellent news, as Obama says, that those opportunities exist. And that, on an economic level, they’re significantly more attractive than an art history degree.


I think that a lot of the problem is that people are treating a Bachelor’s degree in the Arts & Humanities like a technical degree. Studying Art History/Art/Creative Writing/Whatever does not mean that it’s the only thing that you can apply those skills towards. The auxiliary skills are what will get you a job.

Art History isn’t a degree for lazy people (I am an art professor, so I see this firsthand.). I’ve found that Art History majors tend to be the most organized, curious, and dedicated students in the classroom. It requires a lot of reading, writing, memorization, and analyzation. Many art students are scared to take art history courses because of how difficult it is to memorize 16+ things about 150+ works of art, to then only be tested on 10 of them.

Education is not just about learning a specific technical skill set, but also is learning how to THINK. Learning how to think critically and solve problems creatively is an invaluable skill that can be used in many occupations that are not directly related to degree field. Arts and Humanities majors are hungry for constructive feedback. They aren’t just interested in being told that they got the “right answer,” but instead they want to know how to improve their work.

There are more options than you think, and just because they aren’t directly arts related doesn’t mean that their degree has somehow failed them. (if this is the case, college has failed most people)

It’s a very disciplined degree, and an art historian could easily tackle law school. …Or a spreadsheet. Whatever they want.

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Pension politics

Felix Salmon
Feb 13, 2014 00:12 UTC

David Sirota has a very important scoop today: the PBS series “Pension Peril” has secretly* been funded by John Arnold, a billionaire powerbroker with an aggressively anti-pensions political agenda. This looks very bad for PBS — but it’s also bad for Arnold, who generally gets glowing press, and who would seem to have no good reason to have insisted on secrecy when writing the $3.5 million check that made the series possible.

The PBS series in question seems to fall uncritically into line with the beliefs of Arnold and other Very Serious People — that pension liabilities are a huge problem, and that the only way to fix them is to reduce the amount that pensioners get paid. But of course it’s not nearly as simple as that.

The John Arnolds of this world tend to assume that three things are always true:

  • Defined-contribution pensions are better than defined-benefit pensions;
  • Funded pensions are better than unfunded pensions;
  • Individual pensions are better than group pensions.

It’s easy to see why people think this way. If there’s no money, then what assurance do you have — really — that you’ll be paid? If you have to share your pension with others, how can you be sure that they won’t end up with more than their fair share? Isn’t it better to just keep all your money for yourself, and make sure to save enough that you can live well in retirement?

This is a pretty libertarian, every-man-for-himself view of retirement: it makes few concessions to the idea that there’s a societal obligation to the elderly, or that groups can achieve more together than they can individually. At heart, it’s a view which benefits people like John Arnold, who pay a lot of taxes, at the expense of the poorest members of society, who might take out more than they put in. And, of course, it’s a view which benefits successful investors, like John Arnold, over schmucks who have no idea how to best invest their paltry 401(k) funds.

In reality, big pooled pension funds are much more efficient — and generate much higher returns — than anything an individual is likely to be able to manage. And in the specific realm of public finance, the case for group-funded defined-benefit schemes is even stronger. That’s because public servants — police officers, elementary school teachers, you name it — tend to have much longer tenure at their jobs than, say, hot-shot fund managers. They are also willing to work for relatively low salaries precisely because they know that their pension benefits are good: that they don’t need to worry about how they’re going to make ends meet in retirement. That peace of mind is hugely valuable, and rarely factors in to the calculations of the pension opponents, who seem to think that worrying about your individual retirement investments is a good thing.

Around the world, indeed, in places like Hungary and Poland, the roll-your-own pension plan model is being, reversed, and governments are reverting to the “trust us” model. The mechanism has been particularly drastic in Poland, where the government recently confiscated some 150bn zlotys (€36bn) of Polish government bonds and government-backed securities, seizing them from private pension-fund managers. The Poles then cancelled those bonds entirely, which had the effect of reducing Poland’s national debt overnight, by a substantial 8 percentage points. Given debt-ceiling rules, that gives the Polish government a lot more room to run deficits than it had before. In return, the Poles who were counting on the retirement income which was going to be generated by those bonds are just going to have to make do with a standard pay-as-you-go system, where they’ll receive a state pension which is paid for out of general tax revenues.

This is not as dreadful as it necessarily looks at first blush. Governments can always find a way to reduce pensioners’ incomes, through taxes or any other means. And now, at least, those incomes will be less tied to the vagaries of market returns. Indeed, Poland isn’t all that far from the United States: although we do put a lot of government bonds into the Social Security trust fund, it’s entirely up to the government how much money pensioners take out of that fund. It can be less than the fund is earning, or more: the decision is political, and doesn’t bear much relation to the income being generated, or even whether the trust fund has any money in it at all.

Still, the Polish move is a pretty bad one. The pension funds still exist, but now they’ve lost most of their fixed-income component, so they’ve become a lot more volatile. The playing around with the national-debt figures is a silly, and dangerous, trick. And without strong domestic pension funds, Poland has now lost an important source of investment flows — the kind of money that helps to keep an economy innovative and productive.

So pension funds are, generally, a good thing. And when you have a pension fund, it’s a good idea to fund it well. But they’re not a panacea, and in general the answer to the problem of underfunded pensions is just to fund them better, rather than to start cutting benefits.

The John Arnolds of this world should remember one thing: it’s just as easy to tax retirement funds as it is to cut defined pension benefits. If America really needs to start taking money from future retirees, then maybe the politicians will start looking at a much juicier target — the massive tax expenditures being spent on things like IRAs and 401(k) plans. Those tax breaks are not fair — they benefit the rich much more than the poor. Maybe the sensible thing to do is to take those tax expenditures, and use them instead to shore up distressed public pension plans. If indeed those plans are in as much peril as John Arnold says they are.

*Update: Leila Walsh, the director of communications at the Laura and John Arnold Foundation (which also responded to Sirota’s article), emails:

You stated that the “PBS series ‘Pension Peril’ has secretly been funded by John Arnold.” This statement is entirely inaccurate. Information about the grant is available on the LJAF website. We have nothing to hide and have publicly disclosed the amount, term, and purpose of the grant.

WNET also issued a statement this afternoon that says, “The Arnold Foundation is a supporter of this initiative, which has been clearly disclosed on the three PBS NewsHour Weekend broadcasts (produced by WNET) that have included segments funded through this project.”

“poorest members of society, who might take out more than they put in”

It is dishonest to use a word like “might” in a sentence like this. You “might” be hit by lightening; or you “might” win $100 million in the lottery; or John Arnolds “might” go and sell all his possessions and give the money to the poor (Matthew 19:21) – ie highly unlikely possibilities compared to the almost certainty that the poorest members of society will take out more than they put in. And then there is this: “the United States: although we do put a lot of government bonds into the Social Security trust fund”.
Here is what Social Security says about the SS trust funds that receive SS taxes:

http://www.ssa.gov/oact/progdata/fundFAQ .html

“How are the trust funds invested?”

“By law, income to the trust funds must be invested, on a daily basis, in securities guaranteed as to both principal and interest by the Federal government. All securities held by the trust funds are “special issues” of the United States Treasury. Such securities are available only to the trust funds.”

“What happens to the taxes that go into the trust funds?”

“Tax income is deposited on a daily basis and is invested in “special-issue” securities. The cash exchanged for the securities goes into the general fund of the Treasury and is indistinguishable from other cash in the general fund.”

In other words, SS Trust money is treated just like ordinary tax revenue except that the government promises to repay these monies plus interest to the SS as needed. These trust funds are government debt obligations and can only be repaid by raising taxes (unlikely) or increasing overall government deficits.

http://www.salon.com/life/life_stories/i ndex.html?story=/mwt/feature/2011/04/02/ late_in_life_excerpt

“the first recipient of Social Security, a bookkeeper named Ida May Fuller, started to collect her checks in 1940. She proceeded to live another thirty-five years, long enough to witness the ascent and disbanding of the Beatles and the landing of the man on the moon. For her total $24.75 contribution, she received $22,888.92 in benefits”

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Be happy that Stan Fischer worked at Citi

Felix Salmon
Feb 10, 2014 18:30 UTC

Last week, Justin Fox had a great post entitled “How Economics PhDs Took Over the Federal Reserve”. The first Fed chairman of the modern era was a banker, Marriner Eccles; he was succeeded by Thomas McCabe, who had a bachelor’s degree in economics but whose main qualification was having been the CEO of Scott Paper. Then William McChesney Martin moved over to the Fed from Treasury; he was a former stockbroker and New York Stock Exchange president, and ushered in a new era:

Under Martin, regulating the economy through monetary policy pushed aside bank regulation to become the central bank’s No. 1 job. So hiring economists, and bringing people with serious economics backgrounds onto the FOMC, became a priority…

The new Fed Board of Governors (assuming the Senate confirms the latest nominees) will include veteran economics professors Yellen, Stanley Fischer, and Jeremy Stein, plus Lael Brainard, an economics PhD who has spent most of her career in Washington but did teach at MIT for a few years early in her career. The other three members are lawyers who have spent much or most of their careers in government. As for the Federal Reserve Bank presidents, eight of the 12 have economics PhDs and seven of those have spent much or all of their careers at the Fed. Two of the non-PhDs have spent their careers at the banks they lead, while only two bank presidents — Atlanta’s Dennis Lockhart and Richard Fisher of the Dallas Fed — fit the pre-1950 Fed mold of successful bankers/businessmen doing a stint as central bankers.

The ascendancy of the professoriat didn’t serve the Fed particularly well: without real-world business or banking experience, the FOMC ignored the problems of growing leverage, particularly in the financial sector, for far too long. Alan Greenspan’s Fed was run on laissez-faire principles: the market is a self-correcting mechanism which doesn’t allow banks and shadow banks to become too leveraged. Or, to put it another way, if investors are happy buying structured credit products at razor-tight spreads over Treasuries, then who are we at the Fed to spoil their party.

When the credit crisis first hit, in 2007, worries spread out from Wall Street: mortgage bankers first, then banks more generally, then the New York Fed, which is very plugged in to real-world concerns in the financial sector. The problem was the final leg, from the New York Fed to the Federal Reserve Board: for all that there might be a problem in practice, the economists in Washington couldn’t see how it would be a big problem in theory. And so they convinced themselves, in the notorious words of Ben Bernanke, that the subprime problem was going to be “contained”.

It’s therefore a real problem that the American central bank — which is, after all, a bank, and an incredibly profitable one, at that — has precious few actual bankers on its governing board. I’m all in favor of having a significant number of monetary economists who can think deeply about the effect of short-term interest rates on employment and inflation. But at the same time, it would be nice to have a few people who understand financial markets, and the pass-through mechanisms which define them. Not to mention a relatively sophisticated understanding of what banks actually do, on a day-to-day basis. After all, the Fed is the main prudential regulator of the banking system, and its board needs to understand where the stresses are.

All of which serves to underscore what an excellent nominee Stanley Fischer is as vice-chair of the Federal Reserve. Yes, he’s a professor — indeed, he wrote the definitive macroeconomics textbook, which is now in its twelfth edition and still going strong. He’s also a deeply experienced central banker and international policymaker. But he also has some real-world banking experience, having worked in a senior level at Citigroup from 2002 to 2005.

According to Pedro da Costa, however, Fischer’s years at Citi will count against him when he appears at his confirmation hearing:

The nominee for Fed vice chairman is likely to face questions at his confirmation hearing about whether he would be a tough regulator of big banks after earning several million dollars at one.

This is, let’s say, unhelpful. Yes, Fischer earned good money when he was at Citi. But the reports about his financial disclosure form I think draw too much of a causal connection between his Citi tenure and his wealth. Here, for instance, is Bloomberg’s Joshua Zumbrun:

While Fischer has spent much of his career as an academic and government official, he served as vice chairman of Citigroup Inc. from 2002 to 2005 and amassed a personal fortune of between $14.6 million and $56.3 million, a sum that would make him one of the wealthiest Fed officials.

The implication here is that Fischer had a modestly-remunerated public-service career before he joined Citi and cashed in. Which really isn’t true. Fischer’s tax-free income at the World Bank and IMF was substantial, and he surely made just as much money when he was at MIT. But the real money, I’m quite sure, came from that textbook, which he co-wrote with Rudi Dornbusch. It was the macroeconomics textbook of the late 1970s, and, like all standard textbooks, became something of a license to print money. (The trick is to keep on updating the textbook with new editions, making old second-hand versions useless and forcing students to pay three-digit sums for the version being used in class.) If Fischer took his textbook proceeds and invested them conservatively into the great bull market of the 1980s and 1990s, that alone would make him a very wealthy man today.

Fischer left Citi before it imploded, but he was there while it was manufacturing many of the toxic subprime products which ended up proving all but fatal. Mortgage products weren’t Fischer’s area, but he did work very closely with Robert Rubin, who was blithely unconcerned about the risks being built up. That’s an incredibly important and valuable lesson to learn: you can’t trust wise men like Rubin to see what’s going on in front of their face. And when bank CEOs tell the Fed board that they have everything under control, Fischer will know better than most just how little those statements can be trusted.

I doubt that Fischer will have any real problems being confirmed. Any senators who want to cause mischief can certainly do so — they can point to his private-sector experience, or they can bellyache about how he has various different nationalities rather than being “100% American”. But Fischer is probably the best central banker in the world; it would be completely insane for the Senate to block him. Especially given that he brings some of the actual banking experience that the Fed so desperately needs.


LOL Felix ascribes to the “Great Man” theory of history, which is largely not true and anachronistic after-the-fact rationalizing. Does Felix really think that the Fed has influence over the economy? Another Fischer, Fischer Black, who won the Nobel in 1997, thought not. And the Fed has staff that does the hard work behind the scenes; the chair is largely a figurehead. As for voting, it’s been found that most of the players follow the lead of the head, that would be Yellen. I doubt therefore that nixing Fischer would be so bad, and, like the posters say before me, might send a message that rich fat cats from Citi are not to be rewarded.

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Those noisy payrolls figures

Felix Salmon
Feb 7, 2014 16:13 UTC


The chart of the day comes from Betsey Stevenson, and helps to show just how noisy the payrolls data really are. The big headline figures of the day, 113,000 is ostensibly the increase that we saw, in January, in the number of people on American payrolls. It’s a disappointing number, while a print of say 200,000 would have been decidedly encouraging.

But just look at how we got to that 113,000 figure. We took January’s workforce, of 135,396,000 people, and then subtracted December’s workforce, of 138,266,000 people — for a total decrease of 2,870,000 jobs. But we know that the number of jobs in America always decreases in January — even when the economy is surging. It’s cold out, making outdoor jobs very difficult to do, and the Christmas seasonal jobs are all in the past. So the BLS institutes some seasonal adjustments. In this case, it subtracted 880,000 jobs from the December number, and it added 2,103,000 jobs to the January figure.

All of which means that the 113,000 headline figure is, in fact, 135,396,000 + 2,103,000 – 138,266,000 – 880,000.

You want to trade on that being 70,000 jobs lower than you thought it would be?

But wait: we’re not even close to being done. This month’s payrolls release is much longer than normal — 2,465 words — because it has to explain a lot of changes. As it says in a big box at the very top of the page:

Changes to the Employment Situation Data

Establishment survey data have been revised as a result of the annual benchmarking process and the updating of seasonal adjustment factors. Also, household survey data for January 2014 reflect updated population estimates.

These changes are not small: last month’s preliminary number, for instance, was revised up — on a seasonally adjusted basis — to 137,386,000 workers from 136,877,000. That’s a difference of more than half a million people.

The noisiness of the payrolls report is good news, truth be told. Now that the taper is well under way, there’s very little doubt about the direction of monetary policy for the next year or so. We’ll taper all the way to zero, QE will be over, and then we’ll look at where we are and start wondering whether and when rates might actually start rising. The employment situation when QE is finally over will have almost nothing to do with what happened this month, or next month, or the month after that. Most importantly, it will have to do with the number of people actively looking for work: as the unemployment rate comes down, and the economy continues to grow, will discouraged workers start returning to the workforce, or at least start looking for work again?

There are a lot of unemployed and underemployed workers on the sidelines of the economy, who would work much more if work was available. The Fed’s full-employment mandate means that it’s Janet Yellen’s job to find work for those people. How she’s going to interpret that mandate is something we’re not going to get a real hint of for a long time yet. But one thing’s for sure: we’re not going to be able to guess anything useful by looking at today’s payrolls report.


Felix, great that you’re pointing this out. The press release also discloses the margin of error which tells the same story. It’s sad that the mainstream press is ignoring this.
We really shouldn’t be dumbfounded by why Wall Street trades on the “noise”, it isn’t that surprising. You need variability (i.e. “noise”) to make money. If it’s easy to predict what the number is, then the profits would disappear.

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Puerto Rico needs to prepare for its default

Felix Salmon
Feb 5, 2014 23:40 UTC

Ryan McCarthy has a good round-up of Puerto Rico’s debt problems, which have now been exacerbated by S&P downgrading the island’s bonds to junk status. (Moody’s and Fitch are certain to do so as well, in short order.) For a good one-stop overview of most of the big issues, I can recommend Nuveen Asset Management’s note, which includes this chart:

Screen Shot 2014-02-05 at 5.21.10 PM.png

What you’re seeing here is a vicious cycle: as debt problems pile up, economic activity decreases, which causes even bigger debt problems, even lower economic activity, and so on. Puerto Rico is now shrinking at a 6% annual pace, and that number is probably going to get worse before it gets better. The chances of the island’s economy actually growing at any point in the foreseeable future seem remote: indeed, the country has essentially been in one long and nasty continuous recession since 2006.

Puerto Rico has $70 billion in debt outstanding, all of it needing to be repaid with interest — and the simple fact is that there’s no way it’s going to be able to do that, if its economy continues to shrink and its most talented nationals continue to decamp for the mainland, where their prospects are much brighter. Labor mobility from Puerto Rico to the rest of the US, and particularly to Florida, has never been higher, while most of the migration in the other direction comes in the form of retirees, who are not exactly going to kick-start the economy. In fact, in terms of the labor force participation rate, they’re just going to make matters worse, on an island where only 1.2 million of the 3.4 million inhabitants are employed.

In many ways, Puerto Rico is similar to those other tourist destinations, Portugal and Greece — it’s highly indebted; it’s not particularly well educated (only half of Puerto Ricans over 25 have graduated from high school, and only a quarter of high-school graduates go on to get a bachelor’s degree); and it is hobbled by being unable to devalue its currency.

All of this is a clear recipe for default: if Puerto Rico can’t repay that $70 billion in debt, then it won’t. The only alternative is a bailout — but as Martin Sullivan explains, the US government has already extended a back-door tax-code bailout worth some $2 billion per year, and even that is both insufficient and constitutionally dubious. A more explicit bailout is not going to happen — not when Detroit is being left to deal with the ravages of bankruptcy on its own.

The good news is that the increasingly-inevitable default is not hugely harmful in itself. It’s not fully priced in: the funds owning Puerto Rican debt are going to take more losses, if they don’t sell now. And the insurers who have wrapped some $15 billion in Puerto Rican debt are going to have to get used to making a lot of coupon payments for quite a long time. But that’s their job. This is the way debt markets should work: if you lend money at high rates of interest to someone who can’t pay it back, then you have to understand there’s a pretty good probability of default.

The default will be messy, however, since there’s no chapter of the US bankruptcy code which encompasses Puerto Rico. A lot of different court cases will be held in a passel of different jurisdictions, and a lot of lawyers will get rich. In the end, everybody is going to have to take a nasty hit — including the island’s retirees, whose pension fund is woefully underfunded. From a legal perspective, there will be some fascinating arguments about sovereign immunity, and whether (and how) bondholders can attempt to enforce their contractual rights, absent any kind of overarching bankruptcy regime. In the end, restructuring terms could end up simply being dictated by Congress.

Still, the important thing is not the process, it’s the final outcome. If Puerto Rico manages to emerge from default freed of its massive debt burden, it will finally have a chance to start growing again. If it doesn’t, it won’t. The problem is that there’s no easy way of herding the bondholders and bond insurers, all of whom are going to want to maximize their financial recovery, thereby making Puerto Rico’s real recovery that much more difficult.

My advice to the Puerto Rican government, then, is this: start having quiet conversations in Washington about a piece of legislation which would give the island the legal freedom and ability to restructure its debts in a clean, one-and-done manner. Such a law would not be a bailout: it would involve no money flowing from DC to PR. But it would allow Puerto Rico to default on its debt and come out the other side, without the risk of years of legal chaos. While bondholders would squeal, at least they would get certainty. And Puerto Rico would get something much more valuable still — an opportunity to finally drag itself out of its horrible recession.


Also: PR will prioritize its voters’ pensions over Yankee bondholders who don’t vote.

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