Streetwise Professor

There is an I-told-you-so tizzy going on about the revelation of the BATS exchange that a system (or programming) error had resulted in the execution of about 450,000 orders at prices worse than the best bid/offer (BBO).  Oh, the humanity!

A little perspective here.  According to BATS, the total loss (which is a wealth transfer, mind you) totaled . . . brace yourselves now . . . $420,000.  Excuse me.  $420,360.

There seems to be some presumption that there was a Golden Era of trading, before the invasion of the dreaded machines, when intermediaries had hearts of gold rather than a hunger for it.  When bids and offers were never violated.  When there were never trading errors.

Wrong.  There was no Golden Age.  Nirvana is still just a band.

Think that the BBO was never violated on exchange floors?  Think again.  Sometimes this was inadvertent in the chaos of the pits/trading posts during active markets.  Sometimes it was very advertent (is that a word?)  May I remind everyone of the FBI sting on the CME and CBT, which discovered that some brokers would collude with locals to execute customer orders at off-market prices, and split the proceeds, sometimes delivered by bagmen-literally, guys passing paper bags of bills.   Given the relatively crude time stamping of trading cards, it was very difficult to construct an accurate audit trail.  Trades couldn’t even be sequenced with precision, and since the bid/offer were not recorded continuously or time stamped, it was impossible to see whether  a trade violated the BBO.  There were pit monitors who tried to keep an eye on things, but no human monitoring was capable of detecting all violations.  Indeed, the sociology of the floor and the member domination of exchanges (a subject I’ll turn to shortly) meant that social pressure discouraged cracking down too aggressively, particularly on the most powerful.

Enforcing the BBO on the floor was in many ways constrained by a lack of data.  If anything, current market monitors have the exact opposite problem: they are drowning in a sea of data.  But as BATS shows, it is possible to go back through years of this data and pick up mistakes that cost customers about $1 per error.

Then shall we discuss out-trades?  Out-trades-trading errors, where trade terms submitted by the buyer and seller didn’t match-were common on the floor.  Brokers were on the hook for errors, and there were stories of brokers writing six figure checks to make a customer whole for a loss.  I would not be surprised that on an inflation adjusted basis, a single broker wrote a check to a customer that exceeded $420,000 in 2013 dollars.

But this reality of the way things were doesn’t stop the hue and cry about the fallen state of today’s computerized markets.  The biggest huer-and-crier (emphasis on the crying) is Jackass Joe Saluzzi of Themis Trading.  Here Joe outdoes himself, by suggesting that we need to go back to the days of non-profit exchanges in order to restore public confidence in broken markets. (h/t Blivy.)

JJ apparently believes the old mutual non-profit exchanges were freaking charities, like the March of Dimes or something.  Uhm, no.

Let’s look at the facts.  The old mutual exchanges were cartels of intermediaries.  They restricted membership in order to enhance the rents of those members.  For decades, most of them ran brokerage cartels that fixed commissions.  Some created monopoly privileges for some members (e.g., NYSE specialists).  Others (NASDAQ comes to mind) had order handling rules that basically precluded public customers from competing with member market makers in supplying liquidity: NASDAQ was also the nexus of a flagrant conspiracy among market makers to fix spreads at supercompetitive levels.

Non-profit status had nothing whatever to do with the charitable urges of old time brokers and market makers.  As I showed in research done just as the transition from non-profit to for-profit status was occurring, exchanges chose the non-profit form because the non-distribution constraint inherent in that form prevented the exchange from choosing pricing policies that transferred wealth among heterogeneous members with very specialized human capital.  (An abbreviated version of the argument is here.  The full version was published in J. Law & Econ. in 2000.)  Electronic trading undermined the rents and the specialized assets that drove the choice of non-profit form, so the move to electronic trading in turn impelled the transformation of exchanges to for-profit entities.

In other words, non-profit form was chosen by very greedy, profit-driven individuals to protect their profits.  And a good chunk of those profits resulted from the exercise of market power and the adoption of collusive arrangements by exchanges.

So spare me nostalgia.  Indeed, methinks that a good deal of the nostalgia-and the related criticism of modern electronic markets-is a shriek of rage by those who profited under the old system, and are furious that someone ruined their racket.

Joe does get one thing right (cf. blind hog, acorn).  He attributes the specific BATS problem, and the increased complexity of the equity markets, to RegNMS.  This is correct.  The information-and-linkages approach chosen by the SEC led it to adopt regulations that socialized order flow.  This was done with the explicit goal of encouraging competition among trading platforms.

Another example of “be careful what you ask for: you might get it.”  Pre-RegNMS, NYSE executed about 85 percent of the trades in its listed stocks, and the bulk of the remainder was executed in Third Markets which did not contribute to price discovery.  NYSE was essentially the natural monopoly supplier of price discovery.  Now, NYSE market share is in the low-20s, and executions are shared pretty much equally among a handful of platforms.

But this socialized order flow model requires linkages between the execution venues.  It is that necessity that accounts for the complexity of the current equity markets.  The interconnection imperative is directly responsible for the proliferation of order types that many find so vexing, and which indeed give advantages to specialized electronic traders.  Note that the BATS error was in an order type designed to ensure compliance with RegNMS rules relating to the BBO.

You can criticize this market structure.  But if you do so, you have to grasp the nettle of the fundamental trade-off.  The choice is binary.  You can choose to socialize order flow, or not.   If you do, you get something like the current equity market structure, with intense competition among execution venues linked by a complex web of fragile connections and a proliferation of order types.  If you don’t, you get something like the pre-RegNMS market structure, or futures market structure past and present.  A market that tips to a single execution venue that exercises market power, either by restricting access (the old mutual model) or by charging supercompetitive prices (the new for-profit exchange model).

Those are the choices.  But the debate is almost never framed that way.  Instead, bat sh*t crazy people like Saluzzi (enabled by folks like the CNBC talking head in the BATS Hit video) take up all the oxygen screaming about how bad the current market structure is and retailing myths about some Golden Age that never was.

Political economy considerations almost certainly ensure that the SEC is not going to go back on RegNMS, and it is truly invested in the information-and-linkages approach it chose.  So we are likely to see a continued series of controversies over problems that are inherent in the socialized order flow model.  The SEC will pull its chin, and deal with each problem as it appears in an ad hoc way, just adding to the complexity as the new games are devised to exploit the new rules implemented to stop the old games that exploited the old rules.  This will make for never ending media appearances for the likes of Joe Saluzzi, but  don’t buy his line about the good old days.  The good old days that existed when regulation effectively opted for the other binary choice (no socialization of order flow) weren’t all that great.  There was a different set of problems, and a different set of people and firms profiting off the inefficiencies that inhere in the network nature of financial trading.

One of the predictable though unintended consequences of Frankendodd (and its European cousins) will be to increase concentration in the banking sector.  Not just predictable: predicted, including by me (notably at the JP Morgan Commodity Conference in October 2011, and here on SWP).

The logic is fairly straightforward.  Frankendodd creates a huge regulatory overhead that in turn leads to scale economies.  Smaller-to-medium-sized entities will not be able to afford these overhead costs, and will exit the business, and the bigger firms will get bigger.  The overall level of activity is likely to go down as a result of the exit and expansion, but the biggest firms are likely to get bigger even if the market overall gets smaller.  Moreover, the capital and collateral requirements in Frankendodd, including in the derivatives title, have disparate impacts on different market participants  Since the smaller entities typically have higher capital costs than the bigger ones, this increase in capital needs to support trading businesses in particular will lead the smaller market participants to contract more than the bigger ones; this increase in their capital costs may also induce them to exit altogether, especially when taken in conjunction with the increase in regulatory overhead associated with trading businesses in particular

Given that Frankendodd was allegedly intended to address the too big to fail problem, it is perverse that one of its predictable consequences is to increase concentration, and likely increase the size of the biggest firms in the market.

We may be seeing the first major move in this direction, just as Frankendodd’s big boot is starting to kick in.  Morgan Stanley announced deep job cuts, and rumors are flying that it will exit the fixed income trading business:

Now the storied company — whose take-no-prisoners trading desks have at times been rivaled only by firms like Goldman Sachs — is cutting even deeper, raising questions among some on Wall Street about whether it should spin off or ditch much of its trading business as its Swiss rival UBS has, a suggestion the firm eschews.

. . . .

Morgan Stanley’s board, said people briefed on the matter, has discussed closing its fixed-income department. Instead, the firm is shrinking the unit, arguing that it is important to offer its customers those trading services. By cutting jobs and costs and exiting lines like structured products and other complex financial investments and focusing on less risky, less capital-intensive businesses like the trading of interest rates, executives contended that the division can generate a healthy return.

So they’ve discussed it, but decided to keep it in a shrunken state.  But it may have to revisit the more drastic measure:

In recent years, the fixed-income department has not been able to make enough money to cover the cost to Morgan Stanley of this capital, according to people briefed on the matter but not authorized to speak on the record

If it hasn’t covered its cost of capital pre-Frankendodd, lotsa luck with covering it afterwards.

Frankendodd will cause a contraction of the financial sector, which isn’t necessarily a bad thing.  But the contraction will be uneven, and the fundamental nature of Frankendodd favors a relative expansion, and perhaps an absolute expansion, in the biggest-the JP Morgans and Goldmans and Deutsche Banks.

Hardly what was intended.  But that’s different to say it wasn’t predictable.

Stephen Bainbridge, an eminent UCLA law prof of my (slight) acquaintance, has been rocking on the Ace Greenberg suit against the federal government.  He brutally eviscerates those in Congress and the media that exhibited their high dudgeon at the temerity of AIG’s board in even considering joining the Greenberg suit.  But more importantly, he reinforces and complements the point in my previous post on the subject.  Specifically, he argues that there are serious issues at stake here.  That the fact that the government provided “assistance” to AIG during crisis conditions does not give the government carte blanche to dictate the price of that assistance, if in so doing (a) it tramples on the legal rights of AIG shareholders, and (b) expropriates wealth from those shareholders by exploiting AIG’s financial distress to impose punitive conditions on that assistance.

During the crisis, the government asserted that the gravity of the emergency justified extraordinary measures that trampled well-established legal protections and procedures.  The terms of the Chrysler bailout are one clearcut example.  The AIG case is plausibly another.

This turns things on their head.  If particular measures-like protecting AIG’s derivatives counterparties-are so important that they create a substantial amount of wealth, paying fair compensation shouldn’t be a problem. Moreover, doing that reduces fears that the government will expropriate wealth in the future, and that limits the chilling effects on investment that expropriation threats engender.  In contrast, the attitude that property and legal rights are forfeit when the government in its wisdom deems that emergency conditions justify it, has an extremely corrosive effect.

Put differently, a government that creates a reputation for protecting property and legal rights even during extreme circumstances also creates an environment that is conducive to growth.  In contrast, one that creates a reputation for opportunistically exploiting crisis situations by transferring wealth to itself, or to favored constituencies (like Chrysler’s unions), creates an environment that is hostile to investment and growth.

Sort of like Russia, in other words.

The US Senate s sometimes called the World’s Greatest Deliberative Body.  At times-most times, in fact-it seems that it would be more apt to call it the Deliberative Body With the World’s Greatest Proportion of Room Temperature IQs.  Many notable dimwits come to mind-Barbara Boxer, for instance. But the dearly departed (from the Senate, anyways) Blanche Lincoln was oh-so-special in her dimness.

As a sort of parting gift prior to her electoral rout in 2010, Blanche succeeded in inserting the eponymous Lincoln Amendment into Frankendodd.  This was the “swaps push out” provision, which precluded any “swaps entity” from receiving assistance from the Federal Reserve.  This requires banks to “push out” dealing in derivatives to separately capitalized subsidiaries that have no access to the Fed discount window, or other sources of federal support.

Crucially, the Lincoln Amendment was limited: basically, only equity derivatives, some credit derivatives, and commodity derivatives (with the exception of gold) were pushed out.  Banks were allowed to maintain their bread-and-butter rates derivatives business, as well as some of their credit trading businesses.  I guess the theory was that commodities are scary risky, but banks can’t jeopardize themselves by playing in interest rates.  Or something.

Well, that’s true of US banks, anyways.  But due to the meticulous drafting that characterizes Frankendodd, branches of foreign banks cannot avail themselves of the same exemptions.  This includes behemoths like Barclays and Deutsche Bank.

So now the Fed is trying to clean up after Congress, endeavoring to find ways to blunt the effects the provisions of the Lincoln Amendment on foreign banks.  Easier said than done, because despite the fact that “Ms Lincoln called her amendment’s treatment of foreign banks’ uninsured US branches a ‘significant oversight’ that was “unfortunate and clearly unintended. . . . the language of the legislation is clear, regulators are unable to use [Lincoln’s] statements on the Senate floor to unilaterally change the implementation of the law. ”

Good times.  Good times. Just another of the land mines lurking in Frankendodd.  Think of how many more are to be found.  And how many are buried in Obamacare.

Like I said.  Good times.

Lord knows, I yield to no one in my disdain for Timmy! But with the appointment of consummate DC apparatchik and noted infighter Jack Lew to succeed Geithner at Treasury, I think we may soon look back wistfully on Timmy!’s days as SecTreas.  I am missing him already.

AIG has attracted a lot of ridicule and anger with the announcement that it might join Ace Greenberg’s suit contesting the Constitutionality of the firm’s bailout in 2008.  The prevailing theme is that AIG is being extremely ungrateful.  If the Feds hadn’t bailed it out, it would have gone bankrupt, and its shareholders would have gotten nothing.

Well, Greenberg’s point is that its shareholders did get nothing, and gave up something valuable in return.  That the government exploited AIG in its hour of distress.

I realize that the suit has a snowball’s chance in hell, and that there is a rather tragicomic aspect to it.  But, contrarian that I am, I feel obliged to offer up a couple of counterpoints to the conventional wisdom.

Most notably, bankruptcy law incorporates several provisions intended to protect the claimants of financially distressed firms from the depredations of would-be saviors.  Preference and fraudulent conveyance provisions of the bankruptcy code permit other creditors to claw back money from a “savior” that buys assets from a distressed firm at bargain prices.

AIG didn’t declare bankruptcy, so this isn’t a legal issue.  Moreover, it would be a remedy available to creditors, not shareholders.  But the basic principle is pretty clear: you can’t take advantage of a firm’s financial distress to extract unduly favorable loan terms, or to buy the firm’s assets at unduly favorable prices.

That’s the gravamen of Greenberg’s claim.  That the Fed and Treasury obtained control of AIG at a fraction of its true value because the firm had no alternative but to accept these terms.  “The firm was  going to fail if it didn’t accept my terms” doesn’t fly in bankruptcy court.  Given the implicit principle in that, why shouldn’t the same argument apply to the US government?  I would actually suggest that the question should be: why shouldn’t that argument apply with special force to the US government, given its disproportionate power, especially during such extraordinary times?  Bankruptcy law is structured to protect the creditors of desperate firms from the the predations of those who exploit that desperation.   An efficiency-driven economic story can be told to justify that structure.  That story applies when the potential exploiter is the government.

Interestingly, at the time of the crisis, Bernanke testified before Congress that due to the liquidity crisis, market prices of assets were far below their fair values based on discounted expected cash flows.  He did so, in part, to justify Fed assistance to everyone from banks to money markets: “It’s a liquidity problem, not a solvency problem, so we’ll get paid back.  It’s not really a bailout.” Given the evaporation of liquidity and the implosion of asset markets at this time, it is pretty clear that conditions were extraordinary, and those with money to spare-like the Fed and the Treasury-wielded the whip hand.  The liquid were in a dominant position to extract wealth from the illiquid.

And that in a nutshell is what Greenberg is claiming that the Fed did: the Fed exploited AIG’s illiquidity (which reflected the general implosion of liquidity) in order to get assets for a song.  So Greenberg’s claims should not be dismissed out of hand.  Indeed, Bernanke’s Fire Sale Chat provides considerable validation for his claims.

That said, there are other considerations.  Moral hazard, for instance.  Bagehot’s dictum for the lender of last resort-lend against good collateral, at penalty rates-reflects a balance between liquidity and moral hazard considerations: the penalty rate provides a disincentive to court trouble.  Pour encourager les autres, it was appropriate to pay below fair value for AIG’s assets/equity, lest others take excessive risks in the comfort that a Fed put would protect them from the worst.

But how much below?  That’s a harder question.  But it’s by no means obvious that 100 percent below is the right answer.  Those responding to Greenberg and AIG in such high dudgeon believe it is the right answer.  Contrarian that I am, I wouldn’t be so sure.

Proving again that Al will never let consistency of principle stand between him a a big payday, he is walking away from the sale of Current TV (surely you’re eyes are always glued to that, right?) to Al Jazeera with a reported $70 million.  Al Jazeera, of course, is largely funded by the Qatari government.  And Qatar is a major producer of the fossil fuels that Al dreads so much, particularly natural gas.  Indeed, Qatar is the world’s largest exporter of LNG, accounting in 2011 for 75.5 million tons out of a world total of 241.5 MT, far outdistancing number two exporter Malaysia which exports only a third of Qatar’s volumes. Quite impressive, given that Qatar only began LNG production in 1997.

But maybe there is some consistency here.  Al hates fracking.  Qatar hates fracking too.  Increases in output of gas in the US due to the fracking revolution, and the potential migration of that technology to other regions, represents a major threat to Qatari export volumes, and the price it can get from those exports.  Qatar is already cutting back spot volumes trying to lock Asian customers into long term contracts in anticipation of increased competition resulting from increased output of non-conventional gas, as well as gas offshore gas produced in Australia.

Qatar is no doubt looking for ways to crank up the propaganda war on fracking, and Current TV’s prog audience (to the extent it has an audience) is highly receptive to that message.  Need proof of that? New York governor Andrew Cuomo is allegedly spiking a state-commissioned report that demonstrates that fracking does not present a health risk. Why? Well let’s hear it from the horse’s mouth (and yeah, the other end too), the New York Times: “Mr. Cuomo, a Democrat, has long delayed making a decision, unnerved in part by strident opposition on his party’s left.”

So Current, which would not even enter into negotiations to sell to Glenn Beck because “they wanted to sell to someone they are ideologically in line with”, has apparently succeeded in that objective.  They found a fellow fracking foe to buy the network, therefore no doubt easing whatever qualms they have about selling to a network known for Jew hatred, which receives funding from a country that has become notorious of late for being the main arms trafficker for civil wars in Syria, Libya, and now Mali, with many of these weapons allegedly going to Al Qaeda affiliates.

Qatar bears watching.   It is difficult to figure out what its game is.  It is, as just noted, heavily involved in intramural Muslim conflicts in Africa and the Middle East.  Some of this is easy to understand: fighting Syria is a proxy war against arch-foe Iran.  The broader support for radical Islamic elements is far more difficult to understand, and quite troubling.   Is Qatar operating on its own?  Is it a Saudi cutout?  Qatar has also had tempestuous relations with Russia, culminating with a downgrading of relations following the battery of three Russian diplomats including the ambassador at the Doha airport: the fight erupted when Qatari securities and customs personnel attempted to wrest a diplomatic pouch from the ambassador.

But Al apparently doesn’t care about all this.  He has the green, and his green conscience is salved by a transaction with a fracking foe.  Even one whose gas exports account for 206,250,000 tons of CO2 every year, and whose oil production generates another 205,000,000 or so tons, volumes that commenter Green as Grass helpfully points out allow Qatar to claim the title of world’s largest CO2 producer per capita.  There’s an inconvenient truth for you, eh Al?

One of the kerfuffles that is adding to the sense of panic in DC is the prospect for a doubling of milk prices if a new farm bill doesn’t pass.

The story is not the most important thing going on, by far, but it does illustrate the bizarro world that is normality, DC style.

Here are the details.  In 1949, Congress passed a law that required the government to support the price of milk at 75 to 90 percent of 1914 parity levels.  That is, farmers would be guaranteed a price equal to as much as .9 times the price of milk in 1914.

By the early 1980s, it became clear that this price was insanely high given the substantial increases in productivity (driven, for instance, by mechanization and by artificial insemination that improved the quality of the dairy herd.*)  There was a very visible sign of how out of line the official price was.  The US government accumulated huge inventories of cheese that it bought and stored to prop up the price of milk.  By 1981, government cheese could have filled a freight train stretching from the tip of Maine to the Florida Keys.

But rather than let the market determine the price of milk, Congress periodically set new support levels.  These levels were above the competitive price, but below the parity price.

Here’s the kicker: the support levels are time-limited, and if Congress doesn’t pass a new support level when the old one expires, the support level reverts to that set by the 1949 bill.

That’s where we are now.  Congress hasn’t passed a new farm bill, and the support levels set in the old bill are about to expire.

This problem is easily solved.  Pass a farm bill that (a) sets no new price support, and (b) repeal the reversion to the 1949 bill. Then milk prices would go down.

Since prices going up is a bad thing, prices going down should be a good thing, right? Right?  It works both ways, right?

But that isn’t even on the table.  Instead we get this shrieking about the return to the 1949 law, as if it’s somehow sacrosanct.

It gets better.  Agriculture Secretary Tom Vilsack gave a 5 hanky interview with Obama shill Candy Crowley in which he lamented the failure to pass a new farm bill as a sad testament to the powerlessness of rural America.

Seriously?

The persistence of price supports, in milk, and in sugar, and in other ag commodities, is in fact a testament to the disproportionate power of the ag lobbies.  These programs transfer billions of dollars from urban and suburban America to farmers.  Much of the impact is felt by poor Americans.  But don’t worry!  We’ll offset that by food stamps-pardon me, SNAP-a program that has metastasized, almost doubling in size in terms of participation, and more than doubling in dollars since Obama took office.

These price supports are an abomination.  They are textbook examples of redistributive government policy creating deadweight losses.

For Vilsack to get all weepy about the political weakness of rural America just adds insult to injury.

I knew Ross Perot was an economic idiot when during the 1992 campaign he expressed bewilderment at how the political power of the agriculture interests increased as the farm population declined.  Basic political economy provides the answer to that: small, concentrated interests exert disproportionate power The benefits are concentrated, the costs are diffuse.  The beneficiaries have a strong incentive to pay pols to advance their program because each individual gets a relatively large amount of money in the bargain, and those who pay the costs don’t have the incentive to organize an opposition because no individual pays a big cost (even though the collective costs are huge).  An individual farmer might make several thousand additional dollars.  An individual consumer pays a few dollars more.  No individual consumer has an incentive to spend to oppose the bill, but individual farmers do.  As the farm population has shrunk, it has become more concentrated and homogenous, and much more powerful as a result.

This is not the biggest policy disaster we face now, but it does demonstrate the dysfunction of our politics.  And no, it’s not the dysfunction that the Vilsacks and the other DC denizens routinely bewail: the inability to get things done.  In fact, getting things done is exactly the problem .

And what gets done is us.  Who gets milked to pay for the milk program? You do, sucker.

The apparent “solution” to the so-called Fiscal Cliff supposedly addresses this issue.  Oh joy.  Just another bolt on that Frankenstein’s neck.

The bill the Senate passed is truly a monstrosity.  It is wrong on every dimension.  It raises marginal tax rates on some, but doesn’t address any of the wasteful, and completely unjustified, inefficiencies in the tax code.  That is, it doesn’t eliminate any of the politically popular but economically inefficient deductions.  It raises taxes on capital (dividends and capital gains), which is horrible because capital taxes are highly inefficient.  It doesn’t cut spending.  It doesn’t address entitlements.  At all.

And to add to the seasonal joy, the IRS today announced rules related to Obamastein, AKA the Affordable Care Act.  Per the IRS, it won’t be so affordable for families.  Although ACA mandates that employers who provide insurance make available reasonably priced policies for employees, it says nothing about family coverage.   The IRS rules don’t either.  Meaning that a likely outcome is that many employers will offer cheap individual policies, and outrageously expensive family coverage.  Thereby driving people to . . . exchanges that many will not be eligible for?  Exchanges that might not even exist?

Obama assured us “you’ll be able to keep the coverage you have.” Hahahahahahahaha.  Joke’s on you, suckas.

So I wish you a Happy 2013, my fellow bovines.  Like all those cows who exist because of the federal government, you are about to spend 2013, and many years to follow, getting screwed then getting milked.

* My dad was president of an AI firm back in the 1970s, Curtiss Breeding Service.  It was a subsidiary of GD Searle.  The business’s bread and butter was a bull named Paclamar Astronaut, who sired upwards of 40,000 offspring.   My parents have a large print of Astronaut in their house.  He paid the rent for quite a while.  Until Don Rumsfeld became CEO of Searle, and disposed of Curtiss.

It’s been known for centuries that comparative advantage and relative factor endowments should drive trade patterns.   The fracking revolution has led to a dramatic change in US comparative advantage and factor endowments.  Basic economics tells us that this should drive a change in trading patterns, and in particular, it makes it efficient for the US to export natural gas, once the requisite infrastructure is in place.

Prices tell the story.  There is a a yawning gap between prices in Europe and Asia, and prices in the US.  Price signals are screaming: invest in export infrastructure, and export gas.

But politicians are deaf to basic economics, and to policies that promote efficiency.  They listen to the importuning of organized interests, and these interests are often diametrically opposed to economic efficiency.

Natural gas is a case in point.  Rep. Ed Markey (D-MA) has long been beating the drum to restrict natural gas exports.  And now he has company, Senator Ron Wyden (D-OR):

New discoveries of natural gas are beginning to transform the U.S. economy, and energy companies say exporting it is the next logical step. But a call for restraint is coming from Sen. Ron Wyden.

The Oregon Democrat, who will have a powerful perch in Congress to influence the debate, has been fielding substantial home-state opposition to such exports. The brewing fight illustrates how energy abundance can be just as divisive in Washington as a shortage, a theme likely to play out in coming years as the U.S. deals with growing energy supplies.

. . . .

Hours after the report came out, Mr. Wyden was sitting at Bistro Cacao, a French restaurant a few blocks from the Capitol, with Andrew Liveris, chief executive of Dow Chemical Co.,  one of the largest natural-gas-consuming companies in the U.S.

. . . .

“I want to make sure we look for the opportunities…to the greatest extent possible, to export value-added products rather than the raw material,” the senator said in a recent interview.

“Natural gas is a strategic American advantage,” he added. “We’ve got it. The whole world wants it.”

And the market is the best way to determine the most efficient way to exploit that advantage. But Sen. Wyden, thinks he is Goldilocks, and knows the price that is just right:

That is one reason Mr. Wyden hasn’t proposed an outright energy export ban. Instead, he suggests softer restrictions such as a cap. “How can policy makers look to find a sweet spot where you can allow exports to keep wells in production without letting exports drive prices so high that they hurt the American manufacturers?” he said.

This is an illustration of the Peltzman-Becker theory of regulation in action.  Politicians buy political support by balancing between competing interests.  Wyden is trying to buy support from domestic gas consumers by proposing to restrict exports, thereby keeping prices lower.  But he doesn’t want prices too low, because that would lead to fierce opposition from energy producers.  So he is looking for “softer restrictions.” He wants to take, but not too much.

How generous of him.  But it’s not generosity, really.  It is the logic of the stationary bandit, and the optimizing politician balancing support and opposition.

Distributive effects drive politics and regulation, not efficiency.  Efficiency is not irrelevant, because politicians like to have a bigger pie to divvy out, but they are willing to incur substantial efficiency penalties in order to achieve distributive goals.  Here, Wyden is proposing to deliver a big gift to Dow and other chemical producers (and other major industrial consumers of gas).  But for every dollar Dow gets, somebody else loses a dollar, and crucially, some cents are destroyed.  There will be deadweight losses.   Too little gas will be produced.  Too little gas will be exported.  Too much will be consumed domestically.

This is just one example of how politics and regulation destroys wealth.  Multiply this thousands of time over, in just about every good and service you can think of.  Everything from haircuts to energy to medicine.  These things kill income and growth, by a thousand cuts.

The amazing-and disturbing-thing about the Wyden article is the very matter-of-fact treatment Wyden’s threatened intervention gets in the article.  It’s the natural order of things that a senator can just arrogate to himself the power to shift around billions at a whim.

And the whim part is important.  Any investment, and plan, is vulnerable to the whims of politicians looking to redistribute wealth to favored interests.  You do something that creates a substantial amount of wealth, you attract those who believe it is their God given right to redistribute it.  In essence, politicians have an option on innovation and the fruits of hard work: tails you lose, heads you share .   This uncertainty, this risk, and the innovators’ short option position are drags on investment and hence growth.  Moreover, management of this risk involves the direction of valuable resources-including the time of top management-into rent seeking activities.  More waste, another drag on growth.

All the yammering over the “fiscal cliff” is a distraction, a near irrelevance.  All the fear mongering is predicated on Keynesian mumbo jumbo, so it will be more of a pothole than a cliff.  The real threat is the accumulation of interventions like those that Wyden is proposing, that collectively serve to reduce wealth and income, and sap growth.   That is the real cliff we have to worry about.  All of the budgetary and fiscal issues become far more more intractable, the lower is growth.   The sclerosis that results from the overbearing interventions in matters large and small will make a fiscal crisis far more likely, because our ability to create wealth will not be able to accommodate the insatiable demands of the entitlement state.

I laughed out loud, and very hard, watching this video (from RT, no less, though via Tabb Group) about HFT.  It is an interview with David Greenberg, who spent 25 years trading CL on the floor of the NYMEX.

What made me laugh?  The part (starting around the 1:30 mark) where Greenberg notes that when public news comes out, HFT traders pull their quotes “in nanoseconds.”  But back on the floor, there would be brokers who would be quoting customer limit orders, and “before his clerk could grab him on his neck, I could go ‘SOLD!'”

Let me translate.  Floor traders had a speed advantage over customers off the floor who were trading by limit order.  When market-moving news came out, floor traders like Greenberg could exploit their speed advantage, and trade against stale customer limit orders that were entered before the information was released. In so doing, the locals, due to their time-and-space advantage, took money from customers.

Yeah, it didn’t happen in a nanosecond, but that doesn’t mean jack.  What matters is that even on the floor, the faster took money from the slower: seconds, nanoseconds, whatever.  This was true in 1990, 1890, and hell, in 1790 or 1690 in the Osaka rice market.  Locals on the floor had a speed advantage over those off the floor, which they exploited ruthlessly .  And this inevitably resulted in wider markets, as off-floor traders quoted wider spreads precisely because of their vulnerability to being picked off.

Not to go all Einstein on you (as if), but speed is relative.  The stale quote problem is not a function of the absolute speed with which some traders can react, but the relative speed.  Humanoid locals in the pit were pitifully slow, compared to robot traders-especially customers who had to play telephone (literally) to yank their orders.  But that doesn’t mean that predatory trading-taking advantage of the slowest gnu in the herd-was less severe on the floor than in an electronic market.  What drives the losses from stale quotes is relative speed.  And I would argue that relative speed differences were even greater in the floor days than now.

And what ticks off old-timers like Greenberg is that the easy pickings aren’t there for the taking anymore.  HFT traders, through their tremendous speed, and their ability to scrape numerous sources of electronic information, can pull their quotes in an instant when market-moving news comes out.  They thereby protect themselves from being picked off.

Which is precisely why they can quote very tight markets.  And which is precisely why guys like Greenberg hate them.  They have ruined a total racket.  How dare they?!?!

Greenberg also talks about how in the floor days prices would move in stages to a new level after information was released.  Now the movement is much faster.  That’s bad how, exactly?

One could argue that if HFT completely withdraw their quotes, that the market will overshoot.  Prices move a lot because HFT traders totally pull their quotes.   Once the information has been digested, they quote again, and presumably the new quote level is between the pre-information release price and the quote/price immediately following the pulling of HFT quotes.

This has a testable prediction: price reversals should be larger in electronic markets than floor markets.  Or to refine the test: price reversals in the aftermath of big price moves (in response to the release of particularly salient information) should be bigger in electronic than floor markets.  To refine the test: the magnitude of price reversals should vary directly with the prevalence of HFT.

This all brings to mind two conversations, held more than 10 years apart, with a legendary trader.  A guy who made 100s of millions of dollars.  In about 2000, this trader told me he was ecstatic about the advent of electronic trading because he was “tired of getting raped by the floor.”  (Exact quote.)  In 2012, he was lamenting the advent of electronic trading because he couldn’t keep up with HFT.

Keep this in mind when you hear laments about HFT, especially from market veterans.  It’s all about whose gnu is gored, or about how the gnus have become so fast that it’s hard to gore them anymore.