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Competition, Rent-Seeking, and High-Frequency Trading

Warning: Wonky

Below the fold are yet further, very wonky reflections on Steve Landsburg’s claim that private investments by high-frequency traders to shave milliseconds off of the time required for price information to be transmitted from point A to point B are socially wasteful.  My argument – first advanced here – is that Steve has no good basis for his claim.

One appropriate way to test claims that X market activity is socially harmful is to muster coherent arguments and empirical details that are specific to X in order to determine if these arguments and facts indeed persuade one of the proposition that X is socially harmful or reveal that, in fact, X is not socially harmful.  Such an approach can take many forms.  For example, one can show that some activities that are alleged to be without any (or without sufficient) social benefits (beyond helping the few private actors who initiate these activities) in fact do generally generate significant social benefits beyond those that are captured by the relatively few private parties who initiate the activities in question.

Much of the “new learning” in the 1960s and 1970s about antitrust economics was of this type.  For example, many economists, regulators, and judges who assumed that resale price maintenance was socially wasteful came to understand that this marketing strategy is likely socially beneficial once Lester Telser and other economists explained in some detail just what social benefits might flow from resale price maintenance.

Another way to examine claims that X market activity is socially harmful is to explore just how consistent such claims are with other arguments whose validity is not in question.  If the claims that X is socially harmful imply that other activities that are generally believed not to be socially harmful are indeed socially harmful, then the analyst who is suspicious of X activities must either explain that in fact X differs in relevant ways from these other activities or demonstrate that these other activities are, contrary to popular belief, also socially harmful.

Regarding the social merits of high-frequency trading, here are three links of the first sort.  Each of these links explains in some detail just how high-frequency trading likely helps people other than just successful high-frequency traders themselves.  I offer them here in no particular order:

– Tim Worstall writing at Forbes.

Manoj Narang writing at Institutional Investor (HT Methinks)

Holly Bell writing for Cato.

These (and other) analyses of the costs and benefits of high-frequency trading are to be encouraged.

But at a deeper level of analysis, the burden of proof ought not to be upon defenders of high-frequency trading to prove or to persuade that such trading is socially worthwhile.  As long as all participants in the market spend and risk their own funds (or funds voluntarily entrusted to them), and as long as there are no government-erected barriers to entry or government-granted subsidies targeted at participants in the market, that market (whether it be for financial assets or for cans of pickled okra) should be presumed to generate net social benefits regardless of whether some academic analyst can or cannot see or imagine what the details of those benefits might be.

The burden of proof is not – or ought not be – on defenders of high-frequency trading to defend that market or that activity.  The burden of proof rests – or ought to rest – squarely on those who allege that such trading is socially harmful.  It is not sufficient to do as Steve does – namely, to ask (I suspect rhetorically):

What do you imagine is the social value of executing a trade .03 seconds faster than it would otherwise have been executed?

This question, asked non-rhetorically, is valid as an academic exercise.  But the inability of an observer to answer the question does not mean that that observer then has the burden of proving that the activities in question are in fact socially beneficial.  If the private activities in question are of a kind that generally occur in private property competitive markets – and if the parties to the discussion agree that private activities of consumers, entrepreneurs, and investors interacting in private property competitive markets generally are socially productive – then all that the defender of the activities in question must do is to point out that the activities in question differ in no relevant ways from similar activities in other private-property competitive markets.  The burden is then shifted to the person who claims that the private activities in this particular private property competitive market are somehow (presumptively) socially wasteful.

The inability of a person to answer Steve’s question (quoted above) is no more relevant than would be the inability of that person to describe the social value of advertising, or of investments to increase the size of already-huge super-store retailers, or of the popcorn-pricing policies of movie-theater owners, or of resale price maintenance, or of any other observed phenomena emerging from private property competitive markets.

I believe that Steve is also in error when he writes the following in his comments section about high-frequency trading:

HFT is (as far as I can tell) socially wasteful for exactly the same reason that robbery is socially wasteful: It consumes resources without producing anything of value.

This claim is foundationally mistaken.  Robbery is an involuntary transfer of resources from victims to the robbers.  For reasons so obvious that we need not here rehearse them, resources spent to rob innocent people are wasted from society’s standpoint.  Expenditures of resources on robbery, while beneficial for each robber, are indeed socially wasteful.

In high-frequency trading there is no such involuntary transfers or destruction of any physical resources or pieces of intellectual property.  There is indeed, as Steve says, destruction of some of the value of other producers’ investments.  But such value destruction is routine in competitive private-property markets.  Again, there’s nothing substantively different about a now-faster high-frequency trader destroying some of the market value of other financial firms from a now-more-culinarily-accomplished restaurant destroying some of the market value of other restaurants.  In both cases this value destruction should be presumed generally to be more than offset by social-value gains due to the new investments.

The important reason for this presumption is that no consumers’ options are obstructed.  All value changes occur only through the process of consumers voluntarily changing the patterns of their spending ‘on their own’ or, more likely, changing the patterns of their spending because suppliers who are competing for more consumer patronage carry out this competition not by obstructing consumers’ options but by offering consumers different, hopefully improved options.  All resulting changes in the value of resources ultimately reflect the voluntary choices of consumers – and this fact, perhaps seemingly innocuous, makes all the difference in the world.  It is what separates rent-seeking activities from profit-seeking activities.

Whether they are correct or not in doing so, nearly all economists regard vigorous competition to reduce costs and to better serve consumers as socially beneficial.  Competition for consumers’ dollars, even at the expense of other producers, is emphatically not rent-seeking activity.  Resources spent on these competitive activities are, therefore, presumed to be spent efficiently and productively rather than wastefully.  Why does Steve Landsburg presume the opposite for investments to speed the transmission of information about asset prices?

It’s fine to object to my argument by alleging that economists are mistaken to identify as wasteful only those expenditures that are used (1) to transfer recognized property rights involuntarily from V to R (such as occurs when R robs V) or (2) to obstruct voluntary market exchanges between B and S in order to reduce M‘s need to cater attentively to consumer demands (such as when government imposes tariffs on imports of steel).

That is, as a matter of logic, it would be legitimate to object to my argument by saying that economics should count the competitively reduced market values of competitors’ legitimate investments as a cost of competitive activity.  (Justifying this objection would be a different matter altogether!)  But economics (sensibly) doesn’t so roundly condemn all private-market competitive activity.  If it did do so, then not only would the fiber-cable tunnel built by high-frequency traders be suspect, but so, too, would nearly all market activity be economically suspect.

Steve’s suspicion that it is socially wasteful for high-frequency traders to consume real resources in their private attempts to shave milliseconds off of price-transmission times implies a suspicion of all competitive private-property market investments.  Perhaps such suspicion is justified, but, if so, that suspicion would have nothing to do specifically with high-frequency trading and everything to do with the nature of private-property competitive enterprise itself.


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