A nagging question about the rationality of stock markets

For some time, I have been puzzling over media reports and economic analyses of the movement of stock markets.  Almost invariably, the goal is to uncover/understand the thinking of investors, on the assumption that this is what is moving markets.  So it makes a lot of sense that the Nobel Prize for Economics was awarded to a pair of economists for their work on "rational expectations" in economic theory.

But the question that has been nagging at me is this:  does it really make sense anymore to assume that the stock markets' behavior reflects actual (human) thinking, rational or otherwise?  Depending on the market and the source of the estimate, forty to sixty percent of stock-market trading is driven by the algorithms of computer programs.  It goes by a variety of names - high-frequency trading, flash trading, automated trading, program trading, robotic or robo-trading - but its essence is that trading is based on pre-defined parameters written into a program.  "Thought" obviously goes into the construction of algorithms (though they are proprietary and not open to public inspection), but once a program has been written and put into effect, there's no thinking behind the trade that it executes, no individual's assessment of market conditions as the basis for specific trades.

So the ink, digital or otherwise, that is spilled daily in an effort to discern the thinking of market participants as the key to the markets' behavior seems increasingly futile.  Program trading needs to be pulled from the margins of our attention to the center, which, according to a recent report in the New York Times, may actually be happening.  As the Financial Times' Jeremy Grant wrote recently of the UK, "there is growing concern that exchanges have moved too far from their traditional role in facilitating capital-raising as they chose other business streams to satisfy shareholder returns."  Understanding stock markets - their behavior and their practical function - now requires as much, if not more, attention to the thinking of algorithm writers than to the thoughts of sentient traders.

False efficiencies - the professional "stretch out"?

In an op-ed piece about "secretaries," past, present, and future, in this morning's New York Times, the following words caught my eye:  "we're living through the end of a recession in which around two million administrative and clerical workers lost their jobs after bosses discovered they could handle their calendars and travel arrangements online and rendered their assistants expendable."

Once a clerical worker myself, and having now logged twenty-plus years as a professional, I am struck by the technical inefficiencies generated by this kind of "economic" efficiency.  Maybe I'm particularly sensitive to this issue because making some rather complicated travel arrangements for a research trip this summer is  consuming inordinate amounts of my time right now.  Or maybe it's because I work in a sector of the academy where staff support for individual professionals (rather than administrative units) is virtually non-existent.  In any case, this trend afflicts not just the business world but increasingly the legal and medical professions as well as the academy:  in the name of economic efficiency, the powers that be are cutting tangible costs by reducing clerical staff and shifting clerical work from clerical workers to professionals.  But what about the less tangible costs that this generates in the time that professionals now must devote to clerical work?

Where's the efficiency in having relatively highly paid (in some professions, very highly paid) professionals doing their own clerical work?  If the implicit assumption is that professionals will do their own clerical work on top of their regular workload--a professional "stretch out," in other words--that is surely unwarranted. Most professionals already work long hours, so clerical work inevitably cuts into the time one has for professional work.  If someone put forward a proposal explicitly recommending that lawyers, doctors, or professors reduce the time they devote to professional responsibilities, in order to free up their time for clerical work, it would end up where it belongs, in the trash bin.  Much more efficient--in terms of value for money--would be to retain at least some of the clerical support staff and use computers and the web to enhance their efficiency.  Instead, we have false economies and false efficiencies.

Buffett, derivatives, and smoothing earnings

"Perhaps the most insightful nugget in [Warren Buffett's recent testimony to the Financial Crisis Inquiry Commission]," wrote Andrew Ross Sorkin in the New York Times on March 15, "was Mr. Buffett's explanation of why corporations use derivatives--and why they probably shouldn't."  They do it to hedge currency or price risks that can affect their business (examples include Coca-Cola and Burlington Northern)--no surprise there.  Or corporations use derivates to smooth earnings.  This other "agenda" seems to surprise Sorkin, and Buffett evidently frowns upon it.

What's missing from this picture is quasi-government policy, that of the Financial Standards Accounting Board.  As I wrote here in May 2009:

In the nineteenth and early twentieth centuries, many public companies regarded it as prudent to set aside a portion of their earnings as reserves against a rainy day.  The idea was that the reserves would enable them to continue paying dividends – and thereby safeguard the market value of their shares – in years when their current earnings were inadequate. 

In 1975, this practice was ruled unacceptable by the Financial Accounting Standards Board.  Its FAS Statement No. 5 required reserves to be accrued for losses that were “probable” and could be estimated; it explicitly prohibited “reserves for general contingencies” (§14).    The board was fully aware of the arguments in favor of a general reserve fund.  In its words, “The Board recognizes that some investors may have a preference for investments in enterprises having a stable pattern of earnings, because that indicates lesser certainty or risk than fluctuating earnings.  That preference, in turn, is perceived by many as having a favorable effect on the market prices of those enterprises’ securities” (§65).  But the alternative to setting aside reserves – purchasing insurance or reinsurance – was preferable, the Board concluded, and it overruled prudence:  “Earnings fluctuations are inherent in risk retention, and they should be reported as they occur” (§65). 

FAS Statement No. 5 thus tied public firms more closely to the ups and downs of the market (and surely stimulated the insurance/derivatives market as well), with pro-cyclical consequences, as others have noted.[2]

So it's not at all surprising that corporations use derivatives to smooth earnings--what other choice do they have?  Now if the Bretton Woods regime of fixed-exchange rates hadn't broken down in 1971, and Chicago institutions hadn't responded by extending the concept of commodity futures to currency in 1972 and then well beyond currencies, they really would have no choice but to let earnings fluctuate in real time.

Aggregation + mobility = power2, or ruminations on corporations, unions, and governments

This morning's Financial Times offers a classic expression of the "alarmed capital" argument.  First articulated in the US in the 1850s, this is an argument against business regulation that highlights capital's ability to up and leave for more favorable jurisdictions:

Manufacturers could shift production out of the US to Canada or Mexico as a result [of Pres. Obama's "anti-business" proclivities], warned George Buckley, chief executive and chairman of 3M.

In the context of the current controversies here in Wisconsin, this has gotten me to thinking about power and the mobility of corporations, unions, and governments ....

Buckley's "manufacturers," as a rule, are not individuals but corporations like 3M.  And corporations are collectivities, aggregations of capitalists. To think of labor unions as collectivities takes no leap of the imagination today, but we've lost that perception of corporations. To regain a sense of it, listen to Henry Clay, portraying corporations as safe for a budding democracy in a speech to the U.S. Senate in 1832 (p. [100]):

The joint stock companies ... are nothing more than associations, sometimes of hundreds, by means of which the small earnings of many are brought into a common stock, and the associates, obtaining corporate privileges, are enabled to prosecute, under one superintending head, their business to better advantage. Nothing could be more essentially democratic or better devised to counterpoise the influence of individual wealth.

Corporations and unions, in this sense, are two sides of the same coin--the one, an aggregation of capitalists, and the other, an aggregation of laborers.  Organization enables both "to prosecute, under one superintending head, their [members'] business to better advantage."

Recognizing this essential similarity helps us to understand why, in the age of "trusts and monopolies" at the turn of the 20th century, comparably large organizations of labor sprang up just then.  The organization of labor, in other words, developed in tandem with the organization of industry.  At the Chicago Conference on Trusts (p. 330), hosted by the city's Civic Federation at the height of the Great Merger Movement, Samuel Gompers of the American Federation of Labor described the historical dynamic in these words:

In the early days of our modern capitalist system, when the individual employer was the rule under which industry was conducted, the individual workmen deemed themselves sufficiently capable to cope for their rights; when industry developed and employers formed companies, the workmen formed unions; when industry concentrated into great combinations, the workingmen formed their national and international unions[;] as employments became trustified, the toilers organized federations of all unions--local, national, and international--such as the American Federation of Labor.

And it is why the Sherman Anti-Trust Act of 1890 could be applied to unions, as it initially was.

But capital is generally more mobile than labor, since it's easier to move one's money around than to uproot oneself, one's person. And aggregated capital (a corporation) is more mobile than aggregated labor (a union), because a union is more securely tied to a locality.  One can easily imagine 3M moving its operations off-shore, as countless American manufacturers have done.  This is what makes the "alarmed capital" argument a credible threat and gives it such potency.  But how could a union relocate?  And what kind of threat would that pose?  The idea seems nonsensical.

The fact that mobility, whether actual or threatened, is a potent weapon in the arsenal of capital, but not of labor, helps to explain the declining power of private-sector unions as the mobility of corporations has increased so dramatically since the 1970s.  (Notice that I say "helps to explain"--there are obviously other factors at work as well.)  And, by extension, paying attention to the power that derives from mobility helps to explain why public-sector unions have not experienced the same decline:  their employers, though also organized (into governments at all levels), are anchored, by definition, to their locality.  Governments' inability to threaten to leave town, in effect, levels the playing field for unions.  So public-sector unions have tended to retain their strength as the power of private-sector unions has declined.

Viewed from this perspective, what Gov. Walker of Wisconsin is trying to do, in his strident efforts to limit the power of public-sector unions, is to tilt the playing field in the favor of government to the same degree that it is tilted in favor of corporations in private sector.

Unfunded pensions and benefits in WI? Not so much

One would never know it from Gov. Walker's extremist campaign to limit public-sector collective bargaining rights in Wisconsin, but Wisconsin is one of the best performers when it comes to unfunded pension liabilities and health care benefits. 0n a per capita basis, its liabilities are down there with those of Florida and South Dakota. So reports the New York Times Magazine today in a piece on Gov. Christie of New Jersey, which does really have a problem.

The Times chart is based on a Pew Center on the States' report, which notes:

Some states are doing a far better job than others of managing this bill coming due. States such as Florida, Idaho, New York, North Carolina and Wisconsin all entered the current recession with fully funded pensions.

The Pew report rates Wisconsin a "solid performer" (its top rating) in managing its pension and non-pension obligations.

Isn't it time, Gov. Walker, to drop the pretense and negotiate?

The life and times of "free enterprise"

The term "free enterprise" is clearly a WWII-Cold War product, at least according to Google's Ngram (searching English-language books published in the US, no smoothing). The results show a very rapid rise during the war and a peak ca. 1945. In British English-language publications, interestingly, use of the term peaked about the same time but it enjoyed a resurgence in the 1980s that was not paralleled in the US.

Cost-cutting by merger - time for the American states to consider it?

Gov. Walker's CEO talk, together with the pending merger of the New York Stock Exchange and the Deutsche Börse, driven partly by cost savings from combining back-office operations and information technology, has gotten me to thinking ....

What if the United States as a whole brought in a management-consulting team to advise it on ways of cutting costs? I'd bet that the first thing to catch their eye would be the U.S.'s shockingly large number of "divisions," i.e., states. Think about the waste! 50 governors, 50 state departments of this and that, 50 legislatures, and so on, all carrying out more or less the same functions. Not to mention 50 "divisions" competing with each other for resources. No company could survive with such an unwieldy, cost-magnifying structure. How can a nation do so in our increasingly competitive global economy?

Of course, a completely centralized structure (the so-called U-form) hasn't made much sense for businesses of any size since the diversification of product lines (in the 1920s) and then conglomeration (after WWII). The multi-divisional structure built on product lines or product groups has been the structure of choice ever since.

Surely our consultants' top recommendation would be to merge the 50 states into, say, 5 or 6 regional groupings. If the NYSE-DB merger is expected to yield $400 million in annual savings, imagine what the American states could save via a series of mergers that reduced their number to 5 or 6!

Gov. Walker, interested in taking the lead on this one?

When is a CEO not a good Governor?

Turbulent times here in Madison, Wisconsin, have gotten me to thinking about CEOs and governors.

In his State of the State address on Feb. 1, Scott Walker, Wisconsin's new governor (in case anyone doesn't know that by now), portrayed himself as a "CEO" "hired" by the citizens of Wisconsin. This was by way of justifying his take-charge approach to his new duties, the consequences of which are on full display up on Capitol Square this week.

It is worth noting, first of all, that if Wisconsites did indeed hire a CEO, the man they recruited for the job has no CEO experience in the private sector. By his own account, he worked for IBM while he was a student at Marquette University and then was employed full-time "in financial development" by a non-profit organization. Since 1993 he has been a politician.

And it is precisely because he lacks hands-on experience as a CEO in the real world, I suspect, that he evidently equates being a CEO with being an autocrat. Vision, yes; leadership, yes; decisive action, yes - those qualities are essential in CEOs and governors alike. But what about the process by which one arrives at the point of action? Walker seems to be unfamiliar with contemporary management thinking about the values of collaboration and negotiation in increasing productivity and efficiency. Indeed, Walker's behavior since taking office makes me think of Richard T. Ely's 1887 description of the despotic enterprise, marked by "the unconstrained control of a single man."

Can a CEO be a good Governor? It seems entirely possible, but only if he or she is a modern-day CEO, not a nineteenth-century throw-back like Walker.