On the value of Trading, Shorting vs Doctors, Inventors and other do-gooders

Prompted by talking with a friend, the long running debate online about whether financial business has become too large in our economy and recent posts between Felix Salmon and John Hempton about the value of shorting — here is my view on valuing human activity and bold claims such as:

But equally he could quit his job and do something genuinely productive instead, and that would surely benefit society much more than he’s doing right now. In fact, Hempton’s part-time lifeguard gig is clearly better for society than his day job is.

Similarly, my friend/coworker Chris suggested that rather than proprietary trading, my time would be more efficiently allocated towards inventing or running a real business (insert your favorite example here, it doesn’t matter).

Before we proceed, we must agree on a couple things. First, a distributed, capitalistic model of resource and labor allocation is more efficient in our modern society and on large scales than a command and control model. This may not apply to certain things like national defense, education, etc. only because of externalities, widely distributed costs/highly concentrated benefits, etc. but in general capitalism > socialism is the rule, not the exception. The implication here is that the market, the invisible hand, collects the (often times simple) opinions and knowledge of a wide variety of diverse participants and  combines them in non-obvious and almost always very complicated ways. Please read Eric Falkenstein’s brief overview of this concept before proceeding if it is not clear why a group of diverse and yet simple opinions can allocate resources much more efficiently than even the most brilliant wizard.

Now, our system is not a perfect free market economy. Very far from it in fact. So when people present to me the argument that resources are not allocated efficiently, there can be only two implications in my eyes:

1) The market has failed or at least has not yet succeeded in allocating those resources efficiently. This is tantamount to saying the market is wrong but I’M RIGHT. Free markets are efficient, that does not imply that they are always “right”. It implies that they will be sub-optimal intertemporally (time is always flowing, there is never an equilibrium we are always shifting from one to another) but there is no way for humans to figure out in which direction they are sub-optimal. This surely can not be what intelligent people refer to when they say the market has misallocated resources as it is tantamount to saying MSFT is too cheap, the price should be higher.

2) The market is being kept from functioning properly, typically as a result of rules imposed on the system by government or a failure by the economic agents to act in a sufficiently rational manner.  The latter is a sticky subject since we are all human and identifying specific cognitive biases and their direct effect on market prices is tough in practice. The former is more straight forward and can be used to argue that resources are misallocated.

Given this framework, we can look at the simple example of shorting publicly traded stock. The beauty is that we don’t need to start from scratch and deduce why buying stock can be considered  ”good” (for example, it could help provide capital for entrepreneurs to fund businesses which make the world better, more efficient, whatever) and why the opposite may be “bad” because there are dozens of potential arguments filled with nuance and exceptions here. When we get down to the core, publicly traded corporate equity creates widely disseminated and generally better signals of price/value than the alternatives. In a market, more information, and more accurate information, is strictly better given enough participants and some other basic prerequisites.

These market prices serve as signals and effect the allocation of resources in an almost unlimited variety of potential ways. This is why markets work — they can perform incredibly complex calculations and allocation decisions that no one individual could ever divine. A publicly traded stock does not merely help the company raise equity to pursue new projects, but it gives competitors an idea of how well they are doing relative to their peer (which has direct consequences on the decisions they make themselves), a signal as to what kinds of activity is being viewed as profitable/unprofitable in the future which can trigger a literally infinitely complex chain reaction response of resource allocation and reallocation. A simple example of “socially beneficial, good, efficient” shorting is trivial to come up with. Anything which moves the price towards a more efficient representation of value is efficient, good, and socially beneficial! If the market believes that MSFT is currently overvalued but there is a lack of selling pressure from current holders, shorts are able to drive the price down to a more accurate representation of value. Here comes the infinite cascade of reallocation; falling MSFT prices, which required the added effort of shorts since long holders were insufficiently informed or more likely institutionally limited to create the necessary supply, signal to competitors and future enterprises a potentially failing business model. Venture capitalists will be less interested in investing in firms that plan to behave like MSFT, or maybe even in software companies as a whole! As jobs move towards other industries, labor also adjusts. Some students at some universities choose a finance concentration in the business school instead of electrical engineering and computer science in the engineering school. And so it goes. The point is, price signals have incredibly complex and rich effects on a large and diverse economy (such as ours). The large and more diverse the economy, the more profound and important the effects of those signals are and the more critical it is that our prices are as efficient as can be.

Going back to the simple framework outlined above, it is easy to see that if anything there is not nearly enough shorting going on due to the many regulations and limitations placed on the activity. The consequences of this are disastrous. Stock prices as a whole are surely more likely to be inefficient, more frequently overvalued than undervalued, and less quick to adjust to new equilibria overtime. We can conjecture that this would cause overinvestment over time, as a guideline. Maybe if shorting was easier and more prevalent, economies would identify an oversupply of investment/capital sooner in economic cycles leading to more frequent but more modest recessions without the debt overhang of bailouts? What about those evil shorts who drive potentially salvageable companies into ruin thanks to malicious rumor? Aleph blog touched on this a few times during the crisis, the point being a solid firm should/will not be vulnerable to short term swings in equity prices. If a firm is vulnerable, that is a risk that they took and should be held accountable. If a financial firm relies on a stable equity price to do business, they should face the consequences of the risks they take that may jeopardize that. Indeed, they should also face the consequences of the risks their peers take which may also harm their equity price due to the opacity of their activity and inability of market participants to distinguish good from bad apples.

It is pretty straightforward to extend this anywhere in the economy. Would I do more good to society as a doctor rather than an exploiter of extremely short term mispricing in fixed income markets? I am better compensated by the market doing the latter. The barriers to entry to doing the latter are also drastically smaller. In fact, the explicit goal of limiting the admission into med schools is to keep the supply of doctors artificially low and therefore keep their wages up. It is difficult to compete in that market, there are limits to free trade! If anything, this is a signal that doctors are overpaid relative to freer segments of our economy — such as proprietary trading of financial markets by individuals or other self-funded entities, or more simply, say, computer programmers. I don’t want to extend this to investment banking or hedge funds, at least not in this post, since it gets more nuanced when you introduce the principal-agent relationships and conflicting utility curves. Is it fair to say that because doctors are paid less than some successful proprietary traders that they are less socially useful? Of course it is. Life can be assigned a value, the statistical value ranges in the few million dollars+ and is a function of age, health, education, income etc. If the argument is about intangibles, I say bullshit and anything can be assigned a range of tangible values. If the argument is that certain occupations create enormous positive externalities and are therefore socially good (like John Hempton as a lifeguard), I say this is a market failure and you saying they are socially good is equivalent to saying people should do you favors without compensation.

What about inventors? Should I quit my job and try to invent something new to change the world, or start a business? Most of these ventures fail, the vast majority. It’s not an easy path to take. It is definitely the riskier one. Yes I may be very intelligent, but I am also quite risk averse. Given my utility function and the payoffs available to me by taking different occupations and financial risks, it is up to me to calculate those trade-offs.  As long as the barriers to free trade are removed, in the case of new ventures I feel like we are OK in this regard, the market will be most efficient at allocating the amount of resources (in new venture funding and even grooming/support of young entrepreneurs as done by start-up incubators).

The big takeaway is that the impact of price signals are not obvious and very wide-reaching. Be cautious when making claims about certain occupations/industries being overcompensated. Unless there is a barrier to free trade (typically in the form of regulation) which is causing this, it is safe to say we are doing  the best we can.

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