Stock image: the New York Stock Exchange reopens after the Easter holiday, 21 April. Photo: Getty
Show Hide image

HFT: the latest scam devised by Wall Street and the City

Felix Martin discusses Flash Boys by the American financial writer Michael Lewis, which examines high-frequency trading (HFT).

Flash Boys, the new book by Michael Lewis, America’s explainer- in-chief of all things financial, is an account of “high-frequency trading” (HFT) – a technique developed by financial firms that deploys vast computing power to trade electronically on the world’s stock exchanges at extreme speed.

That may sound pretty esoteric. However, the book is generating an enormous amount of attention because it argues that HFT is the latest in the litany of scams that Wall Street and the City have devised to relieve unwitting investors of their money.

Whenever you hit Enter to buy shares through an online brokerage, Lewis shows, your order does not go straight to the stock exchange as you might think. Instead, HFT firms get a look-in first – and they use their superior speed to “front-run” your order by buying the shares ahead of time and then offloading them into the market at a marginally higher price. The resulting profits are tiny on any individual order but they run into the billions when you add them up. And they are made at your expense. Given how many people have a stake in the stock market these days with their Isas and their Sipps, this is certainly a disturbing revelation. Lewis deserves all the praise he is getting for exposing it.

Yet, to my mind, Flash Boys is even more important than this. For it exposes HFT as a prime example of one of the major problems of our age: the unintended consequences of technological innovation. Technologists, regardless of their political bent, tend to be idealists – it probably requires a healthy dose of idealism to take the risks required to innovate. But all too often, idealism can slip into naivety. The unstated assumption is that if new technology can be used to better the lot of the individual, it will. Everything will be OK so long as you “don’t be evil”.

Unfortunately, it doesn’t always work like that in the real world. The new technologies developed by well-intentioned young geeks in Silicon Valley and Old Street get grafted on to an economy that is still dominated by big, profit-seeking corporations run by shrewd old-economy dinosaurs. Innovation is driven by the admirable belief that new technology is a tool for the emancipation of human creativity and self-fulfilment. Less thought is given to what might happen after, say, News International buys your app.

The point is more general than just the compromises that come with commercialisation by big business. What the technologists are missing is the crucial importance of the social context in which new technology is deployed and, above all, the role of that most reliable of social scientific regularities, the law of unintended consequences.

The canonical problem is that we design some new technology to solve a problem but in doing so we make a crucial assumption: that everything else will remain unchanged and in particular the way that people interact, the social context, will be unaltered. What happens is that behaviour adapts. The technology succeeds – the old problem is eliminated – but new problems arise.

An example that is almost guaranteed to have infuriated anyone reading this at some time or other is the computerisation of personal credit scoring. Companies such as Experian or Equifax apply information technology to the problem of deciding who should and should not get loans.

In an economy where mortgages and mobile-phone contracts are considered essentials, the decisions that their computers churn out are important. Their claim is that their algorithms are not just cheaper than the Captain Mainwaring-style bank manager of old but also more objective and therefore fairer.

If it were true that people’s behaviour had remained constant after the introduction of computerised credit scoring systems, that might be the case. But in reality, people game the system. Personal finance articles and chatrooms warn them that cappuccinos and city breaks flag them for a downgrade, so they take a breather for three months before applying for a mortgage – and then they start up again as soon as the ink on the contract is dry.

It is no different from the snag that the Soviet Union discovered with a planned economy. You could solve the problem of low productivity – at least as the bean-counters captured it – with more demanding targets. The underlying disease of demotivation proved more resilient, however. As an aphorism of the period had it: “They pretend to pay us and we pretend to work.”

The story that Lewis tells of HFT is a perfect example of the law of unintended consequences at work in the technological transformation of the stock market, one of the most basic institutions of our capitalist economies. The computerisation of stock exchanges that began in 1986 promised to make them simpler and more efficient. The world of barrow-boy traders bellowing at one another in the pit and the old-boys network of City stockbrokers was abolished in favour of anonymous electronic trading on a virtual exchange.

The intention was to stop investors being ripped off by an uncompetitive industry. However, this assumed that behaviour would not adapt. The stockbrokers and pit traders did hang up their red braces and garish blazers but a new generation of rent-seekers emerged in their place. As Flash Boys documents, the fixed commissions levied by the stockbrokers of yesterday were replaced by the cuts taken by the HFT firms of today.

So, what is the lesson to be learned from Lewis’s latest blockbuster? Well: this past week, the government’s ambassador for digital industries announced that schoolchildren should learn less French and more code. Maybe. But the lesson of the burgeoning HFT scandal is that the naive application of technology can be a uniquely dangerous force. We should be teaching our budding technologists not just code – but the law of unintended consequences.

Felix Martin is a macroeconomist, bond trader and the author of Money: the Unauthorised Biography

This article first appeared in the 14 April 2014 issue of the New Statesman, Easter Double

Getty
Show Hide image

We're racing towards another private debt crisis - so why did no one see it coming?

The Office for Budget Responsibility failed to foresee the rise in household debt. 

This is a call for a public inquiry on the current situation regarding private debt.

For almost a decade now, since 2007, we have been living a lie. And that lie is preparing to wreak havoc on our economy. If we do not create some kind of impartial forum to discuss what is actually happening, the results might well prove disastrous. 

The lie I am referring to is the idea that the financial crisis of 2008, and subsequent “Great Recession,” were caused by profligate government spending and subsequent public debt. The exact opposite is in fact the case. The crash happened because of dangerously high levels of private debt (a mortgage crisis specifically). And - this is the part we are not supposed to talk about—there is an inverse relation between public and private debt levels.

If the public sector reduces its debt, overall private sector debt goes up. That's what happened in the years leading up to 2008. Now austerity is making it happening again. And if we don't do something about it, the results will, inevitably, be another catastrophe.

The winners and losers of debt

These graphs show the relationship between public and private debt. They are both forecasts from the Office for Budget Responsibility, produced in 2015 and 2017. 

This is what the OBR was projecting what would happen around now back in 2015:

This year the OBR completely changed its forecast. This is how it now projects things are likely to turn out:

First, notice how both diagrams are symmetrical. What happens on top (that part of the economy that is in surplus) precisely mirrors what happens in the bottom (that part of the economy that is in deficit). This is called an “accounting identity.”

As in any ledger sheet, credits and debits have to match. The easiest way to understand this is to imagine there are just two actors, government, and the private sector. If the government borrows £100, and spends it, then the government has a debt of £100. But by spending, it has injected £100 more pounds into the private economy. In other words, -£100 for the government, +£100 for everyone else in the diagram. 

Similarly, if the government taxes someone for £100 , then the government is £100 richer but there’s £100 subtracted from the private economy (+£100 for government, -£100 for everybody else on the diagram).

So what implications does this kind of bookkeeping have for the overall economy? It means that if the government goes into surplus, then everyone else has to go into debt.

We tend to think of money as if it is a bunch of poker chips already lying around, but that’s not how it really works. Money has to be created. And money is created when banks make loans. Either the government borrows money and injects it into the economy, or private citizens borrow money from banks. Those banks don’t take the money from people’s savings or anywhere else, they just make it up. Anyone can write an IOU. But only banks are allowed to issue IOUs that the government will accept in payment for taxes. (In other words, there actually is a magic money tree. But only banks are allowed to use it.)

There are other factors. The UK has a huge trade deficit (blue), and that means the government (yellow) also has to run a deficit (print money, or more accurately, get banks to do it) to inject into the economy to pay for all those Chinese trainers, American iPads, and German cars. The total amount of money can also fluctuate. But the real point here is, the less the government is in debt, the more everyone else must be. Austerity measures will necessarily lead to rising levels of private debt. And this is exactly what has happened.

Now, if this seems to have very little to do with the way politicians talk about such matters, there's a simple reason: most politicians don’t actually know any of this. A recent survey showed 90 per cent of MPs don't even understand where money comes from (they think it's issued by the Royal Mint). In reality, debt is money. If no one owed anyone anything at all there would be no money and the economy would grind to a halt.

But of course debt has to be owed to someone. These charts show who owes what to whom.

The crisis in private debt

Bearing all this in mind, let's look at those diagrams again - keeping our eye particularly on the dark blue that represents household debt. In the first, 2015 version, the OBR duly noted that there was a substantial build-up of household debt in the years leading up to the crash of 2008. This is significant because it was the first time in British history that total household debts were higher than total household savings, and therefore the household sector itself was in deficit territory. (Corporations, at the same time, were raking in enormous profits.) But it also predicted this wouldn't happen again.

True, the OBR observed, austerity and the reduction of government deficits meant private debt levels would have to go up. However, the OBR economists insisted this wouldn't be a problem because the burden would fall not on households but on corporations. Business-friendly Tory policies would, they insisted, inspire a boom in corporate expansion, which would mean frenzied corporate borrowing (that huge red bulge below the line in the first diagram, which was supposed to eventually replace government deficits entirely). Ordinary households would have little or nothing to worry about.

This was total fantasy. No such frenzied boom took place.

In the second diagram, two years later, the OBR is forced to acknowledge this. Corporations are just raking in the profits and sitting on them. The household sector, on the other hand, is a rolling catastrophe. Austerity has meant falling wages, less government spending on social services (or anything else), and higher de facto taxes. This puts the squeeze on household budgets and people are forced to borrow. As a result, not only are households in overall deficit for the second time in British history, the situation is actually worse than it was in the years leading up to 2008.

And remember: it was a mortgage crisis that set off the 2008 crash, which almost destroyed the world economy and plunged millions into penury. Not a crisis in public debt. A crisis in private debt.

An inquiry

In 2015, around the time the original OBR predictions came out, I wrote an essay in the Guardian predicting that austerity and budget-balancing would create a disastrous crisis in private debt. Now it's so clearly, unmistakably, happening that even the OBR cannot deny it.

I believe the time has come for there be a public investigation - a formal public inquiry, in fact - into how this could be allowed to happen. After the 2008 crash, at least the economists in Treasury and the Bank of England could plausibly claim they hadn't completely understood the relation between private debt and financial instability. Now they simply have no excuse.

What on earth is an institution called the “Office for Budget Responsibility” credulously imagining corporate borrowing binges in order to suggest the government will balance the budget to no ill effects? How responsible is that? Even the second chart is extremely odd. Up to 2017, the top and bottom of the diagram are exact mirrors of one another, as they ought to be. However, in the projected future after 2017, the section below the line is much smaller than the section above, apparently seriously understating the amount both of future government, and future private, debt. In other words, the numbers don't add up.

The OBR told the New Statesman ​that it was not aware of any errors in its 2015 forecast for corporate sector net lending, and that the forecast was based on the available data. It said the forecast for business investment has been revised down because of the uncertainty created by Brexit. 

Still, if the “Office of Budget Responsibility” was true to its name, it should be sounding off the alarm bells right about now. So far all we've got is one mention of private debt and a mild warning about the rise of personal debt from the Bank of England, which did not however connect the problem to austerity, and one fairly strong statement from a maverick columnist in the Daily Mail. Otherwise, silence. 

The only plausible explanation is that institutions like the Treasury, OBR, and to a degree as well the Bank of England can't, by definition, warn against the dangers of austerity, however alarming the situation, because they have been set up the way they have in order to justify austerity. It's important to emphasise that most professional economists have never supported Conservative policies in this regard. The policy was adopted because it was convenient to politicians; institutions were set up in order to support it; economists were hired in order to come up with arguments for austerity, rather than to judge whether it would be a good idea. At present, this situation has led us to the brink of disaster.

The last time there was a financial crash, the Queen famously asked: why was no one able to foresee this? We now have the tools. Perhaps the most important task for a public inquiry will be to finally ask: what is the real purpose of the institutions that are supposed to foresee such matters, to what degree have they been politicised, and what would it take to turn them back into institutions that can at least inform us if we're staring into the lights of an oncoming train?