Flash Crash Lessons and Fixes

In the aftermath of a crisis or accident crowds have an unfortunate tendency to build momentum behind overwrought and foolish responses. This is especially bad when the response is promulgated through government, which is ever capable of codifying bad ideas into law but only rarely manages to repeal them.

May 6 saw a “flash crash” in U.S. equity markets: a crisis that started sometime after 14:00 and was essentially over by the time the market closed at 16:00. It revealed a number of problems in the current market structure, and it also cost some market participants serious money. On May 6 we learned:

  1. Official market makers will not always make reasonable markets (see “stub quotes”)
  2. Beyond official market makers, there are significant liquidity providers who contribute to market efficiency but who can suddenly step away
  3. You should never blindly enter an order to trade without a limit price
  4. You should probably put limits on any standing stop orders, too
  5. At least one “sophisticated” market participant was using a poorly programmed algorithm (that would be the one that was sending orders to sell short stocks at a penny!)

These lessons were clear within a week of the flash crash. Yet in response the crowds seem to have concluded that the correct “fix” to these problems is to put “circuit breakers” on individual listings to halt trading on any stock that experiences a sudden change in price exceeding some threshold. This is a bad idea.

For one thing, stock-level circuit breakers could easily spark a contagion effect through the ETFs and index futures (which investors may use to protect themselves while a particularly large stock is halted). Furthermore, stock-level circuit breakers would actually tend to exacerbate volatility on stocks that begin to trade near any threshold that is set.

What’s the right response? Well, we do still need to look into whether market makers are fulfilling their obligations. But there’s a simple way to ensure that nobody will unwittingly lose money in a flash crash ever again: Require that all orders, at least from retail investors, include a limit price.

Farm Subsidies Plumb New Depths

Commodity farmers are a tenacious special interest, and the federal government seems to have no shame in pandering to them.

The Obama administration would rather subsidize foreign farmers than reduce domestic subsidies that violate our trade agreements:

Rather than reduce the U.S. subsidies to American cotton farmers that are the cause of the trade fight, the Administration is proposing that U.S. taxpayers also compensate Brazilian cotton farmers for the harm done by the U.S. subsidies. Thus the absurd U.S. cotton program would dip into the Commodity Credit Corporation to pay what is a bribe to Brazil so it won’t retaliate.

Currency Arbitrage – Update

Updating a topic of longstanding bemusement, the WSJ reports:

It costs the federal government up to nine cents to mint a nickel and almost two cents to make a penny.

Coinflation.com tracks the intrinsic (“melt”) value of metal coins.

A letter several years ago noted:

When the half-cent was abolished in 1857 it was worth more than eight cents in today’s currency. People then had no problem living in the following decades, during which the smallest unit of currency was worth more than our dime today. In fact, they persevered through that transition without the luxury of the many cashless means of electronic transaction we enjoy today (which, even after penny abolition, can preserve prices to the cent).

It’s silly that the U.S. continues to mint pennies and nickels. Just as silly is the fact that American businesses and consumers continue to carry them around for regular use in cash commerce.

Are Government and Union Employees Overpaid?

In a free market the concept of an “overpaid employee” is not a serious concern: If employment contracts are voluntary, and employers pay wages from their own resources, then it is hard to argue that any employee is overpaid, since evidently his employer believes he is worth his cost.

Union and government employees break this link. Unionized government employees seem to be a double-whammy! Updating a trend that has been increasingly evident, Gary Shilling explains:

Years ago, there was an informal “social contract”—public employees generally received lower wages than private-sector workers, and in return they got earlier retirement and generous pensions, allowing them to catch up. That arrangement has long since gone by the boards. The result is a remarkable trend. State and local government employees for years have received pay increases in excess of inflation, and BLS figures show they now have wages that are 34% higher on average than in the private sector.

Of course, unions vociferously deny any such assessments. But I don’t think we need to get into comparative statistical arguments to prove that union employees are overpaid. The labor market itself gives us two simple tests:

  • Do union employees voluntarily quit their jobs at rates significantly lower than similar non-union employees?
  • Are there significantly more qualified applicants for new union jobs than for similar private-sector jobs?

If the answer to either or these questions is yes (and it does appear to be so), then the market has spoken: Union employees are relatively overcompensated. Their excess rents come at the expense of employers, customers, and labor market competitors.