Academic Eric Posner's Great Idea to Solve All Future Problems

My friend and reader Kim asked me to comment on the following opinion published on Bloomberg and asked me to comment on opinions expressed. I'm quote it in its entirety, apologies for a long quote, but there are just many idiocies in it, that you need the full picture.

In February, Mary Schapiro, chairman of the Securities and Exchange Commission, said the agency is looking for ways to rein in high-frequency traders. That is, the people who use computer algorithms to buy and sell derivatives at lightning speed to make instantaneous profits.

High-speed trading can waste resources and cause market disruptions. So the commission is right to look into high-speed trading. But it must realize that this is only one issue at the edge of a vaster problem that requires significant government intervention.

I don't understand: Is the author saying that HFT is dangerous? Or that making money using HFT is against his morality? Did HFT cause any financial crash? How does he define HFT anyway? Is it the role of the government to decide how people should spend their money? Is the author making any sense?

The larger challenge is that much of the U.S. financial system is devoted to wasteful activity -- useless trading that advances no important economic interest but, at the same time, creates a dangerous risk of economic crisis.

Who's the author to say that this wasteful activities, and that people shouldn't be doing wasteful activities anyway? Shall we ban casinos, cinemas, drinking places because they are wasteful activities? Shall we also ban him for publishing any opinion because reading his opinions are such a waste of time, and also so dangerous for our freedoms to spend our time and money the way we want?

The way to control this wasteful speculation is to require government approval of all new financial products, subjecting them to the same sort of examination and regulation that the Food and Drug Administration applies to new medicines.

Again, complete nonsensical proposition. HFT are trading highly liquid instruments, such as stocks and futures. Would the author's FDA ban stocks and futures to prevent what he considers to be wasteful activities?

Before there was an FDA, quacks peddled useless, and sometimes dangerous, tonics like radium water. Yet for all the harm such concoctions caused, they may never have matched the risk and waste of some financial derivatives -- what Warren Buffett has called “financial weapons of mass destruction.”

 If the FDA didn't exist, there would be plenty of other companies, not funded by the tax-payer, which would take on that role. They would more efficient and quicker to produce their reports. It would in the pharmaceutical firm's interest to obtain approval from those companies.

Moreover, the FDA is preventing people whose lives might be saved by experimental medicine to make the decision to use them, and hence, they are also contributing to peoples death.

A credit-default swap, a financial product that pays off if a bond defaults, might seem sensible. If you own a Greek sovereign bond and a CDS, when the bond defaults, the CDS pays you back. But if what you are trying to do is make money with low risk, you could buy U.S. Treasuries rather than Greek bonds. Normally, the buyer of a CDS on a Greek bond doesn’t buy the bond itself (making it a “naked” purchase). Such a transaction cannot reduce risk in the financial system as neither party is hedging a risk they already face. Instead, they are seeking to evade capital-adequacy regulations that aim to limit institutions’ risk exposures or to gamble more cheaply than would be possible if they had to take an explicit short position on the bond.
In the years leading up to the 2008 crisis, traders commonly used CDSs to gamble on default by a country, corporation or package of mortgages and to evade financial regulations associated with such bets.

The problem is not the CDS. The problem is that they are unfunded, uncollaterised. This a decision that both the sellers and the buyers have such instruments have knowingly made, and they should bear the risks associated to them.

Moreover, "gamblers" (term showing the negative opinion of the author) or speculators, provide liquidity to the market, and take risk off the hands of their counterparties. As such, they do bring value to the market.

Finally, how do you decide who's speculating, and who is not? Again, it would require the government to be all judgmental, and we know how this always ends with governments.

From 2000 to 2007, the notional size of the CDS market ballooned from zero to $62 trillion. Little, if any, of this activity served legitimate hedging purposes; almost all of it was tax and regulatory arbitrage or speculation. When the financial crisis hit, we all paid a steep price for the risks that this speculation had concentrated in a few institutions.

We didn't have the pay the price. We were robbed by the politicians. If the author is stupid enough to think there were no other choices, he should read a few articles and speeches by Ron Paul.

Not all financial innovations are this bad. Retail index mutual funds, created in the 1970s, have helped businesses obtain financing and have enabled people to diversify their investments across a range of stocks. And most mutual funds are useless for speculation because they are designed to be less volatile than the underlying stocks or bonds.

How, the author is creating the goose which lays golden eggs! I'm all for it. But they exists only in fairytales, not in the real world. But the real world is so far away from the academics living in their ivory towers, that I can very much understand where these ideas come from.

Creative economists have recently invented other derivatives that enable homeowners to protect themselves from a decline in housing prices.
So the federal government should address the risk posed by derivatives not by taxing or banning them uniformly, but by regulating them selectively, as it does with beneficial, but risky, medical drugs. Before pharmaceutical companies can sell their drugs to the public, they have to prove the products are safe.

Same as a couple of paragraphs above.

Likewise, the SEC, the Commodity Futures Trading Commission or a whole new federal agency could require financial innovators to prove the safety and efficacy of new derivatives. Their analysis could be done far faster and more cheaply than a typical drug review, because they could base it on existing economic data -- the same data companies use to project demand for their product.
The Federal Trade Commission and the Justice Department use similar procedures to project the likely effects of proposed mergers.

We've seen how successful the SEC, the CFTC and the FED have been in the past, so let's build more such successful organizations!

Regulators would distinguish the demand for the derivative’s beneficial uses -- diversification and insurance, supplying information to the market -- from the demand for its harmful uses -- avoidance of taxation and regulation, speculation and high-frequency trading. These assessments would help the agency determine whether the financial instrument should be licensed, restricted or prohibited.
If such a review had existed in the 1970s, the retail index mutual fund would have passed with flying colors.

Yes, because the brightest and most intelligent people always look for jobs as "regulators", and these omniscient people, which we used to only find in USSR and China, are now also available in the economic dreamland of academics leaving in their ivory towers.  

On the other hand, the reviewing agency would have seen that CDSs would be used not so much to reduce risk as to enable speculation and arbitrage. Traders might have been permitted to buy CDSs only if they owned the underlying bond, and naked CDSs would never have existed.

It doesn't make a difference at all. The problem is not the instrument, is the way the trade was collaterized, and the fact that the government decided to rip off people to save their lobbyist banks.

If our proposal seems radical, that is only because the deregulatory fervor of the past 20 years has created an atmosphere of lawlessness. Before Congress lifted restraints on the derivatives market in 2000, many new financial products were subject to review by the CFTC, in the understanding that speculative financial trading produces limited benefits and subjects the economy to great risks. That is a bit of wisdom we must now rediscover.

 The proposal is not radical. It's simply stated, utter nonsense. The problems we face are originating in too much regulation, and too many government entities feeding credit and fiat money into the system.

(Eric Posner, a professor at the University of Chicago Law School, is a co-author of “The Executive Unbound: After the Madison Republic” and “Climate Change Justice.” Glen Weyl is an assistant professor of economics at the University of Chicago. The opinions expressed are their own.)

Eric Posner is an economist illiterate, living in an Ivory Tower at the University of Chicago, and should probably keep on think twice before publishing another opinion of his.