2014 Reports

Tapping the Brakes: Are Less Active Markets Safer and Better for the Economy?

Stiglitz, Joseph E.

Keynes was very clear in his view that markets could be excessively active. There are many forms that such excessive activity can take. There can be excessively rapid transactions (associated with high frequency trading); relatedly, holding periods can be excessively short; there can be excessive short-term cross-border capital flows; or there can be trading in new products, like derivatives or CDS's. Each of these forms of transactions has come under scrutiny, in popular discussions , within the academic literature, and among policymakers. (Not surprisingly, those engaged in these transactions have robustly defended them, often citing academic studies in support of their position.) In this paper, I provide a brief, mainly theoretical, survey of some of the key issues. I begin (in section I) with a brief reference to two basic theoretical propositions, which should frame discussions in this area: there is no presumption that unfettered markets lead to (Pareto) efficient outcomes, or even that movements towards "better" markets lead to welfare improvements. Section II. focuses on a well-studied context--that of capital market liberalization--where there is now a broad consensus that unfettered markets are welfare decreasing. The remainder of the paper is devoted to areas in which research is more recent. Section III focuses on one aspect of "excessively active markets," cross-border capital flows. Sections IV and V focus on high frequency trading--section IV on the alleged benefits in terms of improved price discovery, section V on the alleged benefits in terms of greater liquidity. Section VI concludes with remarks about other ways in which markets may be excessively active, e.g. in the creation of derivatives, and with policy responses.