Programmed Trading is NOT Innovation

Huffington Post - Dan Froomkin is Washington Bureau Chief of the Huffington Post, and also Deputy Editor of NiemanWatchdog.org, where this post first appeared.

Excerpts and Commentary

A series of articles appeared on the Nieman Watchdog Web site that collectively present the idea that this current crisis was not cyclical in nature, but instead is an expression of structural problems. From their conclusions, there are seven things that everyone, especially policy makers, should know. Most of all, the myth that Wall Street used to justify their outrageous compensation packages can be debunked once and for all. The investment banks and program traders do not create wealth through innovation; they merely move numbers around, stealing from slower and more gullible investors. Like playing musical chairs in kindergarten, those holding the worthless pieces of paper when the music stops, are like those proverbial Norwegian pension funds who have no other recourse but to sue the big banks for their questionable practices. As for everyone else, the fall out is yet to come.

No. 1: The middle class may never be the same again.
For most members of the middle class, their sense of financial well-being was largely based on the size of their 401(k)s and their equity as homeowners. While 401(k)s have somewhat bounced back, about one in four homeowners now actually have negative equity -- are "underwater". For long stretches of time, the growth in the nation's GDP has gone almost entirely to the top 1% or less of the population. That has resulted in an dramatic shift in wealth away from the middle class, made the economy more vulnerable to disaster and made the toll of such a disaster more catastrophic to all but the wealthiest Americans. ... Elizabeth Warren, an emerging hero among progressives in her role as chair of the congressional bailout oversight panel, writes:

America today has plenty of rich and super-rich. But it has far more families who did all the right things, but who still have no real security. Going to college and finding a good job no longer guarantee economic safety. Paying for a child's education and setting aside enough for a decent retirement have become distant dreams. Tens of millions of once-secure middle class families now live paycheck to paycheck, watching as their debts pile up and worrying about whether a pink slip or a bad diagnosis will send them hurtling over an economic cliff.

She concludes: "America without a strong middle class? Unthinkable, but the once-solid foundation is shaking."

Without the strong backbone of the middle class, American life will be dominated by the oligarchy of the rich and powerful, the multinational lobbyists, the wealthy Republicans who cared more about their own freedom than the well-being of fellow Americans.

No. 2: The recovery could take a really long time.
And the recovery, such as it is, has been largely fueled by government money -- not just the stimulus, but also the bailouts, targeted programs such as the home buyers tax credit and "cash for clunkers," and emergency spending on such things as extended unemployment insurance. What happens, however, when those stop? And none are designed to go on forever.

Washington Post financial columnist Steven Pearlstein recently put it this way:

My best guess is that the current upswings in economic output, confidence and financial asset prices are largely a reflection of the extraordinary fiscal and monetary juice provided by Treasury and the Federal Reserve, along with the natural rebound that occurs after a collapse in consumer and business spending like that which occurred in the first half of 2009. The surprising strength of the bounce-back testifies to the wisdom of the underlying strengths of the U.S. economy and the success of the policies, but is likely to peter out as the stimulus begins to wear off and the inventory correction is completed.

It is already clear that the first round of stimulus has been insufficient, and also inefficiently implemented, with a result of billions still unassigned, sitting idly in the Treasury. By contrast, the socialist Chinese stimulus programs have been lightning fast in response and implementation, and efficient in the distribution of funds to the middle class consumers. Indeed, China is now reining in credit to prevent the economy from overheating. At 10% growth last year, China overtook Japan as the world's second largest economy. Although the American economy is still by far the world's largest, at three times the size of next national economy, if the current state of affairs continue, China will be similar in size as the American economy within a couple decades. Even now, regional economies such as The European Union and the up and coming East Asian Community will take on increasingly leadership roles in the world. America cannot allow complacency to lose its future place in the world.

No. 3: The recovery could only be temporary
In an interview with Fox News back in November, Obama himself raised the possibility that the economy could once again into a tailspin:

I think it is important though to recognize that if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the US economy in a way that could actually lead to a double-dip recession.

Clinton-era Labor Secretary Robert Reich recently speculated a 20 percent chance of a stalled recovery.

The commercial real estate market craters, carrying with it hundreds of regional banks and exposing how much junk is still on the books of major Wall Street banks. This triggers a long-awaited "correction" in the Dow and pushes the nation into another recession. Job losses rise.

If the trillion of dollars pumped into Wall Street through TARP and by means of low or no interest loans from the Feds were used to buy and stop short all the millions of foreclosures that occurred in the past year, American home equity would not be nearly as badly off as they are now, with possibly a significant percentage of them above water, instead of being under water. It is indisputable that the Wall-Street bail out programs have been woefully inadequate and inefficient in terms of saving the American economy, in terms of preventing a future economic meltdown. Jamie Dimon of JPMorgan Chase was quite correct when he answered the Congressional inquest into the financial crisis. As far as he and his banker pals are concerned, another once-in-a-century financial meltdown may occur again. It is unavoidable. They have no idea how to prevent another one. It is up to Congress and the American people to prevent it.

No. 4: Then what? This time, we don't have the tools to get out of a recession
The recognized way of dealing with a recession is to lower interest rates in order to stimulate the economy. But the Federal Reserve can't lower the rate to below zero, so that's out.

The government can pour vast amounts of money into the economy, either through a stimulus or a massive bailout -- or, as the case may be, both.

But next time around, that money might not be there. Not only could the political will be lacking, but there is an upper limit to just how much money the country can borrow and spend at one time without it doing more harm than good.

The problem is worst than described above. The Feds have already created negative interest rates by the sleigh of hand through no interest loans to the big banks. It is why Wall Street and the investment banks rebounded so quickly, with a flush of liquidity directly from the American people's coffers. Unfortunately, instead of directing the liquidity to Main Street, Wall Street decides to drown themselves in self-congratulatory bonuses. The Feds, in fact, has been compromised by the bankers and little has been done to stimulate the economy using Feds funds.

No. 5: The ‘very serious' people in Washington are still obsessed about the deficit
New York Times columnist Paul Krugman noted recently, "the calls we're already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder." He adds:

But if those calls are heeded, we'll be repeating the great mistake of 1937, when the Fed and the Roosevelt administration decided that the Great Depression was over, that it was time for the economy to throw away its crutches. Spending was cut back, monetary policy was tightened -- and the economy promptly plunged back into the depths.

When the firm is still struggling to meet operating margins, still striving to recover revenue lost to economic downturn and customers going through hard times, is it time to cut back on credits and cut back on staff and cut back on structural investments? The medicine is worse than the disease and will likely kill the patient. Slash and burn deficit reduction may balance the books, but at what cost? Will the America that survive be the society that is still called America? President Obama just announced a freeze on programs. When more stimulus is required, this freeze is no different from cutting cost. Now is not the time to count beans when the house is falling down.

President Obama stated in his first State of the Union Address to the Congress that the freeze will only take effect beginning in 2011. Let's hope the economy recovers quickly and job creation produced sufficient results to tolerate the freeze. A weakened patient is susceptible to even a mild shock.

No. 6: Whatever is making the stock market go up could go away
The giddiness over the recovering stock market makes it easy to overlook some key questions about its rise. But what exactly has sent the Dow up almost 70 percent since March? Could it be another bubble? And could it burst?

Was it a function of the extraordinary liquidity pumped into the system, first through the bailouts and now through nearly zero-interest loans to the banks? Was it foreign investors attracted by weak dollar and low interest rates? Where's all the money coming from?

No one seems to know. (Does anyone really care?) But whatever it was could presumably come to an end, devastating the market and the economy.

The current "irrational exuberance" (as past Feds Chair Alan Greenspan described a previous bubble) clearly demonstrates the disconnection between Wall Street and Main Street. To put it in less poetic and more scientific terms, the stock market evaluation of company capital and earning potential has nothing or little to do with the fundamentals of the economy. Indeed, it is this disconnection which propelled the latest fad in program trading, the Quants. As seen in the book review in the Wall Street Journal, Scott Patterson's new book, "The Quants." These self-proclaimed geniuses dress up program-trading using esoteric mathematics and algorithms and called it innovative investing. Program trading already caused crashes in 1991, and before that in 1987. Without regulation and supervision, the bankers who make hundreds of millions each year decide to allow this risky practice, and reap billions in profits, instead of safeguarding the hundreds of billions of people's savings, entrusted to them because they say they know what they are doing, because they say they are the experts. The past year has shown the transparency of the Emperor's New Clothes. Let's call Wall Street naked selfish greed for what it is.

Wall Street JournalIn his new book, "The Quants," Wall Street Journal reporter Scott Patterson suggests how a new breed of mathematicians and computer scientists took over much of the financial system and inflicted the damage that led to the financial meltdown.

No. 7: The hugely irresponsible financial sector remains unchastened
Back in March, Obama described modern Wall Street as a "house of cards" and a "Ponzi scheme" in which "a relatively few do spectacularly well while the middle class loses ground."

In his major speech on the economy in April, the president proclaimed that "we cannot go back to the bubble-and-bust economy that led us to this point." He continued:

It is simply not sustainable to have a 21st-century financial system that is governed by 20th-century rules and regulations that allowed the recklessness of a few to threaten the entire economy. It is not sustainable to have an economy where in one year, 40 percent of our corporate profits came from a financial sector that was based on inflated home prices, maxed-out credit cards, over-leveraged banks and overvalued assets. It's not sustainable to have an economy where the incomes of the top 1 percent has skyrocketed while the typical working household has seen their incomes decline by nearly $2,000. That's just not a sustainable model for long-term prosperity.

Economist Simon Johnson (the subject of one of Hanrahan's articles) recently said on CNBC:

The conventional wisdom is you can't have back-to-back major financial crises. I think we're going to push that, we're going to have a look and see whether that's true. And the next 12 months could really be exciting. People could be very positive, but we are setting ourselves up for an enormous catastrophe.

Indeed. By Obama's biblical analogy, our economy is still very much built on sand --and the next big storm might not be very far away at all.

The worst is yet to come, if the banks are not regulated, and the Obama Administration does not do more to stimulate the economy, and homeowners continue to be left out on their own to be foreclosed by banks that are too big to care. When the Second Great Depression comes, America will lose its leadership position in the world to China, and will remain a has-been superpower for decades to come.

Now it's the time to take action, chasten the financial barons, whip Congress into passing needed legislation, and move Main Street back to the top of the agenda.