Last night's was one of those posts one regrets immediately after hitting "publish". Somehow, those always attract notice. (Thanks Felix!) But, sometimes when one puts more cards on the table than one intends, it's a good way to start a conversation. In fact, unintended candor is one of the great blessings of the blogosphere, and we must be thankful for that, even when we are our own victims.

Anyway, let's continue the conversation. Who deserves to get paid in capital markets? I wrote...

Bears who were right deserve to get paid just as much as bulls who were right, and justice delayed is justice denied for shorts.

Felix Salmon's rejoinder:

[T]here's only one species of investor who "deserves to get paid", and that's an investor with a contract which guarantees him money. I think they're called bondholders. If you buy a security in the hope that its price will rise, or sell a security in the hope that its price will fall, you don't "deserve to get paid" anything, whether you're right or whether you're wrong. Markets are not some kind of primary-school sports day where prizes get awarded to the most deserving. In the words of parents worldwide, "life's not fair".

Life is not fair, and Felix is quite right to note that markets don't exist to mete out some kind of wise and just reward to each and every trader. But at the same time, markets ought not be poker games or casinos, where it is the lucky who are compensated, or those whose talents have to do with games disconnected from real events. Market outcomes are supposed to attach to external referents. It is no tragedy when the winds of randomness overtake any particular trader. But on the whole, for a capital market to be "good", in a strong normative sense, it ought to compensate predominantly those who make wise judgments about the application of capital to real world enterprises, and to punish those who make poor judgments. Capital markets, actual, historical, and conceivable, are not all alike, and it is quite possible, and quite right, to make normative distinctions between. A capital market is not good because its prices go up. Nor do happy investors and happy fund-seekers define a good markets, in and of themselves. As Martin Wolf recently wrote, "Finance is the brain of the market economy." What distinguishes a good capital market from a bad capital market is how well it does the economy's thinking.

Bondholders absolutely do not "deserve" to get paid, any more than stockholders, or holders of derivatives, or any other financial position. A bondholder who lends to profligates to fund consumption, for example, absolutely deserves to lose, coupon and principal. And an investor who finds a firm that needs capital, and who correctly judges the firm's activities and management as being of the sort that could put capital to good real world use, absolutely deserves to be paid, regardless of whether that payment comes in the form of capital appreciation, dividends, or interest. The purpose of capital markets is to compensate managers of capital for putting scarce resources to good use, and to punish managers who squander what is precious. Markets needn't and can't offer perfect justice. But if they fail on the whole to compensate the deserving and punish the wasteful, then we might as well banish them to riverboats.

Many of the best and brightest of this giddily corrupt moment err by forgetting that capital markets are human creations subject to wide variation in design and behavior. They mistake whatever some prominent market does for "the market outcome", and forget that alternative arrangements in security design, regulatory regime, macrostructure of financial instititions, and microstructure of trading systems are all possible, and might produce very different outcomes, all of which would have equal claim to being "market-determined". And the fact of a market doesn't absolve us from making judgments about whether outcomes are good or bad, even though our nonmarket means of evaluating the world are at least as flawed as our markets. Failing to subject markets to reality checks, relying on them entirely for all of our economic thinking without letting other measures of economic sense weigh in at all, invites corruption.

I write not to attack markets, but to defend them. Dani Rodrik has suggested we must save globalization from its cheerleaders. It is equally urgent that we save capital markets from their cheerleaders. I believe that well-designed markets generally are the best way to make most large-scale economic allocation decisions, and that market-like systems could be productively employed in a variety of other contexts as well. But current capital markets are frankly off the rails, in a manner that most people not subject to ideological blinders are perfectly capable of seeing. I could be wrong. I'm not a market, after all, so perhaps I have no standing to opine. But even still, I could be right.

Which gets us back to the bit about short sellers. If I am right about bad things down the road, good capital markets should, on average, compensate me if I trade on my superior-to-market knowledge of future bad outcomes. The repricing brought about by my trading and the trading of many others who see what I see should work to make those bad outcomes less likely and less damaging. The "on average" is important here. I can be right, but foolish in execution or just unlucky, and get wiped out. That's life. But markets that are systematically biased towards integrating positive information and ignoring negative information (until sudden "Wile E. Coyote" moments), that have institutional biases against short-selling or that delay price declines because some actors have more at stake in market prices than real-world referents, may, on average, fail to compensate shorts. If so, then rational people won't short, prices far higher than reasonable economic value will be stable for long periods of time, "greater fool" strategies of investment will be profitable, and "adjustments" will come sharp, large, and painful when underlying economic realities can no longer be papered over. Markets compensate next-to-last fools in preference to wise allocators of capital, and leave everyone else with a mess. That, unfortunately, is the world we live in today.

Felix writes:

Steve is living in cloud cuckoo land if he believes in the "real-world meaning of market prices on the basis of direct valuation of the assets being traded". If that was really the case, then there would never be any price difference between voting shares and non-voting shares, for starters. Capital markets, in this sense, have been failing for as long as they have existed. And a lot of smart, long-term investors have made a lot of money by arbitraging those failures. On the other hand, a lot of smart, long-term investors have also lost a lot of money by attempting to arbitrage those failures. Being smart and right is not enough to make you rich.

Although I plead guilty to living in cloud cuckoo land, I do not actually believe that actors trade only on the basis of real-world valuation. I do, however, believe that to the degree actors trade for "strategic" rather than fundamental reasons, they are corruptors of price signals, creators of noise, and that well-designed market systems will work to punish rather than compensate their behavior. To the degree there are "limits to arbitrage" that systematically pay off game-players and punish those who price the real world accurately, that's a real problem that should be fixed. Felix is right that being smart and right will never be enough to make one rich in capital markets. Life is uncertain, and luck always matters. But if on average people who are smart and right about underlying realities lose, that's a problem.


But the surprising thing is precisely that there is some efficient allocation of real resources – not that there is inefficient allocation of real resources. Real resources have always been allocated inefficiently, and they always will be. Just look at the fashion industry.

No human institution is perfect. A glass is always empty or full by some fraction. But, when the glass seems so empty that you think lots of people are going to die of thirst, looking on the bright side is not the appropriate response. Maybe, hopefully, I'm just mistaken. But if one sees capital markets as broken in ways that could cause serious hardship and perhaps outright catastrophe, pointing out the flaws, even ranting a bit, is not entirely uncalled for. Or so I like to think.

On a personal note, my previous post was perhaps too "heartfelt". The fate of my own portfolio doesn't matter that much, even to me. I'll not starve when I'm forced to cover my shorts. I only personalized the tale because, after telling others they should be ashamed of themselves, I felt ethically bound to reveal that my scolds could be taken as self-interested and manipulative.

I'll end with a bit of Keynes, which resonates with my view of investing, short or long:

I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holding with equanimity and without reproaching himself. Any other policy is anti-social, destructive of confidence, and incompatible with the working of the economic system. An investor is aiming or should be aiming primarily at long period results and should be solely judged by these.

Update History:
  • 14-July-2007, 3:40 p.m. EET: Replaced wordy "bears no relation to" with "disconected from", "external reality" with real events".
  • 19-July-2007, 4:52 a.m. EET: Removed the ungrammatical "s" from "a good capital markets".
Steve Randy Waldman — Friday July 13, 2007 at 6:15pm permalink
Jed Harris (www):
I agree with nearly all of this, and I think it needs to be said and repeated. I think we need to pin down people who disagree and determine the nature of the disagreement.

We give a lot of protection, support, and latitude to finance on the ground that it contributes in major ways to social self-regulation and self-organization. To the extent that it is a fancy parimutual system with no social value beyond entertainment, it deserves no special treatment. The impassioned cries of those who operate the system are irrelevant unless they can demonstrate its value for others.
7.13.2007 8:14pm
Steve Randy Waldman (mail) (www):
I'm glad to agree with nearly all of your agreement. If capital markets have become "fancy parimutual system with no social value beyond entertainment", then they deserve worse than special treatment. Horseraces don't much affect anything outside of the track. But events on Wall Street do very much affect lives and circumstances everywhere. If they don't do so in a socially beneficial way, than they probably do so in a harmful way, and on a very large scale. People who trade and chatter about markets all day sometimes forget that the games they play create consequences for billions of people. If those consequences are sufficiently adverse, there might be "blowback".
7.14.2007 1:18pm
Hanhan (mail):
Dear Steve, I hope you still remember me:) suddenly log onto your blog and want to keep in touch.
American capital markets run quite well all over the world, with its well-known accounting and disclosure regulations as well as its efficient financial system. From my perspective, the point of this "short seller"issue is essentially about personal preference. If you compare Warren Buffet with George Soros, you might find the methods they manipulate stock markets are quite polar. Soros is regarded as a short seller, at least it could be proved in 1997 Southeastern Asia financial crisis. However, both men have done an excellent job in creating fortunes.
Everyone executes their own comparative advantages to fulfill more wills, which makes macroeconomic difference between labor-intensive industry in China and capital-intensive industry in US. In the light of this statement, money will always follows money in a free market. The one who holds a larger amount of capital will always be the victor in capital markets, because he or she is the one who can ultimately controls the situation. And "short seller" you mentioned, who I assume is the one who holds less capital, is at a more disadvantaged situation comparing to those financial superstars.
Somehow, I still propose more regulations over the capital markets, although sometimes they can distort its normal distributional and organizational ways. This is particularly necessary for a healthy domestic market, at least it could benefit the mid-class people who forms the majority of American society. Nevertheless, with global capital markets gradually coming into being, an effective global regulating guidelines could not be realized too soon. This said, it might provide some financial crocodiles with precious opportunities to earn again.
P.S. I haven't been in capital markets yet, so all these are just a premature view from an 18-years-old undergraduate whose major is ironically not Finance. But maybe I might try to enter it two months later, when I am supposed to accumulate some starting-up money this summer.

Still good luck to your enterprise in wall street!

Yours, Ellen C.
7.15.2007 11:44am
Steve Randy Waldman (mail) (www):

Of course I remember you well.

I'm not sure either Warren Buffet or George Soros would consider themselves to be manipulators of stock markets. Soros clearly does sometimes act with intent to alter the price of what he trades, but he might argue, with some justification, that he is really fighting against (and profiting from) unsustainable manipulations by others, rather than doing the manipulating himself.

I'm no longer a huge fan of American capital markets — I once was, but not now. There is a lot of regulation, a kind of opaque transparency (a "public" version of the universe is carefully crafted and made available to all, but that fails to capture a great deal about what's really going on), and lots of action, "liquidity". But, as I write ad nauseum, I'm skeptical that the broad outcomes and incentives produced by US capital markets are, in fact, good.

There's a delightful kind of naive cynicism in your comments, "The one who holds a larger amount of capital will always be the victor in capital markets, because he or she is the one who can ultimately controls the situation." Capital markets are not supposed to be so manipulable, so at the mercy of the deepest pockets. They are supposed to reflect realities that cannot necessarily be bought. But, what how capital markets ought to behave, and how they do behave, are two very different things.

Good luck to you in your studies!
7.18.2007 9:03pm
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