John Cochrane has an excellent article in the Journal of Economic Perspectives, discussing a wide range of finance problems. Here’s a small sample:
The period after a news announcement often features high price volatility and trading volume, in which markets seem to be fleshing out what the news announcement actually means for the value of the security. For example, Lucca and Moench (2012, Figure 6) show a spike in stock-index trading volume and price volatility in the hours just after the Federal Reserve announcements of its interest rate decisions. The information is perfectly public. But the process of the market digesting its meaning, aggregating the opinions of its traders, and deciding what value the stock index should be with the new information, seems to need actual shares to trade hands. Perhaps the common model of information— essentially, we all agree on the deck of cards, we just don’t know which one was picked—is wrong.
That is something I’ve noticed as well. Here’s a proposed solution to high frequency trading:
Suppose that an exchange operated on a discrete clock, as a computer does in order to let signals settle down before processing them. The exchange could run a once-per-second, or even once-per-minute, matching process, with all orders received during the period treated equally. If there are more buy than sell at the crossing price, orders are filled proportionally. Such an exchange would eliminate extremely high-frequency trading, because there would be no gain or loss from acting faster than a minute.
Here Cochrane discusses whether finance is too big:
Demand that shifts out can shift back again. Demand for financial services evaporated with the decline in housing and asset values in the 2008 recession and subsequent period of sclerotic growth. Much of the “shadow banking system” has disappeared. For example, asset-backed commercial paper outstanding rose from $600 billion in 2001 to $1.2 trillion in 2007—and now stands at $300 billion. Financial credit market debt outstanding in the flow of funds rose from $8.6 trillion in 2000 to $17.1 trillion in 2008—and now stands at $13.8 trillion. Employment in financial activities rose from 7.7 million in 2000 to 8.4 million in 2007—and is now back to 7.7 million (according to the Bureau of Labor Statistics). Study of “why is finance so big,” using data that stops in 2007, may soon take its place alongside studies of “why are Internet stocks so high” in 1999 or studies of “why is there a Great Moderation” in 2006. . . .
. . . It is possible that there are far too are far too few resources devoted to price discovery and market stabilization. In the financial crisis, we surely needed more pools of cash prepared to pounce on fire sales, and more opportunities for negative long-term views to express themselves.
Surveying the current economic literature on these issues, it is certain that we do not very well understand the price-discovery and trading mechanism, nor the economic forces that allowed high-fee active management to survive so long.
Note that economic theory predicts that society will devote too few resources to ferreting out useful information about corporate values.
PS. I thought David Henderson made a very good point in this critique of Krugman on waste in finance:
Now to the three possibilities:
1. If the payments made by Thomson-Reuters and others who get the information earlier are needed to give U. of M. the appropriate incentives to gather quality information, then the payments are not wasted.
2. If the payments made by Thomson-Reuters and others who get the information earlier are not needed to give U. of M. the appropriate incentives to gather quality information, then the payments are producer surplus to the U. of M. and there is no social loss from the payments–it’s just a transfer.
3. If in case #2 above, the producer surplus is used for low-value uses at U. of M.–this is both a non-profit university and a government university, after all–then there is a waste.So only in case 3 above is it “unproductive finance.” I’m pretty sure Krugman isn’t going with case 3.