This week marks the fifth anniversary of the flash crash. For those who don't remember, the Flash Crash was when the stock market lost almost nine percent of its value from its opening level, with most of this decline occurring in a five-minute period.
The market quickly recovered most of this loss. As long as you didn't sell stock in the 30-minute crash interval, you weren't affected by this plunge. But the crash did reveal the extraordinary instability in the stock market due to short-term trading.
The issue of short-term trading is the key here. There was no event in the world that triggered the plunge. There was no outbreak of war, major terrorist incident, or natural disaster that sent stock prices plummeting. There wasn't even a bad profit report from a major company. The crash was based simply on program trading that fed back on itself, turning a downward blip into a major plunge.
Much of this trading came from high-frequency trading, program trading that profits by jumping ahead of major movements in the market. This has led to an unfortunate focus on high-frequency trading, an ill-defined concept, as opposed to the more general issue that we have seen an explosion of short-term trading in recent decades.
The average holding period for a share of stock is now less than five months, with short-term traders often flipping over the same shares several times in a day. This huge volume of trading adds nothing to the economy, but it can lead to immense fortunes for the traders. Of course, the fortunes for the traders come at the expense of the rest of us.
If a trader has designed a mathematical algorithm that allows them to jump in and buy large blocks of Apple stock just as a pension fund is looking to make a major purchase of shares, then the trader will get a portion of the gains that otherwise would have gone to the pension fund. This story applies to all areas of the market. Farmers that sell futures on their crops, airlines that buy futures on jet fuel, mutual funds buying government bonds, all can expect to see a part of their gains siphoned off by short-term traders that manage to beat them on market timing.
The traders now siphon off more than $200 billion (1.3 percent of GDP) a year from the productive economy. Much of this money is the income of super-rich bankers and hedge fund partners.
There is a simple and easy way to reduce the amount of money being drained away by short-term traders. A financial transactions tax, effectively a modest sales tax applied to trades, would drastically reduce the amount of short-term trading while raising a huge amount of revenue.
Earlier this year, Maryland Congressman Chris Van Hollen proposed a schedule of taxes comparable to what the European Union is likely to implement next year. It would tax stock trades at a rate of 0.1 percent (10 cents on $100) and trades of derivative at a rate of 0.01 percent (1 cent on $100). Extrapolating from a recent study of the revenue such a tax would raise in Europe, Van Hollen's tax would raise more than $130 billion a year or more than $1.5 trillion over the course of a decade.
This is real money even in Washington. This is almost twice projected spending on food stamps over this period. We could pay for huge amounts of education, research, infrastructure or whatever else is on the wish list with this money.
And almost all of it comes out of the hide of the financial industry. The short-term traders will of course pay the bulk of the tax. But most middle-income households with 401(k)s or other savings are likely to be almost completely unaffected by the tax. The reason is that trading volume will typically fall roughly in proportion to the increase in trading costs due to the tax.
While few middle-class people actively trade stocks, they own mutual funds which have managers that trade stock. Research shows that if a tax increases the average cost of a trade by say 50 percent, then fund managers will reduce their trading by roughly 50 percent. This means that people with money in a 401(k) would see little change in their total trading costs. Their fund would charge them more for each trade, because of the tax, but since it is trading less, they will end up paying the same. And, since people don't on average gain by trading, this ends up as a wash for the average 401(k) investor.
In short, we are talking about a policy that can raise a huge amount of money, mostly from the richest people in the country, by raising the cost of financial transactions back to where they were 10-15 years ago. It also might remove some of the instability we have seen in financial markets in recent years.
That sounds like the sort of policy that a presidential candidate who is pushing for everyday people would support. We shall see.