Does stock trading / futures speculation create economic value?

October 7, 2007 11:10 AM

[EconFilter] Does stock trading / futures speculation create economic value?

Here's what I recall from my (very shallow) knowledge of economics: if I bake and sell a loaf of bread, I have created new economic value in the world, because the value of that bread to a customer is probably greater than the value of the wheat, water, yeast, etc., that composes it. And it was this conception of economic activity (business isn't a zero-sum game) which partially led to the rise of capitalism over mercantilism. Correct me if I'm wrong here.

So my question is: is all that true for, say, stock or futures traders, or other people who don't directly create anything, but analyze market conditions to determine the best times to buy / sell stocks? It seems like investing in someone's business could create value indirectly: allowing the baker to buy a better mixer, and thus create bread more efficiently, etc. But buying and selling stock seems more like a global game of poker, where the pot is the sum of the growth of all actual businesses. And all the research that goes into determining what stocks to sell at what time is analogous to finding a better poker strategy.

So if I make my living buying / selling stock in clever ways, am I adding economic value somehow, or am I just finding ways to get myself a bigger piece of a pie that other people made?

posted by molybdenum to Work & Money (17 answers total)

Yeah, there is some value in providing liquidity.

Eg, I'm a long term holder. I don't trade. However, at any given time, I might want to sell up, say because there's a family emergency. Or I might want to buy, because I have identified a potentially good long term investment. If it weren't for traders, I would have to wait a longer time before I could find someone to do deal with. Traders reduce my risk that I can't turn my assets into cash.
posted by i_am_joe's_spleen at 11:22 AM on October 7, 2007

Traders are middlemen. It is not their job to "create" value, but rather to match buyers to sellers and to set prices. Modern financial markets and their participants have evolved and specialized somewhat and thus we often forget their role.

Now you may think that the middlemen should be cut out of the process, but throughout the history of mankind it has be shown again and again that we should all stick to what we know how to do best. Some of us know how to make things, others know how to sell them.
posted by randomstriker at 11:22 AM on October 7, 2007

Futures traders are taking over risk from other people. In a sense it's like a form of insurance.

A farmer says, "I am sure my crop will come in this year and I'm going to have a lot of wheat to sell. But I don't have the slightest idea what the market price will be when time comes to sell it, so I don't have any idea how much money I'll make from it. That means I don't know whether it makes sense for me to invest (e.g. in fertilizer) for my crop. It could just be money into the toilet."

The futures market says, "We'll let you sell a futures contract for your crop right now which permits you to lock in a price. It may not be as high a price as you might get when you finally sell, but it will be certain and will permit you to make plans without having to worry about future price fluctuations."

The farmer says, "Right, I'll do it". The economic value of the futures market is to permit people like that farmer to be protected from price fluctuation.

But for such a market to exist, there has to be someone willing to buy that contract. That means there has to be potential profit in doing so. Said profit is not itself a "creation of wealth"; it's more like a fee paid by the guy who does create wealth to compensate the futures trader for assuming risk from the wealth creater.
posted by Steven C. Den Beste at 11:29 AM on October 7, 2007

Best answer: The idea is that allocation of capital should be efficient, otherwise people who could otherwise be creating valuable goods and services by employing that capital as an input are deprived of the ability to do so because they can't access the capital they need.

Here's an example. If I possess a million bucks, buy 1200 oz. of gold and hide it all under the mattress, my wealth does no one any good. If I lend a million bucks to an unemployed baker, that baker can rent out a bakery and make 100000 loaves of bread that year. Assuming that there are buyers for those loaves of bread, that's 100,000 loaves of bread out in circulation that would never have existed if I'd allocated my capital inefficiently.

Capital markets - like stock and futures exchanges that you mention - provide a number of utilities to the economy. By participating in funding IPOs with my million bucks, I can choose where to allocate my capital among a wide array of choices.

Now here's the kicker. If I participate in the BakeryCorp IPO with my million bucks, I'm going to obtain stock in BakeryCorp. I want to know that those stock shares are going to be priced efficiently in the future, before I'm willing to make my investment. If the shares gain value, but I can't sell them to anyone, they're no good to me. If the shares gain value but people are only willing to buy them for less than their true value, they're less good to me than they otherwise would be and I might think twice before I bought any.

The existence of stock and futures markets in theory allows the price of stocks and commodities to "seek their own level," that is, the market contains all the information necessary to establish the true value of a stock share. This is called the "efficient markets hypothesis" and for it to happen you need to have a market where trading can go on. If you have a market where trading can go on, it will go on - as you see.

This is the convoluted and drawn-out argument that stock traders, futures traders, hedge fund operators, and arbitrageurs use to justify their utility to society. I think that to the extent the efficient markets hypothesis is true, the amount of value these guys add to the economy is considerable. I also think that with abuses such as insider trading, the amount of value these guys can take out of the economy and put into their own pockets is really very high and that is why people get so exercised about SEC regulation violations.

There are plenty of arguments against the Efficient Markets hypothesis; the wikipedia article on it is probably a good place to start.
posted by ikkyu2 at 11:46 AM on October 7, 2007 [2 favorites]

But isn't the value created less than that lost by the trader not actually working/producing?

Trust me, traders are working. Very long, intense hours, in fact.

As for production, market demand obviously shows that the trader's time would be better spent a performing service that requires high expertise and qualification rather than putting in shifts at a sheet-metal factory.
posted by randomstriker at 11:50 AM on October 7, 2007

Yes, stock/bond/securities traders create economic value.

Here is one way they do this:

People have to decide how to allocate their savings over different types of assets (e.g., stocks, bonds, real estate, paintings). The asset allocation decision depends on things like how much risk the person is willing to take on, the rate of return on the asset, and how liquid the asset is. Depending on where the person is in their lifecycle, they will have different preferences for the types of assets they would like to hold. For example, a young person would probably want to hold risky assets that pay a high rate of interest, whereas an elderly person would probably hold assets that are not risky and can easily be converted to cash if medical emergencies arise.

Stock/bond/securities traders allow people to buy and sell assets whenever their life circumstances change and this is a valuable activity. For example, as a person gets older, they’ll start moving out of risky assets and into less risky assets, and it is the traders that help them to do this, by finding people who would like to purchase their risky assets.

You could ask yourself, do used car lots perform a valuable service to society? The answer is yes. If used car lots did not exist, then people who no longer needed their two seat sports car after they had kids might be stuck with it for a longer period of time. The used car lot helps these people to easily match the type of car they would like to drive with their current life circumstances, just like the asset markets.
posted by Jasper Friendly Bear at 11:51 AM on October 7, 2007

Is all that true for, say, stock or futures traders, or other people who don't directly create anything, but analyze market conditions to determine the best times to buy / sell stocks?

No, it isn't true. You've conflated many different things into one.

Timing the market is called "technical analysis" (charting). I.e. looking at past price movements to determine future price movement. It is a very specialized profession, mainly employed in active investment management.

Stock traders are, very broadly, traders who buy stocks in public companies. They might use technical analysis, fundamental (i.e. value) analysis or a combination of both. They might automate the process and mine historical data for hidden patterns...i.e. quantitative finance.

Futures contracts are agreements to sell a commodity at a set price for X length of time regardless of actual future price movement. Just like your fixed rate mortgages. The purpose being to mitigate price volatility.
posted by randomstriker at 12:02 PM on October 7, 2007

I also think that with abuses such as insider trading, the amount of value these guys can take out of the economy and put into their own pockets is really very high and that is why people get so exercised about SEC regulation violations.

Insider trading is upsetting and gives the finance industry a bad name, but the overall economic effect is completely immaterial. Trillions and trillions of dollars worth of securities are traded daily. Other than the moral offense, what does it matter to you and me if a few hundred traders were able to skim a few million each every year?
posted by randomstriker at 12:23 PM on October 7, 2007

Response by poster: Thanks everyone for the answers!

ikkyu2 - it sounds like you're saying that stock traders create value in that they faciliate the "invisible hand" pushing prices so they they reflect the good's actual value (assuming you buy the Efficient Markets hypothesis). Is that accurate?

randomstriker - I certainly don't mean to suggest that stock traders don't work hard! Part of what makes me ask the question is my brother-in-law. He has a master's in computational finance, is wicked smart, and works his ass off -- for a company that analyzes futures prices and figures out the optimal time to buy / sell them. The heart of my question is: I always wondered if he would create more economic value if he simply quit his job and became a baker (sort of luriete's question). It may be that I'm inaccurately conflating his job and stock trading in general, but they seemed, to my untrained eye, like similar activities.
posted by molybdenum at 12:31 PM on October 7, 2007

Don't conflate economic value with societal value.

randomstriker: Insider trading is upsetting and gives the finance industry a bad name, but the overall economic effect is completely immaterial. Trillions and trillions of dollars worth of securities are traded daily. Other than the moral offense, what does it matter to you and me if a few hundred traders were able to skim a few million each every year?

It isn't anywhere near that simple. There are countless manipulations that may or may not be prohibited, but nonetheless cause the market to be less efficient. Ever heard of a bubble?

molybdenum: I always wondered if he would create more economic value if he simply quit his job and became a baker (sort of luriete's question).

He would likely do far more good for society, but that isn't related to economic value.

Perhaps this line of thinking leads to Marxian economics..

randomstriker: Now you may think that the middlemen should be cut out of the process, but throughout the history of mankind it has be shown again and again that we should all stick to what we know how to do best. Some of us know how to make things, others know how to sell them.

As with everything else, that is true right up to the point where it isn't. Expertise has more value than general labour, certainly, but if you overly specialize, you are ripe picking for any middle man who wants to take you for a ride. Sort of like Marx's wage slavery, I guess.
posted by Chuckles at 1:01 PM on October 7, 2007

molybdenum: The heart of my question is: I always wondered if he would create more economic value if he simply quit his job and became a baker?

The main assumption in neoclassical economics (the main type of economics now taught in universities) is that people try to do the best they can given their circumstances. If a person who is working as a stock trader thought society would value him more (i.e., be willing to pay him more money) as a baker then he would change jobs on his own. The fact that people actually work as stock traders must mean that at a personal level, they are valued more as traders than bakers.

Sometimes you have situations where people benefit individually from engaging in an activity but harm other people in some way. These types of activities are said to have a negative externality. Factories that dump toxic waste into rivers and make people ill and then not pay the medical bills for the sick are an example of this. In this type of activity, the social benefit (i.e., the total benefit to society) may be lower than the private benefit to the people engaging in the activity. Society would be better off limiting (but probably not completely shutting down) the production of these types of activities. Asset trading probably does not impose a negative externality on society, and so society would not be better off if some people were forced out of trading and into baking.
posted by Jasper Friendly Bear at 1:09 PM on October 7, 2007

The "invisible hand" was Adam Smith's way of explaining how competition drives prices down, in other words the first supply-side explanation of one way markets determine prices. This was a revolutionary idea because it was one of the first formulations to explicitly state a reason for the policy of "laissez-faire," that leaving the market be was the best way to get prices to be what they ought to be. The efficient markets hypothesis is an extension and elaboration of these early ideas.

Stock markets antedated these ideas but the incentives that created the markets were basically what I outlined above. I would say that according to the efficient markets hypothesis, having the market there is supposed to magically set prices to the correct level. But if you watch the market it fluctuates a lot. That's because things like perfect information about the future (required by the Efficient Markets hypothesis as a prerequisite) do not actually obtain in the real world. Traders (when acting in good faith) contribute their expertise to the task of making the market as much like an efficient market as possible, even when they don't realize that's what they're doing. The more the market behaves like an efficient market, the more capital will flow into it. So in a sense traders are helping the invisible hand do its work more effectively, if you want to look at it this way.

Central banking, money supplies, and fiat economies really throw a monkey wrench into these ideas. If you really look at the efficient markets hypothesis, it states as a corollary that the market ought to be able to anticipate the (presumably goal-directed) actions of the central banks, price them out fully in advance, and in doing so incidentally nullify the ability of the central bank to achieve the goal / create the effect that their actions were intended for. That means that any time the Fed take an action, they are trying to break the invisible hand and make it stop pushing the way the markets say it's supposed to.

Keeps it interesting.
posted by ikkyu2 at 1:41 PM on October 7, 2007

But isn't the value created less than that lost by the trader not actually working/producing? Couldn't he/she create more value that way? In the long run, isn't it worse for the society overall?

The same could be said for truck drivers. They don't create anything (except pollution); they just move things around.

But "moving things around" is economically valuable. It permits manufacturing concentration which permits economy of scale. Truck drivers make it possible for big factories to exist, which can produce goods for a lower per-unit cost, because they make it possible for the factory to sell their products to a larger market.

Also railroads, barge-pushing tugboat crews, sailors on cargo ships. Same thing.

And the same is true for stock and futures traders, but in different ways. They themselves don't create value, in the sense you're thinking of, but because they exist other people are more efficient at producing value, and the net result is larger than it would be if the stock traders all became bakers. As bakers they'd create bread, but all the people who needed stock/future trading to make their businesses more efficient would not have them. Net total is down.
posted by Steven C. Den Beste at 1:52 PM on October 7, 2007

Maybe this is a slight derail, but it seems related -- Jasper Friendly Bear's comment makes me wonder, given that it's hard for us to explain how stock brokers create value, why do they get paid more than say, people who research some pressing problem (say, how agriculture will have to shift with climate change). I have some guesses as to why, in laymen's terms, but I can't explain it in economic terms. It's not supply and demand (is it?). It seems more related to the ability of a society to act collectively or value those things that benefit them as a whole...
posted by salvia at 6:35 AM on October 8, 2007

Salvia, in that case, the argument would probably be that people who research pressing problems, as a whole, require resources to do so.

By directing capital to areas where it has the greatest return, as ikkyu excellently explained, stockbrokers efficiently allocate resources towards projects that have the greatest social gain, as measured in dollars, and away from less productive projects.

This has the caveat, of course, that not all social gain can be measured in dollars. But it's hard to think of a more consistent, better measure of societal benefit created by activity.

Basically, you can see this as a factory floor writ large. A manager on a sheet metal factory floor, while not producing any sheet metal himself, directs resources and labor to increase the net production of sheet metal at the factory by the workers who operate the machinery. Stockbrokers can be likened to those managers.
posted by I like to eat meat at 11:14 AM on October 8, 2007

Explaining labour market outcomes is very difficult because there are many different things that have to be taken into account.

For example, in this discussion people have been comparing baking to stock trading. Bakeries are most likely a perfectly competitive industry, an industry where it is easy for new firms to enter or leave the industry, whereas stock trading and especially government bond trading is an oligopoly, an industry controlled by a few large firms like Goldman Sachs where it is difficult for new firms to enter the industry. Wages are set differently in perfectly competitive industries and oligopolies.

Another issue that arises, and this is what I think you’re getting at when you say, ``It's not supply and demand (is it?). It seems more related to the ability of a society to act collectively or value those things that benefit them as a whole...,`` is what is known as the public good problem. Public goods are things that are valued by society and everyone benefits from and no one can be excluded from enjoying the benefits. The fact that everyone benefits from the provision of public goods leads to an interesting problem. When you buy a Big Mac from McDonalds, you are willing to pay for it because you will enjoy the benefits from it. If you don’t pay, you won’t enjoy the benefits from it. If climate scientists solve the problem of global warming, you will enjoy the benefits of their research regardless of whether or not you paid for it. This is called the free rider problem. You might think to yourself, ``You know, I’ll let someone else pay for climate research, and then enjoy the benefits for free(!) when the global warming problem is finally solved.`` The problem is that everyone else might think this way and no one will pay for climate research and there will be no climate research and no jobs for climate researchers.

In a pure market economy (i.e., one without any government) there will tend to be an under provision of public goods because of the free rider problem. Public goods and the free rider problem are one economic justification for having a government. The government can force people (through taxation) to pay for the provision of public goods. The process the government uses to make funding decisions is kind of a mystery (this is what political scientists study and they look at things like the power of lobby groups, the power of individual politicians and the committees they sit on, whether it’s an election year, the size of the tax base, etc.). Solving global warming is even more complex because it requires governments from around the world to work together and decide on funding.

In the simplest type of labour market, one where there are large numbers of workers and large numbers of firms and there are no information asymmetries, the wage is determined (simply) by supply and demand. In this market, if the demand for two services is exactly the same, then people who have skills that are more scarce (like the ability to do the complicated math required in bond trading or throw footballs at a great distance) will be paid more than the people with a more common set of skills.
posted by Jasper Friendly Bear at 11:16 AM on October 8, 2007

Thanks, Jasper and IL2Emeat, those explanations are great. And thanks to molybdenum for tolerating my related question!
posted by salvia at 6:09 PM on October 8, 2007