Home > Uncategorized > Bitcoin, efficient markets, and efficient financial sectors

Bitcoin, efficient markets, and efficient financial sectors

from Dean Baker

John Quiggin had a good piece in the NYT, pointing out how the sky-high valuations of Bitcoin undermine the efficient market hypothesis that plays a central role in much economic theory. In the strong form, we can count on markets to direct capital to its best possible uses. This means that government interventions of various types will lead to a less efficient allocation of capital and therefore slower economic growth.

Quiggin points out that this view is hard to reconcile with the dot-com bubble of the late 1990s and the housing bubble of the last decade. Massive amounts of capital were clearly directed towards poor uses in the form of companies that would never make a profit in the 1990s and houses that never should have been built in the last decade.

But Bitcoin takes this a step further. Bitcoin has no use. It makes no sense as currency and it is almost impossible to envision a scenario in which it would in the future. It has no aesthetic value, like a great painting or even a colorful stock certificate. It is literally nothing and worth nothing. Nonetheless, at its peak, the capitalization of Bitcoin was more than $300 billion. This suggests some heavy-duty inefficiency in the market. 

Quiggin is on the money in his analysis of Bitcoin and its meaning for the efficient market hypothesis, but it is worth taking this line of thinking in a slightly different direction. The purpose of the financial sector is to allocate capital. In principle, we would want as small a financial sector as possible, just like we would want a small trucking sector.

Both sectors are providing intermediate services. While they are both essential for the operation of the economy, they do not directly provide benefits to people, like health care, education, and housing. In general, we think more of these and other final goods and services are better, but we want to have as few resources (labor and capital) tied up in finance and trucking as possible.

We have seen the opposite story with the financial industry over the last four decades. If we go back to the mid-1970s, the narrow financial industry (securities and commodities trading and investment banking) accounted for a bit more than 0.5 percent of the economy. It has nearly quintupled relative to the size of the economy, as it now accounts for more than 2.3 percent of GDP. The difference of 1.8 percentage points of GDP is almost $360 billion annually in today’s economy. This should be a cause for serious concern.

We currently have a bit less than 1.5 million workers employed in the trucking industry. Suppose that the industry were more than four times as large and instead employed 6 million workers. This would be a huge drain on the rest of the economy since we would have to pay for the salaries, trucks, and fuel for four times as many workers.

If we had something to show for these additional trucks and drivers then we might decide the additional cost was worth it. If it meant, for example, that we had less food spoil in transit or that we were all getting the goodies we ordered online within minutes after we clicked the purchase button, then perhaps the additional expense from this much larger trucking industry would be reasonable. But suppose we had four times as many trucks and truckers and our service was no better than it had been before.

Arguably, this is the story of the financial industry. Is there any reason to believe that it has done a better job of allocating capital to its best uses in the last two decades than it did back more than forty years ago? Sure, some innovative companies have gotten startup capital and changed the world, but that was true fifty years ago as well. Just at the most basic level, productivity growth was much more rapid in the 1950s and 1960s, when we were devoting a much smaller share of our resources to the financial sector than is the case today.

This is why I am such a big fan of a financial transactions tax (discussed in chapter 4 of Rigged: How Globlalization and the Rules of the Modern Economy Were Structured to Make the Rich Richer [it’s free]). Even a modest financial transactions tax (FTT) would effectively take a sledgehammer to the financial industry. A tax of 0.2 percent (20 cents on one hundred dollars) on stock trades, and scaled for other financial instruments, could plausibly cut the size of the narrow financial sector in half, freeing close to $200 billion a year for productive purposes. (That’s more than $600 per year for every person in the country.) In addition, this would be a huge blow against inequality since many of the richest people in the country get their income from the financial industry.

Anyhow, that’s the economics of an FTT and it follows pretty directly from the demolition of the efficient market hypothesis. If we can’t count on a larger market and more transactions to move us to a better allocation of capital, then let’s look to make the sector smaller and stop wasting resources that accomplish nothing. This would essentially mean fewer stock trades and fewer complex financial instruments. That would be a better world.

  1. charlie
    February 16, 2018 at 3:47 am

    i have been grappling with this idea for the last few years. There just cannot be an efficient use of money in the financial sector. Thanks for this suggestion.

  2. February 16, 2018 at 4:16 pm

    As I write here https://pavlos.geekhost.org/2013/10/ the Efficient Market Hypothesis is nonsense because timing matters. Traders in securities try to optimize their capital gains based on entering and exiting at specific times. They do not individually try to predict the value of dividends in the infinite future. The market in aggregate pursues an unknown mix of motivations, from speculative gain to long-term investment, and not 100% the latter as the EMH claims. In a timing context, bubbles are rational.

    The job of finance is not to allocate, as in move, capital between different investments. That’s based on a parochial view of finance, banking, and money that we call the gold standard. The essence of this view is that there’s a fixed amount of money “tokens” and prices adjust so the value of the economy equals the number of tokens. One problem with this system is scamming by miners (of gold or Bitcoin) who generate more tokens. The bigger problem, as we know, is that matching the economy to a static money supply stagnates the economy.

    But modern financial economies work differently. The job of banks in the real world is to assess the value of durable assets, generate in their books an amount of money tokens that roughly matches the value of the assets, and credit them to roughly the right people. If banks get that mostly right the economy is somewhat efficient and fair. If they over-issue tokens we get bubbles. If banks have to cancel money tokens we get financial crises, and if they under-issue them for a long time we get austerity.

    So when you say finance is inefficient at allocation or Bitcoin has no inherent value I’d say these are irrelevant aspects of an imaginary financial system. Our actual financial system is inefficient because it claims too large a fee, in the form of ordinary mortgage interest, for the service of creating money tokens to match the value of assets, mostly houses. And because it does a poor job, in terms of stability and accuracy, of setting the money supply to match the value of those assets.

  3. February 17, 2018 at 2:30 am

    Thanks for highlighting the idea of the Financial Transactions Tax, Dean. You do a really good job of explaining many of its virtues in your book.

    The purpose of the financial sector is to allocate capital.

    I understand why you make this statement, but I think ignores a very important truth about the transactions that would be taxed.

    For the most part, the tax would be applied to transactions that occur in secondary markets.

    In these markets, with very few exceptions, none of the money that is spent on stock purchases ends up in the hands of firm owners/managers who will then use the money for real economic investments (the only kind of ‘investment’ that actually ‘grows the economy’).

    That usually only happens prior to an IPO, when underwriters hand over money to a firm that is issuing shares of stock for sale.

    Thereafter, when the stock is sold at one of the big exchanges (NYSE, NASDAQ, etc.) the only thing that occurs is one rich person hands over a bunch of money to another rich person for a title of ownership of some already existing asset.

    By and large, it is not economic capital that is being pumped into such markets, just speculative money that will never end up being used to improve the productive capacity of the economy.

    Most of the waste that occurs in these markets arises from the use of money (not for real economic investments, but) for a purpose that serves no beneficial economic end, but merely keeps adding fuel to a pure inflation event (which is what all asset bubbles are, from an economic perspective).

    From this perspective, the FTT does not actually impose any real economic cost on the economy whatsoever. The tax will not make any of the shares of stock, or the companies they represent, disappear. From a real economy perspective, there is no real loss whatsoever. Only a reduction in the waste that is inflation driven price increases.

    Tax this kind of economically wasteful behavior? Absolutely! And eliminate the favorable treatment of capital gains by the tax authorities while you’re at it…

    • February 17, 2018 at 2:31 am

      WTF happened? :/

      • Rob Reno
        February 22, 2018 at 8:20 pm

        HTML gremlins ate your tags James ;-)

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