Challenge for Europe

Current economic theory on markets strongly promotes their liquidity. Markets should be as liquid as possible, in order to approach the theoretical optimal state of equilibrium. Perfect liquidity would mean that any actor should be allowed to buy and sell at infinite speed, and at zero cost, any quantity of the assets being traded on that market, with the objective that none should remain stuck with assets in his/her portfolio that she would like to get rid of.

Current large financial markets, such as the stock markets of developed countries, foreign currency exchanges, debt and obligation markets and major trading places for raw materials (e.g. the London Metal Exchange) do approach this objective of perfect liquidity. The prices at which assets are being traded are valued continuously (every hour or less), at an amazing level of precision (3 or 4 significant digits are the minimal standard). The adaptation of these prices to the instantaneous relation between world-wide demand and supply is ensured by armies of arbitrageurs that work with razor-thin margins (in the order of a hundredth of a percent).

Firms on the other hand, and despite the current acceleration of the pace of the economy, still need several days or weeks to manufacture goods through the production cycle, several months to develop a new product or conclude a large contract, and several years to master new technology or enter a new market. In addition, their margins and profitability are in the order of several percentage points, and therefore rely on prices that are estimated with at most 2 or 3 significant digits.

Individuals and households have the same relatively slow pace in their economic behaviour: purchasing equipment is a matter of weeks of decision-making, purchasing a house can take months, and salaries are paid on a monthly basis.

In addition, these “real” economic actors have a legitimate preference for stability and predictability, in order to be able to make long-term investments in technical and organisational improvements to their processes and products. They try by many means to protect themselves from market volatility.

Therefore, it appears that the market dynamics are (very) much higher than those of their users in the “real” world of economic transactions of goods and services. Market liquidity at its current level may therefore not be justified by the needs of economic actors.

Taking the theoretical justification into consideration, market liquidity, despite claims that it helps markets reach equilibrium, has not delivered on its promise. Stock Markets remain highly unstable and volatile. They are the locus of permanent and erratic short-term movements, speculative bubbles and crashes.

The social utility of market liquidity may therefore strongly be questioned[i].

Proposal

These considerations support my opinion that markets should be forcefully slowed down, and their liquidity reduced. This may displace them away from “optimality”, in the sense that the prices may differ by a few hundredths of percentage points from what the “optimal” value would have been. This is of limited consequence, since no sensible economic actor in the real world of production and distribution of goods and services relies upon prices defined with this level of accuracy in its computing of operational margins. This measure would on the other hand significantly stabilise the markets, make them more coherent with the needs of economic actors in the “real” life of production and exchange.

The means to obtain this limitation of liquidity are those that cause market actors to slow their decision-making. One way would be the imposition of a tax on market transactions, such as the one proposed by Tobin: making transactions more costly, they require actors to think more about the sense of their decision. Another would be to impose a fixed delay (e.g. one week) between the moment when an order is passed and the moment when it is executed.


Scientific contribution to reflection:

An interesting insight into this issue is provided by:

Arthur, W.B., J.H. Holland, B. LeBaron, R. Palmer, and P. Taylor. 1997. “Asset pricing under endogenous expectations in an artificial stock market”. In W.B. Arthur, S.N. Durlauf, and D.A. Lane (eds) The Economy as an Evolving Complex System II Reading, MA: Addison-Wesley, pp. 15-44, downloadable at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2252

The authors simulate the eco-system of beliefs about the future evolution of a market. They convincingly demonstrate that the survival of a rich eco-system of competing, but ungrounded and mainly self-fulfilling, prophecies that fuel volatility, technical trading and speculation is a rational, endogenous phenomenon, that is caused by the speed at which actors can re-adjust their strategies following feedback information from the market. If actors can re-adjust their expectations to observations at high speed, then the rich eco-system of competing beliefs, speculation and bubbles appears and maintains itself, with high volatility and trading volumes. If however, the speed of adaptation is slow, the only surviving belief is stable, and coherent with the rational expectations theory, with stable prices, low volumes and low volatility.

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