Critics Corner with Jon Hartley

Aug 11, 2021

On this episode of Critics Corner, Oren is joined by Jon Hartley, a visiting fellow at the Foundation for Research on Equal Opportunity and a former senior policy advisor to the U.S. Congress Joint Economic Committee. They discuss the purpose of finance, the value it creates, the places it can go wrong, as well as the pros and cons of various policy responses—including some they actually agree on.

About Critics Corner

Today’s public policy debates consist primarily of people conversing within their own echo chambers while tuning out disagreement. To make progress on contentious issues, we need to better understand opposing perspectives, clarify points of agreement and disagreement, and collaborate on finding a constructive path forward. American Compass has no shortage of critics, so we figured, let’s have them on a show.

Critics Corner brings together those who disagree—whether on fundamental questions or specific policies—in the spirit of American Compass’s commitment to combining intellectual combat with personal civility. Neither debate nor interview, it’s a conversation between people eager to identify the source of their disagreements and the potential for common ground.

Transcript

Oren Cass: Jon, thanks so much for joining us.

Jon Hartley: Thanks for having me.

Oren Cass: We are here to talk about financial markets, the financial sector, financial regulation. I think it’s certainly an area where we probably start from some of the same premises, but come to a lot of different conclusions. So my thought was that we should probably start by just talking about how we understand what’s going on in the financial sector, and whether there’s a problem at all. At American Compass, we’ve argued it is oversized in terms of just its role in the economy and the profits it generates, the talent it attracts and that, conversely, it doesn’t seem to be actually facilitating the growing productive investment in the real economy that should be its task. But give us your thoughts on that. How do you read the state of the world?

Jon Hartley: Sure. So I think you pose an interesting question and that is, is finance bad? Or in other words, in economist speak, is finance a negative externality? Are there negative perennial spillovers from the growth of finance that inhibit fixed investment and economic growth elsewhere in the economy? I think your answer to this and the American Compass answer to this is yes. You guys have put out a lot of very interesting white papers and other materials and articles that have argued that. I think that this fact that you illustrate, that fixed investment is falling at the same time as the financial sector has become a larger fraction of the economy as measured by GDP, I think, in my opinion, is more correlation versus causation.

The idea that I think too much finance overall is a native externality, I think, is a very unproven one in that there’s no real sort of natural experiment where we’ve seriously eliminated or banned large sectors of the finance industry. Certainly one so integrated as finance into the rest of the economy. So by sort of the modern standards of economists or academic economists, the rigor that they demand is how do you come up with a counterfactual? That’s really important. Identification is the word that’s often used by economists, is essential in evaluating policy. You need essentially some sort of like a randomized control trial or a national experiment where you have a treated group and a control group.

We haven’t really gone to a place or we’ve never really run this experiment. So it’s really hard to know. So we’re really talking from a sort of first principles standpoint, incentive standpoint, really a theory sort of standpoint when talking about a lot of this. But on the correlation causation sample, we could argue that, since there’s been no Marlon Brando movies since around 1980, or we’ve had all these problems in that inequality has risen, wage growth has fallen and so forth. Maybe it’s because the Marlon Brando movie stopped.

I think the alternative thing that’s often used is that Ronald Reagan was elected in 1980. Since then, you’ve seen a lot of these trends. There have been trends since then, whether that’s post policy or correlation and not causation, or reverse causation is sort of, I think, the question that we’re sort of getting at. So my take is … I think you could look at a few examples here that might be something close to natural experiment, but I’d still be very hesitant to say something like that. For example, when we have financial crisis, they tend to be really bad for the overall economy.

My interpretation of this is probably going to be a little bit different from your interpretation of this. For example, 2000, we had the tech sector blow up, we had a small recession. In 2008 or 1929, the financial sector blows up, some of the worst recessions in US history. So what is the financial crisis? My interpretation is, like in 2008, when companies don’t lend anymore. I think it really speaks to just how important finance is to the broader economy and why we need it. You’re not financial companies, you really depend on borrowing. We saw this in March 2020 of last year in how important it was for companies to raise a lot of money in the bond markets, for example.

The Fed obviously played a role as well during that period, a pretty consequential one. Also, just to caveat with this, I’m not here to say that finance is all good. I think that there are two areas in particular that justify finance regulation; those be more of a moral hazard and in systematic rescue. So moral hazard does give me Wall Street bailouts create incentives for banks to taking excessive risk. Systematic risk, does one bank going under threaten to take down the whole system? With moral hazard, I think, since Basel three capital standards put in place, I think they seem to be working fairly well. The banks did okay in March of 2020 unlike 2008. They certainly fared much better, and I think that can largely be attributed to higher capital standards.

With systemic risk, I think we’ve done okay. We’re centrally clearing drovers now, versus being OTC traded. There’s a lot less complexity. We don’t have these private label, mortgage backed securities and a lot of inner dependencies across firms that were sort of not well known. But there are some things like prime money market funds, which had sort of gone 0 for two, if you will, in both 2020 and 2008, in the sense that they had some serious, serious liquid problems, essentially a run both in ’08 and in 2012. Where’s the banks however sort of got one for two in that they were very well capitalized in 2020.

I think the areas where I think we’re probably going to disagree a little bit is in the areas of the realm sort of outside of traditional banking,  what we might call bank finance, areas of I think alternative investments; hedge funds, private equity, the areas of derivatives. I probably still take the view that derivatives are generally a good thing, that hedge funds and private equity firms provide value in the sense that they are … All these things, in a sense, are helping investors, financial investors, diversify risk in different ways, in the same way that sort of like an insurance company does. An insurance company, does it create a lot of your real economic value? I think, in the sense of what you think is really important, no. Is it a great investment strategy? No, it’s not. But it does provide this service, in the sense that it is offering you cash flows in certain states of the world, for example when we have a flood.

So, in a way, hedge funds, private equity firms and derivatives enable you to sort of diversify your risk a little bit better. If you’re a pension fund, for example, that obviously beneficiaries, we’re talking about firefighters, teachers, public sector employees and so forth. So, it’s not always  high net worth individuals, but that that sort of, I’d say, my general defense of finance in general and why I think it’s important, and why I don’t think, broadly speaking of finance as a whole, is bad or that we have too much finance, per se. I think certainly, around 2008, we could talk about maybe there was a little too much finance then, and the systematic risk was sort of part of that story. You could also argue that maybe there’s a moral hazard story going on, and that the sort of bail out culture that’s been established is  creating bad incentives and excessive risk taking.

I think those are fair points, but I don’t totally buy the whole too much trading is really, really bad. I think liquidity is really important, and we can talk a little bit more I think about how primary markets versus secondary markets and derivatives markets also work together. I think, in your view, I think you view them pretty separately. But I would argue that they’re very much integrated and dependent on each other in the sense that a company, when it … I think you’ve actually done a great service in separating your financial investment from fixed investment. I think one of the most frustrating things of all time in the sense that these two very different things get the same name, and I think you’ve done a real service in separating these things.

But I don’t necessarily buy that companies themselves are totally walled off from these secondary markets and derivative markets. When we price secondary markets, we use derivatives, for example, black shoals. We’ll back out prices out of options prices, for example. That’s how Wall Street’s operated for awhile.

Oren Cass: Black-Scholes is my red flag. If we’ve gotten to Black-Scholes, we’re probably a little far in the weeds. But I take your point on the role that derivatives pricing plays. I mean, obviously, there’s a ton to work with there and I kind of just want to dig into a few pieces of it. I think the piece that jumps out at me first is just a really interesting place to start, is sort of the theory versus empirical distinction, because I think you’re obviously right. We can’t run some natural experiment on the economy at different scales in the financial sector. But it seems to me insufficient or inadequate to say, well, therefore, we must just default to an assumption that things are working very well, that is I could just as well say, well, we can’t run some natural experiment that proves that what we have now is actually efficient or effective, or delivering a good return.

So I think policymakers generally and certainly in the realm of something, like what is the role of financial markets in the economy, where we somewhat inevitably fall back somewhat to a theoretical discussion, at least for sort of defining what our defaults should be. So I guess that’s a place where I’ve found very interesting the question of just what is our default assumption about how financial markets are going to operate? Because I sense in a lot of the analysis, and somewhat in your answer, that our default assumption should be, if financial markets are attracting a lot of talent and doing a lot of trades and generating a lot of profit, we should assume that that is efficient and an appropriate and socially valuable allocation of resources. The burden of proof would be on someone through natural experiments to prove otherwise.

But it’s not clear to me what the actual basis is in economic theory for saying, for instance, well those private equity firms made a lot of money and paid people really well, so that must mean that what they’re doing is really valuable and it’s good for society in the economy that it is the number one draw of talent out of our top business schools. So I look at that and say, just intuitively, that seems very unlikely to be the case, and I’d want to see some some pretty compelling evidence that we should be comfortable with it. But how do you break down a question like that?

Jon Hartley: It’s a really good question. I think there’s a different pieces to it. Also, to be clear, I’m also not necessarily saying that all these things are social optimum and so forth. I think some areas where we probably would, I think, agree a lot on is that I think the idea that capital and labor aren’t taxed equally. It’s somewhat problematic. Yeah, the fact that we have the carried interest deduction is unfair. I remember that Jeb Bush campaign 2016. One thing that Governor Bush was in favor of was ending carried interest deduction, and certainly this upset many donors. Why that’s persisted, we could have a whole long political economy argument as to why, and I think that labor should be taxed at the same amount, and perhaps there has been a subsidy toward capital that’s been somewhat unfair. I would argue that it has been unfair.

Now, I would love … while maybe in exchange for raising the cap gains tax rate,  to bring the corporate rate down to zero. I think individuals are a lot less mobile than say capital, whether it’s trading activity or corporations and so forth. So I think the general principle with analyzing these sorts of things is, generally, if negative externalities are … forget about finance for a minute. Negative externalities, think pollution, are bad and we should tax those. In general, when we design a tax system, we want to raise a certain amount of revenue to fund government, we want to have the least distortionary tax system. So I think having lower or next to zero corporate rates, taxing mobile capital less and taxing less, and taxing people who are less distortionary and less mobile, is a more optimal thing to do.

Also, taxing capital labor equally I think is sort of the right approach. So now, what’s happened though is capital is not being taxed equally. So perhaps that’s contributed to some of this growth. But I still think that there’s a lot of other things to talk about here in terms of, for example, executive compensation. There’s a lot of really great work that’s been done by Harvard, really trying to understand why is it that executive compensation has exploded over the past 2030 years.

Part of the answer has to do with power laws. But just in nature, we see highly unequal distributions of not just income and wealth, but we see this all over and sort of in nature and elsewhere. At some level, there’s this sort of natural thing going on, that’s kind of like a Matthew effect. But more recently, what’s really driven this trend is globalization, in the sense that a company that a private equity firm could buy, not only is just selling into the US now, but now they can sell to 120, 150 some odd countries in the world. So largely, the rise in executive compensation, and this isn’t just for executives, but also for private equity executives, not just corporate executives, that really what’s going on here is just some of the size of companies, certainly in the sort of top end of the size distribution, have grown enormously.

Oren Cass: Okay, but that’s not actually where … I mean, if you look at a private equity firms business model, and especially the top firms, in size and the publicly traded ones, most of their revenue isn’t coming from anything the operating companies are doing. It’s coming from fees that they charge to their passive investors. So I take your point. We could do a whole podcast just on the executive comp question in the actual operating company sector. But here, we’re talking about the financial companies that are at least one degree removed from that. So if you’re talking about a private equity firm, you’re talking about people who are collecting their fees for the buying and selling of the companies.

Then even more broadly, if you go from there to hedge funds, you’re talking about people who aren’t even buying or selling companies necessarily. They’re simply speculating in the secondary market on asset values. So I guess I’m struck by your focus on negative externalities as the sort of unit of currency for this discussion, which again sort of assumes as a starting point that absent a negative externality, this would be the sort of most efficient allocation of these resources. So I just want understanding, from the perspective of your intuition, when you look at the sort of economic position that these firms hold in the economy and the talent they attract, and the profits that they generate, what is the basis for understanding them as having created any sort of actual value commensurate to that?

Jon Hartley: Yeah, so that’s an excellent question. I think there’s an important distinction to be made about what we mean by efficiency, and what we mean when we talk about welfare analysis. I’m not making an argument … efficiency does not have anything to do with the distribution of wealth, at least in the sense that I’m talking about. Efficiency, let’s just call this the size of the pie, and let’s call equality or welfare analysis sort of how that’s distributed. Again, sort of getting back to the earlier point, I think that the service that hedge funds and private equity funds are delivering is very much like an insurance for premium.

You’ve very accurately pointed out that both hedge funds and private equity fund returns have not been great, certainly on average over the past 20-25 years or so. Also, for what it’s worth, both private equity fund fees and hedge fund fees on average have declined quite a bit. So there’s been a real revelation about active management, its promises, how much active management, whether it’s private equity or hedge funds, can can really deliver. This also has fueled the growth of passive investing as well over the past 15 to 20 years. BlackRock, State Street Vanguard, they’re offering synthetic hedge fund replication vehicles or private equity, ETF vehicles, vehicles that they can replicate the returns of hedge funds and private equity funds at much, much lower fee.

So I do think that there has been a reckoning, perhaps a slower one than then you perhaps might think, in the sense that, on average, these funds aren’t delivering the returns that they once did. But I would still contend though that, again, what these public pension funds or Sovereign Wealth Funds or other types of endowments, or other institutional investors are looking for with these funds is they’re looking for the fund that they think is going to really outperform. In particular, I do think that there’s some evidence that certain funds have been able to outperform. It’s very few, I think, but you look at statistical arbitrage, systematic funds, Renaissance Technologies, and others, the Medallion Fund, they’ve been able to do extremely well for very consistent periods of time.

So I think that’s essentially the value proposition. Then on top of that, I think, even if you were just to talk about average returns because, to your point, you’ve also pointed this out that alpha, if you will, that is returns in excess of the market or net of the market, is a zero sum game. This is true. But I think what’s also important to understand is the value of risk. It’s not just about adding up returns, but it’s also about diversifying risk. Hedge funds, along with power equity funds, in part because they have this illiquidity premium, they tend to outperform the market during bad times, and they outperform the liquid markets.

For example, the S&P 500 in bad times, and so there’s this sort of portfolio insurance component, or mitigating downside risk. You could think about it like an insurance policy. It’s like why do you buy insurance? You don’t buy insurance to make money. You buy insurance to cover yourself in some bad state of the world. That’s essentially the value proposition that these sorts of hedge funds and private equity funds, I think to some degree, are adding to portfolios.

Oren Cass: Sure. I think the risk point, and kind of going back to the number of really interesting points you raised the beginning, the second that really jumped out at me was this point about managing risk and the idea that what private equity or hedge funds offer. Again, I think it’s important emphasize, at this point we’re not talking about anything they’re actually offering to operating economies, or productive investment in the real economy. We’re talking about a service that they offer to passive investors as holders of assets. The argument is that they’re providing this diversification, they’re providing hedging, obviously, in the case of hedge funds.

I guess the problem that I find they’re in the data is twofold, and I’ll kind of throw the two things at you and you can pick up on them on however you see fit. One is that they just don’t actually seem to be doing that really very well or at all. Private equity at this point, its performance is correlated very closely to the public markets. If you look at the persistence of fund performance over time, it firms, again, with very few notable exceptions, show no correlation between the performance of one of their funds and the next. Whereas on the hedge fund side, they don’t appear to even hedge as well as just a 60/40 equity debt.

They’ve been complaining for a decade that, well, of course they can’t do well in this endless bull market. Then we had the COVID crash, and they still weren’t any better than just a 60/40 passive portfolio through the COVID crash. So, question one is I understand the theory, but for the kind of broad swath of options out there and the fees that they command and the talent they attract, are they actually doing that? Then question two would be, to the extent that the insurance analogy is apt, and I think it is somewhat, what is the justification for the industry operating as it does? That is, I agree entirely that insurance, as you said earlier, is this sort of kind of boring … these are my words, not yours, but somewhat kind of boring, backwater industry. It provides a service-

Jon Hartley: I wouldn’t use the word backwater.

Oren Cass: Fair enough, but particularly if you’re talking about the kind of … you’re talking about property and casualty insurance, yeah that provides a valuable service to people and there are actuaries and others out there who do that, and they make fine salaries. They seem to be a proportion of the economy commensurate with what they are actually delivering, which these alternative asset classes are not. So, if what we’re really looking for is the insurance function you describe, do we really need this massive alternative asset industry, which doesn’t actually seem to be doing its job very well to be doing it?

Jon Hartley: I partly reject the premise that they’re not doing this diversification service well. When we’re talking about this evaluation of how well the alternative asset management industry is doing, we’re talking about in aggregates. We’re talking about the HFRI index for hedge funds, we’re talking about maybe the Cambridge associates index for private equity or … there’s several indices that are essentially the aggregate of each of these. But I think what’s really important to understand is the role of customization. The idea that one pension fund wants to … this applies to derivatives as well. Derivatives are a zero sum game as well, they are. But the point is, say a pension fund, for example.

I think a great example is like Orange County. Orange County pension fund faced severe solvency problems in the 1990s. Why was this? This is because they didn’t manage their interest rate risk. What happened was the Fed raised interest rates in the Greenspan fed. Essentially, they held a lot of bonds with a lot of duration or interest rate risk. When interest rates go up, bond prices fall. So what happened was they were not managing their risk well. Now, what they should have done, and what most asset managers would do is they would use interest rate swaps to do this because … and why would they do this rather than, for example, selling bonds or using cash bonds is in part because it’s cheaper to do it with interest rate swaps, and that’s because they’re so liquid.

So the point I’m trying to make is that the Orange County story, and let’s say they needed to, for example, invest in some sort of a macro fund that was hedging interest rate risk. Say, I don’t know, Paul Tudor Jones at Global Macro Fund had a very bearish view on interest rates. So thinking, for example, right now that interest rates were going to go up like they did in the 1990s, you would buy that hedge fund in part because it helps you, in a very custom way, mitigate that interest rate risk. Whereas another pension fund, for example, let’s take a New York State Pension Fund, might have a lot of well risk and be very afraid of oil prices crashing, so they may invest in, I don’t know, some sort of commod fund or something that has some sort of expertise in sort of managing commod risk.

Or they might invest in various oil derivative contracts, for example. So the point I’m trying to make is I don’t think that you can assess the value add from the alternative asset industry just from looking at aggregates alone. I think there’s a reason why these very skilled pension fund managers and people at Sovereign Wealth Funds, people elsewhere in the institutional investor community are still using hedge funds and private equity funds.

Now, to be fair, they’re using them less now than then than say they were 15 years ago. CalPERS isn’t investing in hedge funds anymore. For example, they’re one of the largest pension funds in the world in California. But most of them are still using derivatives, so I think … Again, they’re managing money for public employees. These are people who are in the lower to middle income quintiles. So there is this benefit that can be traced to lower to middle income quintiles that is coming from this industry. That would be my guess is that customization is so important here.

Oren Cass: Well, I think the pension fund question is an especially interesting one because, as you said, there’s a huge public interest there in having that money managed well. I guess the the one tweak I would maybe offer to your formulation is that, because those are all guaranteed benefit plans, it’s not actually the pensioners who are at risk, at least pending a state bankruptcy. It is the taxpayers who are at risk. The pensioners are going to get their pension payments regardless. The question is, how much more are taxpayers going to have to pony up to fill the gap or what other services are going to have to be cut?

Jon Hartley: So we’re talking state pension plans. We’re not talking … we could also be talking corporate defined benefit pension plans, all our friends at GM.

Oren Cass: Yes.

Jon Hartley: GM asset management, for example.

Oren Cass: Yeah, sure. Although, then there’s the whole other Federal Insurance Scheme for those pensions.

Jon Hartley: Absolutely.

Oren Cass: The public pension funds, I think, my understanding is they are the largest pool of investment in both private equity and hedge funds. They’re saying like $5 trillion of assets, and then you throw in sort of nonprofit endowments, universities, foundations, there’s sort of another $2 trillion there. I guess we should segue a little bit here to the discussion of what if any policy actions are appropriate? If nothing is wrong, maybe no policy actions are appropriate. But. At American Compass, we find the public pension issue particularly interesting because, it seems to me at least that, from the perspective of sort of very free market oriented analysis, we would expect to have massive problems with the way public pension funds allocate their resources, and actually to be extremely skeptical that a public pension fund managed by people overseen by a politically appointed board with incentives not at all aligned with the taxpayers were ultimately on the hook, we would be extremely skeptical that we’re getting good resource allocation out of that.

Empirically, I at least think there’s a lot of evidence, minor things that the more assets these funds are allocating to alternatives, the worse they perform. Actually, Cliff Asness in his group at AQR published a very interesting paper about private equity last year, essentially saying, not only do pension funds not seem to be getting the extra return they should expect for the liquidity they accept. In fact, they seem to be willing to pay a premium for the liquidity. That is that, if you are managing a public pension fund, you like the idea that you can give the money to someone else, can’t touch it for 10 years, can’t really Market to Market, can’t be held accountable for how it’s performing.

So maybe that more than anything explains why some of these asset classes remain so popular despite their under performance. So I guess I’m just curious. From a policy perspective, I don’t think you want to necessarily step in and start finding things to ban, but do you think would at least make sense to subject those kinds of investments to much more scrutiny, meaning requiring much clearer disclosure of what the public assets flowing into these funds are, how those funds then allocate the assets, and how the funds are are performing on a regular basis?

Jon Hartley: Absolutely. I think disclosure, when it comes to government, I think is generally a good thing. Also, when it comes to finance, I think certainly not every … Yeah, I think most fund managers are certainly in accordance and upholding with laws and regulations, but not every fund manager out there is. You look at the Bernie Madoffs of the world, who fooled people for quite some time and left quite a few people very, very hurt. Perhaps if was more disclosure and more sort of double checking that Bernie Madoff story, Ponzi scheme fund manager story wouldn’t have persisted as long as it did.

So yeah, I think disclosure is in general a good thing, but I still think that hedge funds … Certainly, if a public pension plan could invest in a hedge fund like RenTech, Renaissance technologies … There’s a new book that came out over the past few years about Jim Simmons who started a Ren Tech mathematicians, a systematic type, arbitrage type hedge fund strategy that has done very well and performed pretty consistently well over the past 20 years. It would be awesome. I wish I could invest in that. I can’t. I know there are some pension funds out there that can, and I think it’s to the benefit of those beneficiaries that-

Oren Cass: Sorry, just to jump in. The Medallion Fund has been closed since since 1993, right?

Jon Hartley: Yeah. The Medallion Fund … or there’s been other Ren Tech funds that haven’t done quite as well, but others are able to invest there as well. To be able to invest in in any Ren Tech fund I think would be a great value proposition.

Oren Cass: Yeah, that’s good. So I think the concrete proposal that we’ve offered is we’ve said, Look, whether you’re a private equity fund or a hedge fund, if you are accepting money and collecting fees from public pension funds, from nonprofit endowments and foundations, you should have to essentially both report what is the source of the assets you’re collecting, report on an annual basis what are the transactions you’ve conducted, and how are you valuing them, and then report all the fees that you’ve collected.

Jon Hartley: Absolutely.

Oren Cass: Does that have the Jon Hartley seal of approval?

Jon Hartley: Oh, absolutely. Absolutely. I think more transparency, especially when it comes to the invest in public assets, is absolutely a good thing. I think the whole decrease in the just the trend and declining management fees and decline performance fees for hedge funds over the past decade or so, which have dropped pretty enormously, reflects a certain change in attitudes toward how much of a value add is there from hedge funds. I’ll give you that that value add today is certainly a lot less than what we thought it was, or what the industry thought it was in the mid 2000s.

Oren Cass: No, that’s a good point about the piece as well. All right, last question for you, maybe a policy issue where we can disagree more imminently. Financial transaction taxes,  we have written very much in favor of the idea of a basic financial transaction tax. So say 10 basis points on any secondary exchange of stocks, bonds, derivatives, etc. You wrote an excellent piece, I thought, for National Review Online, making the case that essentially financial transaction taxes are a terrible idea generally. Give us the 30 second version of why we shouldn’t have a financial transaction tax, and then I want to pitch you on a grand bargain.

Jon Hartley: Sure. So my argument against financial transaction taxes is that they’re highly distortionary in that they make people change their behavior. When we want to tax in general, and I think when we want to raise revenue, that’s generally the purpose of taxation, except for the cases where we want to defeat negative externalities. Again, we can have this debate about whether finances is a negative extranaliuty or not. But ultimately we want to raise revenue from inelastic agents, people for example that can’t move or things are generally immobile.

So in my response to financial transaction tax or FDT from here on out, the problem is that trading activity will move elsewhere. For example, if there’s an FDT in New York state, the New York Stock Exchange they’ve threatened could move out of New York and move to Miami. Some amount of jobs will go with it. Probably not a ton, but some will move elsewhere. New York City, I think, certainly could use those jobs, certainly in the way that tourism maybe crushed in the coming months, I don’t think that’s something that they want as a further blow to the economy.

The third thing is, again, a little revenue gets raised. CBL estimates that, from a federal or national FDT of 0.1%, the federal government would raise only about $70 billion a year, which is relatively small. So again, trading activity will move elsewhere, very distortionary. Some amount of jobs being lost and a little revenue being raised. Sweden, Japan, others have tried implementing FDTs in the past, reduced liquidity and trading volumes. So this experiment’s been tried elsewhere in a number of countries. It has not worked out well in almost all of these cases and countries have abandoned them since then.

Oren Cass: Yep. All right, excellent summary. So our view, the 10 basis points, it certainly would be federal. I think you’re right, New York state imposing one and having people leave for Florida is not likely to work very well. The level would be similar to what, for instance, the UK and Hong Kong both already impose as well. Now the let’s make a deal portion of the program. You say $70 billion isn’t a lot. I would have said $70 billion is a massive amount. So two things you could do with $70 billion a year. One is you could go to full expensing in capital investment, and another is you could pretty much eliminate capital gains on very longterm investment.

So to your point that we want to put taxes where they will create the least distortion or relatively speaking discourage relatively less valuable things and encourage relatively more valuable things, how do you feel about a financial translation tax paired with the longterm capital gains tax cut or paired with immediate expending of all capital investment so that it’s revenue neutral overall?

Jon Hartley: I’ll be totally honest. I wouldn’t take that deal. One, so the $70 billion estimate from the CBL, that’s a static estimate. So, that’s not including the amount of jobs that would go with it. So let’s say the NYSE decides to move to the Bahamas. There’s all those jobs, all those other Wall Street market making jobs that move and, say go to the Bahamas or elsewhere.

Oren Cass: Just to pause there, obviously the London Stock Exchange hasn’t moved under attacks of that size. Essentially, the other largest financial sectors in the world have attacks exactly like this.

Jon Hartley: But I think you have to look carefully at the UK financial transactions tax. There’s essentially, in the UK, a massive exemption on their stamped tax. Basically very few end up paying it. So it’s one of those cases where it’s an FDT which really doesn’t exist or get enforced.

Oren Cass: Well, it raises as a share of GDP an equivalent of $50 billion a year in the US, so it’s actually quite close in scale and coverage to what we’d be talking about I think.

Jon Hartley: Well, I’m not so sure about that. I know a lot of traders that do a lot of trading in the UK. My understanding is that, if someone can do a trade on swap, they don’t have to pay the FDT. There’s a lot of ways to get around it.

Oren Cass: Yep.

Jon Hartley: I’m not sure about how much exactly US traders are paying. You probably looked at this a little bit more than I have, but the vast majority of trades going through the London Stock Exchange are exempt from this tax. That I know for sure. I think another thing that I think is really important to understand here is … So one, what is exactly the … I’m just trying to understand what’s the benefit of an FDT in the sense that, getting back to this argument, let’s just say not just finance and negative externality. We’re talking about that a little bit before, but let’s just talk about trading activity.

Is too much trading activity a bad thing? I would argue the opposite. I don’t think that it’s a bad thing in the sense that who benefits the most from high frequency trading I think is really retail investors. High frequency trading has largely allowed no commission trading to exist. The Robinhood GameStop story, which is a story I think people like, and one certainly the populous like, is that HFT has allowed people to play snow commission trades and, in part, allowed retail investors to crush Melvin capital.

But even before GameStop, a lot of this has to do with the fact that, if we look at a bunch of ETFs, I think ETFs are one of the best wealth building tools that for example the lower to middle class has in the sense that they can put their money in ETFs, in S&P500 ETFs, and they grow with the equity risk premium at let’s say eight percent a year. It’s helped the middle class grow an enormous amount of wealth. Certainly the top income quintile, the higher net-worth individuals have benefited the most from investing, and I’ll give you that. But would we want to ban ETF investing for retail investors or make it more costly for them? I don’t think we would.

I think it’s a great tool for them, and I think an FDT is sort of on the margin as sort of a step in the direction of making retail ETF investing and index funds or ETFs somewhat more costly.

Oren Cass: That’s interesting. So Jack Vogle, the founder of Vanguard and sort of the king of low cost retail passive investing is a huge fan of financial transaction tax. He said he loved it. His argument was, yes, there’s some very small marginal cost, probably in the tens of dollars to the typical retail investor. Yeah, but first of all, if one of the things it does is discourage more churn of the things retail investors are putting their money in, that’s probably good. But more importantly, to your earlier point about alpha and things being a zero sum game at the end of the day, high frequency trading … if we are to believe that the market is at all rational and high frequency traders are making money, they certainly invest a lot in technology and so forth, they have to be making money versus someone else.

High frequency traders are not creating value in the economy. It is almost purely a zero sum game. So isn’t it the retail investors that they’re front running on that allow them to make any money?

Jon Hartley: This is what I would say. Part of the reason why … I think it would make a lot of sense if Jack Vogle, legendary investor, founder of Vanguard, would like FDTs. Vanguard is a very index fund oriented business. Almost historically it’s been an index fund oriented businesses or a mutual fund business. Mutual funds, 1940 Act mutual funds have daily liquidity compared to the business of State Street or Black Rock which largely are ETF businesses. So they benefit a lot from intra day liquidity because EFTs can be traded at any time during market hours.

So in a way, I think an FDT would, if one were to be imposed, would seriously put the Vanguard business model above its competitors of Black Rock and State Street. That would be my one guess, but I can’t speak for him. But I do think it would benefit his business. On the HFT side, it’s interesting. They’re essentially picking up pennies or very small amounts off every trade. I do think that, one, I think commission free trading is a very positive thing, and I think if you look at a lot of studies, I think commission free trading is a benefit to retail investors.

Now, that being said, I think at some level there is competition between HFTs and traditional market makers. Are HFTs making pennies off … Ultimately, are they trying to weight the profits of traditional market makers, think the Goldman Sachs, Morgan Stanley trading desks of the world, versus some of the biggest HFT traders out there are places like Citadel or other competitors. I think that, in that zero sum game, I think they’re really making money off of more traditional market makers and they’re helping to narrow spreads and increase liquidity.

Just so sort of put the bar on it here, I do think that there is a relationship between liquidity or this financial market world and the fixed investment real economy world. I don’t think that they’re totally separate. In this world where a company, an AT&T, an IBM, when they raise money in the primary market, say they do an IPO or they do a dead offering, if they’re raising money from the sale of bonds or stock, that’s going to be used to create jobs and building machines, building factories, building equipment and so forth.

The ability to raise capital in an IPO or in a dead offering, I do think has a lot to do with secondary market liquidity. These things aren’t totally separate. This idea that it’s just a one and done sort of thing, I don’t see that as being the case. I think one thing companies want when they want to go public, one of the things they fear is that the IPO is not going to be a success. They want to raise as much money as possible when they do an IPO. Ultimately, being able to sell … because when they do an IPO, they use joint bookrunners, so there’s now direct IPOs.

We can talk a lot more about how that market is changing, but ultimately a company wants to raise as much money as possible when they sell their stock, then they sell their bonds. So if for example … say they’re doing an secondary liquidity offering. They already have some stock that they’ve already IPO’d before. They want a higher stock price and they want liquid markets in the sense that the investors are able to buy and sell stocks or bonds without prices changing too much.

HFTs provide liquidity to that market and sort of enable that process to happen. So I don’t think that it’s the case that HFTs are these sort of … or hedge funds or playing roulette wheels. In your example in one of your white papers, sort of fans at that Dallas Cowboys game betting on a game and are totally isolated from it. I’m a huge Cowboys fan, so I do partly like the team you’re using there as an example, but I don’t think it’s the case. I think the fans, in a way, are participating.

Maybe it’s, if you want to call it, the 12th man phenomenon or whatever have you, I do think that there is. and certainly in a much more real way than that anecdote. I do think that things like buy backs, for example, I think that this is another thing that’s sort of misunderstood in the sense that, when a company issues a buy back, the returning capital is sort of the opposite of an IPO or a bond offering. A company, for example if it doesn’t have that present value opportunities, its responsibility … If it doesn’t have a positive present value projects, its responsibility is to return value to shareholders.

Certainly, if a company has declined, perhaps it should be doing that. But ultimately, when buy backs are issued, the vast, vast majority of those buy backs get reinvested. It’s not like money is being taken away from productive business. What’s happening often is that this money that’s being returned to shareholders, it’s not new money that’s being created or some great return or something like that. Buy backs tend to signal that companies may be doing well, and that’s why we tend to see stock prices going up when buy backs are announced. But ultimately that money tends to make its way back to smaller companies, and that’s why, if we look empirically at every buy back activity, generally uncorrelated with fixed investment.

So I think it’s the case that … getting back to sort of causation versus corelation, generally speaking, causation implies corelation. But I do think we can make it a case that counter positive is that no corelation should also imply no causation. So again, we’re talking about areas and things like that, but in terms of the cycle of capital and what’s going on, I don’t think it’s the case that, for example, the HFTs are doing this unproductive thing on one side of the field and traditional finance is doing its thing on the other side of the field. I think these things are very much integrated.

Hedge funds, private equity funds are trying this sort of insurance mechanism, any different sort of exotic insurance mechanisms. We’ve got HFTs that are providing liquidity that makes it easier for traditional companies that had the big machinery, the IBMs and so forth to issue capital. Then some companies are returning some of that capital to financial investors when they don’t have these positive net present value projects that involve fixed investment. If they don’t have productive projects, they should return that capital and they do. Then that capital then gets reinvested to corporations and others that can make productive uses of it and invest in high productive fixed investment sorts of projects that are the ones that I think you like in the sense that are sort of part of the vibrant worker real economy.

Oren Cass: All right, well we have to leave it there. As usual, we have, I assume, failed to persuade each other of anything. In fact, to the contrary, now that I know that a financial transaction tax would also be catastrophic for Robinhood, I’m more enthusiastic than ever. But hopefully we have … I certainly have a better understanding of some of your points. Hopefully the converse is true, and especially hopefully this has been valuable to our listeners. So Jon, thank you so much for making the time.

Jon Hartley: Thanks for having me.

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