PETER CRABB: Ed Lotterman is off base in how society values liquidity

You don’t have to buy Wall Street’s arguments, but when it comes to how best to regulate financial markets, you should be skeptical.

Economist Ed Lotterman suggested last week that the rhetoric coming out of big financial firms is self-serving. Professor Lotterman isn’t wrong to say that we should not “buy Wall Street’s arguments.” What industry doesn’t oppose regulations or taxes that will reduce profits? His argument, however, is based on the mistaken belief that society doesn’t value liquidity.

In fact, the extra benefit to society of faster trading is not zero. It can be worth billions of dollars to our economy. Specifically, nations with more liquid financial markets have faster economic growth on average.

What high-frequency trading provides is more buyers and sellers in the market. That is, these active traders increase the likelihood we can sell our stocks or bonds when we need to.

The additional volume of trading these traders create goes even further to reduce the cost of trading for all of us. You wouldn’t be seeing the low costs per trade commercials from E*Trade and others were it not for very active stock markets.

High-frequency trading is risky, but benefits society by increasing the volume of trading in the United States’ security markets. With a higher volume of trading, more investors are willing to put their capital at risk, and participants in the financial markets clearly value liquidity.

We need only look to the Treasury market as an example.

Despite a credit downgrade this summer, the value of U.S. government debt remains at record highs. The reason is that investors value the liquidity — ease of entry and exit — this market provides in times of uncertainty.

If anything was learned from the financial crisis of 2007-09, it is that investors place a large value on liquidity. Despite the Fed’s actions during this crisis period, many financial markets outside of Treasuries dried up. Banks were reluctant to lend to one another and trading in the corporate bond market slowed to a crawl.

Without high-frequency traders and other large volume participants in the stock market, the financial crisis would have been much worse. For evidence, we need only to look at the downturns in less liquid markets at the same time. One of the most illiquid stock markets in the region, Mexico, lost two-thirds of its value during the crisis.

A widely cited research study by economists at the World Bank showed that countries with more liquid stock markets in the 1970s grew much faster over the next 18 years than countries with illiquid markets.

More recent research by Campbell Harvey at Duke University shows that open and active financial markets are positively correlated with economic growth.

Professor Lotterman points to the May 6, 2010, “flash crash” as evidence that high-frequency trading is harmful. This event should be looked on with amazement, not skepticism.

U.S. investors should be amazed at how well stock trading works today, and has for decades.

What is surprising about the mistakes that led to the large drop in the price of some stocks that day is that they haven’t happened more often in the storied history of Wall Street.

The issue is much bigger than Professor Lotterman suggests. While it may be hard to see or measure, active and liquid financial markets are good for society.

PETER CRABB Professor of finance and economics at Northwest Nazarene University in Nampa