Time is money

The time value of money is the corner stone of capitalism; it dates back to capitalism’s origins in the Renaissance (as historian Carlo Cippola “Clocks and Culture” describes). It is in deep trouble. The twenty first century capital markets are becoming so strange, this simple notion is being turned into a bizarre mixture of hyper-instantaneity and stagnation. First, the stagnation. In most of the developed world, the cost of capital is near zero. Japan has arguably never had a properly functioning cost of capital and interest rates in Europe and America are at extreme lows. And in many parts of the developing world, especially China, the discipline of the cost of capital does not function well. This means that the time value of money is not functioning as it should. The president of the Dallas Fed, dissenting from the majority view that rates should be kept low pretty much indefinitely, described what happens when the time value of money fails:

Now, put yourself in the shoes of a business operator. On the revenue side, you have yet to see a robust recovery in demand; growing your top-line revenue is vexing. You have been driving profits or just maintaining your margins through cost reduction and achieving maximum operating efficiency.

You have money in your pocket or a banker increasingly willing to give you credit if and when you decide to expand. But you have no idea where the government will be cutting back on spending, what measures will be taken on the taxation front and how all this will affect your cost structure or customer base.

Your most likely reaction is to cross your arms, plant your feet and say: “Show me. I am not going to hire new workers or build a new plant until I have been shown what will come out of this agreement.”

Moreover, you might now say to yourself, “I understand from the Federal Reserve that I don’t have to worry about the cost of borrowing for another two years. Given that I don’t know how I am going to be hit by whatever new initiatives the Congress will come up with, but I do know that credit will remain cheap through the next election, what incentive do I have to invest and expand now? Why shouldn’t I wait until the sky is clear?

This is pretty much what has happened for over two decades in Japan and is threatening to occur in America and Europe (much of Greenspan’s policies of monetary easing were designed to avoid a Japan-style slowdown, although in the end the measures proved counter-productive). Such stasis more resembles a socialist system than a capitalist system and the risk is that developed economies are turning in that direction.

Now, let us then turn to what is happening in the capital markets. The time value of money is being rendered useless, but for the opposite reason. Andrew Haldane from the Bank of England notes that the average speed of transactions on the NYSE has fallen from 20 seconds a decade ago to one second today. More than two thirds of the trade is high frequency trading (he describes the situation as the “race to zero”). Micro seconds are not what matters; a third of a second is an eternity for these algorithms. Algorithmic trading is also starting to dominate in foreign exchange markets and some futures markets. As Haldane describes it, it is a race to zero time, or at least dealing in nano-seconds.

Such speed represents an absurd misalignment between what capital is supposed to be for — funding commercial activity — and what it is being used to achieve. Money is being decoupled from what it is supposed to represent.  A preposterous circular argument is mounted in its defence: that it creates “liquidity”. This is like saying “if we have more transactions, we will have more transactions.” True, and entirely useless. The point surely is that we must ask what the transactions are for, which is to exchange information and to trade based on differing views about the value of underlying assets. Algorithms are unable to do that; they work precisely because they can be applied to any asset or asset type indiscriminately. They simply read patterns of behaviour, they do not shift because the value of the asset has shifted. The result is that, as they proliferate, the utility of capital is being destroyed.

So on the one hand we have dangerously slowed down time, what is happening, or not happening, in the “real” world of developed economy commerce. And on the other hand we have dangerously sped up time, the absurdities of algorithmic trading. They both seem to me to be symptoms of the dying of the industrial era in developed economies, where there is over supply of just about every consumer product. As I have suggested before, the future lies in post-industrial commerce: for example changes to developed economies’ industrial systems that reduce their use of finite resources, or reduce pollution.

No doubt that is wishful thinking. Far more likely is a long period of low, or stagnant, economic growth in developed economies and unbalanced growth in emerging economies. However, the risks associated with an economic slow down are being compounded by the absurd acceleration of money. In the Great Recession, like the Great Depression, questions about the future of capitalism are being posed. So far all we are getting is a dangerous lack of governance and abrogation of political responsibility. Just as we need good governance to increase growth in developed economies (i.e. increase the rate of transactions), we also need good governance to slow down the trading systems (i.e. slow the rate of transactions). Neither is in evidence.

We know from experience that socialism and communism are not the answers; excessive central government control is not the right path. But knowing what we should not do does not help us find the answers to this situation when the very system of money is under threat, from two directions. The financial system is threatened by a cyber world of hyper speed, which sits on a “real” world of money that is dangerously slowing down. If there is no action to head off the risks.

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  1. Great post – I have indeed found my head being swamped by the data flying around this week.

    Unless you are an excellent trader I feel you need to step back and long at the very long term trends and get into them at early opportune times.

    Betting against good governance may be a start.

    • +1 It seems so obvious, but unfortunately such a tax is only payable by those shuffling large quantities of money around (yes, I mean those with political pull)

  2. Well, some sort of tax, anyway. It could be miniscule and it would stop most of the nonsense. The problem is how to do it across jurisdictions.

      • $20, you need to shop around, of course i expect them to get cheaper brokerage based on volume, the brokers would be stupid not to attract business by giving discounts…

        heres a simple idea to stop HFT.. minimum trade hold = 5secs..

  3. SoN

    Re the cost of capital issue where you reference 20 years of Japan and being joined by the US and Europe, what’s your view of Australia? And is Australia important?


    • That would punish the thrifty for the benefit of the profligate….think about the lessons that would be drawn from that.
      It’s also obscenely self-focused given that for the last 40 years the West has refused to cancel sub Saharan Africa’s burgeoning debt….are you going to include that debt in your debt amnesty? or is the money they owe us to stand?

      • +1

        you cant just call out ‘mulligan’ or press the reset button because the debt situation has gotten out of hand… people have to learn that their is a down side to speculation/ponsi/cheap credit growth/Keynesian economics… that is BANKRUPTCY.

        Can you think what sort of precedent it would set, the next time the debt would be bigger and grander with an expectation for the system to just ‘reset’ when it all becomes too hard.

        In mortgage arrears Michael?

  5. I think Australia is one of the few places with a proper cost of capital. Perhaps because we are between the developing and developed world (i.e. first world country but supplying resources to China etc). But Australia is not important to the current dynamics being played out, we are on the margin.

    • Agree with both points. But my experience is that Australian investors have an inflated view of the cost of capital and the timing of returns which is equally bad

    • Agree on cost of capital, overall. I do find the lack bond and preference equity seems to distort the middle of the market though. This is particularly evident when looking at VC / small business investments.

      I have had the opposite experience to Deep T, with people very reluctant to give up equity, or expecting unsecured loans at rates approaching home loans. Much of this expectation is probably driven by the fact that for many SEs home LOCs is their primary alternative funding arrangment.

  6. The solution to the HFT and algorithmic trading mess is to simply charge 2c per bid or offer – it’s not the actual completed trades which are the problem, the real problem is the trillions and trillions of unfilled bids and offers spawned by HFT/algorithmic trading. A little 2c fee everytime a bid or offer is made will help resolve that problem.

  7. What you say about the prevalence of algo-trading is interesting, but I wonder if it is qualitatively different from any of the many program-trading methods that have preceded it.

    I have to admit, I know nothing at all about this stuff, but I’m interested to know – if what is happening is an array of computers inter-act with each other, how this differs from an array of human voices, each trying to out-guess the next?

    And how does the domination of automated trading alter anything for, say, the humble Self-Managed-Super-Fund? From the standpoint of the humble private investor, nothing much seems to have changed: the market is still prone to speculation, doubt and promise, and is still an endless iteration of price-revisions.

  8. “The cost of capital is near zero.” Not true. The cost of borrowing a unit of currency is near zero – true. Currency is not
    capital. If it were, capitalism would have no need for labor or
    commodities. It could just print wealth. This is unfortunately
    not true, as Nobel laureate Soddy in his work “Wealth, virtual
    wealth and Debt” made clear. Currency is merely a claim against
    existing and future wealth. If it fails to bring forth that wealth,
    the existing supply is merely bid up in price to compensate.

    • What happens when that future wealth never eventuates?

      The price can be bid up and up, but if it doesn’t exist it just becomes worthless.

      Look at what happened to France in the early 1700s, that’s almost exactly what’s happening in America now. Just swap the swamps of Louisiana with dodgy home loans.

      I wish more economist studied economic history…

      • “Currency” enables accounting to take place. It is an abstraction from or of value, not value itself. But so what? If we didn’t have currency, we would have to invent it in order to allow economic processes to operate.

        Currency allows values that apply in one place or at one time to one “exchange set or event” to be compared with and expressed in the same terms as values that apply in other places or times and to other “exchange sets or events.”

        Because currency is transferable (redeemable) for alternate exchange sets both spatially and temporally, it is an accurate analogue for value. That is, currency and value, while different, are in some ways interchangeable ideas from the standpoint of the currency-holder.

        This invites the question, what is value? In our economy, value can be thought of as one of two interchangeable things: it is the means required for the creation of additional value (that is, it is investment capital); or it is the means required for consumption (that is, it is income).

        When we speak of the cost of capital, we usually refer to the cost attached to borrowing “currency”. But this is not the only way to measure the cost of capital. More broadly, the cost of capital has to include the return payable on equity as well as debt, and, obliquely, includes that portion of capital that is lost or written off during production. This latter cost is an internal cost, in a sense, while other costs are external.

        At the moment, it is useful to consider that the cost of borrowing for some (though certainly not all) classes of borrowers is very low – so low as to be negative in real terms. But this is only part of the cost matrix. The cost of equity capital has been rising (inversely to the price/earnings ratio of stocks), while the internal costs of capital consumed and/or written off during production are also likely to be rising (as a result of excess investment in the past).

        The derivation of “costs” is a dynamic process that involves relating one set of circumstances – that is, those that apply in the present, and which can be defined with a high degree of certainty – to alternate sets of circumstances to which a high degree of uncertainty is attached.

        The very low “cost of money” applying to the US Government debt market reflects relative measures on the certain/uncertain spectrum, rather than the rescission of the concept of the time-value-of-money. In fact, because the concept of certainty embodies the idea of time, the very low rates in force simply illustrate the force of the relationship between security-of-value and certainty-over-time.

        Aside from the US Government debt market, capital is not generally cheap. The costs diverge, depending on the quality of the payers and the time spans involved.

  9. StroppyTheWonderDog


    should the Fed just start raising rates?

    Would that be a positive signal to the economy, irrespective of the state of the underlying economy?

    That is what gets me. I don’t see how i-rates at near 0 are good for anyone. At some point the rate is simply lowwwwww (1.5%? maybe) and cutting further won’t encourage borrowing for real investment.
    If the Dissenting Dallas Dude is right then rates lower than lowwwwww are a disincentive to investment.

    Would a couple of “blind faith” i-rate raises make things worse?

  10. Short-termism is the problem – It does not matter whether it is measured in nano-seconds or days.

  11. Walt Disney's Frozen Head

    I was at a HFT conference in NYC last year where hardware vendors were touting their goods, e.g. “our router is 0.1 microseconds faster than their router”. It is all about shaving as much time off calculations and execution as possible.

    The major banks etc. are obsessed with this stuff and the NYSE provides them with an advantage, assuming one exists, by providing them with faster access to data, relative to the average punter (by letting them set their computers closer to the exchange computers than the public can get).

    The reason these people pursue this strategy is that they believe that the market has structure at the microsecond level. As the time scale lengthens, to seconds for example, the structure “washes away” and you are left with the pseudo lognormal distribution. Structure gives them an edge over others provided that they can identify the structure and trade faster than others. Hence the “arms race.”

    Of course none of this has anything to do with the purpose of having a stock market.

  12. “Such stasis more resembles a socialist system than a capitalist system and the risk is that developed economies are turning in that direction.”

    Understatement of 2011

  13. El Zorro Dorado

    A good provocative post.The transition of markets –to being mere speculative casinos for TBTF players to dominate all in a short-termist frenzy–is an enormous problem for everyone because it undermines trust within the larger social and economic system. It changes expectations ( as in the scenarios cited by the Dallas Fed)and causes investors, businesses to stand aside rather than participate, and thereby create emnployment. Fundamentally, finance sectors and regulators have created a false reality which has taken over — who believes that low interest rate will persist for another two years? Soon the massed funds available will gain their own potential “momentum” –similar to the psychological impact of a share overhang.

  14. Is this problem du to the non-decaying value of the value signifier ( whether real money or virtual) … can it be that the concept of stored value without decay, is only made obvious by zero-interest rates.

    Should money acquire a decay rate?? Forcing a more “natural” desire to reinvest??