Uncertainty about federal economic policy is greater than any time in the last 40 years. On one hand we have senior policy makers calling for increasing already massive budget deficits, locking in the loosest imaginable monetary policy for the foreseeable future, and boosting taxes on businesses, Wall Street and the rich if inflation rates spike higher. On the other hand we have a President and senior economic officials who are solid members of an alliance among mainstream liberal academic economists and Wall Street executives who have dominated Democratic party economic thinking since the Carter administration.
In the absence of clear, credible pronouncements by top officials, a recent paper co-authored by Treasury Secretary Janet Yellen’s husband, Nobel laureate economist George Akerlof, may be our best insight into the Biden administration’s intentions. While the paper represents no official policy, it’s telling that Yellen is thanked in the acknowledgements, and Akerlof has collaborated with many Democratic-insider economists in the past.
The paper is particularly valuable because it centres on one issue of dispute between academic liberal economists and Wall Street executives: Tobin taxes. The idea goes back to a 1972 lecture by Nobel laureate economist James Tobin. Tobin suggested that a tax on short-term financial transactions could make markets more stable and efficient. Many liberal economists find the idea appealing. Wall Street hates it.
So while Akerlof might have written about Tobin taxes without thinking of the political reaction, and his wife might have helped only with technical comments, this might be a suggestion that Wall Street input will be excluded from policy making and liberal economists will try to find common ground with progressives. In arguing for a Tobin tax, the paper considers scheduled release of information about a security, like a corporate earnings announcement. It assumes dealers, market makers and proprietary trading firms will buy if the news is good and sell if it is bad. Despite the oversimplifications, the model correctly predicts that dealers and market makers position their inventories before scheduled announcements to best accommodate expected order flow. This is normally considered a good thing as it smooths the market impact of events. One of the complaints about the Dodd-Frank rules is that they discouraged holding long or short positions, leading to less efficient markets and widening bid/ask spreads.
The paper then introduces some transparent rhetorical tricks to make inventory positioning seem bad. The market makers holding inventory are called “front runners.” Front running is a crime where a broker or other agent transacts for itself before executing a client order. Akerlof stretches the definition to mean any pre-emptive action by a broker. This is no minor lapse, with the phrase used 100 times in the short paper. So the entirely legal and ethical practice of inventory management is labeled with a phrase referring to a criminal act. Most market makers manage inventory passively. If they wish to accumulate a positive inventory, for example, they get slightly more aggressive in filling sell orders, and slightly less aggressive in filling buy orders. In the Akerlof model, market makers build inventory by seeking out “unsophisticated” investors. It seems to imagine that retail investors are ignorant about the scheduled information release and can be enticed to part with their securities by bids fractionally above the last transaction price.