The possibility that economic theory is ‘performative’ – that the theory creates the reality – has long fascinated me. I talked about it in my Tanner Lectures earlier this year. Donald Mackenzie of Edinburgh University has long related the concept to the financial markets. It was with what I thought was some dramatic hyperbole that I described financial economics as Frankenstein’s Monster, on the rampage still despite the crisis. Melodramatic because at that time – although I had read Mackenzie’s An Engine Not A Camera: How Financial Models Shape Markets and Do Economists Make Markets?, Robert Harris’s thriller The Fear Index, and a few articles about the 2010 Flash Crash, including this one also in Wired, not to mention some regulatory reports and specialist algo trading publications – even so, high frequency trading hasn’t been dominating the headlines.
Now we have had, of course, the Knight Capital meltdown. I’ve also come across some other things well worth reading, among them Scott Patterson’s excellent Dark Pools (which I reviewed here),a new Wired feature, Raging Bulls, and among several by Felix Salmon this blog post with an astounding animation showing the growth of high frequency trading. On my list too is Sal Arnuk’s Broken Markets.
I do sincerely hope financial regulators are not too busy fretting about their failures to limit the credit boom to pay attention to the next financial disaster. Algo trading is how it’s going to happen. Besides, as Patterson’s book makes clear, there is no efficiency gain here; this is a zero sum game in which algo traders win and investors (you and me) lose.