Finance and the allocation of human capital

How finance sucks human capital from more productive activities. FT Alphaville:

... a bloated financial sector can also suck in more than its share of talent, hampering the development of other sectors.8

That last sentence is a smack in the face, isn’t it? FT Alphaville was dying to know what Footnote 8 would contain.

Here it is:

8 See S Cecchetti and E Kharroubi, “Reassessing the impact of finance on growth”, BIS, January 2012, mimeo

So we looked it up. From the introduction:

… in our examination of industry-level data, we find that industries that are in competition for resources with finance are particularly damaged by financial booms. Specifically, we show that manufacturing sectors that are either R&D-intensive or dependent on external finance suffer disproportionate reductions in productivity growth when finance booms.

At first, these results may seem surprising. After all, a more developed financial system is supposed to reduce transaction costs, raising investment directly, as well as improve the distribution of capital and risk across the economy. 1 These two channels, through the level and composition of investment, are the mechanisms by which financial development improves growth. 2 But the financial industry competes for resources with the rest of the economy. It requires not only physical capital, in the form of buildings, computers and the like, but highly skilled workers as well. Finance literally bids rocket scientists away from the satellite industry. The result is that erstwhile scientists, people who in another age dreamt of curing cancer or flying to Mars, today dream of becoming hedge fund managers.

See also my earlier post A reallocation of human capital (pre-financial crisis).

The bubble algorithm for human capital allocation

According the this WSJ article, at the peak of our finance bubble about a third of MIT graduates and almost half of all Harvard grads went into finance! Not so long ago a friend of mine at a derivatives desk made offers to 2 percent of the Caltech graduating class (only 4 people, but still).

To what field should society allocate the (N+1)-th big brain to achieve the highest marginal return? For years I've been told that the answer is finance -- markets are efficient after all, and price signals must be correct! ;-)

WSJ: Like nearly 30% of Massachusetts Institute of Technology graduates in recent years, Ted Fernandez set his sights on finance. Though he majored in materials science and engineering, he was wowed by tales of excitement from friends who went to Wall Street.

But when he stopped by an investment bank's booth at a job fair a year ago, it was eerily empty. The booth belonged to Lehman Brothers Holdings Inc., and the date was Sept. 18, three days after the 158-year-old bank filed for bankruptcy. Now Mr. Fernandez, 22 years old, is getting a master's in engineering at M.I.T. and aiming for a career in solar-power technology. [Another bubble? Let's hope not!]

"Undoubtedly, I would have gone into finance if the financial meltdown hadn't occurred," he says. "Now I won't make as much money, but I can go home at night and feel good about what I do. That's worth more than any amount of money."

Over the past 20 years, finance grew faster than almost any other sector of the U.S. economy, offering rich pay and luring a growing share of bright minds to trade securities, make loans, manage portfolios, engineer mergers and turn mortgages into complex derivatives. Now the finance bubble has deflated, forcing hundreds of thousands of employees to search for other work and sending new graduates looking elsewhere for careers.

... Harvard's 2009 graduating class shows the shift in career directions. Those entering finance and consulting tumbled to 20% of graduates this year from nearly twice that in 2008 and 47% the year before, according to a survey by the university's newspaper, the Crimson. ...

Even a modest of shift of talent could have an effect on society. When smart people become entrepreneurs, "they improve technology in the line of business they pursue, and, as a result, productivity and income grow," said a study by economists Kevin M. Murphy, Robert W. Vishny and Andrei Schleifer in 1990. By contrast, they said, allocation of talent to professions such as finance and law -- where returns come from distribution of wealth from others rather than wealth creation -- leads to lower productivity growth, fewer technological opportunities and slower economic growth. [Yes, I know, this argument is far from complete... better people making capital allocation decisions probably does lead to more efficient outcomes... but at what point do we reach saturation?]

"Some professions are socially more useful than others, even if they are not as well compensated," the economists said.

The figure below is from this earlier post:

Capital and Human Capital

According to this study of money managers, PhDs outperform on a risk adjusted basis, as do people who attended high SAT undergraduate institutions. MBAs do not outperform on a risk adjusted basis, but they take more risk.

See also The real big money is run by a physicist , The real smart guys , A tale of two geeks.

What a Difference a Ph.D. Makes: More than Three Little Letters (http://ssrn.com/abstract=2344938)

Abstract: Several hundred individuals who hold a Ph.D. in economics, finance, or others fields work for institutional money management companies. The gross performance of domestic equity investment products managed by individuals with a Ph.D. (Ph.D. products) is superior to the performance of non-Ph.D. products matched by objective, size, and past performance for one-year returns, Sharpe Ratios, alphas, information ratios, and the manipulation-proof measure MPPM. Fees for Ph.D. products are lower than those for non-Ph.D. products. Investment flows to Ph.D. products substantially exceed the flows to the matched non-Ph.D. products. Ph.D.s’ publications in leading economics and finance journals further enhance the performance gap.

An excerpt from the paper:

... The existing literature has explored some aspects of the link between managerial talent and both ability and education in the context of money management. For instance, Chevalier and Ellison (1999) find that mutual fund performance is related to certain educational characteristics of mutual fund managers. In particular, mutual fund managers graduating from undergraduate institutions with higher average SAT scores achieve higher raw fund returns. Similarly, Chevalier and Ellison (1999) also find that raw fund returns achieved by managers with an MBA outperform those without an MBA by 63 basis points per year. However, upon adjustments for risk, only the differential in risk-adjusted performance between the managers graduating from undergraduate institutions with higher average SAT scores and those graduating from undergraduate institutions with lower average SAT scores persists, whereas the risk-adjusted performance differential between funds managed by MBAs and non-MBAs disappears. ...

Conclusions:

In this paper, we analyze the relation between investment performance of domestic equity products managed by institutional money manager and a broad spectrum of managers’ demonstrated academic ability. We focus on possession of a Ph.D. degree, as well as managers’ publication records in top outlets in economics and finance). Using gross returns (returns measured gross of fees, but net of transaction costs), we find that the performance of investment products managed by Ph.D.s is superior to the performance of non-Ph.D. products along several metrics widely employed to measure risk-adjusted product performance (objective-adjusted returns, Sharpe ratio, four-factor alpha, information ratio, and manipulation-proof performance measure). The performance differential in gross returns is preserved, even slightly enhanced, once fees are taken into account (fees for Ph.D. products tend to be slightly lower than fees for non-Ph.D. products).

Hiring employees to maximize assets under management is of first-order importance for money management companies. We find that net flows to Ph.D. products substantially exceed net flows to the non-Ph.D. products matched by style, assets under management, and recent performance. This difference is particularly accentuated in the top quintile of past performance. While the underlying cause of the relation between flows and educational attainment may ultimately stem from ability, knowledge, or soft skills, this finding provides a clear economic justification for the aggressive recruitment individuals holding a Ph.D. to serve in key positions in money management companies.

Finally, our analysis reveals that, among Ph.D. firms, a product’s performance is strongly positively related to the firm’s key personnel publication record in the top outlets in economics and finance. This finding indicates the extent to which proven academic ability at the highest percentiles of achievement translates into successful institutional money management.

Is the finance boom over?

At least for a while. Note the dip after the great depression -- is that where we are headed?




This data comes from papers by Thomas Phillippon (MA in physics, Ecole Polytechnique, PhD in economics, MIT -- vive Les Grandes Ecoles!). See here and here; via Zubin Jelveh.

From 1900 to the mid-1930s, the financial sector was a high-education, high-wage industry. Its workforce was 17% more educated and paid at least 50% more than that of the rest of the private sector. A dramatic shift occurred during the 1930s. The financial sector started losing its high human capital status and its wage premium relative to the rest of the private sector. This trend continued after World War II until the late 1970s. By that time, wages in the financial sector were similar to wages in the rest of the economy. From 1980 onward [deregulation!], another shift occurred. The financial sector became a high-skill high-wage industry again.

The figure below (click for larger version) shows the relative incomes of engineers and financiers over time. The data on the right is for those with postgraduate degrees. Perhaps the collapse of the finance bubble will reallocate human capital back into more "productive" activities?

More human capital mongering

See also Elite universities and human capital mongering. The numbers below suggest that the top 30 schools enroll half or more of all students who are in the top, say, half percent of ability as measured by SAT/ACT.

Chronicle: ... In past decades, many of our best students attended state universities close to home, where they often received an excellent education at reasonable cost. Today, such students are likely to be vying for admission to the nation's most elite colleges and universities. Does this widening of the "prestige gap" between elite and lower-tier institutions, this "tracking" of students into educational institutions by their ability, raise matters of public concern? Or are these shifts simply of interest to institutions at or near the top? We think they raise issues of general social importance.

The increased interest of top students in attending the most- prestigious institutions is easily documented. During the 1980s, for example, 59 per cent of the finalists in the Westinghouse Science Talent Search (one of the nation's premier academic contests for high-school students) chose to enroll at one of just seven institutions -- Cornell, Harvard, Princeton, Stanford, and Yale Universities, the California Institute of Technology, and the Massachusetts Institute of Technology. The same seven institutions led the list in the 1970s, but enrolled only 48 per cent of the Westinghouse finalists.

Further, by 1990, about 43 per cent of students scoring above 700 on the verbal section of the Scholastic Assessment Test chose one of the 30 "most competitive" colleges listed in Peterson's Guide to Four-Year Colleges, up from 32 per cent in 1979. And Richard Spies, vice-president for finance at Princeton, has estimated that from 1976 to 1987, the probability increased by about half that a student with a combined S.A.T. score above 1,200 would apply to one of the 33 elite private institutions belonging to the Consortium on Financing Higher Education. This trend in applications has continued into the 1990s. ...

The Chronicle also has a related article about the field of Political Science (see comment thread!):

Chronicle: ... Departments at 11 elite universities provide half of the field's tenured and tenure-track professors, according to an analysis of more than 3,000 professors.

Placement numbers for theoretical physics: Survivor: theoretical physics.

A reallocation of human capital

Another article on the theme of rich vs super-rich in the NYTimes. The article profiles an MD and a PhD in economics, each of whom left their original career path to head into finance. It's very much along the lines of recent posts on this blog -- in today's world, financial activities, as opposed to "productive" ones, reap outsize rewards.

...Such routes to great wealth were just opening up to physicians when Dr. Glassman was in school, graduating from Harvard College in 1983 and Harvard Medical School four years later. Hoping to achieve breakthroughs in curing cancer, his specialty, he plunged into research, even dreaming of a Nobel Prize, until Wall Street reordered his life.

Just how far he had come from a doctor’s traditional upper-middle-class expectations struck home at the 20th reunion of his college class. By then he was working for Merrill Lynch and soon would become a managing director of health care investment banking.

“There were doctors at the reunion — very, very smart people,” Dr. Glassman recalled in a recent interview. “They went to the top programs, they remained true to their ethics and really had very pure goals. And then they went to the 20th-year reunion and saw that somebody else who was 10 times less smart was making much more money.”

The opportunity to become abundantly rich is a recent phenomenon not only in medicine, but in a growing number of other professions and occupations.

...Three decades ago, compensation among occupations differed far less than it does today. That growing difference is diverting people from some critical fields, experts say. The American Bar Foundation, a research group, has found in its surveys, for instance, that fewer law school graduates are going into public-interest law or government jobs and filling all the openings is becoming harder.

Something similar is happening in academia, where newly minted Ph.D.’s migrate from teaching or research to more lucrative fields. Similarly, many business school graduates shun careers as experts in, say, manufacturing or consumer products for much higher pay on Wall Street.

And in medicine, where some specialties now pay far more than others, young doctors often bypass the lower-paying fields. The Medical Group Management Association, for example, says the nation lacks enough doctors in family practice, where the median income last year was $161,000.

“The bigger the prize, the greater the effort that people are making to get it,” said Edward N. Wolff, a New York University economist who studies income and wealth. “That effort is draining people away from more useful work.”

What kind of work is most useful is a matter of opinion, of course, but there is no doubt that a new group of the very rich have risen today far above their merely affluent colleagues.

...In an earlier Gilded Age, Andrew Carnegie argued that talented managers who accumulate great wealth were morally obligated to redistribute their wealth through philanthropy. The estate tax and the progressive income tax later took over most of that function — imposing tax rates of more than 70 percent as recently as 1980 on incomes above a certain level.

Now, with this marginal rate at half that much and the estate tax fading in importance, many of the new rich engage in the conspicuous consumption that their wealth allows. Others, while certainly not stinting on comfort, are embracing philanthropy as an alternative to a life of professional accomplishment.

...“It has to be easier than the chance of becoming a Nobel Prize winner,” he said, explaining his decision to give up research, “and I think that goes through the minds of highly educated, high performing individuals.”

...By his own account, Mr. Moon, like Dr. Glassman, came reluctantly to the accumulation of wealth. Having earned a Ph.D. in business economics from Harvard in 1994, he set out to be a professor of finance, landing a job at Dartmouth’s Tuck Graduate School of Business, with a starting salary in the low six figures.

To this day, teaching tugs at Mr. Moon, whose parents immigrated to the United States from South Korea. He steals enough time from Metalmark Capital to teach one course in finance each semester at Columbia University’s business school. “If Wall Street was not there as an alternative,” Mr. Moon said, “I would have gone into academia.”

Academia, of course, turned out to be no match for the job offers that came Mr. Moon’s way from several Wall Street firms. He joined Goldman Sachs, moved on to Morgan Stanley’s private equity operation in 1998 and stayed on when the unit separated from Morgan Stanley in 2004 and became Metalmark Capital.

As his income and net worth grew, the Harvard alumni association made contact and he started to give money, not just to Harvard, but to various causes. His growing charitable activities have brought him a leadership role in Harvard alumni activities, including a seat on the graduate school alumni council.

Still, Mr. Moon tries to live unostentatiously. “The trick is not to want more as your income and wealth grow,” he said. “You fly coach and then you fly first class and then it is fractional ownership of a jet and then owning a jet. I still struggle with first class. My partners make fun of me.”

Against finance

Paul Krugman rails against Goldman's big quarterly numbers in yesterday's Times. He goes as far as to claim that Goldman's success is bad for America!

At the core of his argument is the following observation:

Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been “financialized.” The business of moving money around, of slicing, dicing and repackaging financial claims, has soared in importance compared with the actual production of useful stuff. The sector officially labeled “securities, commodity contracts and investments” has grown especially fast, from only 0.3 percent of G.D.P. in the late 1970s to 1.7 percent of G.D.P. in 2007.

Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? Financial firms, we now know, directed vast quantities of capital into the construction of unsellable houses and empty shopping malls. They increased risk rather than reducing it, and concentrated risk rather than spreading it. In effect, the industry was selling dangerous patent medicine to gullible consumers.

This point has not received enough attention in the volumes of analysis produced by the financial crisis. Some comments.

1. Markets and capitalism are good -- overall, they benefit society by providing (mostly) efficient allocation of scarce assets (including human, as well as other, capital).

We've just been through a bubble, with resulting misallocation of resources, but perhaps bubbles are an unavoidable side effect of capital markets, and perhaps their short term negative consequences are compensated by the long term benefits of market economics. Of course, it is beyond our capabilities to address this question with high confidence, so what is left is people arguing their priors. At the bottom of this post are some previous comments of mine on this topic.

2. Concentration of the control of wealth is inevitable, given advances in communications and information technology, the complexity of our economy, and cognitive limits of average people. By control I don't mean ownership, I mean investment and allocation decisions -- think mutual fund investors of modest means, but whose money is aggregated into a billion dollar fund controlled by a few investment professionals.


Given 1 and 2, I doubt Krugman really wants to eliminate the financial sector. His outrage is really motivated by populism, and relates to the following question:

3. How should these professionals be paid? How much value do their decisions actually add to the economy?

This is the fundamental question, also unanswered. Would less extravagant pay for money managers (e.g., as a consequence of more egalitarian cultural values) lead to reduced economic growth? By how much? (By the way, I don't think we can lay all the blame for the current crisis on the professionals -- millions of Americans participated in the housing bubble.)

Personally, I think Wall St. compensation practices need to be changed. I debated this and related points with a hedge fund manager in some previous posts: On the benevolence of financiers , Money talks.


Here's what I wrote in 2008 on topic 1 above. Can anyone do better than these estimates?

Now to my heterodox heterodoxy: always estimate costs and benefits when making a decision. A little calculation is in order: suppose unfettered markets lead to systemic crises every 20 years that cost 15% of GDP to clean up. I think that's an upper bound: a $2 trillion (current dollars) crisis every 20 years. [That $2 trillion was an estimate for the direct housing bubble losses, but I can see now that the collapse of credit markets and of business and consumer confidence is going to increase that number substantially.]

Easy Question: What growth rate advantage (additional GDP growth rate per annum) would savage, unfettered markets need to generate to justify these occasional disasters?

Answer: an additional .1 percent annual GDP growth would be more than enough. That is, an unregulated economy whose growth rate was .1 percent higher would, even after paying for each 20 year crisis, be richer than the heavily regulated comparator which avoided the crises but had a lower growth rate.

Hard Question: would additional regulation decrease economic growth rates by that amount or more?

Unless you think you can evaluate the relative GDP growth effects of two different policy regimes with accuracy of better than .1 percent, then the intellectually honest answer to the policy question is -- I don't know -- no shouting, no shaking your fist, no lecturing other people, no writing op eds, just I don't know. Correct the things that are obviously stupid, but don't overstate your confidence level about additional policy changes.

(Note I'm aware that distributional issues are also important. In the most recent era gains went mostly to a small number of top earners whereas the cost of the bailout will be spread over the whole tax base.)

The benevolence of financiers

Olivier Desbarres is (now former) head of Asia FX strategy at Barclays. Condolences to my friends in finance who have to work with people like this. Struggle not with monsters, lest ye become a monster!

(In anticipation of comments: yes, people from all walks of life have meltdowns, but anyone familiar with global finance can detect authentic banker arrogance in this guy...)

Careful observation reveals it's disproportionately sociopaths at (and near) the top.





What a tremendous misallocation of human capital. See The illusion of skill.

The New New Meme

The other day on Jay Leno, Obama said (video here ; @13 minutes in):

We need young people, instead of a smart kid coming out of school wanting to be an investment banker, we need them to decide they want to be an engineer, a scientist, a doctor or a teacher. If we are rewarding those kinds of things that actually contribute to making things and making peoples' lives better, that's going to put our economy on solid footing. We won't have this bubble and bust economy we've been caught up in in recent years.

I hope this meme takes off! I've made this kind of argument in the past, for example here in a 2006 post on financier pay, where I wrote

I'm anticipating reactions like "Well, of course they deserve it, their decisions have disproportionate impact on the economy, allocating massive resources. The market is efficient, after all!" All well and good if you can show that the 173,340 people (2006 BLS) working in investment banking really do produce better decisions than the people who would occupy those jobs in return for lower compensation. If not, there are some rents or inefficiencies hidden here :-)

Today in 2009 it should be abundantly clear that the market doesn't always know best :-(

Earlier related posts:

The best and brightest

Is the finance boom over?

A reallocation of human capital

A new class war



Some related comments from Brad DeLong below. I don't agree in detail with everything he writes, but you can see the same sentiment at work.

The engineers of Silicon Valley startups are significantly smarter and work a lot harder than do the traders of Wall Street. Some of the engineers of Silicon Valley make fortunes: they are compensated with relatively low salaries and large restricted equity stakes in the startup businesses they work for, and so if the businesses do well they do very well indeed--in the long run, in the five to ten years it takes to assess whether the business is in fact going to be a viable and profitable going concern. And the engineers of Silicon Valley have every incentive to use all their brains and all their hours to make their firm viable and successful: they get their cash only at the end of the process. They don't get big retention bonuses if they stick around until the end of a calendar year. They don't get big payouts if they report huge profits on a mark-to-market basis.

The traders of Wall Street, by contrast, get their money largely up front. If the mark-to-market position is good, they get paid--even though it is almost surely the case that nobody has tried to actually sell the entire position to somebody else. If the strategy produces short-run profits, they get paid--even though not nearly enough time has passed for anybody to be able to assess what the risks involved in the strategy truly are.

Why no bailout?

Representatives in Congress received thousands of phone calls and emails from constituents against the bailout, which some wags have characterized as "no banker left behind" :-)

We can trace this popular reaction against CEOs and Wall St. to growing income and wealth inequality. Ordinary people no longer feel they have a stake in the system. Their reaction may be irrational (even the poorest American has a big stake in the continued functioning of the economy), but it was certainly predictable.

Next spring, unlike last year, less than half of the Harvard graduating class will take jobs in finance. I guess that signals a top in the market 8-/


Related posts:

financier pay

all about the benjamins

a reallocation of human capital

a new class war

non-residential net worth

working class millionaires

$1.2 trillion college loan bubble?

See also When everyone goes to college: a lesson from S. Korea. Returns to a "college education" are highly dependent on the intrinsic cognitive ability and work ethic of the individual.

WSJ: College Loan Glut Worries Policy Makers

The U.S. government over the last 15 years made a trillion-dollar investment to improve the nation’s workforce, productivity and economy. A big portion of that investment has now turned toxic, with echoes of the housing crisis.

The investment was in “human capital,” or, more specifically, higher education. The government helped finance tens of millions of tuitions as enrollment in U.S. colleges and graduate schools soared 24% from 2002 to 2012, rivaling the higher-education boom of the 1970s. Millions of others attended trade schools that award career certificates.

The government financed a large share of these educations through grants, low-interest loans and loan guarantees. Total outstanding student debt—almost all guaranteed or made directly by the federal government—has quadrupled since 2000 to $1.2 trillion today. The government also spent tens of billions of dollars in grants and tax credits for students.

New research shows a significant chunk of that investment backfired, with millions of students worse off for having gone to school. Many never learned new skills because they dropped out—and now carry debt they are unwilling or unable to repay.

... nonprofit colleges, which enroll about 2.7 million students a year. A report released in May by Third Way, a nonpartisan think tank, revealed that among students who enrolled in 2005, on average only half graduated from such institutions within six years. On average, nearly four in 10 undergraduates at those schools who took on student debt earned no more than $25,000 in 2011, the same as the typical high-school graduate. ...

Location, location, location

The Sunday Times on innovation and Silicon Valley. It's all true, although the author is a bit too sanguine for my taste -- he's ignoring Skype, Baidu, and a host of others. Nevertheless, if you're starting a tech company, consider moving it to the bay area. Otherwise, be prepared for the sickening feeling that you're running a race in the outside lane on a circular track.

NYTimes: In our celebrity-studded world, where we make a cult of genius and individual achievement, the mind rebels at the notion that geography trumps personality. Yet the inescapable lesson of the iPod, Google, eBay, Netflix and Silicon Valley in general is that where you live often trumps who you are.

Just ask Sim Wong Hoo. About seven years ago, I met Mr. Sim in Singapore, where he was born and was then living. He talked about the rising creativity of Singaporeans and with a flourish, as if to dramatically make his point, he pulled out a prototype of a hand-held music player that he insisted would replace Sony’s famous Walkman.

Mr. Sim’s device was breathtaking, possessing all the elements of what we now know as the MP3 player. Yet today, a Silicon Valley icon, Apple, dominates the market for MP3 players with the iPod. In recognition of its emergence as a music powerhouse, last month Apple dropped the word “computer” from its name.

Some months after my Singapore encounter, I visited the thriving code-writing communities in Tallinn, Estonia; Reykjavik, Iceland; and Helsinki, Finland, three Nordic cities that were being transformed by advances in cellphones, mobile computing and the Internet. Their tight-knit network of engineers seemed poised to create the tools required to make good on a much-hyped prediction: the death of distance. After all, if necessity is the mother of invention, no one had more need than the hardy Estonians, Icelanders and Finns, living on the frozen edge of Europe, when it came to killing distance as a barrier.

Yet these Nordic innovators were blindsided by two Silicon Valley engineers whose tools we experience whenever we “Google” the Web. Their company, Google Inc., posted a quarterly profit of $1 billion on Jan. 31.

Google’s astonishing rise and Apple’s reinvention are reminders that, when it comes to great ideas, location is crucial. “Face-to-face is still very important for exchange of ideas, and nowhere is this exchange more valuable than in Silicon Valley,” says Paul M. Romer, a professor in the Graduate School of Business at Stanford who is known for studying the economics of ideas.

In short, “geography matters,” Professor Romer said. Give birth to an information-technology idea in Silicon Valley and the chances of success seem vastly higher than when it is done in another ZIP code.

No wonder venture capitalists, who finance bright ideas, remain obsessed with finding the next big thing in the 50-mile corridor between San Jose and San Francisco. About one-quarter of all venture investment in the United States goes to Silicon Valley enterprises. And, according to a new report from Joint Venture: Silicon Valley Network, a regional business group, the percentage has risen, to 27 percent in 2005 from 21 percent in 2000.

Many times in the past, pundits have declared an end to Silicon Valley’s hegemony, and even today there are prognosticators who see growing threats from innovation centers in India and China. Certainly, great technology ideas can come from anywhere, but they keep coming from Silicon Valley because of two related factors: increasing returns and first-mover advantage.

These twin principles, debated in head-scratching terms by professional economists, essentially explain why Intel maintains a lead in high-performance chips, why Apple sustains a large lead in music players and why Google’s search engine remains a crowd pleaser.

On a gut level, we all can understand how these two factors work. Who wouldn’t want to play for a perennial contender? For the same reason that Andy Pettitte signs with the Yankees, the best and the brightest technologists from around the world make their way to northern California.

“All that venture capital attracts a lot of ideas — and the people who are having those ideas,” said Stephen B. Adams, an assistant professor of management at the Franklin P. Perdue School of Business at Salisbury University in Maryland who has studied the rise of Silicon Valley.

Newcomers plug into an existing network of seasoned pros that “isn’t matched anywhere else in the world,” says AnnaLee Saxenian, dean of the School of Information at the University of California, Berkeley, and author of “Regional Advantage,” a book about the competitive edge held by tech centers like Silicon Valley and the Route 128 suburbs near Boston. “That allows people to recombine technical ideas much more quickly here than anywhere else,” Professor Saxenian added.

“In terms of creativity, the Valley remains as far ahead of the rest of the world as ever,” she said. “People in the Valley generate new ideas and test them much more quickly than anywhere else. They aren’t a super race; it’s their environment.”

Silicon Valley is not invincible. The logic of increasing returns and the first-mover advantage can be overdrawn. Other clusters in the United States and around the world will commercialize great ideas, and the Valley will endure down cycles again, as it has in the past. Remember how the Japanese conquered memory-chip manufacturing in the 1980s, until then a staple of the Valley’s business? And, of course, the dot-com bust of five years ago remains a painful reminder of how success breeds hubris and humiliating failure.

Americans naturally harbor many fears about losing their edge, especially with the nation mired in war, the dollar’s value sliding and the health care system strained. Rivals, notably in India and China, see Silicon Valley’s pre-eminent position as a prize that they will inevitably take. Yet they face an elusive foe. Every time Silicon Valley recovers from failure, it seems to grow more durable, almost in the same way a person becomes “immune” to a disease after a brush with it.

Fifty years ago, chips were the engine of Silicon Valley. In the late 1970s came the personal computer and data-storage drives, then software, and more recently the dynamic vortex of the Web, new media and online commerce. (EBay, Netflix and, of course, Google and Yahoo are among the names that come to mind.)

These serial renewals are a marvel.

SIR PETER HALL, the British scholar of urban clusters, asks in “Cities in Civilization,” his history of geography and business innovation: “What makes a particular city, at a particular time, suddenly become immensely creative, exceptionally innovative? Why should this spirit flower for a few years, generally a decade or two at most, and then disappear as suddenly as it came?”

Sir Peter’s words highlight an enduring human mystery. In the case of Silicon Valley, the world rightly waits for the flame of creativity to burn out. That’s fair enough. To each, a season (or maybe a few). Living long and large, Silicon Valley surely will wither like a dead flower someday. My advice, though, is: Don’t hold your breath.

G. Pascal Zachary teaches journalism at Stanford and writes about technology and economic development.

The speed of finance

The speed of light is not fast enough if you're in the business of vacuuming up micropennies (keeping bid ask spreads tight) using an automated trading system. You've got to have physical proximity to the exchange in order to keep lag times short! I guess the endpoint to this arms race is to have your servers co-located in the same facility as those of the exchange! Or, to be fair, the exchange could impose a random delay on all trades which is of order of the light travel time around the earth.

Is this kind of activity "making markets more efficient" -- the usual defense of financial shenanigans -- or just gaming the system as much as possible (the other standard description :-) ? If we're talking about milliseconds, I imagine that is about as efficient as we need. Also, I'm a bit confused as to why an outside system would be better at matching bids and asks than the internal algorithm of the exchange itself (unless it is taking on a little risk; see below). It's not surprising that these two types of entities -- trading automatons and exchanges themselves -- would eventually start stepping on each others' toes.

The next step is a little more AI in the algorithms. They probably already peek at futures and options prices to predict the direction of movement in the underlying, taking a bet rather than just locking in an arbitrage.

WSJ: NORTH KANSAS CITY, Mo. -- About four years ago, Dave Cummings moved his trading firm's computers from a storefront in this Kansas City suburb to buildings in New York and New Jersey that house central computers for two big electronic stock exchanges.

The move shaved a precious fraction of a second from the time it takes Mr. Cummings's firm, Tradebot Systems Inc., to buy or sell a stock on computer-based exchanges like Archipelago. It now takes Tradebot about 1/1000 of a second to trade a stock, compared with 20/1000 before the move -- a difference of about the time it takes a computer signal to zip at nearly the speed of light from Kansas City to New York and back.

That may not seem like a big difference, but in Mr. Cummings's obscure corner of the stock-trading universe, speed is critical and fractions of seconds loom large. Tradebot's computers are programmed to detect, among other things, tiny, fleeting differences between bid and offer prices of stocks, then to pounce, buying stocks at one price and almost immediately reselling them for a fraction more. If his firm hadn't moved its computers, says Mr. Cummings, "we'd be out of business."


Dozens of other firms, ranging from Citadel Derivatives Group to a brokerage unit of J.P. Morgan Chase & Co., also employ split-second trading strategies. That has set off an arms race to shave the time it takes for orders to reach the computers of electronic exchanges. In their quest for the choicest locations, at least 40 of Tradebot's competitors have carted their computers to the same buildings, a practice known as co-location.

The kind of trading practiced by Mr. Cummings is a particularly fast form of "algorithmic" or "black-box" trading, in which computer programs decide when to buy and sell securities. Hedge funds such as SAC Capital Advisors, D.E. Shaw & Co. and Renaissance Technologies have been using computers in their investment strategies for years. These days, a variety of new computer strategies rely on lightning-quick trading. For example, computers are being programmed to take news headlines into account when executing trades, and media companies including Dow Jones & Co., publisher of The Wall Street Journal, and Reuters Group have begun releasing news in computer-readable formats that cater to them.

Mr. Cummings's strategy -- which is shorter term than most and is highly reliant on speed -- was made possible by the growth of electronic-trading networks. These trading platforms -- Globex at the Chicago Mercantile Exchange, Archipelago at NYSE Group, INET at Nasdaq Stock Market and others -- account for more than half of all trading in household-name stocks and financial futures contracts.

Trading mostly Mr. Cummings's own money, privately held Tradebot, which has about 20 employees, makes between $30,000 and $150,000 a day and up to $20 million a year, people familiar with its finances say.

Electronic exchanges use computer systems to match buyers and sellers. They execute orders without involving floor traders known as specialists, who arrange transactions through auctions on the NYSE. For years, these specialists and the Wall Street dealers who traded Nasdaq stocks profited on gaps between bid and offer prices.

Opportunity for Profit

The electronic marketplaces bill themselves as a democratizing force -- a way to cut out specialists and dealers. Mr. Cummings realized that these electronic-trading pipelines also provided a new opportunity for profit: If he used fast enough computers and programmed them just right, he could harvest the same kind of trading profits that specialists and dealers long have gathered, albeit on a smaller scale for Mr. Cummings.


In Mr. Cummings's world, the fundamentals of a stock are of little consequence. His firm favors large stocks, such as Microsoft, because it can trade in and out quickly. On one recent afternoon, a computer screen in Tradebot headquarters indicated that the firm accounted for more than 10% of that day's trading in Microsoft. On many days, Tradebot's trading totals account for as much as 5% of all Nasdaq trading, on par with trading levels at such giant firms as Fidelity Investments.

"He's had a huge impact," says Jamie Selway, former chief economist of Archipelago and now head of White Cap Trading, a small New York brokerage firm. By constantly trolling to buy and sell, he says, Mr. Cummings enables others to trade more quickly. "You're probably trading with Dave Cummings, but don't know it," Mr. Selway says.

Mr. Cummings, 37 years old, learned to program as a teenager when he also worked at his father's computer-software store. After earning an engineering degree at Purdue University, he worked for three years at a health-care software company. In the mid-1990s, he moved to the Kansas City Board of Trade, donning a forest-green jacket and taking to the pits with other traders, buying and selling futures contracts tied to stocks and wheat prices.

In 1999, he quit his trading job, settled at a computer in a spare bedroom of his house and set out to develop software to replicate the actions of a floor trader in an arena where floor traders don't exist -- the electronic marketplace. Months later, he rented a small office in a bank building, furnished it with old furniture and a few computers, and launched Tradebot with $25,000 of personal savings.

Harold Bradley of American Century Investments, a Kansas City-based money-management firm, saw Mr. Cummings demonstrate the system while Tradebot was hunting for money to trade. Mr. Cummings told potential investors that he had created a robot to do what floor traders did -- hence, the name Tradebot. His firm would buy and sell based on signals from its computer program, collecting lots of nickels and dimes by being faster than other traders. Mr. Bradley says he declined to invest, figuring it would be difficult to make money on a large scale.

Mr. Cummings raised several hundred thousand dollars from a Chicago trading firm that wanted to use his programs. (Mr. Cummings bought this partner out in 2002.) Tradebot focused on stocks listed on the Nasdaq, which were easier to trade electronically than those at the New York Stock Exchange, where rules, at that time, limited electronic trading.

Tradebot took no long-term views on where stock prices were heading. Instead, it aimed to profit off tiny differences between what investors were willing to pay for heavily traded stocks and what others were willing to sell them for. In 2000, when stock pricing began shifting from increments of 1/16 of a dollar to one cent, many Wall Street trading desks gave up that business, figuring it was no longer profitable enough. That left Tradebot and competitors such as Citadel, Automated Trading Desk and Getco LLC to go after the profits.

Mr. Cummings's programs took into account fluctuations in stocks as well as in financial instruments such as stock-index futures. His computers, for example, would simultaneously try to buy Microsoft stock from investors at, say, $27.69 a share, and to sell it at $27.70, for a penny-per-share profit. Theoretically, human traders could spot the same opportunities, but Mr. Cummings's computers could usually get there first. His firm sometimes traded more than 1,000 times a minute. It ended most days owning no stock, cashing out all its positions.

Tradebot's employees constantly monitored the program trading. Mr. Cummings says he figured that once in a while the strategy wasn't going to work. It was often best, he concluded, to move out of the way when the market was moving sharply in one direction or another. He did not want to be stuck holding big blocks of stocks when their values unexpectedly plunged. If trading in a particular stock began losing money, an employee could switch off the program for that stock.

In the early 2000s, electronic marketplaces such as Island ECN and Archipelago courted professional traders. They offered rebates on certain kinds of complex trades such as "limit orders," in which traders offer to buy or sell shares within certain price parameters. The rebates allowed Tradebot to profit on some trades that merely broke even, according to several former employees.

By 2001, other firms were employing computer strategies similar to his, and some of them had an advantage: Their computers sat in Island's headquarters building in lower Manhattan. As a result, Tradebot's computers were a fraction of a second behind its rivals in trying to grab the best prices. "We were excluded because of the speed of light," Mr. Cummings says. "We had to move our computers."

Mr. Cummings discussed the problem with Island executive Matthew Andresen. "Our customers outside of New York are at a big disadvantage," Mr. Andresen recalls telling him. "We agree it should be a level playing field."

In addition to transaction fees Mr. Cummings's trades generate for Island, he agreed to pay a few thousand dollars per month to put Tradebot's computers in Island's facilities. The difference was significant: In the 1/50 of a second it used to take to execute an order from Kansas City, Tradebot could buy and sell at least 20 times.

Archipelago, an Island competitor now owned by the NYSE, was also after Tradebot's business. Mr. Cummings told Archipelago he was concerned that its system could take as long as a second or two to process his orders. "I can't manage that risk," he told Mr. Selway, then Archipelago's chief economist, Mr. Selway recalls. At times, Tradebot had to "throttle back" its Archipelago trading because that exchange's system couldn't handle the volume fast enough, says Mr. Cummings. Mr. Selway figures he spent a hundred hours on the phone with Mr. Cummings discussing how to make Archipelago better.

A few months after sealing the Island deal, Mr. Cummings visited Archipelago Chief Executive Gerald Putnam in Chicago and sized up the firm's computer room. Archipelago executives worried that letting Tradebot move its computers in would prompt complaints from other brokerage firms. They told Mr. Cummings to wait for Archipelago to complete a new data center in Weehawken, N.J., that could accommodate traders' computers.

Mr. Cummings didn't wait. He moved some Tradebot computers about a mile away from Archipelago's Chicago office. Then, when Archipelago finished its New Jersey data center, he moved the computers there. If a rival's computers "are in the exchange, and I'm across the street, then I lose," Mr. Cummings explains.

On Oct. 9, 2002, Tradebot for the first time traded 100 million shares in a single day, most of them stocks listed on Nasdaq. At that time, the NYSE was still a private cooperative controlled by floor brokers and specialists who traded stocks the old-fashioned way. It maintained limits on electronic trading, including restrictions on certain big orders and on rapid in-and-out trading. With an eye toward trading more NYSE-listed stocks, Tradebot bought Philadelphia-based Bloom Staloff Corp., which traded NYSE stocks from its specialist business at the Philadelphia Stock Exchange. Tradebot installed faster computers, but the NYSE restrictions proved troublesome. Mr. Cummings shut down the operation at a loss within six months and continued focusing on Nasdaq stocks. (In October of this year, the NYSE started opening its 2,700 listed stocks to electronic trading.)

Analysts estimate that Mr. Cummings's net worth surpassed $10 million several years ago. His trading business is probably worth several times that, although as a private firm, its finances aren't disclosed.

Over the past three years, about 40 other firms have moved their computers closer to the action, with bigger brokerage firms following smaller trading firms. Merrill Lynch & Co., Goldman Sachs Group, Deutsche Bank AG and J.P. Morgan Chase all have computers sitting near marketplace mainframes, or at least in the same neighborhoods.

Some exchanges, such as the Chicago Board of Trade, have resisted co-location, mostly because they don't want to put at a disadvantage investors who trade through firms that haven't moved their computers.

'Question of Fairness'

"It begs the question of fairness," says Andrew Brooks, head of stock trading at mutual-fund firm T. Rowe Price in Baltimore. "You shouldn't win just because you have better access to speed." Some investors also complain that rapid traders often cancel and resubmit orders, clogging the trading systems of electronic exchanges when markets are busy.

The Securities and Exchange Commission allows co-location, as long as electronic marketplaces give firms equal access to prized computer locations. The SEC has looked into the fairness issue and intends to continue to monitor it, according to two people familiar with the agency's approach.

Last year, Mr. Cummings says, he grew worried about the future of his trading strategy. More firms were co-locating. Consolidation in the exchange business, he feared, would lead to higher fees. The NYSE had acquired Archipelago, and Nasdaq had bought Island's successor company, INET.

In 2005, Mr. Cummings turned over day-to-day management of Tradebot and shifted most of his focus to a new venture: creating an exchange-like competitor to the NYSE and Nasdaq that would match buyers and sellers for a small fee. He called it Better Alternative Trading System, or BATS.

That June, he emailed about 100 traders and other industry contacts about BATS. Within days, senior executives from both NYSE and Nasdaq called to ask why one of their biggest customers was setting up a rival marketplace.

"The market needs competition," Mr. Cummings recalls telling Robert Greifeld, Nasdaq's chief executive officer.

"I wish you luck, but it's harder than you realize," Mr. Greifeld recalls replying.

Mr. Cummings has already poured about $4 million into the venture, which now occupies most of his time. He now travels on monthly sales calls and sends potential BATS clients a wooden baseball bat with the company's logo.

A few months after starting in January, BATS drew minority investments from Lehman Brothers Holdings Inc., Credit Suisse Group and Morgan Stanley. BATS now regularly handles about 5% of Nasdaq trading, the firm says.