Boom-Bust Cycles and Trading Practices in Asset Markets, the Real Economy and the Effects of a Financial Transactions Tax

Abstract

This paper begins with a puzzle. Over the past three decades, in asset has become progressively more short-term oriented (faster), with traders attempting to exploit intraday price trends. Yet, over this time, asset prices have continued to move in a sequence of alternating markets and markets, often lasting several years. Which type of behavior over the (very) short run leads to the irregular bull and bear phases over the longer run? The paper finds that (bear) markets are brought about because upward (downward) price runs last longer than counter-movements for an extended period of time. This pattern results from trading as usual, which employs so-called technical analysis to exploit asset price trends and, in doing so, reinforces the price trends. The recent financial crisis spilled over to the real economy mainly through the simultaneous devaluation of stock, housing and commodity wealth. The severity of these markets was the result of the upward climb of prices during the preceding markets. The paper argues that a financial transactions tax (FTT) would reduce the profitability of short-term trend-chasing in derivatives (fundamentals-oriented would hardly be affected). By doing so, a FTT would limit the magnitude of the long swings in asset prices.