Should We Ban Naked CDSs? - Grasping Reality with Both Hands: Oh my oh my, Brad DeLong prof Noise Trader Risk ... himself seems to have left noise traders completely out of the story. Point 3 (used to be point 4 and I'm still throwing the same cow)
People who have done research and learned information about the structure and likely evolution of the market can bet on their knowledge: they win because they make their positive expected-value bets"
In the real world half of them win and the other half lose. The assertion as quoted assumes that all people have rational expectations so bets by people who have done research must be positive expected-value bets. So why did the average pension fund underperform the S&P 500 even though the average pension fund beta was 1 ? (I'm citing our co-author Andrei). If you abandon your new found faith in rational expectations (which you absolutely assume in the quoted passage) you must agree that it is an empirical question whether super smart people who try to beat the market reduce or increase the mean squared (or mean absolute) deviation of prices from fundamentals. The answer seems to be totally obvious to me. There has been a huge increase in research and active trading and employment of braniacs in finance and asset price volatility has increased. Asset prices are much much too volatile to reflect rational updating. I look at the rough correlation and guess that the hard working smart people trying to beat the market are driving prices further from fundamentals. OK so you will bring up Luskin and say that they just can't overcome the effects of the idiots. However, you can't explain how more developed etc financial markets can make it easier for a rational investor (if one exists) to affect prices without making it more easy for Luskin to affect prices. Oh and if you type "market selection" then I will rethink my atheism, since demonic possession would be the only possible explanation.
As far as naked CDS shorts are concerned, they make it easier for pessimistic noise traders and pessimistic fundamentals traders to affect prices. Optimistic noise traders and optimistic fundamentals traders can already affect prices--they go long CDSs, take on risk, and so lead to the construction of new houses.
The question of whether more developed financial markets are more or less vulnerable to noise trading is a hard one, and I'm not sure that it is as clear-cut--that more sophisticated financial jobs do a worse job of sending price signals to the real economy--as Robert suggests...