Hayekian markets reconsidered

by Daniel on August 5, 2003

A week late and a couple of dollars short, here are my thoughts on the now defunct Policy Analysis Market. I’d note right up front that this “market” always looked suspicious to me; even when it was going, the website seemed to consist of precisely five flat, static HTML pages, and this for a website that was meant to be going live with active trading in October. Particularly since nobody seems to be at all clear on the details of what this market was meant to achieve (was it open to the general public? Only to specialists? Was it going to trade “assassination futures”? Or just derivatives on the EIU political stability indices?), let alone on its clearing arrangements, confidentiality clauses, etc, I rather suspect that the whole thing was disinformation from start to finish. That’s why I didn’t want to comment on it at the time.

However, I do want to comment on the fact that a number of bloggers analysed it in terms of Hayek’s concept of tacit knowledge and markets as information-creating social entities. Henry had an excellent first cut at trying to develop a more rigorous Hayekian analysis last week, but I’d like to take issue with some of his points and make a couple of my own about the characteristics of successful markets.

Just to start out and for the record, if this idea had been genuine, which I suspect it wasn’t, and if it had got off the ground, which it didn’t, it might not have been a bad thing. I’m not inclined to take seriously those critiques based on bubbles or based on supposed inefficiencies of market behaviour, at least not unless they have some explanation of why these are particular flaws of market behaviour, rather than general organisational pathologies of groups of homo sapiens. I am always in favour of people being made to put their money where their mouth is when they’re shouting off about questions of global importance, and as Henry notes in the piece linked above, one of the potential functions that the PAM might have served would be as a means for low-ranking CIA officials to signal their genuine opinions, rather than those which were politically correct at the CIA. This is obviously not a first-best solution; first best would be a culture of honesty at the CIA. But a working market would be a benefit if it had the effect of creating a “back channel” of honest communication.

But here immediately we see what the real problem with a working PAM would be; as commenter Dan Hardie pointed out on Henry’s post, it’s not actionable information. If the “Saudi Arabia might attack us” index suddenly goes through the roof, what do you do? I admit that the immediate precedents of US and UK policy have not been wholly heartening, but somehow I don’t think that even Tony Blair would have the brass neck to point to a rising price and volume trend on a chart of ten days’ trading action and ask us to commit blood and treasure to a war of aggression. These prices are just too much of a black box to be a decision support tool on their own. So, what would actually happen if the Saudi contract roofed it? Well, this would apparently be the trigger for “more analysis” by the CIA and similar agencies. With respect to all involved, we’ve seen what “more analysis” does for you and so far all we’ve got to show for it is a couple of sterile mobile labs, some aluminium tubes and the starting handle for a centrifuge hidden under someone’s rose bush. The point being that if the overall intelligence process is corrupt, even the addition of an honest indicator isn’t going to help matters.

And this can be generalised into a wider critique of the unthinking application of “market solutions” to problems of this sort, on Hayekian grounds1. One point on which I think I quite strongly disagree with Henry, and by extension with the people he was discussing, is that I don’t believe that Hayek’s discussion of “tacit knowledge” is relevant to the question of a Policy Analysis Market. The defining characteristics of Hayekian tacit knowledge is that it’s practical, non-propositional and local in time and space. I actually think it’s something approaching a category-mistake to suppose that anyone could be in a position to have tacit knowledge relevant to the question “Is the chance greater than 22% that the government of Saudi Arabia face a coup attempt this year?”. It’s a question which demands an answer in the form of a proposition, not like the question “Is orange juice for September delivery too dear at $5 8/16 a contract?”, which demands an answer in the form of an action.

And this matters. Hayek’s view of a market as a knowledge-creating entity is one which actually sits pretty uneasily with such things as the efficient markets theory, arbitrage pricing and other strands of thinking about markets and information which rely on reading off the closing prices and using them as if they were propositional information about something else. In the sense in which Hayek uses it, a market is an information processing system because it takes tacit knowledge as inputs and has the co-ordination of human activity as an output. The actual prices and volumes traded are epiphenomena; in general, they match up reasonably well to events in the real world (which is how the Soviets were able to use price data from Western markets as an essential input into the planning process), but that’s not the point of a market, any more than it’s the point of a kettle to increase the humidity of your kitchen.

Why does this matter? Well, it suggests that the prices struck in a market will be informative only if the market is well stocked with buyers and sellers operating on the basis of their own tacit knowledge. And this is not just an obscure point of Hayek scholarship; it’s actually written into the rules of the Chicago Mercantile Exchange.

The Merc, and several other commodities exchanges, makes a distinction between “hedgers” and “speculators”. They do this for practical reasons; hedgers are allowed to run larger positions, because it is assumed that they are willing and able to take or make physical delivery of their contracts if necessary, and because they need to. But the distinction can also be made on sound grounds of Austrian economics. Consider the following sketch of a theory of the commodities market (to make it concrete, we’ll consider the grain futures market):

The market exists because of the hedgers; farmers are structural sellers of wheat contracts and bakers (etc …) are structural buyers. Both farmers and bakers are in the market because they want to fix their prices ahead of time in order to be able to make long-term plans about growing wheat or baking bread, and the futures market allows them to make these plans in the knowledge that they won’t be rendered unable to pay their debts because of sudden price movements in the spot market. Both the farmers and the bakers have plenty of (practical, unverbalised) tacit knowledge about grain, and the market price converts this tacit knowledge into a plan for co-ordinated action.

But experience has shown that it is pretty difficult to operate your market if you only have hedgers in it; in general, markets which don’t have speculators are illiquid. Speculators supply liquidity to the grain market, taking on the other side of the trades which the hedgers wish to make, in order that the market doesn’t have to wait until a hedger with an equal and opposite demand shows up. Speculators don’t in general have tacit knowledge of the underlying security (in extreme cases, nor do they want to; the old proverb “the stock doesn’t know you own it” comes to mind). Speculators assist the market’s functioning because they have tacit knowledge of the market; they have practical, nonpropositional information about the way in which liquidity is best provided to hedgers.

It follows from this that in order to be an efficient information-creating entity, a market has to have both hedgers or speculators. Although speculators are vital to the functioning of the market, you can’t have a market with nothing but speculators. And if you think about it, all the really successful “speculative” markets are ones in which the speculative activity clearly takes place in the context of a two-way market between hedgers. Commodities markets have structural demand from manufacturers and structural supply from primary producers. The stock market has structural demand (for stock) from people who want to save, and structural supply (of stock) from companies who want to raise money. The money market has structural demand from borrowers and structural supply from lenders.

There is nobody (to a reasonable first approximation) who has structural demand for more terrorism. The only people who have tacit knowledge of terrorists and would be considered to be on the long side of the market, are terrorists, who would presumably not be material participants. The problem is the same with respect to “weather derivatives”, “catastrophe derivatives” and other such markets which (with due respect to the well-intentioned and often frighteningly intelligent people who try to make them work) have never taken off2. The problem is that one side of the market has no tacit knowledge, and so the market does not really perform its function as an information processing entity.

I actually think that as a predictive tool over whether a market is going to work or not, this simple model works pretty well. Commodities exchanges – work well. Money markets – work reasonably well, but can be upset by the government coming in as a big player with no tacit knowledge. Stock market – can work just fine, but didn’t in the 1990s as the corporate sector became a net buyer of stocks, leaving no tacit knowledge on the short side. Betting spread “markets” – entirely speculative and notoriously subject to home town effects and long-odds effects. Hewlett-Packard-s internal market for forecasting sales – works fine and actually quite a good way to resolve what would otherwise be an organisational problem between salesmen (systematically interested in talking projections down) and engineers (wanting to talk them up). And so on. For the time being, then, I’ll assume that there was no great loss to society when the PAM bit the dust, as there is nobody who is systematically interested in the probability of terrorist attack being higher.

Update: As an example of the sort of thing I’m talking about, I’ve dug up this rather nice paper from the wonderful SSRN. It’s the latest contribution to the debate on orange juice futures as a tool for weather forecasting. Ever since Richard Roll’s widely misunderstood 1984 paper on the subject, there’s been an urban myth going round that the frozen concentrated orange juice (FCOJ) futures market provides a better forecast of the weather in Florida than the weather channel. Not only did Roll not find this, he actually thought he’d found that the variance in the FCOJ contract price was about five times greater than anything that could possibly be explained by weather movements. The paper I’ve linked above revists the issue and is rather more favourable to the efficient markets thesis in this regard, but for our purposes, we only need to note two things. First, the market doesn’t care about “the weather”; it cares about whether it’s freezing or not, because that’s the only thing that matters for orange production (practical knowledge). And second, the market reacts to today’s temperature news; there’s no attempt here to defend the proposition that the futures market forecasts the weather.

Anyone who likes the same kind of films as me would never be fooled by the orange juice/weather forecast connection, by the way. As Eddie Murphy showed us in “Trading Places”, about 40% of the volatility in the Fall FCOJ contract takes place on the single day in October on which the USDA releases its preliminary orange production estimates. Obviously, this well-observed phenomenon of the market is inconsistent with the FCOJ traders having any weather forecasting advantage over the USDA.

1I should probably point out that my interpretation of what Hayek was trying to say is not universally shared; it comes from Prof. John Gray of the LSE. However, several CT contributors were also taught by or worked with Gray at some point in the past, so in as much as there is an official editorial line on Hayek exegesis, “Grayek” is probably it.

2What trading takes place on these “catastrophe exchanges” usually takes place between reinsurance companies who have made bad underwriting mistakes and are trying to get out of them on the quiet.



Russell L. Carter 08.05.03 at 3:06 pm

And the idea seemed to be a strategy for transferring the responsibility for hallucinatory exaggerations such as the Iraqi ‘threat’ from fallible humanoids to an infallible, or at least mechanistic agent: a market. Will to honesty as opposed to herd mentality in the players would have been the only countervailing factor. But honesty is never in demand…


Adrian 08.05.03 at 3:25 pm

How can PAM and similar initiatives have come so far if they can be discredited by such a straightforward refutation? Can it really be that in some corridors of power free-market ideology has become so unhinged from common-sense?

Until now I had seen the blogosphere as the “back channel of honest communication” to counter the institutional bias of establishment media. Now I see it also has a role to play in constraining the influence of libertarian ideologues in influential policy institutes.

Thank you for the enlightenment.


dsquared 08.05.03 at 3:34 pm

It’s not really all that straightforward to anyone except a Hayek nerd, and I must confess that if the Iowa Electronic Markets are as good as they claim to be, Ihave a hard time fitting that into my theory.


Shai 08.05.03 at 4:06 pm

This may be a facile observation, but couldn’t would be terrorists watch the market as well? It’s like telling me I’m about to raise my hand. If I know that I might choose to punch you in the stomach instead.


Adrian 08.05.03 at 4:10 pm

I’m not a Hayek nerd. I’m not even an economist. I’m just a securities trader but I know what it takes to make a market work properly. I’m not sure I need to know anything about Hayek to understand the significance of what you’re saying.

Anyway, the devisers of the PAM are themselves Hayek nerds. So even granting your premise, they still have no excuse.

I can’t be too impressed by the Iowa exchanges. As a market-based form of opinion poll about an event that is itself an opinion poll – an election – shouldn’t we expect them to be close to accurate? What’s so remarkable? Why should we accord them any more respect than IG Index?


Jeremy Osner 08.05.03 at 4:37 pm

Nice post — off the main subject of the post but I’m interested in the idea of the PAM being disinformation — what would the point be? Just that Pointdexter was tired of his job and needed a way out?


dsquared 08.05.03 at 4:41 pm

The whole point about disinformation is that it doesn’t always have a point. If it was always connected to something, it would be information, of a sort. Just like the worst case for communication is a signal that’s misleading 50% of the time, not 100%.


BAA 08.05.03 at 5:02 pm

David Warsh provides a nice summary of the economic history of markets as analytical tools here: http://www.economicprincipals.com/issues/03.08.03.html

He also notes the effectiveness of the Iowa markets, and links to relevant papers.


dsquared 08.05.03 at 5:28 pm

THanks. I have to say that the Iowa study looks like advertising material to me; there are a number of things they do (chiefly, not time-pairing the poll and market predictions) which just don’t make sense.

Also, the (IIRC) poll data has already been filtered to make it a better discriminant (to make it answer the win/lose question more clearly), which would have the effect of making it a worse predictor of vote share. I’d like to see some more high-powered statistical tools brought to bear before I started trusting the Iowa markets; visual examination of the chart of the Gore/Bush winner-take-all market* suggests to me that there were a couple of serious speculative bubbles.

*Curiosum; under the specifics of the IEM contract, the market predicted a Gore win and actually paid out on Gore and not on Bush, because Gore won the popular vote.


Scott Martens 08.05.03 at 6:19 pm

You mean to tell me that “Trading Places” accurately describes the functioning of the frozen orange juice concentrate market? To me, that’s a good order of magnitude more surprising than the idea that it might correlate dimly with the weather in Florida. Even the Farmer’s Almanac is actually a better predictor than guessing.

I suppose it’s not impossible for an Eddie Murphy comedy to be accurate. Eddie Murphy’s last movie accurately describes the regulatory environment for commerical daycare services.


dsquared 08.05.03 at 6:26 pm

Actually, there’s a big inaccuracy in Trading Places; the Nymex has circuit breakers which bring a halt to trading if the contract moves more than 5 cents a pound. For this reason, it would have been impossible to make the trades that Murphy and Ackroyd make in the film.


alkali 08.05.03 at 7:10 pm

The inaccuracy D^2 refers to is in service of the plot, as are a couple of other incidental inaccuracies. By and large, the film is surprisingly coherent and accurate on the mechanics of commodities trading as it was done at that time, which is quite amazing.


cp 08.05.03 at 7:20 pm

Adrian: the Iowa markets are a bit more impressive when you realize that whereas the general election polls the populace as a whole, the Iowa markets poll mostly idealogues and zealots, who are disproportionately represented on the Internet and are the only sort of political junkie who would participate in such a market. Any system that channels the wisdom of zealots to accurately predict the behavior of non-zealots must be interesting indeed.


Jack 08.05.03 at 7:23 pm

That is an outrageous slur on a fine movie. Did Nymex/CSCE/NYBOT have circuit breakers in 1983?

An assasination futures market could use life insurance policies as a deliverable although that might be frowned upon.

I am willing to believe that markets don’t work without a little lubrication but is there a standard example of a market big in “natural” demand that suffers or suffered real liquidity problems because of a lack of speculators? Energy? Tobin taxes seem based on an opposite proposition but maybe still compatible with a Grayek view of markets.


pathos 08.05.03 at 9:28 pm

Your post is a convincing argument that the market in Policy Analysis will never be as accurate or as useful as the market in wheat. Of this, I am utterly convinced.

However, the efficiently determined price of wheat will almost never provide useful information on international policy.

I feel as though these arguments against PAM set up a straw man to be knocked down by showing that the Policy markets could never be as good as “real” markets.

But, of course, that’s the completely wrong comparison. The only relevant question is, will a Policy Analysis Market produce more or less useful information than the current methods being employed to decide on Policy.

Assume that the wheat market would be 10 times more efficient than the Policy market. So what? It might still be 10 times MORE efficient than the current state of Policy analysis (a conglomeration of briefings by the CIA, State Dept., Pentagon, Georgetown University Middle Eastern Studies Dept., Ronald Reagan’s personal astrologer, etc.)

It is easy to point out flaws, but I am still unconvinced that the idea may not be better than the at-least-equally-flawed alternatives.


dsquared 08.05.03 at 9:48 pm

I thought I’d dealt with that in the first couple of paragraphs; even a perfect PAM would be useless for practical purposes because it’s not decisionable information; it’s just one more input to a policy process known to be bad.


pathos 08.05.03 at 11:18 pm

In my mind, you were making a valid comparison to items like “weather derivatives”, which I understand to be relatively less valuable than commodities, but hardly completely worthless.

The idea that the “President will be assassinated” stock will rise and therefore the assassination will be prevented is, of course, ridiculous.

But, if the “coup in Saudi Arabia” stock soars and the “nuclear attack from North Korea” stock stagnates, that might provide relevant information on the appropriate distribution of personnel and resources.

Or, am I completely misinterpreting? Did the “weather derivatives” fail to adequately provide any useful data on the weather? I thought that they did have some value.


Andrew Edwards 08.05.03 at 11:42 pm

I just want to say that this is fucking brilliant, as usual.


Dan Simon 08.06.03 at 1:44 am

“I’m not inclined to take seriously those critiques based on bubbles,” you write. But isn’t the point of the rest of the posting to provide solid justification for a critique based on bubbles? In other words, aren’t frequent bubbles one likely manifestation of the market flaws you describe?

(This isn’t a criticism of the post, mind you–rather, it’s a defense of those of us who originally dismissed this story with a somewhat casual critique based on bubbles, and don’t want to feel stupid now.)


dsquared 08.06.03 at 6:41 am

Pathos: My understanding is that the weather derivatives market provides information about the state of the reinsurance market; whenever pricing gets a bit harder, someone has another go at weather derivatives.

Dan: hmmmm welll perhaps yes I hadn’t thought of it that way.


Anthony Rickey 08.06.03 at 6:50 am

Not only a very entertaining post, but intriguing in that it considers this idea ‘disinformation.’

Watching the story develop, I really wonder how much of this was a particularly creative, albeit pretty bad, idea that was picked up on by a media looking for some good solid controversy to chew on. I mean, it sounds like something that someone wrote a memo on, and the memo got circulated, and then…

For the reasons you mention, I can’t imagine the market would have worked, although it’s sad that it’s been attacked so harshly. It’s an interesting ‘thinking outside of the box’ thought experiment, and I wonder about the degree to which the vitriolic reaction it’s received will prevent such things in the future.


cass 08.06.03 at 8:51 am

Nice to get a thoughtful post on this question out of the blogosphere, up until now it had just been….’Now that I think about it, this was a pretty good idea’…’this was the high tech lynching of the efficient market hypothesis from reactionary and opportunistic politicians.’


Dan Hardie 08.06.03 at 12:53 pm

I do of course take full credit for having been the first to come up with the non-actionable argument, (D-squared, a week ago:>Dan has hit on the real weakness of the model here< ) but the bit on the lack of tacit knowledge is excellent. James Surowiecki has been mounting furious defences of PAM on DeLong's website and in Salon (or Slate, I forget)- he needs to come here. When I have been putting the non-actionable argument on DeLong's website for the last week, and the best I got was 'but there will be other sources of information'- ie PAM would be a good idea so long as we never have to rely on it. To which I think you have to reply that if it is one of a number of sources being considered, it would stil effectively have to be relied upon if it was one of a number of sources arguing that 'Hezbollah will bomb Chicago' against a number of sources arguing the opposite.


dsquared 08.06.03 at 2:40 pm

I was going to credit the nonactionable point to Dan in the article, but then I forgot. Sorry, I suppose.


Jack 08.06.03 at 3:56 pm

The “non-actionable” point compares the PAM suggestion to a system that actually works. Given recent events that might not be the appropriate standard by which to judge it.

If it had to have a direct connection to government action it would be a step ahead of markets we are prepared to tolerate. Call the further analysis due diligence say.

It is easy to see how a scheme like PAM might make itself useful in a small way. Imagine futures on a terrorist activity index. Name a list of states most likely to be involved in terrorism before 9/11 I suspect that off the top of their head would come up with roughly the axis of evil. Closer observers would however be putting Saudi Arabia, Pakistan, Afghanistan and others well up on the list. Trying to explain why Iraq was number two on the hit list when it ranked below Saudi Arabia and Pakistan.

PAM wouldn’t have to come up with anything staggeringly insightful to be interesting, even representing current received wisdom would be useful. For example as a student with no special knowledge of the Balkans in 1992 I signed a letter, rather pompously, warning that Kosovo might suffer the same fate as Bosnia and should not be allowed to do so. The problems in Kosovo where plainly visible to armchair newspaper readers everywhere years before the real trouble happened. Even so preventative action was woefully lacking and, although better than in Bosnia, remedial action was also woefully late. A running score of world situations would definitely be helpful, especially those which change slowly in importance or mood.

On the other hand I don’t know what there is to worry about, it looked like a huge waste of money and could easily have been piloted using say foresight exchange (do they have rules against this kind of bet?) or betfair?


Dan Hardie 08.06.03 at 4:07 pm

Oh, be gracious, amend the article to give credit where due…

The simple model of what a futures market needs to work seems excellent to me and ought to be published as a short working paper asap.


dsquared 08.06.03 at 5:38 pm

Oh go on then …


Anurag 08.07.03 at 1:54 am

Why is trading on weather derivatives one-sided? Eg if it is an exceptionally hot summer, crops and farmers do worse, but more AC is used and energy companies benefit. An opportunity to reduce risk exists for both.

Also, I don’t understand why the only people with tacit knowledge about terrorism are the terrorists themselves. I am told that if I were to wake up 100 people waiting for a delayed plane and ask them when it will depart, the mean will be a very accurate estimate. Presumably, this is not because they are all airplane mechanics, but because they live in a world where planes are delayed.


dsquared 08.07.03 at 6:37 am

Basically because most “weather” derivatives in which there is any trading are derivatives on hurricanes, tornadoes and other extreme weather events.


kokmo 08.07.03 at 11:32 pm

I fail to see how the information PAM would provide is any less actionable than information provided by a human analyst.


Nabakov 08.08.03 at 8:39 am

Couple of things I don’t understand about that terrorist futures market (TFM) proposal.

Firstly markets work on self-interest. The higher the price on a given predictive event, the higher its likelihood of occurence, right? But what about “profit-taking”? When, say, a suicide hijacking seems imminent, what’s to stop traders from cashing in, therefore causing the price to dip and communicating a sudden drop in the threat level unrelated to the actual danger?

And secondly, terrorists can read the market too (the airline futures thang just before 911 has not been properly explored or explained to my knowledge) so what would have stopped them from using the TFM as advance warning of much was known about their plans?


Bill 08.10.03 at 6:30 pm


“When, say, a suicide hijacking seems imminent, what’s to stop traders from cashing in, therefore causing the price to dip and communicating a sudden drop in the threat level unrelated to the actual danger?”

How exactly does that work? I have a future that is, imminently, going to be worth $1. How is it that I start selling it for less than $1? Lots of people would like to buy it for less, but no one would be willing to sell it for, say, $0.90. So I guess I don’t understand why the price would drop as the attack became imminent. I might “cash in”, but only for approximately $1, and never much lower.

“what would have stopped [the terrorists] from using the TFM as advance warning of much was known about their plans?”

Not sure I parsed this correctly, but I’m not sure that this is a bad thing. If I am a terrorist, and suddenly I hear that my enemies know what I am about to do, then I don’t do it. Is this not a good thing? Apart from actually catching the terrorist, preventing their attacks would be the next best thing, right?

Or are you worried that I, the terrorist, might have a portfolio of attack plans, and I would use the futures market to determine which is the best one to carry out? That is, to determine the one that is least suspected?

Or are you worried that I, the terrorist, would never get caught, since I would be forewarned of any attack that had a large probability of failure?


Bill 08.10.03 at 6:43 pm

Daniel (Dan?, Dsquared?),

“The point being that if the overall intelligence process is corrupt, even the addition of an honest indicator isn’t going to help matters.”

I don’t think this is necessarily true; an overall bad decision process may have a bad information processing system. Improving the information processing system will probably improve, or at least be a step in improving, the decision-making process.

If by “corrupt” you mean “No matter what information they get, they’ll do something stupid” then you are assuming what you want to prove. I’m not saying you’re wrong :-) but it isn’t a good argument.


Bill 08.10.03 at 6:52 pm

“I actually think it’s something approaching a category-mistake to suppose that anyone could be in a position to have tacit knowledge relevant to the question “Is the chance greater than 22% that the government of Saudi Arabia face a coup attempt this year?”. It’s a question which demands an answer in the form of a proposition, not like the question “Is orange juice for September delivery too dear at $5 8/16 a contract?”, which demands an answer in the form of an action.”

This is quite confusing. Can you explain the difference between the following, showing me how one “demands an action” and one “demands a proposition”?

– Should I accept a deal where I get $100 if the government of Saudi Arabia faces a coup attempt by September, and pay $100 otherwise?

– Should I accept a deal where I get $100 if September’s OJ price is less than $5 8/16 a contract, and pay $100 otherwise?

There are many differences between the two, but I don’t understand which differences make one “demand an answer in the form of an action” and the other “demand an answer in the form of a proposition.”


Bill 08.10.03 at 6:56 pm


“So, what would actually happen if the Saudi contract roofed it?”

Presumably it would be one input into the decision-making process. It would be information that you combine with other expert’s information to decide what to do.

You have to assume the CIA is reasonably competent and reasonably interested in making good decisions, but if you don’t assume that, you are arguing against the CIA, not against the futures market.


Bill 08.10.03 at 7:36 pm


“The market exists because of the hedgers … It follows from this [and the other arguments] that in order to be an efficient information-creating entity, a market has to have both hedgers [and] speculators.”

It seems to me that if you replace hedgers with experts, the market still works (according to your theory). In other words, a market will be an information-gathering entity if it has experts and speculators, with no hedgers. If true, this invalidates most of your article, since you use ideas that only apply to hedgers, not experts. You seem to know more about these ideas than I do, so perhaps you can tell me where I have misunderstood your argument.

Hedgers trade, not to profit from their information, but to insure themselves against uncertainty. For example, if I am a baker, I want to focus on baking, not tracking the flour market to see when is the best time to buy my flour supply. So I buy futures, thus removing that uncertainty. Similarly with wheat growers. Speculators might find someone who is willing to pay $5 a contract, someone who is willing to sell for $4 a contract, and complete it, making a $1 per contract profit.

However, this can work not just with hedgers, but experts who want to make money off their information. So, if I am an expert in the middle east, and you are an expert who disagrees with me, a speculator can make the same kinds of deals between us as between hedgers, thus setting prices.

For example, if you think there is a 95% chance of rain, and I think there is only a 5% chance of rain, we don’t have to argue about it, we can just make a bet. If it rains, I pay you $100; if it doesn’t, you pay me $100. We both like this deal, and we both are trying to profit off our information. With lots of people doing this, speculators can “help” us set a price (more complicated than the above) that in some way describes all of our information together.

If all of us were weather experts, we would expect this price to be a good indicator or the weather, despite the fact that none of us are hedgers, just experts. Similarly, if we were all experts in the Middle East situation, you would expect the price to give information about the Middle East situation.

So your argument that “It follows from this that in order to be an efficient information-creating entity, a market has to have both hedgers [and] speculators.” doesn’t seem correct. You are confusing (literally, fusing together) the concept of a hedger with an expert, and basing your conclusions on the idea of hedgers without thinking about experts.

For example of this error, you say that no one has an interest in more terrorist attacks, so the market wouldn’t work. You are right, no one would “hedge” this position, but experts might still have information about it. Therefore, the market might still work.

You are also, it seems, confusing the idea of a speculator with an expert. For example, you say that betting markets are “entirely speculative”. This is false, given your definition of speculator as someone with knowledge only of the market, not the underlying situation. Actually, a betting market is about experts going to speculators (the bookmakers). The problem is not that these markets are “entirely speculative” its just that the experts aren’t particularly expert.


dsquared 08.11.03 at 9:07 pm

Bill: the key to our misunderstanding each other is Hayek’s concept of “tacit knowledge”. Your “experts” differ from my “hedgers” because they get their information in the form of sentences, to put it crudely, while my hedgers get their information in the form of empty flour bins and growing fields. Hayek’s point (and I’m not sure I believe it, but I am sure it’s the point he originally made when introducing the concept of tacit knowledge) is that the majority of human information is information which cannot be written down and put into propositional form. You note yourself that the information generated by this “market” is information which could be made available to a planner; it’s essential for Hayek’s critique of planning to go through that this isn’t the case.


Bill 08.12.03 at 1:08 am


I see; I misunderstood your argument. I think I still do.

I think that experts have both tacit and explicit knowledge. Most experts I deal with cannot put into sentences everything they know about their subject. However, they can still act on it, and could make bets about it. A futures market could aggregate all this information, and it might do better than other ways of aggregating information.

So do you think a futures market populated by experts (with both tacit and explicit knowledge) and speculators (to help the market function), would provide good information (in the form of the prices of futures) to policymakers?


Jack 08.18.03 at 2:57 am

I don’t think you are right about what Hayek needs for his critique of planning. People can have knowledge that takes propositional form, is relevant and even explicit and still need a market to put it to use. For example I know that I would like to avoid circling Heathrow waiting for a lot for my plane to land. Equally I’m sure that there is a Mr. Bloggs who knows that his life would be unbearable if Heathrow were to get a new runway. Bewtween me, him and a few million others we have knowledge of whether there should be a new airport at Heathrow that we do not individually.

I also don’t believe that a culture of honesty is a full substitute for all that a market could provide. Humans are very bad at holding and updating competing views on an individual basis and markets aren’t so bad.


Tom Maguire 08.21.03 at 5:55 pm

Love the post, but I wonder about this:

…in order to be an efficient information-creating entity, a market has to have both hedgers or speculators. Although speculators are vital to the functioning of the market, you can’t have a market with nothing but speculators.

How does this square with the very active sports betting markets? Other than Pete Rose, players, managers, and owners (the natural longs and shorts) are barred from gambling.

Beyond that, the prices (betting lines) really are just steam on the window, to borrow your metaphor – very little economic activity, outside of the manufacture of a few bobble-head dolls, actually is affected by the news that the Giants are a 4 point underdog this weekend.

That said, I believe studies have shown that the final market based odds tend to be accurate predictors of final outcomes.

On a second point, I agree with the critics who are range from skeptical to dismissive of the “non-actionable” argument. Just about any one piece of info is “non-actionable” in the sense you are using it.

If, for example, the President, or PM, had received a first hand, eyewitness account of Saddam personally meeting with Osama and handing him a nuclear weapon, we would not have gone to war – more steps would have been taken to verify it. (Or, if the process is hopelessly broken, then no information is actionable, but that does not count against PAM).

And, as folks have noted in other contexts, war is not the only alternative. The President might, based on PAM, order more studies, or increase civil preparedness (change the color scheme!), or move a few troops, or send a diplomat to pose for photos – the menu is endless.

I actually think you have a stronger objection elsewhere in the post – how do we verify the predictions of this market? With orange juice, we have lots of prices and results. Same with football bets. Same with markets predicting Hollywood box office receipts.

With “Coup in Saudi Arabia”, we are going to have essentially one trial. If “the market” says there is a 20% probability of a coup by year-end 2003, we don’t learn a lot come January 2004 whether there was a coup or not. If there is no coup, it may still be the case that 20% was wildy optimistic, or pessimistic as of August 2003 – we have very little against which to compare it.

The idea for PAM seems to be, markets work where there is lots of data and feedback, so they should work with very little data or feedback. Well, they might, but how would we know, either ex post or ex ante?

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