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.