I am an avid fan of capitalism as well as a critic.
While I agree that markets are generally better at discounting the future than individuals, there are inherent flaws in the markets that are difficult, if not impossible, to overcome. I point out these weaknesses because, just like with any mental model and organizing principle, knowing the weaknesses is the first step in avoiding or discounting them.
Imperfect Discounting Mechanisms
Many capitalists believe the markets are sacrosanct and, in their blind devotion, prove why "pure" is the root of puritanical. They cite aphorisms like “the wisdom of the crowd” or the improved predictions that come from crowdsourcing. I accept, acknowledge, and even revere the truth in these observations. After all, markets derive prices by aggregating differing expectations of the future.
But even the agglomeration of crowd opinion cannot overcome an inconvenient fact: time. That is, time marches in only one direction — forward. Effects follow causes. To the degree that causes are repeated, probable effects can be charted.
But the future is capricious. That is why we turn to markets in the first place. Were the future predictable, there would be no reason to aggregate differing views of supply and demand for goods and establish market clearing prices. Only The Price Preeminent would exist — an omniscient price that represents the market clearing price not just for current supply and demand, but for all time.
For example, if we knew in the late 1800s what we now know about the effect of hydrocarbons on the environment, they would have been priced higher. Alternatively, what if we could peer into the future and see the complete trajectory of human existence? And suppose, in that perfectly transparent timeline, we could see that potable water would eventually become scarce enough to result in the end of people? Obviously the signal from this All-Knowing Market would be very different.
But people are not seers. Yes, markets adjust to new information to balance supply and demand, but given our inability to predict the future, many goods and services are currently mispriced — perhaps dangerously so.
There are plenty of examples of markets doing a poor job of discounting.
A number of Samsung’s infamous Galaxy Note 7 phones spontaneously burst into flames causing much mayhem. You could argue that this is not a failure of the markets. But it is. After all, there was a market for these phones. Samsung eagerly supplied them and buyers eagerly purchased them. Once the fire hazard became known and the replacements failed to rectify the problem, the market disappeared. This illustrates both the power of markets and their primary weakness. Yes, the phones are no longer for sale since the entire market for them vanished, but signatories to the market for the Galaxy Note 7, both supplier and demander, failed to see far enough into the future to prevent catastrophe.
Another example is the side effects of prescription drugs that are not fully appreciated until many years into the drugs' use. This despite the extreme level of scrutiny on the front-end of drug development.
Possible Remedies
- Perhaps new products could be evaluated by their closeness to the natural world. For example, timber directly effects nature, consulting not so much. A proximity-to-nature continuum could also serve as a resiliency-monitoring tool. The closer to nature, the greater the need for systems thinking, scenario planning, and caution. This is not an argument for stifling regulation or for you to run out and hug a tree. I am saying that even when armed with market-cleared prices, people can screw things up. This means that any new product directly affecting the environment ought to be overpriced initially. This margin of safety could be put into a profit escrow account, assuming that the market still clears at the new price.
- Alternatively, as products are designed, they should have a built-in plan for the lifecycle of their components as well as contingency programs for how any potentially deleterious effects may be unwound. That is, what is the estate planning for a new product? How do you “put it to bed?”
- Perhaps a new product checklist should be developed, all the components of which must be addressed before a license to market is granted. A variation of the US Bureau of Consumer Protection could be the adjudicating body.
This article is the first in the five-part Where Markets Fail series. Subsequent entries will consider how markets:
- assume a context;
- assume fungibility;
- are not systemic; and,
- have "visible hands."
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author's employer.
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25 Comments
Every resource we deal on earth has a perishable quality to it.
How do we therefore price
a) Milk, when the number of cows at the farm have a life span
b) Electricity, when coal mines are quantifiable to a reasonable extent
c) Medicines, when side effects arise
d) Education - for fun let's take the CFA certification; when capital markets expand and shrink because of regulations, biz cycles etc.
e) Wheat - when harvests suddenly hit the market causing a flooding
Attempts to pad up prices with innocuously appealing objectives like 'unfair markets', 'inefficient nature of markets' etc have come and gone in different avatars. If you want to try price setting in a different system then we can look at Russia where complex math was used to 'price' resources.
The only workable system - is the prices set by free markets. The millions of individuals voting every day, and the crawling of those prices through the layers of productive activity.
Instead, we should be addressing distortions in the functioning of free markets such as
a) Oil - global prices influenced by cartelization
b) Interest rates - Fed and Central Banks sit in judgment on the price of money that should rule in the economy
c) Lobbyists - lobbying lawmakers to protect their industries or pass laws against competing industries (impose a tariff or tax or limit expansion)
The romanticizing with algorithms to fix prices that claim to take into account factors, that presumably, the market ignores shouldn't be taken too seriously.
I say presumably because how do we presumably know that oil at $50 doesn't take into account its 'limited' supply nature? How do we know that oil at $50 isn't discounting the low price of batteries as a source of power 50 years from now?
Also, who is going to pay for the padded up portion of price above the natural market rate? Does the producer get to pocket the higher price? In which case it's a market distortion. More producers will arise, resulting in stress on input resources. Will the government pay? If yes, that means the taxpayer will be burdened. These are questions which came up instantly in my mind as I was reading this.
I don't want to call this Series a prelude to a new 'communist manifesto', but coming from India, which experimented with socialism for the last 60 years, and having seen the benefit of free market capitalism since 1990, I know for sure which side I want to stand on.
Hello Ashok!
So nice to hear from you, and I am so glad that you have commented. Thank you for your extended, and thoughtful comments. Future posts will demonstrate that markets are never "free," and having nothing to do with those dreaded central planners; governments; their agents, such as regulators, and the like. I am not wed to the possible remedies I suggested. But in a world with growing population and growing environmental degradation, I believe we need to be more circumspect about some of our choices with resources. I also think, as an investor, we frequently have a schizophrenia about markets. On one hand we trust them as arbiters of value as cold, steely capitalists. But on the other, we think that they misprice securities and therefore justify active management. I believe pointing out markets' imperfections is healthy for those that participate in them.
Do you have any suggestions for prescriptions? If not, maybe this is an opportunity to stretch yourself and stretch all of us by putting your brilliant mind to work.
Separately, the language in your last paragraph worries me. This is far from a 'manifesto,' don't you think? I know you tried to soften those words, and I recognize my article has flamed your passions, but I request more thoughtful comparisons, if possible.
Again, thank you for taking the time to comment.
Yours, in service,
Jason
This commentary is enlightening and suggests that there is no direct ‘pill for the ill.’ As to scientific discovery in the pursuit of knowledge is ever evolving, so is the evolution of financial theory, tools, and market pricing.
While grounded in ‘free-market-principles’ in setting prices, there is one caveat worth noting here – especially in light of the commentary statement “the only workable solution is prices set by free markets”. This theory is grounded in ‘utility theory.’ The presumption under “utility theory” is that market participants only seek to maximize their wealth for a given level of risk. Yet this is hardly true in reality.
While there is much to be said about this from the behavioral finance perspective (i.e. behavioral bias to emotional intelligence), the discoveries in neuroscience blended with human behavior is much more enlightening (i.e. cognitive brain function- unhealthy stress cortisol releases vs gratitude/giving happy hormonal releases), and thus helpful to where financial theory needs to explore.
This influences pricing and valuations as financial tools. AND, this is quite NOT the ‘communist’ or ‘socialist’ manifesto, but blending the knowledge from science with finance to create better financial tools that reflect the sustainable functioning future of society. Quite frankly, humanity was given two sides of the brain and our design is not to operate under just one side – presumably how ‘utility theory’ denotes. Ignoring this also ignores a distortion in finance theory. (Check out Robert Shiller and John Coates to name a few).
Often, in discussion with finance folks, the conversation begins with acknowledging these misgivings of finance theory and then circles back to the status quo. For the most part markets work efficiently as argued, yet we can always improve upon our tool box by being open to new ideas from multiple perspectives that work towards resolving the misgivings of finance theory.
This is the challenge we need to embrace – thanks all for sharing your perspective.
Hello Joanne,
Beyond brilliant. Very well said. I agree. Let's chart new territory. So impressed with the thinking contained herein. Agree that the mental models developed in the 18th century can be updated.
Very big smiles,
Jason
If markets are infallible towards correctly predicting outcomes why would the same participants in markets be infallible in creating regulation?
What about the unintended consequences of trying to regulate the unknown unknowns?
As Yogi Berra stated predictions are difficult, especially about the future, however, prediction markets have done quite well versus human forecasting.
This is because once more than 3 variables are put into a model its is difficult to determine the weighting for each variable and then there is the unknown variables. This is why most regulation fails to deliver what it promises.
Consider the following counter examples...
What if the world was entering an ice age during the last 100 years (as believed by GreenPeace co-founder and PhD biologist Patrick Moore) and the fossil fuels we have burned have warmed the earth enough to keep it out of an ice age, should hydrocarbons then have been priced lower?
There is a movement called the Right to Try, or something like that. It is made up of terminally ill people who are pressuring the regulatory authorities to let them experiment on themselves with yet to approve drugs that may extend their lives. I believe your ROI and unintended consequences of pharmaceuticals is only relevant or minor conditions. This is not a failure of the market but a misjudgement of risk by people too busy or lazy to do their own research. The side effects suffered by those who take pills for minor conditions are either risk adverse people did not calculate risk properly or are risk takers. This is not a market failure but a market success and failure of individual understanding of risk tolerance.
Instead of your ideas for solutions a study of risk tolerance should be encouraged and then let markets do their jobs. It is simpler and likely more successful than what you have suggested.
Bradley Parkes
Hello Bradley,
Thank you for your comment.
First, I think you meant 'fallible,' and not, 'infallible' in your first sentence. Am I right? Assuming that I am right, this point was raised by one of your fellow readers; see the comments above this one.
Yes, there are always unintended consequences, but some can be undone, whereas others cannot.
Regarding your Yogi Berra quote. There is actually quite a lot of work being done exploring what 'Superforecasters' do that others do not.
Rather than offer up counter-arguments to your points. Let me ask state that, if markets cannot be criticized, then they cannot be improved. Do you believe that they are above improvement? If you side with the 'absolutist' camp on this - that markets are above reproach - then you are helping to support my point that there is a contingent of people that have a blind-faith, almost religious devotion to markets. Their criticisms take on the tenor of a middle ages European Catholic defending their Faith by saying that if those danged monarchs would just let us practice everything would be perfect. Then came Protestantism, to demonstrate another way to view the same situation.
If, on the other hand, you believe they may be improved, let's have that discussion. That's the one I am interested in. With emerging topics that is the state we find all of ourselves in.
Yours, in service,
Jason
Voss- Thanks for going through my comment and responding.
Let me begin with a quote - "It has drowned the most heavenly ecstatic of religious fervor, of chivalrous enthusiasm, philistine sentimentalism, in the icy water of egotistical calculation. It has resolved personal worth in exchange value, and in place of the numberless indefeasible chartered freedoms, has set that single, unconscionable freedom - Free Trade. ... it has substituted naked, shameless, direct, brutal exploitation".
Sounds sophisticated and convincing? This is a direct quote from Marx and Engel's Communist Manifesto.
My purpose of invoking the Manifesto (earlier and now) is to draw similarities in the language and intellectual predisposition of this article and to another commentator's response. It wasn't meant to kindle memories or thoughts of the bloody aftermath, which I presume has prompted your defense.
However, I do think I should be free to comment and bring to the table all sorts of ideas. Therefore, I don't agree with you asking me to tone down or prodding me to choose an alternate set of words etc.
The discussion of Communist Manifesto and other failed ideas should be part of everyday conversation. And I presume one doesn't feel offended to use words like 'blind', 'schizophrenic', 'bloody' or 'degraded' prefixed to capitalism while discussing free market capitalism.
Free market capitalism is usually the orphan that needs to be defended in any context setting where words are freely thrown around. Especially, anyone who calls 'environmental degradation' or 'global warming' or 'scarce natural resource' usually has the attention and empathy of the crowd. And he wins half the argument already.
The ones who plead for the efficiency of price (as an input resource optimizer, as divider of labor, as an allocator of capital, as a mechanism to auction etc) is branded a 'usurper' or an 'evil'.
My simple point is, all that we are doing today is simply throw around terminologies. There is a need for deeper discussion on an epistemological basis. But any attempt at beginning one amounts to stepping into touchy areas. For instance, comparisons with socialist doctrine is repelling.
Someone says 'neuroeconomics' and 'two sides of the brain' and that person is like a God-sent economist to the earth. And someone professes care for timber or coal and he is welcomed with "Sharpe", " Cape" and what not supporting appendages. These are not evidences. Except, ideas in the mind of a coterie of Nobel prize winners (that prize which shouldn't have been given to Economics in the first place, but that again is obviously for discussion for another day) and it's avowed followers.
Thank you Voss for reading through patiently. I look forward to your articles and opinions.
Hello Ashok,
Thank you for offering up the quote from Marx. I actually thought it sounded blind, foolish, and ignorant of the power of markets. As I responded to one of your fellow commenters, and I will quote here again:
"Let me ask state that, if markets cannot be criticized, then they cannot be improved. Do you believe that they are above improvement? If you side with the ‘absolutist’ camp on this – that markets are above reproach – then you are helping to support my point that there is a contingent of people that have a blind-faith, almost religious devotion to markets. Their criticisms take on the tenor of a middle ages European Catholic defending their Faith by saying that if those danged monarchs would just let us practice everything would be perfect. Then came Protestantism, to demonstrate another way to view the same situation.
"If, on the other hand, you believe they may be improved, let’s have that discussion. That’s the one I am interested in. With emerging topics that is the state we find all of ourselves in."
Also, no one is asking you do not bring forth your ideas. I asked you to be careful in how you characterize my thoughts. You need not infer anything about them, as I am right here to provide you with them. I reject being compared to Marx, as a trained economist. But again, do you believe markets are perfect? If so, that is a strong standard, and then you would also have to justify why you are an active manager.
As for free-markets being defended...I believe that human behavior is the source of markets. I note with great interest that in communist and socialist countries that the urge to trade naturally emerges. In the former U.S.S.R. those that wanted cigarettes from the west traded toilet paper for them. Those that wanted jazz records found something to trade. I believe markets are a natural extension of human behavior. So is war. Just because something is the natural expression of human behavior does not mean it cannot be improved. In the case of war, we have realized its deleterious effects. Even when you win, you have lost; if nothing else, by measuring it by its economic costs. One question for the pure markets in the absolute sense folks: if there are suppliers and demanders for nuclear weapons should these markets be allowed to function? What about biological weapons agents? If you agree that there is a role for disabling these markets then you need to roll back your absolutist stance. In response to this kind of an issue, we have created a solution that is outside the context of war, but tangent to it: diplomacy. That is in the same vein of what I am pointing out here. What is the solution that is outside of, or tangent to, markets that may improve them? Again, I don't pretend to have the answers. But I do know that markets fail sometimes, and I want to improve them. Are you on board with that?
Yours, in service,
Jason
I think we are talking about
a) Markets in general
b) Function of prices
c) Stock Markets
d) Policing
In your article, you suggest that (b) is out of whack and you seem to suggest or nudge people to think about more 'elegant' solutions. Which, in my opinion is a 'done and dusted' area of argument. I don't wish to argue something of that epistemological topic in a blog. Now, just because I may not know how the engine works, or have a bare idea of an engine, doesn't mean I am a bad driver. I could lift the hood and look underneath it, if necessary.
But apart from stating my understanding of prices and markets at a high level, I don't wish to engage in a back and forth convo on whether prices should be allowed to function as a free, natural phenomenon between agents or whether someone thinks he is clever enough to construct optimal prices in an excel sheet.
About markets. Markets in general are never perfect. The price is the 'vessel' that carries 'blood' to all parts of the market. There could be frictions at junctions. Health hazards, unfair competition, import dumping etc. We also need Taxation to build out more parts of this 'body' inside the market. Some of these frictions are addressed through less than perfect tools. For example, anti-trust rulings are usually unfair. Because they define the 'market share' so narrowly that the 'monopoly' is more often seen as a predator. Be that as it may.
On nuclear weapons, I think the trigger-happy nations in this regard are the centrally planned socialist countries. This example goes against your stance. Even at a national level, nuclear warfare is a lose all situation because of capitalism. Because nations depend on industries and free markets, a nuke kills the cash cow! Therefore, a two-way nuke threat only results in an equilibrium (Ind-Pak). If the world was comprised of only centrally-planned-no-respect-for-prices-market nations, nuke warfare could be an everyday affair. The equilibrium is also because of the experience gathered from a one-time use. (a case of post facto price adjustment)
Policing of nations, detecting nuke secret transfer etc is necessary. How is that connected to the first three parts above? And how does it weaken the concept of free markets?
Free markets stand on effective laws, regulations and policing. The more effective the laws are that govern free markets, the greater the efficiency of free markets. I don't see any inconsistency that you seem to vehemently portray as the 'clinching' evidence against capitalism.
Laws are the grossbody that support the functioning of free markets. The grossbody is only a scaffolding that supports a vital free market. If you substitute the grossbody for the vital 'organs', then you are mistaken.
About stock markets. Stock markets are the microcosm of prices, reflecting the prices in the real economy. The stock prices are claims on ownership of capital goods, that is, the producers in the real economy. If an oil field is worth $100 Million, the piece of paper that says 'ownership in the oil field' should also trades at $100 Million. Albeit, at that moment. No one is saying the $100 Million is the value written in stone. A guy named Rockefeller transported oil by barrels (a term which we still use today despite there being no barrels in the real world of oil transportation) and made profits applying his ingenuity. The stock paper that 'rode on his back' too increased in value. Why do any of these examples portray 'clinching' evidence against free markets and capitalism as it were? I simply don't understand.
The debates of active vs passive are shallow terms that mean different things in different contexts. Just because purchase and sale of stock paper is intermediated by a less-intelligent person, it is a case for passive investing. If it is intermediated by a more-intelligent person, it is a case for active investing. These terms don't marshall any merit when we are discussing about price setting in free markets. (There is more institutional rivarly than any economic merit in these discussions)
Regards
Ashok
Hello Ashok,
Thank you for your extended and thoughtful reply.
I think you keep thinking that the only alternative to unfettered free markets is central planning. Or, I am getting the impression that you believe I think that. I do not. What I think is that for goods and services that have the potential for great harm, which is now often obvious given our superior understanding of many things based on science, that we ought to be circumspect about granting them free-market access. As an investor, I would add this understanding to the risk assessment of a business before I invest. An example currently is that oil and natural gas companies should be have their share prices discounted at higher costs of capital because reserve replacement ratios are declining. Markets have not priced this, yet.
Regarding my nuclear weapons example. I am not sure how I see my example as not serving my point. My point is just because a market can form, does not mean that it should form. There is a reason why nuclear weapons and their proliferation are controlled. This is a stellar example of my point. That centrally planned economies with these weapons are more dangerous, does not support your point either. That you pointed out that capitalism needs rule of law is important. How did we come to form these laws, some of which run contrary to free-market capitalism? That my specific remedies for how you deal with the imperfection of markets as discounting mechanisms did not agree with you, does not mean that it is not possible to remedy this problem. See above for my point about discount rates and reserve replacement ratios.
An additional point that I have made is that we CAN foresee negative consequences if some goods and services are allowed to enter the market. In the case of nuclear weapons, societies globally have agreed to the wisdom of this, both free-market and centrally planned. Also, as a citizen of the U.S., a mostly free-market, capitalist society, we are the only nation to actually use nuclear weapons. I can think of other goods and services which we should also be circumspect about, given the possible deleterious effects of them on people, and on the environment.
Regarding the active versus passive, I do not believe you answered this very well. To be an active manager requires that you disagree with the market price, presumably, to borrow your term, because you are "a more intelligent person." If you believe markets are perfect discounting mechanisms, then there is no advantage to buying anything but the market. That is the strong-form of the efficient market hypothesis. It sounds like you reject that thinking, yet you defend free-markets as perfect discounting mechanisms. To me, this is not institutional rivalry, as it goes to the heart of whether you believe markets are perfect or not. I do not think they are perfect; which is what I am going to continue to demonstrate in the next four articles, too. Again, my motivation is to help analysts and investors to do a better job.
Yours, in service,
Jason