14 August 2017

Markets make mistakes, that’s their point


Over the weekend, Will Hutton told us something that accords with neither theory nor reality – an impressive achievement. So, either Willy doesn’t understand – in which case why would we listen to him? Or he does, and is simply deploying rhetoric –  in which case why would we listen to him?

The specific point he makes is this:

“Since the elections of Thatcher and Reagan, the leitmotif of Anglo-American economic policy had been that markets do not make mistakes – only governments do that.”

But this is not the case, whatever definition of markets we use. Say that we want to talk about financial markets. We have an efficient-markets hypothesis, which does not say that markets are efficient ways of doing things, nor that markets are always efficient. What it does say is that markets are efficient at processing information about what’s happening in markets.

Eugene Fama got his Nobel for insisting on the strong version of this idea: that all available information will be in market prices. Robert Shiller got his share of the same Nobel for pointing out that this is true only of complete markets. Hence Shiller’s insistence that more speculation, allowing, encouraging or enabling people to bet on falling house prices (via, say, options or futures) would have lessened the housing bubble itself and reduced the pain of it popping.

As for the housing crisis, it was generally believed that there would never be a pan-American housing slump. And, therefore, if you were regionally diversified across housing markets through those securitisations (the CDOs, MBS etc), then you didn’t think you were particularly at risk. Since there had never been a pan-America housing slump, this belief was true.

Until it wasn’t true. At which point, the new information flowed into those financial markets and they slumped rather quickly. As far as anyone knew, it wouldn’t happen until it did. The efficiency of the market was shown in the speed by which prices changed with this new information. And Kablooie went the financial system.

So in answer to the crash, what might a more governmentally minded person have recommended?

We are looking disaster in the face. A British version of Fannie Mae and Freddie Mac must be created now. Legislation to create a Gordon Mac should be introduced before the summer recess. It should be operating by the end of September.

Yes, that was also Will Hutton on 22 June 2008. Fannie Mae and Freddie Mac were bankrupted and then taken into conservatorship on 6 Sept that year. Fortunately, government didn’t do what Hutton recommended.

And what if we were looking beyond Anglo-American economic policy, and the basic use of markets in the wider world. Well there Willy has simply got things entirely the wrong way around. We do not use markets because they do not make mistakes, we use markets because they do.

To take something in the news today, Cornish Lithium. Salt waters – brines in the jargon – and dried out salt water, such as salt flats, are where lithium is generally found. There are many alternatives as well. The rocks of Cornwall have lithium in them, we’re likely to find it with tin and tungsten. And we know those old China Clay pit slurries (again, jargon, we mean mud left over) have some lithium in them. So, if there are hot brines underneath those lithium-containing Cornish rocks, then maybe there’s lithium in the water.

There certainly could be. But we don’t know. Maybe someone should go have a look. Which is what is happening: a start-up project has got a million quid to test the theory. It could go either way. But my point is that since we don’t know, mistakes are bound to be made before we get the answer we want.

Which brings us to that great experimentation machine called the free market. There’s an ever changing roster of things we can do by combining advancing technologies. There’s also some unknown and unknowable set of human desires and wants out there. What we need is a system that will run through the various technological combinations to see which ones, if any, will solve, sate or salve some of those desires.

Our starting state of knowledge is “Dunno”. It is only by going out and making all the mistakes, that we will eventually strike gold – and the right answer.

Compare the Cornish Lithium approach with the government reaction to another recent mining story, Sirius Minerals,which intends to suck potassium for fertilisers out from under North Yorkshire. At one point the government bureaucracy refused to grant the mining license on the grounds that no one would want to buy the product – the specific substance hadn’t been commercialised anywhere.  Fortunately this was a mistake too stupid for even government to stand by.

That’s why Will’s wrong about financial markets. We don’t think they don’t make mistakes, we think they’re good at processing information. And Hutton’s grossly wrong about the wider uses of markets. We don’t use them because they don’t make mistakes, we use them because they process all the mistakes, at a nice low cost, to find those very few things which do work.

And if Hutton can’t grasp that, then why is he commenting upon matters economic?

Tim Worstall is senior fellow at the Adam Smith Institute