Can Financial Markets Save the World?

I’m pretty sure the climate is changing, and I’m pretty sure people are contributing to it. How do I know? I don’t, really: I’m an economist, not a climatologist, so my views (such as they are) are largely driven by what I understand to be the consensus among scientists who study this for a living.

That sounds pretty convoluted, and it is. As David Friedman has pointed out, most of us don’t have first- or even second-hand knowledge of the relevant scientific literature. We aren’t climatologists ourselves, and we didn’t get our views on climate by talking to climatologists. Most of us have at best third-hand knowledge of climate science from having read articles written by science writers who have talked to the scientists who have done the relevant research. Or maybe we’ve read articles commenting on other articles written by people who have read articles by science writers who have talked to the people who have done the relevant research (PhDComics.com—"Dilbert" for academia—offers an entertaining illustration here).

The Problem

This illustrates a knotty problem that isn’t limited to climate change, or even natural science. A lot of people have very strong views and make very confident pronouncements about things they don’t understand. You probably know people who haven’t taken biology since ninth grade who nonetheless have extremely strong opinions about evolution or people who have never taken an economics class who have very strong opinions about international trade, the effects of immigration, and minimum wages. As football season is right around the corner, how often have you watched games with someone who has never played a down of organized football in his or her life but who nonetheless knows exactly what the coach or quarterback should have done on that last play?

We all have a lot of opinions about things that aren’t worth the server space needed to store them on the internet. Even the scientists who have done the relevant research and who are qualified to have a strong opinion about whether the planet is warming are too often permitted to allow their authority to extend to areas in which they don’t have the relevant expertise, such as economics and public policy. Just as knowing a lot about economics doesn’t qualify me to cast a decisive vote on climate science, knowing a lot about climate science doesn’t qualify one to say we should de-industrialize or stop reproducing.

An Opportunity

What is to be done? Even with longer life expectancies allowing us to know a lot more than we could before, we can’t all be experts in all things. How, then, can we survive in a world in which even dilettantes are woefully ignorant?

Financial markets turn our ignorance into useful information. Stock prices reflect market participants’ expectations about a company’s future profitability. Similarly, the price of a futures contract for wheat to be delivered in December reflects market participants’ expectations about what will happen in the market for wheat. Participants in these markets have a credibility that talking heads on TV don’t: they stand to gain or lose real money based on their beliefs. Talk by itself is cheap. Talk backed up by people taking real risks is far more credible. Financial markets aggregate credible talk and real risks into useful signals: prices.

Futures Markets

With global warming, the problem is that there aren’t enough markets for enough assets. Asset markets can turn dire predictions, scare-mongering, and cheap talk into useful information. Futures markets are one example. A futures contract allows you to buy or sell a given quantity of a good at a future date. As I’m writing this, Crude Oil for September delivery is trading at $97.25. If you think crude oil will be worth more than $97.25 in September, then you can write a contract that allows you to buy crude oil at this price. If the price on the spot market (i.e., the market for immediate delivery) is $100 per barrel, then when you get the oil you can turn around and sell it at $100 per barrel and pocket $2.75 per barrel. If you think the price will slide to $90 per barrel, then you can write a contract that allows you to sell the oil at $97.25. Then, if the price on the spot market is actually $90, then you can buy the oil on the spot market at $90 and fulfill your contractual obligation to sell at $97.25, and pocket $7.25 a barrel.

It sounds easy, right? Not necessarily. You can earn a handsome profit if you’re right, but you can lose your shirt if you’re wrong. Speculating in oil futures probably isn’t a very good financial strategy as for many of us as it’s often a lot like putting money on a roulette wheel; however, if you understand better than anyone else in the market what is going on, though, then you can profit from your superior knowledge and do us all the service of better aligning prices with underlying reality.

With respect to resource exhaustion we can get a better handle on the problems by developing longer-term futures contracts for goods like copper and oil deliverable in 100 years. If you think we’re running out of oil, then you should write a contract allowing you to buy oil at today’s price on January 1, 2101. If you think the US government will default on its debt by the end of the century, then you should be able to act on this belief by selling contracts on government debt deliverable on January 1, 2101 (even if the government doesn’t issue 90- or 100-year bonds, a solvent Treasury will probably still be issuing shorter-term debt then over which contracts can be written).

Most of us won’t be around to collect on January 1, 2101, but this presents no significant problem. The contract will still have value because someone who hasn’t been born yet might be willing to buy the contract from you on January 1, 2051 on the anticipation of handsome profits when it comes time to settle accounts.*

Betting Markets

Allowing people to bet on political events, natural disasters, and terrorism the way they bet on football games is another way to allow markets to generate useful information. We can make these very specific. The prices of contracts for things like "there will be a terrorist attack in the United States on September 11, 2014" or "there will be more category 5 hurricanes in 2014 than in any year on record" will give us an idea of just how likely these events are, and they can help us plan accordingly. A betting market for terrorism might sound shocking, but the Defense Department was developing just such an idea before Congress shut it down in 2003 in response to a misguided public outcry. These betting markets can also help us separate useful information from cheap talk. As the economist Alex Tabarrok has put it, "A bet is a tax on bull----, and it is a just tax, tribute paid by the bull----ters to those with genuine knowledge."

The same holds true for financial assets as they allow us to profit from our superior knowledge about the future, if indeed our knowledge . With respect to global warming, resource exhaustion, and a whole host of other problems, the relevant policy question right now isn’t "how can we curb CO2 emissions?" or "how can we get people to conserve oil?" It’s "how can we develop markets for financial assets that will allow us to harness the power of people’s expectations and deeply-held beliefs?" If we do it, we can create a better future while at the same time cutting down on the amount of noise in the present.

*-I’ve left out options contracts intentionally in order to keep this discussion fairly simple.