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Can Financial Markets Save the World?


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 aggregate credible talk and real risks into useful signals: prices.

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.



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Comments
Ratesaver
Ratesaver   |     |   Comment #1
I guess what Art(the above author) is saying we all do on a smaller level... For instance I just bought Propane for the winter months... I purchased it a month ago at 207 a gal.for my 500 gal. tank... Now I am hoping that I made a good deal.... A few yrs ago I got hammered when propane dropped.... Here we go again... 
Anonymous
Anonymous   |     |   Comment #2
Naaa.  You'll be good.  The self-evident global cooling currently underway should cause propane prices to rise this coming winter.  It'll be a doozey!!
Anonymous
Anonymous   |     |   Comment #3
$1.57 here for 274 gallons. A few years ago I buried a 500 gallon tank (underground tanks hold more due to ground cooling effect) so I could buy in bulk. Last winter my neighbors paid $3-4 delivered for their smaller tanks. I wonder what a 2100 contract would cost. Maybe I could be a tanker car full and save even more money. Perhaps the guys in Vegas know. Then again, I  made a call, asked for current pricing and put in my order. That seems to work.
Anonymous
Anonymous   |     |   Comment #4
Ratesaver--When we lived in the country and used oil we bought a used 2000 gallon oil tank from the farm bureau and my husband coated it with some kind of black stuff to keep it from rusting. We used it for over 30 years until we moved. 2000 gallons would last for 4-5 years. We were well insulated and heated 3000 sq feet plus a walk out 1500 square foot walk-out basement with 2 8 foot sliding glass doors. We filled up in 1973 when oil was 19.9¢ a gallon and topped it off when we thought oil was cheap. Sometimes we did not top the tank for 3-4 years. We called around several dealers to get the best price. After getting a satellite dish in 1984 I watched the oil prices on KNBC. Summers it seemed to be cheaper but not always. The more you bought the cheaper it was. In the later years we used a new credit card that paid $500 or so if you charged a certain amount within 2-3 months. Some years we used 2 cards to pay the bill. So watch Ken's site for CC deals also. So maybe you can watch and maybe get a used propane tank to piggy back with your tank or get a  larger tank and watch for when you think the price is cheapest and top the tank or tanks. When you own your tank you are not obligated to purchase your gas from one place. Not sure how much propane you use each year but this might be something to consider. We live closer to town now and have natural gas. I live in a newer 2000 sq foot house plus have a 2000 sq foot walk out basement with 5 windows and a 6 foot slider facing west and only pay $53 a month on the budget plan for heat, hot water, gas dryer and gas stove. For the 3 years we have lived here natural gas has been real cheap. The people that bought our house just put in geothermal heat. I am anxious to find out how much they pay with that system.  She keeps the house much hotter than we did. We set the thermostat between 68-72 and turned it down at night and shut our bedroom doors and opened the windows in our bedroom. We loved to sleep in a 50-55 degree bedroom. She keeps it at 76 day and night. I purchased blankets from Penney's that had Outlast in them and you are warm when it is below zero. But you do not sweat if you leave it on in the summer. It is used in ski jackets and the astronauts clothing used it. 
As for the ----- above why would anyone bet on the futures,  the market etc. The people betting have a hunch no knowledge so--- I deal in reality. What I said about purchasing oil saved us a lot of money and I hope it might  work for you We did this  from 1973 until 2010 when we moved. I left the people with a full tank of oil and they ran out before 3 years were up. With a smaller tank sometime you can sign a contract to buy it at a certain amount for 12 months. 
Anonymous
Anonymous   |     |   Comment #5
With all due respect, outsized and unregulated financial markets nearly RUINED the world in 2007-2009.  Yet right wing supply side economists continue to advocate their ideology that financial markets can address any issue.
David Friedman
David Friedman   |     |   Comment #6
One problem with the 100 year futures is that it assumes a legal framework sufficiently stable so the owner of the contract a century from now can collect. That's not a safe assumption. Another is that it's hard to specify the contract terms (or the bet) well enough, for circumstances that far in the future, to be sure the price tells you what you want to know.
Anonymous
Anonymous   |     |   Comment #7
That's a great point, but presumably the possibility of institutional failure would be incorporated as "default risk." That's why I think this is an interesting frontier issue: how might we specify the contract terms in order to make such assets viable?