Occasionally an article lies so irresistibly
at the core intersection of economic theory
and the professional interests of the "Adam
Smith, Esq." community that, despite
the fact we are not here for a graduate seminar
in economics, it simply demands to be featured.
Yesterday the WSJ had precisely
such a column on its Op-Ed page under the byline
of Henry G. Manne, dean emeritus of the George
Mason University School of Law.
It’s about behavioral finance and, at least
as a "hook" for reeling in the WSJ
readership, the argument for legalizing
insider trading, expressed thusly at the
conclusion of the piece (although that’s
really not what it’s all about:
"We should rethink any current
policies based on a view of pricing in which
we exclude the best-informed traders and
discard the wisdom of the many. For instance,
we now have a new and more powerful argument
than we had in the past for legalizing most
insider or informed trading."
So I’ve told you what I think the piece is not
about; what do I think it is about?
Primarily, the difference in economic analysis
between Aggregate and Marginal behavior,
and also, which is clearly more germane to
readers of "Adam Smith, Esq.," the value
of predictive markets.
Aggregate vs. Marginal behavior first.
Mannes
poses the fascinating question why, if
"close approximation of the efficient market
theory is still the most accurate and useful
model of the stock market that we have,"
it’s nonetheless the case that "the market-model
claim of rationality often does not comport
with actual human behavior." How,
in other words, to square the many many vindications
of efficient market theory (the celebrated
inability of mutual fund managers to beat
the relevant averages over time, for example)
with that theory’s core assumption that investors
behave rationally, when we know by simple
cocktail party conversation that such an
assumption is laughable?
Attempting to answer this (which, in your
author’s humble opinion, he doesn’t finish
doing—but there’s a promised second
part to the series), Mannes points to this
as "containing the start of an answer":
"[I]n F.A. Hayek’s classic “The
Use of Knowledge in Society” (1945),
Hayek (addressing the then-pressing problem
of countering socialist doctrine) made the
astute observation that centralized or socialist
planning can never be economically efficient
because it was impossible for a central planner
to accumulate all the information needed
for correct economic decisions (“correct” in
the sense of displaying efficient market
allocations of goods). The critical information,
he noted, is too scattered in bits and pieces
throughout the population ever to be assembled
in one person’s mind (or computer). Diffused
markets, on the other hand, function well
because the totality of relevant information,
even subjective preferences, can be aggregated
through the price mechanism into a correct
market valuation."This insight of Hayek’s has been a mainstay
of market theory ever since it was advanced,
but it remains merely an observation and
a conclusion. It does not detail how new
information gets so effectively impacted
into the prices of goods and services. In
other words, how does this “weighted averaging” get
done? And why should we assume that the impact
of rational participants would dominate that
of irrational ones in markets?"
Mannes’ answer is, essentially, to cite the
thesis of James Surowiecki’s "The
Wisdom of Crowds," and its near-cousin,
the value of prediction
markets.
Why is this germane?
Because (emphasis supplied):
"The literature on prediction markets
makes clear that the more participants in
a contest and the better informed they are,
the more likely is the weighted average of
their guesses to be the correct one. That
is true, ironically, even though the additional
participants have even less knowledge than
the earlier ones. The only requirements
for these markets to work well are that the
various traders be diverse and that their
judgments be independent of one another."
Back to "Adam Smith, Esq.:" Why
would your firm not create
internal (or even external—what a concept!)
prediction markets in areas such as which
practice areas are expected to grow or to
contract, where the firm should expand or
dial back geographically, and which client
industries/groups will be healthier or weaker
in five years?
I would love it if you would hire me to
make those predictions for you, and I certainly
would enjoy walking through the thought process
with your firm—but I am humbled by
the new learning in economics, Mannes’ article
included, which instructs us that asking
your partners, associates, staff, and even
clients, what they "predict" is going to
happen may be the most telling exercise of
all.
Are you ready?
