I have had the privilege of serving on the World Economic Forum’s global future council for investment. In that context I also had the pleasure of working with Alison Tarditi, CIO of Australian Commonwealth Superannuation Corporation. Our joint opinion piece, Want investors to care about natural resources? Put a price on them, has just been published. However, in the 18 months or so since the first draft my thinking has evolved. Hence this thought piece.
Markets and prices
Even though we now probably view markets and prices as inseparable, markets actually pre-date prices. Although, in non-price form, we may prefer to call them exchanges. How many piglets can I take home to raise, in exchange for my full-grown pig? In essence we are saying there is a meaningful difference between an exchange rate and a price. If there are a gazillion-and-one goods in the world then there will be a gazillion exchange rates for converting my full-grown pig into something else.
In this framing, price is just one of the exchange rates – but a special one. It is the rate of exchange between full-grown pigs and that strange, non-edible substance called ‘money’. It is the invention of the abstract concept of money that allowed us to move from exchange to price. In doing so we drop a gazillion-minus-one exchange rates and just keep the price. When we do this for all objects we enjoy a massive leap in efficiency (or, equivalently, a massive drop in transaction costs).
Efficiency is good, right?
I am currently struggling with a question of whether we have over-prioritised efficiency at the expense of other goals like resilience. I think the main problem is we have never explicitly set our priorities.
What do markets do?
To explain, I would like to start with a question: is the combination of markets plus prices a neutral technology, or an intrinsically biased technology? By ‘technology’ I mean a method for doing or achieving something; by ‘neutral’ I mean capable of being directed to achieve different goals, compatible with different values.
An intrinsically biased technology, on the other hand, cannot be redirected to achieve different goals. It does what it does. If we consider a market as a small-scale system, then we can invoke the phrase ‘POSIWID’ – the purpose of a system is what it does. In other words, a system does not follow someone’s pre-ordained purpose.
So, what is it that a market does? Here we need to distinguish between securities markets and markets for goods and services. For securities, there is buying and selling but no net supply or demand imbalance. Here the purpose of the securities market is to discover the market-clearing price.
For goods and services markets, however, the price is normally a given (and often set by the supplier or seller) and so the market is more about discovering the supply or demand imbalance. This imbalance then triggers changes in the economy. In the short term that could be a price rise (or fall) but in the medium term it will be a change in the quantity supplied. This now gets interesting; an increase in supply means that either a factory has been expanded, or an existing production line has been re-tooled to produce more of the demanded good. Resources within the economy are reallocated. In short, I am arguing that what the market system does is reallocate resources within the economy. And because the market keeps doing this, the market is actually a search engine continually looking for the most efficient allocation of resources – given the prices it has to react to. For what it’s worth, I believe that markets plus prices is one of the most powerful technologies ever invented.
I see where you’re going – you think we are missing some prices!
Yes, exactly – and no. On the ‘yes’ side, the WEF opinion piece mentioned at the start calls for natural resources to be priced appropriately. They currently have an effective price of zero so the market will use them profligately. Set a positive price and we will use less of them.
On the ‘no’ side, I think there are two problems that argue against the (relatively) simple solution of introducing some natural resources prices to solve our current problems. First, how do we set the price(s)? We will not spend long on this as the economics literature deals with price setting extensively. I will stress, however, that the market acts as if the price is correct. A single mistake in setting a price for one of our natural resources actually introduces a string of relative-price errors. The market will then incorrectly allocate resources given those pricing errors.
The second problem is whether we actually want the most efficient solution. I will suggest that we probably want a more balanced solution in which efficiency is but one element.
Promoting the importance of resilience
Why would I not want the most efficient solution? In a word, ‘fragility’. Efficient solutions are fragile because, by design, resources have been pared back to the minimum. We do not want efficient bridges or tunnels, we want over-specified versions; we want resilient versions that can withstand the never-seen-before storm. Given the stresses and strains lined up to greet us in the future, I increasingly find myself wishing for a resilient economy, and not an efficient one. A resilient economy has ‘fat in the system’ (redundancy, in the jargon), or is over-specified. I do not believe that markets or, more strictly, free-market capitalism can deliver resilience. It isn’t what it does.
The answer is constrained markets
Adam Smith’s second book showed us the power of the market (invisible hand) to efficiently allocate resources. His first book showed us that society needs to set the boundaries of the playing field within which the invisible hand operates. The purpose of the boundaries is to constrain the set of possible solutions the market can search through. And the point of that, is to find a solution that better meets society’s goals than would an unconstrained search. The implicit belief here is that there is no set of prices that will naturally guide a market system to the same solution. In a sense, I am arguing for re-regulation (including new legislation, where required). But I think that ship has already sailed – re-regulation is a given and will likely pick up pace. So I guess I am arguing for a pro-active embrace of, and support for, re-regulation by the investment industry.
As an aside, two quick points: first, I am using the term ‘re-regulation’ as I see this following a period of de-regulation which started in the 1980s with Reagan and Thatcher. Second, I am thinking of the economy rather than the investment industry. For consumer protection reasons, the investment industry didn’t really experience a de-regulation phase.
What to do?
This thought piece takes as given that we have been over-using natural resources; it accepts that pricing them would ration their use somewhat, but argues that the market mechanism is not enough; we need more regulation. What do we as individuals or organisations in the investment industry do with this? The answer to that will lie on a spectrum between passivity and pro-activity. Doing nothing and passively observing the re-regulation unfold is a viable choice. Equally viable, and probably preferable, is a more active stance, encompassing:
- Developing the enlightened part of enlightened self-interest within our organisations
- Actively engaging with regulators and the public sector to propose and support high-quality re-regulation within the economy
- Actively engaging with investee companies to encourage enlightened self-interest as well as strategic shifts in the light of shifting societal expectations
- Reworking investment analysis to consider valuations in different scenarios (will my stake in an auto manufacturer be worth more or less in an electric world?)
- Commit new investment capital to growing new assets or businesses that provide solutions to society’s problems / are more aligned with society’s goals.
 Traffic lights are a physical technology, while the rules governing behaviour at traffic lights are a social technology. Together they achieve faster traffic flow
 The internet can be argued to be a neutral technology. It can be directed to achieve much that is commonly regarded as ‘good’, but it can also be directed to expedite the dissemination of things commonly defined as ‘bad’.
 I am ignoring a third, deeply theoretical, problem relating to the completeness of prices. For example, the Arrow-Debreu model of 1954 suggests a set of ‘state prices’ exists, which allows the economy to find the best equilibrium, or most efficient allocation of resources. In this world, I could buy an Arrow-Debreu security that would pay me $1 in October 2029 if more than 25% of the world’s population were vegetarian (which would affect the future price of my pig). There would also be a security for more than 24% vegetarian, and more than 26% vegetarian etc, and yet more prices for September 2029, and November 2029 etc. In short, the set of prices required for the market to do its job properly is close-to-infinite. Adding a few more prices for some natural resources doesn’t help us much.
 The allocation could be a lot better than our current allocation in the absence of those prices – but there is lot that we don’t know here (and it may be unknowable).
 Nassim Taleb explored fragility and its opposite in social and financial contexts in his book Antifragile: Things That Gain From Disorder. The key idea is that antifragility is preferable to resilience or robustness; antifragility doesn’t just weather the storm, it gets better.
 An Inquiry into the Nature and Causes of the Wealth of Nations (1776)
 The Theory of Moral Sentiments (1759)
 Invoking POSIWID again, the point of a capitalist system is to maximise the return on financial capital.
 Among the many examples are (i) the UK’s ban on sales of cars with internal combustion engines after 2030, and (ii) the success of the 30×30 movement leading countries to legislate protection of 30% of their land and sea areas