why do we have markets

09 Oct, 2023

(foreword: this is based on a presentation I gave at the Recurse Center during my batch related to my event contracts market making project! If you'd ever like to talk more about it, feel free to hit me up)

Two reasons

1. They're the best mechanism we have to aggregate diffuse information.

2. It's important to aggregate all this info to determine how to allocate scarce resources.

And in order to solve these two problems? We trade, on a market.

Austrian economist and philosopher Friedrich Hayek (1974 Nobel Prize in Economics) in the 1940's had his thesis of price signals, where he argued in his essay The Use of Knowledge in Society that:

"The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess...a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality"

Honestly, I could spend this whole article quoting most of Hayek's paper, but to keep it brief, two more great quotes from his essay:

"The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity — or rather that local prices are connected in a manner determined by the cost of transport, etc. — brings about the solution.

We must look at the price system as such a mechanism for communicating information if we want to understand its real function...The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.

And hence, point #1 and #2. Market prices give us a way to aggregate information. From there we can figure out optimal allocation.

His essay is considered one of the most important in modern economics, and had a profound impact in the 20th century discourse. It was initially written in response to Oskar R. Lange's proposal of a "central pricing board" and endorsement of a planned economy. Through it, Hayek convinced market socialists, and was positively received by influential economists of the modern day (Paul Samuelson, Robert Solow).

The echoes of Hayek can be seen today too. Experimental economist Vernon Smith (2002 Nobel Prize shared with Daniel Kahneman) in 2004 gave a speech before the Austrian parliament ¹ harkening back to Hayek's writings when he stated:

"...the problem of society is how to utilize human knowledge when it is not, and cannot ever, be given to anyone in its totality. How do you induce people to take the economically beneficial actions without anyone having to tell them what to do?"

So where do we go from here?

Yes, markets are imperfect in many many many ways. Speculation, inefficiencies (there's a reason whole companies exist to help make them more efficient²), volatility, money being thrown around. Finance as a whole is such an absurd, crazy, fascinating world because of the many ways in which it serves as the plumbing for the world to go around, with all its hidden intricacies.

But, even with all these flaws and complexities, they're necessary! So so very much necessary.

In fact, Matt Levine ³ once quoted in his Money Stuff newsletter a wonderful writeup from Interfluidity on why finance is so complex – you can read the whole writeup yourself, but in essence it tells us how complexity in finance is a feature, not a bug:

Finance has always been complex. More precisely it has always been opaque...Opacity is absolutely essential to modern finance...The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky...[financial systems] ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis...[they] are sugar pills by which we collectively embolden ourselves to bear economic risk.

As much as media and your uncle-who-drank-a-bit-more-at-Thanksgiving-dinner-than-he-should-have might decry financial markets for swindling everyone out of their money and being the center of corruption and greed, it's what makes modern society function.

No markets, no progress.