Q: Could you begin by explaining what the question "Can we manage with(out) markets?" means?
This question presents a false dichotomy. We can and must manage with and without markets. We need both. The underlying reason why a school such as SOM should even be interested in this question is that human economic organization is always a mixture of markets and bureaucracy, markets and other institutions.
The underlying reason is, more or less, at the level of biology. What we're looking for is a theory of human organization. And the theory says that some parts of society can be organized very efficiently via markets, while, in other parts of society that have more complex and nuanced relationships, markets would be a disaster.
Markets are a special set of rules of the game that define institutions to enable mass exchange of resources at a low cost. A market is an efficient device which takes many different decisions made under fairly low information conditions, and calculates the redistribution of resources and bids, and reallocates the money to one area and the goods to the other. It is an extremely efficient way of handling desired redistribution of resources.
Because we believe in innovation, we spend much of our time looking for places where markets work. In essence, human beings have so many things to do that they cannot constantly carry hundreds of prices and hundreds of market details in their heads, nor can they constantly deal with bureaucrats. You want to be able to go buy a chocolate bar without a hassle. Once you've bought the chocolate bar, you might vaguely remember that it cost 85 cents. Maybe, next time you buy it, it will be 90 cents. You would go away from the store indignant if it turned out to be $300. The market system enables you to almost always operate with not that much information, not that much need for memory, and not that much need to deal bureaucratically or hierarchically with the people who are selling you the chocolate bar.
We can pretty well date markets to at least 3,000 BC. The Babylonians had the first clear examples of markets. It is of interest to note that the increase in the functioning of markets is not completely smooth. It has not gone up and up and up over all time. For markets to really work, you also have to have the infrastructure of the economy developing at the same time. For example, from early Rome to late Rome, the functioning of markets increased. Post AD 400 they fell.
Things that we take for granted — weights and measures, standard accounting, standard commercial code — are part and parcel of setting the environment for a good market economy. To this very day, our economics departments and, to some extent, even the finance departments, underestimate the importance of accounting, law, and the commercial codes. These features, to put it abstractly, are needed parts of the game. A good business school should be turning out individuals who are highly sensitive to the fact that good standards, honest laws, lack of corruption, consistency in treatment are vital to decent societies and decent economies.
Many of the markets in Guatemala are going to be different than the markets in the former Soviet Union (they had markets, black or otherwise), or the markets in the United States. The corruption indices are different in every one of them. Political factors, such as political disturbance and the features of a kleptocratic society, have an influence on whether or not people will risk utilizing markets.
I must add, on top of that, you cannot have markets without an elaborate money and credit mechanism. The money and credit mechanisms are an invention of human society. They are part of the rules of the game.
Q: Where do you think markets work especially well?
Markets work very well for what in law are called "fungible chattels" — items such as most standard consumer products. Of course, all of us pride ourselves on appreciating fancy tables, fancy sofas, fancy cars, but on the whole, there is something like a more or less standard car or a standard kitchen table.
Many commodities have the property that they are fungible — in other words, one unit looks the same as another. To a gourmet, every orange is different, but to an ordinary individual, oranges are more or less the same. If you have something in which the unit is more or less the same, it is capable of mass production, and it is desirable for mass consumption, a market is the way to go.
Markets do not work that well when the item is highly specialized or it is one of a kind. The market for Yosemite Valley is not a particularly free and open market, and we would be insane to let it just be in private hands. It essentially belongs to the society. They can subcontract it to be run by private enterprise but, essentially, the monopoly rents should be captured by the society.
If, for example, somebody wants to pick up a unique fad, such as collecting bottle tops, society has no particular valuation for this, and if there's a monopoly in it, entry is easy and the market is just reflecting the monopoly, without any externality. In contrast, Yosemite has an externality to all of the society, so to allow it to be appropriated is a problem.
Q: Where do stock markets fall in all this?
Stock markets can and should be virtually automated. They are an example where things could get so efficient that the economic theory is pretty close to the practice.
Now, there's a distinction that I want to make. The stock market is a marvelous mechanism for buying and selling stock efficiently. Whether that mechanism provides the appropriate valuation of stock is a different question. It provides the valuation, obviously, at this second, but it doesn't tell you what the underlying worth of the business is.
The trouble with the financial interpretation of the virtues of markets is that they have allowed modern finance to almost make a disconnect between the actual corporation and the piece of paper representing ownership of the corporation. The market is efficient in redistributing the piece of paper. It is not efficient in the long-term evaluation of the firms behind the pieces of paper. Many people will claim that it is, but there is no substitute for knowing both the physical aspects of the firms and the legal environment in which the firms operate. And that calls for a completely different skill.
Q: Is the move toward private equity that's been happening lately changing how financial markets function?
No. The current move toward private equity will change within a few years and go in the other direction. There are all sorts of markets. Most people misunderstand the stock market, in the sense that they think that the stock market is one uniform market for the financial and manufacturing institutions of society. In fact, there are markets for institutions, as well as stocks of institutions, and the price that a firm sells at might not be the same as the sum of what its shares sell for. That is because there could be an arbitrage between what the public is willing to pay for the shares and what a bunch of private investors who have evaluated the firm and the details of the financing are willing to pay for the firm. When the investors have bought a firm, they may break it up, they may do something else to it, but, basically, a few years later and a few billion dollars having been removed, appropriately, they will take a look at the transformed institution and say "now is the time to go public." They arbitrage between the market for firms and the stock market.
Q: Markets are essentially less centralized than management. Is that an important distinction?
Yes. Enormous. Let me say there was a fake competition between the Soviet Union and the United States, in the following sense. A lot of people thought that the fight was both political and economic, and you could not sort out the two. The odds are that if the Soviet Union had adopted free markets, as China is doing, and had stuck with their political philosophy, they might still be in business.
What I am suggesting is that the idea that markets equal democracy is just false. Democracy is about freedom of political choice. And the question of economic choice simply says little about political predilections.
Q: Is there any advantage to the functioning of markets under a democratic political system?
I think that, on the whole, the functioning of both markets and voting tend to be more and more associated with democratic structures. As a matter of fact, years ago I didn't understand why there were so many different tax authorities in the United States. My memory is that there are over 80,000 different tax authorities. Every local school district, for example, is pretty well its own tax authority. The reason turns out to be that you use markets as the efficient decentralizing device where that works, and where that doesn't work, you hopefully try to use voting as the decentralizing device.
It's not easy to get all of the nice properties that markets have with voting. In particular, a nice property that a competitive market has is that you can devise a price system that essentially no one can argue about. Thin markets are different. You have to have enough competition. And, by the way, enough competition turns out to be a fairly small number. If you have 20 or 30 suppliers of almost anything in an area, that's certainly enough competition. In some cases it could even be four or five.
Q: You mentioned that the former Soviet Union had some markets. What were you thinking of?
You could buy your apartment. There were farmers' markets. They were limited. And there were enormous black markets. As a matter of fact, you see that stopping of a legal market from existing merely presents an opportunity for an enormous black market, and somebody else profits by it.
For that matter, take the whole question of the drug culture. I, personally, would have a government-controlled drugs market, controlled by fairly toughly designed laws, rather than making it illegal. All that making it illegal does is to make a bunch of gangsters rich. It would be much better to make society rich. If there are people who wish to be addicts, use the revenues from them to build their own hospitals and cure facilities. The good example of bad control was prohibition.
Q: Does the scale of the market change the dynamic?
To a certain extent, yes. The bigger a mass society, the more it is absolutely critical to have efficient markets, and the more probable it is that you have them. But the great trouble is that externalities exist in many, many areas of human affairs, like cleaning up smog or controlling traffic.
Take controlling traffic: You can go a long way with market mechanisms, but they are much more complicated than other markets. As you are probably aware, on certain toll roads, you pay according to the time of day. In London, you pay to use downtown London at many hours. A lot of people will argue that this is, quote, "unfair" and it favors the rich. Well, it does favor the rich, but it favors the poor as well, because the rich are being soaked if they want to use the facility at that time.
There are many areas where you can design markets by putting in the laws in such a way that they control the externality, and you can get the market to fit the problem. But market design presents a complicated challenge.
Q: So you have to manage the market.
Yes. You have to manage the design of the market. One of the things that a good business school should be doing is producing market designers. As
a matter of fact, the design of markets is frequently a way for individuals to become obscenely rich. The first person to design a market, if he can commercialize it, will make an enormous gain.
Q: That's a good incentive.
It's an extremely good incentive.
Q: How well do you think theory, at this point, explains the functioning of markets?
I think the last 50 years has seen an enormous jump forward in the understanding of the key role of markets. And not merely the key role of markets, but the other institutions of society that are required to monitor and run a modern economy.
A perfectly good example is given by the clearinghouse: Except for a few people, economists regarded an institution such as a clearinghouse as a quaint triviality. But clearinghouses are a key element in a modern economy. The ability to know that millions of checks a day can all flow into a central institution and have the books balance within a few hours is staggering. And without modern technology and modern law, markets as we know them currently would not function.
By the way, market structure is changing fast. The speed of the emergence of markets is enormous. When I think of things in my own lifetime they are amazingly different now from previously.
Q: Can you give me some examples?
Well, the mere fact that, if you go back to the 1940s, the transaction in a financial exchange was a big deal. The public was almost afraid of the stock markets. If you go back to 1910, the stock markets were strictly for the rich and sophisticated. Anybody else who got near them got taken to the cleaners. You go back 10, 20 years, most people kept their stock certificates in lovely pieces of engraved paper. That will be completely dead within another 10 years. I used to keep virtually all of my stock in stock certificates. Now this option is going down to next to nothing, and it will soon not be feasible to do so at all.
The idea of a future, a put, or a call, or a derivative instrument, all of these instruments have been around in one form or another. I can show you a 17th-century put, and I can argue that there probably were futures in Babylon, but the modern manifestation is totally different.
Q: Are there any dangers in the modern manifestation? Some people worry about derivatives.
Yes. There are dangers. There are enormous dangers, but many of them will be corrected biologically — meaning a bunch of people will get taken to the cleaners, and then somebody will make sure that that couldn't happen quite the same way again. Is the modern manifestation good? I can make out a case that it will be either good or bad. You have to look at it case by case. But there are dangers — in particular, in derivative instruments that are not well designed or understood.
Q: How long have you been studying markets?
About 50 years.
Q: And, over that time, understanding in general has changed. How much have your ideas about markets changed?
Considerably. I had no idea of how close markets were to a general theory of organization or how important information was and the fact that a modern economy is more and more and more an information and an algorithm-transformation economy. Tom Krens [director of the Solomon R. Guggenheim Foundation] pointed out to me that in buying certain forms of conceptual modern art, you can buy the program as to how to build a certain item. And that is, in some peoples' minds, classified as art. I won't get into the art appreciation end of it, but the general idea is that — starting at a point, not far different from the double helix and the ideas in computer science — trade in plans and in algorithms is now becoming more and more real, as contrasted with trade in goods.
I think that game theoretic/information theoretic thinking has impacted our understanding of markets considerably. Understanding what information is needed is critical, and understanding competition is critical.
Q: In a way, that's been acknowledged for a long time, right? Insider trading is a threat to the market because insiders have different information.
Well, there's a question as to whether insider trading is good or bad — it's not always necessarily bad.
If I were in control of market regulation and design policy for the United States, my main concern would be to force as much transparency as possible. I'd hardly worry about insider trading, per se, if that were done. That would mean, of course, that insiders would have to announce their information to the markets as early as possible. But then, what would happen is you would get legitimate insider trading. Let me explain the distinction. Many financial institutions are perception devices. They are like eyes. Some people who have been trained can see things better than others, especially experts. In a certain sense every expert is an insider, whether he wants to be or not. Why? Because, when he looks at a business, he sees many levels of risk, while an amateur has a far cruder picture of the risks.
My feeling is that society would benefit from absolute transparency on all raw data, including costs of production, new techniques, everything. Have an absolute requirement of disclosure. After that, any insider can do, basically, what he wants.
And what would happen would probably be that you would buy the shares where active insiders held large segments of their own business, because you would believe that they are acting in their own self-interest, and your interests are aligned with them. I tend to like markets where, to use the phrase, the purveyors eat their own cooking.
Q: Is there a risk in absolute transparency that, essentially, there's too much data?
It's impossible to have too much transparency, financially.
Q: If you're designing or creating a market, what are the things you have to keep in mind? What are the fundamental rules you have to be concerned about?
What the item being traded is, what the externalities are, what group of individuals it is designed to serve. If you're designing a market for a very sophisticated bunch of individuals, that would be very, very different than designing a market for a very unsophisticated bunch. These are all very different.
I was once somewhat concerned with the design of weather derivatives. Consider the Rocky Mountains. The Rocky Mountains have several major roads through them, which are useful for truck traffic, and they have lots of ski resorts. When there's heavy snow, the roads are slow or even shut down, and the ski resorts are doing great business. When there's no snow, the ski resorts are starving, and the truckers can go through the Rockies with great ease. There's a potential market there. You cook up snow futures where you guarantee the ski resorts and the truckers a minimum living, depending upon the weather. They would offset each other, so there's a market.
Q: What keeps a market like that from forming?
Set-up costs. When we were looking at this derivative, it was too early. In other words, people weren't sophisticated enough, and it would have cost too much to actually get a sellable instrument and inform people that it existed. Once an instrument like that takes off, then it probably has legs for many years.
Q: You teach Security Analysis at Yale. Is that a chance to essentially put into practice your theories?
Yes. Though I would say it's the other way around. Knowledge of practice helps theory more than theory helps practice.
In practicing what I preach, I learn a great deal.
Q: What are you working on now?
I'm finishing my third volume on the theory of money and financial institutions, with the stress being on the importance of markets, the importance of information, the importance of expertise, and the growing closer and closer of the concepts of a general theory of organization with the problems of finance and the role of money and markets in the economy.
I'll just add that, for whatever it's worth, the role of government money is being minimized in the modern economy, because the more the communication gets to be cheap and efficient, the easier it is for subgroups to build networks where they trust each other and where they enforce trust on each other. In doing so, it obviates the need to use government money. And so, you get sub-clearing groups where — I've got a big firm and you've got a big firm, and we do a lot of trade with each other, we can balance the books monthly without having to pay each other in cash. What is happening is that the power of every central bank is weakening considerably. Sooner or later, there will be a proper world central bank, and there will be a hierarchy in area and national central banks.
Interviewed by Jonathan T.F. Weisberg
Photograph by Tony Rinaldo