In a comment on my blog post on the GameStop controversy yesterday, Jonathan Seder wrote:
Remember – the purpose of the capital markets is to facilitate price discovery for equities, and to direct capital to the most productive uses. Passive investors are outsourcing that job to traders – individuals and pros – who gather information and try to identify pricing errors. (I think there’s an argument to be made that people with business expertise have some moral obligation [on top of the financial incentives] to play The Game rather than being passive investors.)
Jonathan’s first sentence is incorrect. He has confused, as many people do, one beneficial result of markets with their purpose. Markets don’t have purposes; people do. Markets come about as a result of people pursuing their purposes. When I buy shares or sell shares, my purpose is not to facilitate price discovery. My purpose is to buy shares or sell shares and, hopefully, make myself better off. Ditto the person or institution on the other side of the buy/sell order.
The distinction between purpose and results is not specific to capital markets. It applies to all markets. In pursuing our own self-interest in any market, we, buyers and sellers, drive the price to some level that informs other people. Let’s say, for example, that the demand for and supply of computer programmers leads to entry-level programmers making $80K a year, and that the demand for and supply of social workers leads to entry-level social workers making $45K a year. Those price signals are valuable information that can help guide decisions of undergrads who are willing to pay attention to them. But the purpose of those price signals is not to tell people what jobs they should train for. Those price signals don’t have a purpose. People have purposes. Price signals are inanimate.
Notice that throughout the paragraph I quote from Jonathan, he makes the same mistake of attributing purposes. He writes:
Passive investors are outsourcing that job to traders – individuals and pros – who gather information and try to identify pricing errors.
I’m a passive investor, but I’m not outsourcing that job to anyone. Those traders are taking on the job themselves and they are trying to identify pricing errors for the same reason I’m investing: to make money. I’m glad they’re doing it. But I’m not asking them to do it.
Jonathan goes even further, writing:
I think there’s an argument to be made that people with business expertise have some moral obligation [on top of the financial incentives] to play The Game rather than being passive investors.
Whence that comes that moral obligation? Simply because they have information and expertise, they should, for reasons not connected to financial incentives, play “The Game?” I don’t agree.
READER COMMENTS
Daniel Carroll
Jan 29 2021 at 6:29pm
I think you are confusing the definition(s) of “purpose.” Individuals have purpose in the form of intentions, desires, goals imposed by the individual him or herself. In that definition, you are right that only sentient beings can have self-imposed purposes. Markets have purposes imposed by others – they have design, laws, rules that govern behavior. Just like a watch has a purpose. Markets can’t impose their own purposes because they are not sentient. However, others can impose purposes on them, and indeed they would not exist if those purposes were not imposed on them. Market failure occurs when markets fail to achieve the intended design. The question for us is whose purposes should govern markets. Should it be governed by the needs of the individual or by the needs of society. Typically, the answer is “yes.”
The “purpose”, or design, of stock markets is to facilitate the long-term financing needs of companies and the economy, and allow investors to earn a return by participating.
The GameStop episode is likely a market failure – lack of liquidity allowed for group of small investors to disconnect the stock price from the fundamentals and disrupt the market. In this case, misinformation can contribute to the volatility. It looks like price manipulation. This is not an episode likely to end well for the last investor standing, and has meaningful questions for credibility and transparency of market pricing. The question is does it matter enough to incur the cost of doing something about it. It is interesting, but unless it spreads to bigger more liquid names, it is not likely to have systemic impacts.
As far as index investing is concerned, index funds do present the problem of free riders. Pricing transparency is needed for liquidity, which has significant positive externalities – most participants benefit from liquidity. But asset prices also contain information that is expensive to generate. Index investors do not pay for that information and do not contribute meaningfully to liquidity, active investors pay for it. As a result, index investors are putting active investors out of business. Who will pay for that information in the future and what will happen when active investors are gone? GameStop actually provides some insight into that scenario, though it is extreme.
Jon Murphy
Jan 29 2021 at 8:38pm
Daniel-
It’s not clear to me your objection holds. You write:
If markets have purposes imposed by others, then they posses no purpose. The “others” posses that purpose.
Alan Goldhammer
Jan 30 2021 at 9:17am
We still don’t know the the full story on who made and lost money from GameStop trades. I would not be surprised if the ‘Flash Boys’ (high frequency traders as documented in Michael Lewis’s book of the same name) were the ones who benefited more than the RobinHood crew. Unlike those trading on the app, they are able to get in and out of positions in milliseconds. The lack of liquidity when trading was halted was a result of financial regulations and RobinHood not having a enough funds to cover all the trades. The bottom line of this event is that it was not investing but gambling.
There was nothing new here as I can remember back to the Yahoo Message boards of 20+ years ago when the same thing was going on. The difference then was the lack of no-fee trading platforms. Those of us who do follow history well know about past short selling wars (the one that stands out for me was the bets that Icahn and Ackman were making on Herbalife several years ago).
As long as markets remain liquid, the GameStop, AMC, Blackberry short wars won’t have much impact on the overall market. Real problems arise with non-liquid investments (Long Term Capital Management in 1994 and the creation of bizarre derivatives in the 200s that brought on the great recession.
David writes,
This really depends on what you are invested in and I don’t think it holds up as a general statement. If your principal investment is in an index fund (generally the meaning of passive investing) you are not benefiting from pricing errors as those tend to be transient. Most index funds are weighted according to market capitalization and you likely are not diversified (though there is some debate about the value of diversification). S&P 500 Index funds are heavily weighted to the top 10 stocks and is arguably more volatile with the addition of Tesla (now the fifth ranked stock by market cap).
Jon Murphy
Jan 29 2021 at 8:46pm
David-
It appears to me that much of the neoclassical literature and theory rests on the mistake you mention: that markets in and of themselves have a purpose and they “fail” when that purpose is not achieved. But one of the powerful strengths of the UCLA school of Alchian-Allen-Hirschleifer-Demsetz is to examine outcomes within the context they occur. In other words, the institutional arrangement matters and evolved as people try to accomplish their goals. With that framework, “market failure” becomes a much more precise thing: it’s not when markets deviate from their “purpose,” but when there is something frustrating people’s purposes.
Thomas Hutcheson
Jan 30 2021 at 6:46am
I steadfastly refuse to read about Game Stop. If there is ant substance to the issue it is one of institutional design which is too far from my expertise for me to have an opinion about, Kaplan-esque “rational ignorance.”
I do want to push back , however, against “markets” don’t have purposes. Yes and giraffes did not purpose to grow long necks so they could eat leaves from tall trees. But it still makes sense to try to understand what evolutionary advantage might be conveyed by a particular feature of a changing dynamic system. So market features or markets themselves DO have “purposes.”
Jon Murphy
Jan 30 2021 at 10:23am
If you want to use purpose in scare quotes, that’s fine. But note that such usage undermines Jonathan Seder’s point. That’s David’s whole point: it is not a purpose, but an outcome of a process.
Thomas Hutcheson
Jan 30 2021 at 6:47pm
I was not arguing with Seder, but with Henderson. My “evolutionary advantage [that] might be conveyed by a particular feature of a changing dynamic system” presumably corresponds to your idea of the purposes of people over time who have interacted in the process.
Jon Murphy
Jan 31 2021 at 11:41am
Right. That’s my point. It’s not obvious your objection holds.
Bill
Jan 30 2021 at 12:22pm
Very Friedman-like.
Henri Hein
Jan 30 2021 at 6:04pm
I am also confused why we can’t use “purpose” to talk about the intent behind a tool or institution. “The purpose of my hammer is to drive in nails.” Dylan’s example with the watch. It will be news to many people these are controversial uses of the word.
I searched for the phrase “the purpose of” in Google. Skipping grammar and dictionary sites, these are the first three uses I found:
What is the purpose of a company
What is the purpose of the word “the”
The purpose of a system is what it does
Jon Murphy
Jan 31 2021 at 11:42am
The intent of the market is not to “facilitate price discovery for equities, and to direct capital to the most productive uses.” That’s a beneficial outcome.
Henri Hein
Feb 1 2021 at 3:20am
That may be the case. I was not trying to make a statement about what the purpose of the stock market is, only that I think it makes sense to assume it has one. Stock traders have built institutions with some similar traits across different time periods and places, which indicates they are looking for certain functions from those institutions. I understand the danger of over-anthropomorphizing, but I still believe most people would think of the intended functions of the stock market as its purpose, and I don’t see anything wrong with that.
andy
Jan 31 2021 at 12:18pm
I think the problem is that many people think markets are ‘created’; and if they were created, those, who created them (or who sustain them), had some intention to ‘use’ them for some purpose. Which comes to a small distinction between ‘market’ as an economics term and ‘market’ as ‘marketplace’.
The economic term ‘market’ doesn’t mean a thing or an institution. It’s an abstract term used to cover an environment where people can trade. It’s like the word ‘forum’; it could mean some abstract environment where people can exchange ideas; or it can mean a particular place, news magazine, social network.
You can make a social site with the purpose of ‘earning money by providing people a fair place to talk and charging them a fee’. But you wouldn’t say that sustaining a public forum (= state respecting free speech rights) has necessarily a purpose. It’s just something that arises in a free society based on mutual respect.
The same with market. It just…happens. You don’t create it. It doesn’t have any purpose.
Jon Murphy
Jan 31 2021 at 2:38pm
It does. A market is an institution in economics.
andy
Jan 31 2021 at 5:19pm
My bad, english being my second langugage, I didn’t see the second meaning of the word ‘institution’ – I meant more something like a particular organization. Actually, the different meanings of the word ‘institution’ show the differnt ways people understand markets – “an organization founded for a religious, educational, professional, or social purpose.” vs. “an established law or practice.”
Jon Murphy
Jan 31 2021 at 5:57pm
Ah yes. I see your point now.
nobody.really
Feb 1 2021 at 12:25pm
And not just to markets.
As other commenters note, Henderson raises a point of semantics: What do we mean when we speak of a thing’s “purpose”? Different people have different meanings. Thus, Henderson and Seder may not disagree about substance, but merely about word usage.
I favor clear thinking and communicating. And since we tend to think and communicate in words, I favor making the structure of language more closely fit the structure of the world as we understand it. As a result, I favor Henderson’s usage here. Specifically, I favor attributing purposes only to SENTIENT creatures.
What different does it make? Socially/politically, it makes a lot of difference.
Many people (especially Roman Catholics) embrace a philosophy called Natural Law/teleology. Proponents of his philosophy argue (among other things) that we can divine the “purpose” of non-sentient things/processes from their desirable results–and they argue that using non-sentient things for any other purpose frustrates the will of God or something. For example, sex promotes procreation. From this fact, proponents conclude that the purpose of sex is procreation–and thus to have sex for any other purpose is wrongful.
I would have thought that this kind of maladaptive thinking would have died out by now. After all, I don’t object if YOU want to conclude that the purpose of a window is to let in light and air, and perhaps afford a view of the outside. But in the event of a house fire, I’m gonna feel free to exit through the window–even if that is not consistent with the window’s purpose. If all the teleologists feel compelled to remain inside and perish–well, perhaps that’s just God’s will.
Knut P. Heen
Feb 1 2021 at 1:30pm
A trade is designed to benefit both parties and thus have a purpose. A market is just the name we use for a collection of trades. People went to the marketplace in order to find good trades. They did not go there in order to create a market.
David Seltzer
Feb 1 2021 at 4:15pm
Some thoughts from an economics perspective. In efficient markets it’s assumed information is universally shared. It’s not necessary that information be universally shared. If a substantial minority of market participants has the information, that is enough. Market participants are price takers. All that is known is impounded in market prices. I am assuming individual purposes are revealed by their behavior. Markets are organized to accommodate those purposes by providing a place to transfer ownership through trading. Market prices transmit information to efficiently clear trades. Thinking in terms of utility, those price changes are weighted by aggregate marginal utilities. Each agent’s marginal purpose, as revealed by their behavior, is new information impounded in the price of the next trade. The buyer values the instrument more than they want their money and a seller wants money more than the instrument.
Jonathan Seder
Feb 1 2021 at 4:52pm
I sure didn’t mean to start a sematic storm. I am consoled by Galbraith’s observation that “If all else fails, immortality can always be achieved by a spectacular mistake.”
I wrote, “the purpose of the capital markets is to facilitate price discovery for equities.”
Investopedia: “Capital markets refer to the places where savings and investments are moved between suppliers of capital and those who are in need of capital. Capital markets consist of the primary market, where new securities are issued and sold, and the secondary market, where already-issued securities are traded between investors.”
I think it’s not entirely incorrect to say that those places (including NYSE, AMEX, NASDAQ, ARCA – once physical, now mostly virtual) were created primarily for the purpose of price discovery. “The capital markets” isn’t exactly an economist’s “market.”
My closing aside – “I think there’s an argument to be made” about a “moral obligation” – was merely the suggestion that we all benefit when when capital is allocated to the best uses – which requires that informed investors take carefully considered positions, and arbitrary index fund criteria may not serve us well.
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