Markets and Predictability

12.23.2005

Free markets work, was the message relayed by Federal Reserve Board Chairman Alan Greenspan recently.

“On average, world standards of living are rising in large part because of the widening embrace of competitive free markets, especially by populous and growing China and India,” he said.

and

Open and competitive markets have made the global economy more flexible and better able to withstand jolts from terrorism and other problems, Greenspan said.

Personal trust, he said, is a key to the smooth functioning of markets.

The issue of trust deserves more attention. It seems to me that trust is part of a larger aspect of functioning market economies – predictability. The question of whether we trust in certain institutions (or certain people) is really the question of whether we can predict how will others function within the rules-based system. If I don’t trust you, I essentially think you are lying and I can’t predict how you will behave.

Predictability is key in functioning of markets because for market activities to take place we want to be sure that contracts will be enforced, property rights protected, and prices will reflect needs and wants of the consumers. Who would want to do business in environments where you don’t know what tomorrow brings? Such environments are characterized by weak rule of law, which means there is a large gap between laws on the books and laws as they are implemented in day-to-day life. Investors, for example, want to be sure that if they invest money in a country, they will be able to take profits out, the domestic currency will not collapse, or that tax rates will not unexpectedly change once they set up operations. If predictability is absent in market transactions, cooperation between people is likely to break down into small, informal arrangements.

What are the real world implications of predictability? When looking at rules (laws and regulations) we have to look beyond what’s written on paper. For example, economies in which there is little trust will still have a hard time attracting investors, even if they introduce some of the most liberal investment regulations.