The logic of price discovery An article considering the problem of the volatility of prices in financial markets from the perspective of the development of scientific knowledge, where expectations of an uncertain future can be tested and falsified through a trial and error process. David Harrison, DAC Beachcroft LLP Speedread Why, in the light of recent stock market turbulence, should financial prices be more erratic and volatile than real economy prices? The testing of expectations of the future about normal goods and services in the economy can take place through the trial and error process of the price mechanism. Competition policy can address distortions in this mechanism. But for capital assets the position is more complicated: the important factor is long-term yield, not fluctuating prices arising from the revaluations of previous investments in liquid investment markets. A more scientific and falsifiable approach in finance and investment, which competition policy might encourage, would be a shift away from what Keynes described as forecasting the psychology of the market, towards forecasting the prospective yields of assets over their whole life. This article presents a theoretical discussion of the issues, and concludes with consideration of possible practical implications. Introduction Competition authorities around the developed world are still grappling with the after-effects of the financial crisis. New and unexpected forms of price manipulation have come to light in finance, on a scale "almost beyond comprehension" (in the words of John Plender of the Financial Times, in "Capitalism: Money, Morals and Markets" (2015, at page 303)). In the UK, the Bank of England's 2015 Fair and Effective Markets Review produced a range of recommendations that it is hoped will restore trust in the wholesale fixed income, currency and commodity markets, in the wake of various high profile abuses. At the same time, persistently low levels of company investment have been linked to short- termism in financial markets (by economist Andrew Smithers, in the book "The Road to Recovery" (2013)), and the way in which investors employ fund managers (see The Economist, "A new contract for growth", August 2015). In the US, Hillary Clinton, speaking in 2015 of the dangers of "quarterly capitalism", has echoed concerns, heard increasingly on both sides of the Atlantic, about short-termism. As recent stock market turbulence illustrates, prices in financial markets often appear less reliable and more erratic and volatile than those in real economy markets. Why should this be? One possibility is that they are controlled by fewer participants, with greater market power. Another is that they are intrinsically more subjective, and reflect expectations of the future more than current economic value. This article considers the problem from the perspective of the development of scientific knowledge, where expectations of an uncertain future can be tested and falsified through a trial and error process. Might a similar approach help finance and investment to be put on a more stable and secure footing? The logic of scientific discovery In the book "The Logic of Scientific Discovery" (1959), published originally in Vienna in 1934 as "Logik der Forschung", and in his subsequent works, the philosopher of science Karl Popper held that induction by repetition is not the basis of scientific knowledge. Rather than proceeding from observations of singular events to universal statements, or theories, Popper reversed matters: science proceeds by putting forward theories that can be tested by observation, and that can be falsified. In this way, as Popper went on to claim in "Objective Knowledge: an Evolutionary Approach" (1972), the problem of induction, or what he called 'Hume's problem', could be solved. In his "Treatise of Human Nature" (1739), David Hume had pointed out that there is no logical justification in reasoning from repeated instances of which we have experience to other instances of which we have no experience. It is only by custom or habit, or for psychological reasons, that we are conditioned by repetitions to expect that instances of which we have no experience will conform to those of which we have experience. Popper argued that while Hume was right to say that there was no such thing as induction by repetition in logic, this is an erroneous way of viewing the growth of scientific knowledge. Science proceeds by putting forward theories that may never actually be proved by observation, or testing, but which can, on the other hand, be disproved, or falsified. The process of testing, disproving and falsification of theories is a highly rational process, involving critical discussion, and returns reason to its rightful place in human understanding. Popper, therefore, made an important demarcation in "The Logic of Scientific Discovery" between science and pseudo-science (or metaphysics). It is of the essence of scientific knowledge that it can be tested, falsified or disproved in some way. If an idea, or a hypothesis, cannot be tested or falsified at all it cannot qualify as a scientific theory. It is then a conjecture, or a myth, which might have some social value or explanatory power, but is not knowledge in the fullest scientific sense. Conjectures and hypotheses need to be put into a form which allows them to be tested against verifiable and repeatable observation if they are to qualify as scientific theories. From this starting point, Popper went on to create an evolutionary and biological explanation of the growth of knowledge. All living organisms have in-built expectations of basic regularities, or patterns (such as the change from day to night) and it is the testing of these expectations against events which determines how successful organisms are. Scientific knowledge is the most communicable and developed form of knowledge there is, but ‘all life is problem solving’ (in the title of one of Popper’s books). The difference between Einstein and the amoeba is just one step: both try to solve problems, but, unlike the amoeba, Einstein can create theories that live and die instead of him. The testing of expectations of regularities by a process of trial and error happens all the time, and is a function of all organic life. Uncertainty, expectations and prices If we rise up the evolutionary scale from the amoeba to economic life, the existence of uncertainty of the future was described by economist Frank Knight in "Risk, Uncertainty and Profit" (1921) as itself basic to the market economy. Genuine uncertainty of an unknown future (to be distinguished from calculable risk) creates economic profits which are exploited by entrepreneurs. As Knight put it (at Section III.XI.8): "It will be observed that the main uncertainty which affects the entrepreneur is that connected with the sale price of his product. His position in the price system is typically that of a purchaser of productive services at present prices to convert into finished goods for sale at the prices prevailing when the operation is finished. There is no uncertainty as to the prices of the things he buys. He bears the technological uncertainty as to the amount of physical product he will secure, but the probable error in calculations of this sort is generally not large; the gamble is in the price factor in relation to the product." The price mechanism attenuates this uncertainty, so there is, for example, as Knight pointed out, no uncertainty as to the prices of the things an entrepreneur buys. The link between the price mechanism in a market economy and the diffusion of knowledge in society was then developed further by Friedrich Hayek, in his 1945 essay "The Use of Knowledge in Society". Hayek described how the price system can act as a kind of machinery for registering change, or "a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement." The knowledge in society which Hayek was referring to is not quite scientific knowledge, in the sense of scientific theory. It is, nonetheless, useful, practical, problem-solving knowledge, which enables economically productive processes to take place. In Popperian terms, the price mechanism allows expectations of an uncertain future to be checked and corrected, through a trial and error process. It follows that distortions of the price mechanism adversely affect this knowledge-distribution process. Where monopoly power exists, and firms can set their own prices without regard to others in the market, or where there is no price mechanism at all, economically useful knowledge is not distributed properly through society. Competition law today prohibits firms from reducing uncertainty by illegitimate means, such as by co-ordinating their sales prices with one another, in cartels. There is a close conceptual link between an open market economy, where free competition allows the price mechanism to promote the efficient allocation of resources, and the open society, as espoused by Popper. In both economic and political terms, the future remains 'open': it is always subject to uncertainty, but, as in science, knowledge can grow, improvements can be made and problems solved in the light of trial and error. Capital assets The position becomes more complicated when we turn from productive processes in the economy to capital assets. Investment in new capital assets may allow more production to take place at some point in the future, but that future is more remote, and subject to even greater uncertainty. Capital assets are more difficult to price than products (goods and services), because they are bought and sold infrequently (if at all). There is no ready Hayekian 'system of telecommunications' to transmit price signals around the economy.