On Thursday Hal Varian had some suggestions on ways to use markets to improve politics. He cites a paper by Robin Hanson, an economist at George Mason.
Once you get the idea, the possibilities are endless. Suppose a company is trying to choose between ad agencies. The board can simply create an option that pays off in shares conditional on which one is chosen, along with the appropriate money options.
Given the increased liability corporate board members are facing, they should welcome ways to make sure their decisions are better aligned with shareholder views. Buying and selling shares is a lot easier than calling a proxy vote.
Mr. Hanson wants to go further and extend the idea to the political domain. Government agencies could define a measure of performance and let markets determine their actions.
Take central banks. Most economists think central banks should care about both the unemployment rate and the inflation rate. Market expectations about inflation can be estimated from existing financial securities, but what about unemployment?
Suppose the Fed creates a security that can be exchanged, at some specific time in the future, for the unemployment rate times $100. If the unemployment rate in December 2003 is 5 percent, then the “unemployment futures contract” would be worth $5.
Now the Fed could issue options on this security. One option would deliver one contract if the Fed sets a short-term rate of 2 percent, another delivers one contract if the Fed sets a short-term rate of 3 percent, along with the appropriate money options that pay off depending on the decision.
All the board of governors now has to do is to see how the market values these two options and carry out whichever action the market recommends. Maybe Alan Greenspan isn’t so irreplaceable after all.
Mr. Hanson speculates that one might even make explicitly political decisions — like setting the tax rate on dividends — by using such a mechanism. Economists would no doubt be active participants in such markets.
This is a great tool to enable government to shift to thinking about performance and less about relying on measuring inputs. Technology, of course, has contributed to reducing the transaction costs that have up until now made such ideas pie-in-the-sky ivory tower fun over beers after work. But think about the potential of so many things that we had thought impossible even five years ago …