Saturday, April 18, 2009

The Path of Prices

What drives individual economic behavior? While there are many inputs, prices are the primary markers on the path of individual economic decision-making. The sum of such individual behavior is the emergent phenomenon we call the economy.

The economy is not something that happens to people, like an earthquake or a storm. It is something that emerges from people, as they react to the prices around them.

The quality of an economy is ultimately traced back to the quality of its prices. Bad prices equal bad decisions equal a bad economy. Reliable prices equal reliable decisions equal a reliable economy.

Much of the mess we see in the world today is the result of bad prices, or more accurately, prices that are distorted. The price of a loan, for example, became extraordinarily low after September 11, 2001 when the US central bank cut its interest rates. Businesses and individuals rushed to lever up their balance sheets, to buy more stuff with borrowed money. That sent the signal to business that people wanted to buy more stuff, so business had to produce more. That meant more jobs, more plant and equipment, more distribution, more marketing, more advertising, etc.

In other words, distorted prices lead everyone down the wrong path. Distorted prices led consumers to make bad consumer decisions and businesses to make bad business decisions. The economy is not in trouble because of careless lenders, careless borrowers, or greed. It's in trouble because individuals acted in good faith and used bad prices.

This is not to argue that prices are an infallible guide to behavior. They're not. They flicker and fluctuate with frustrating frequency in even healthiest economy. Prices reflect the variable and uncertain nature of our existence. Indeed, in a world where so many things change so quickly, the price system is the only way we can convert a uselessly complex network of interactions into bits of actually useful information.

Like the economy itself, prices are an emergent phenomenon. We get into trouble when we try to set prices rather than relying on the prices that emerge from the peaceful, mutually beneficial behavior of individuals.

1 comment:

Ben Asa Rast said...
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