Tuesday, January 22, 2008

Social stability index

I've been toying with the possibility of having a social stability index, and how it could impact economics. Let me explain.

The market -- stock/ commodities/ futures etc -- is essentially a mechanism for price discovery that relies on the wisdom of the traders to find the right price: the right price for wheat, for oil, for Google's share price, etc. The philosophy is that given access to complete information, the traders will rationally compute these prices. The prices then actually pave the path to progress, that is Indian wheat better than wheat from Kazakhasthan, or is Google better than Yahoo, etc. This is how I understand it.

Now, there are a couple of problems in accurate price discovery. This fact cannot be argued against because of overwhelming evidence. The sudden food price inflation is a supreme example -- had the price rise been gradual, it would have been much easier for the poor to cope with it. Human induced climate change is another example -- had the markets listened to the arguments of scientists 50 years ago, they could have induced heavier investments in research for renewable energy or carbon efficient car design etc. The problem I am trying to identify is the robustness of the path discovered by the markets. Evidence such as the sudden food price inflation and climate change show that the path computed by the markets is not robust.

So, why does this happen? My thinking is that robustness is not taken into account by the traders in the market. They should because if they do then they will not make such big mistakes. But maybe they are computationally starved to take such complex environmental and social stability factors into account. So, how can that be changed?

This is where the idea of a social stability index comes up. If we can devise an index using market mechanisms that is somewhat predictive of the social stability of society, then we can make it easier for stock / commodity / futures traders to take this information into account. The CPI (Consumer Price Inflation) index is one such example -- a high CPI signifies social instability, and an unstable society is never good for economics. So, suppose we allow traders to speculate on the CPI, and assuming that these speculators will be smart enough to predict CPI accurately, then their activities will have an effect on the market traders to invest more appropriately.

I think other indexes can also be designed by looking into research in sociology of societies and civilizations. Jared Diamond's book, Guns Germs and Steel, is a good example of an effort in this direction. He wants to look at societal progress in isolated cultures as experiments that tell us something about human behavior and progress on a macro scale of civilizations. Cues from research such as his could be used to design indexes that could be predictive of social stability, I think, and utilizing the wisdom of the crowds through market mechanisms to predict this index for different cities, states, countries, and the world in general, could serve as a source of guiding information for other traders that define economic investments on how the humans move forward as a society.

Any thoughts on this would be most appreciated.