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The Fundamental Theorem of Economics

April 16th, 2002, 2:04 pm

All other things being held equal, an asset will tend to increase in value if moved back in time - meaning if its delivery date is delayed - as people reconfigure economic activities to capitalize on the known existence of, and access to, the asset. This may sound dumb, but it is the thing I have been looking for from which all other properties of liquid markets can be derived. It is the missing piece in the puzzle of participant evolution.To understand why this is so, consider a river. Suppose, on some day in history, it suddenly appears out of nowhere, flowing at 100 cfs. Meaning, it instantaneously jumps from 0 to 100 cfs, and then continues flowing at 100 cfs indefinitely. One day 1, there will be no plants, and the entire 100 cfs will be wasted. On day 365, there will begin to be some plants that have come to rely on the water so, in effect, the price will have gone up. In other words, if we could relocate 50 cfs from the first day to be delivered on the 365th day, there would be more plants, and so it would command a higher price.In every transaction, we know there is a thing called the "economic surplus." Meaning, if an apple is sold for a dollar, generally the buyer "would have been willing" to pay as much as a $1.10, and the seller would have been willing to sell as low as 90 cents, meaning a surplus of 20 cents. According to the fundamental theorem of economics, this surplus should tend to expand over time, though at a declining rate. Notice it doesn't matter if you are a buyer or seller. If you are short and delay your purchase, the price the seller is willing to sell for should tend to go down.This theory is important because it explains two things which have puzzled me. The first is the irrepressible tendency of economic actors to evolve towards delay in locking in hedges, and therefore in transmitting their needs and haves such that others could evolve to meet them. The second is the irrepressible tendency of hedge funds and other types of speculative activities to make money, despite the utterly preposterous myths the managers come up with to explain what they think they are doing. (There are also some interesting concepts involving volume changes, diminishing marginal returns, redundant reactions, and geographic friction...)I learned many years back that, in a bull market, you needed only to enter a trade - long or short it didn't matter - and then put out a limit order at a price that would show you a profit. In a bull market, more often than not, that order will get filled, and you will make a profit, simply by waiting! But I didn't fully grasp why this is so until today, especially why it worked equally well long or short! In truth, it is easy to get distracted by the big picture, and fail to recognize that it is composed of a discrete web of tiny transactions, where every transaction, even if in a loop, falls somewhere along a line across which line the fundamental theorem of economics holds true.Perhaps it will be useful to explain why this problem has been troubling me. I have spent the last several years of my life brainstorming information-exchange and coordination mechanisms by which we could all become a trillion dollars richer. Ways, in effect, for the river to alert the plants that it may only be flowing at 50 cfs today, but they can count on 150 cfs a year out. But two things had me paranoid:1) If people always locked in hedges as soon as their needs became known, there would be no need for my technology. Meaning suppose I think there is 20% chance I'll be going to Paris next Spring, and a 10% chance I'll be going to Mexico. If I started buying .2 ticket-to-Paris futures, and .1 ticket-to-Mexico futures right now - and dynamically adjusted my position as new information about my own needs became known - information would be passed from one end of the supply chain to the other perfectly, and all activities would be coordinated.2) People who did lock in these hedges, and thereby transmitted full-distance demand information in time for counterparties to re-orient manufacturing activities to meet their needs, would have a survival advantage. They would get more of what they wanted. They would displace people who postponed, or who kept their needs hidden. The fact that this didn't happen, and there was therefore a need for my information-exchange paradigm, seemed suspect. I could not coherently articulate what the countervaling evolutionary force was, causing them to postpone hedging at the equilibrium level of transmission.Thing is, I recognized the countervailing force as early as 1998. It occurred to me that, as the world got richer, certain measurements had to rise, such as people's bank accounts. And it occurred to me that while the total wealth must rise irrepressibly, it is possible for people to prevent their own present value from fluctuating through the sophisticated use of hedges. And so it made sense that, if everybody hedged but one person, it wouldn't make one whit of difference if that once person rolled some dice and went long or short. The wealth would have to find a place to expand, and his account would be the only place with the necessary flexibility.And so, in 1998, I came up with the theory that the only necessary ingredient to make money in a hedge fund was simply to expose your account to volatility - to allow it to fluctuate randomly - and the increasing wealth of the world would have to find its way into your account, for lack of anywhere else to go! Meaning, it is a spontaneously-evolving tendency of economic participants to expose themselves to volatility, by postponing locking in a price - and therefore to postpone transmitting their demand which could better coordinate the irrepressible progression of growth. The more you hedge, the more efficient the growth, but the less you benefit from it. And so the natural solution to geometrically expand economic growth, as I have been saying all along, is to innovate ways for people to transmit need and have data, but without locking in a price. The idea is to, as far in advance as possible, be able to say I will have 150 cfs of water available. And then see how many plants grow to meet it, before you lock in a price. That way the money doesn't go to the speculators who buy a call from you, sell a put, and then end up with the people who wrote the put buying at double the strike price on the call. But nor does it discourage the end users from transmitting that they even have supplies and demands which others should gear up to lean on.A hedge has a fundamental asymmetry, to the extent it does not lend itself to growth in operations. If you today obligate yourself to buy 1 at 25, and you find yourself able to buy 2 for 60, you risk only that your counterparty will find himself able to sell 3 for 3. But if you obligate yourself to buy 2 for 60, and you find you are only able to buy 1 at 25, you are downright screwed. So hedges cannot properly accommodate growth and change. People need a better way to coordinate this volatile quantity known as growth, through transmission of visibility using a variety of novel exchange mechanisms. Okay, what did I leave out?MP