When Can Decision Makers Learn from Financial Market Prices?

Abstract

I analyze a general setting where a policy maker needs information that financial market traders have in order to implement her optimal policy, and market prices can potentially reveal this information. Policy decisions, in turn, affect asset values, hence forward looking traders may have incentives to withhold information. I derive a necessary and sufficient condition for the existence of fully revealing equilibria in competitive financial markets, which identifies all situations where learning from prices for policy purposes works, and where it does not. Full revelation may be impossible because the pricing problem is a self-defeating prophecy. Using the result, I demonstrate that some corporate prediction markets are ill-designed and punish traders for revealing their information, and show how to fix it. I also discuss the possibility of using market information for banking supervision and central banking, and the general problem of asset design.