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Thursday, July 09, 2015

Government managing the outcome of a financial market

Government and non-financial products

Suppose a government is unhappy at the price or quality of wrist watches that are being made in the private sector. Should the government indulge in muscular interventions into the free market's outcome?

The standard thinking of public economics runs in three steps: (1) What's the market failure? (2) What's the proposed intervention; does it attack the market failure at the lowest possible cost and (3) Do we have the State capacity to pull off this intervention?

Suppose you wanted to diverge from the orthodoxy. Parliament can write a law which uses coercive power to meddle in the wrist watch industry. This is called "industrial policy". It can decide that quartz movements are a better technology, and ban mechanical watches. It can put people in jail if watches are traded at a price that is different from the price specified with the government. What is wrong with undertaking such interventions?

The problems with such interventions run at three levels. First, the free market works pretty well, and even well meaning politicians and officials have little value to add (other than addressing market failures). Second, politicians and officials may not be well meaning uncles, they are regular guys and chase their own selfish objectives. Third, even if the right objectives are established, implementation is very hard; scarce resources (money and time of top management) will be used up in doing extraneous things which comes at the cost of those resources being applied to the core business of government, i.e. addressing market failures.

If a government insisted on running Hindustan Machine Tools, to make wrist watches, the outcomes are not horrible on a large scale. The outcomes go wrong at a narrow scale. When I look back at this episode, the original sin was barriers to foreign providers. If only HMT had been forced to compete with foreigners making wrist watches, it would have rapidly died, and the problem would have gone away. The twin evils of autarky + public sector production gave a shortage of good quality wrist watches in the country.

In the olden days, many countries tried to have State-run airlines or export-import banks, but such heterodox thinking hasn't stood the test of time. `Industrial policy' was once accepted as the job of government, but today it's generally seen as feeble thinking.

Government and the working of financial markets

All the above arguments apply in the field of finance.

The job of the government is to address market failures. Attempts at doing things that go beyond addressing market failures are a bad idea for the same four reasons as those described above. But diverging from the orthodoxy is  more damaging in finance than it is in non-financial areas.

The public administration problem. When a government tries to shape the outcome of a financial market, problems of malfeasance are amplified as politicians and officials will also do insider trading.  It is hard to create clean administrative structures for a public agency that's trading on markets or (in any way) trying to manage the market price.

As an example, the clean UK solution is that the Monetary Policy Committee votes on everything that the Bank of England does : on the short term money market, the Bank of England will do infinitely large trades to control the short term interest rate, and that target rate is voted on by the MPC, and when the zero interest rate lower bound was reached, the MPC votes on the magnitude of quantitative easing that is to be done in each month. EMs and developing countries have experienced all kinds of problems when trading rooms in the government have tried to do trading in financial markets without sound institutional arrangements. These problems never arose when the government tried to meddle in the market for wrist watches.

The Lucas critique. The next hurdle to cross is the Lucas critique. All participants in the market are rational and react to the actions of the government.

A government says that stock prices won't be allowed to go down? This changes the behaviour of investors who think it's a one way bet and pile on massively. When INR was a "managed appreciation" with small predictable appreciations week after week, this kicked off a surge of capital coming into the country. Risk taking is higher when there is "the Greenspan put".

A government says that exchange rate volatility will be kept down? This changes the behaviour of private participants who feel safe and don't hedge currency exposure. News breaks; INR should have depreciated; government props it up; capital flight by locals and non-residents benefits from a red carpet in the form of a more attractive exchange rate.

The essence of financial markets is risk taking. Everyone in the market should have a keen sense that there is no free lunch. Long term investors should be those who are comfortable dealing with ups and downs. Speculators should know that skill in forecasting will make giant profits, but there is no safety net when they make mistakes.

It takes years to create credibility in the eyes of market participants (a) That the government will keep out and (b) That the market will work properly. Each time these promises are violated, trust is lost and we start all over again.

E.g. Dr. Subbarao did a great job of getting people used to the idea that the rupee is a market and that the RBI does not have an exchange rate target. We didn't think of Uncle Subbarao when we thought about the exchange rate. RBI is now back in action doing currency policy. Now all kinds of private players are back to their old ways: trying to hack into the government processes through which exchange rate targets are determined on a day to day basis, trying to make profits from the daily market activities, leaving currency exposure unhedged, etc.

As the Indian government rediscovered in 2013, and as the Chinese government is rediscovering today, government management of financial market outcomes will always fail. These episodes generate a big mess for the economy. They give the government a bloodied nose.

In the case of the equity market, in the 1990s, when there were sharp declines in the stock price, government would try to get involved by encouraging LIC and UTI to buy shares. Market development took place, the market got more liquid, and these levers became increasingly feeble. To the credit of the government, the understanding took root that MOF or SEBI are not responsible for the level of stock prices or stock price volatility. MOF and SEBI are responsible for addressing market failures, which in this case means micro-prudential regulation of clearinghouses and their members, and enforcement against market manipulation. This new environment has been in place for a long time and the expectations of market participants have been largely reshaped. Nobody in India thinks that an Uncle Xi will determine the stock price.

In terms of scandals, we had the last big scandal in 2000, which is now 15 years ago. With 15 years of boring functioning, market participants are increasingly gaining trust that the equity market just works.

When end-users and financial firms are steeped in this environment, organisational capital starts developing in financial intermediaries, which is what gives depth of market efficiency and market liquidity. That process has been in place for 15 years in India.

In China's case, they would start from scratch in (say) 2016 after the present mess is sorted out.

In India's case, comparable intellectual quality was not found on the Bond-Currency-Derivatives Nexus and we are still in the dark ages.

1 comment:

  1. Savings glut is one possible reason for government intervention. Do you think savings glut is a form of market failure?


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