Be you ever so high, the markets are always above you

by Ajay Shah.

Purposive state action is fraught with error. Human and social systems are poorly understood and contain nonlinearities, so there is a law of unintended consequences. Grand schemes go wrong. What works well is a humble approach, of crossing the river by feeling the stones, in an environment of expertise. There are two rings of containment of power, that help address a regime which diverges from this approach.

Two rings of check-and-balance

The first ring of containment of power is the checks and balances of the political system. Liberal democracies work by dispersing power, by using ambition to counteract ambition. This curtails mistakes.

In some situations, these things break down. Power becomes concentrated, which induces mistakes. The second ring of containment is the financial markets.

1. When Liz Truss was Prime Minister in the UK, the markets pushed back. The 30-year yield went from 3.6% to 5.1%. The GBP dropped 7.6%. The FTSE fell 7%. Ultimately, this led to her being ousted in 44 days.
   
   
2. When Tony Blair and the labour party won the elections on 2 May 1997, the financial markets expressed skepticism. When a new government is greeted with a higher interest rate, this immediately curtails spending power. This pushed the new government to go through with a group of responsible decisions. On 6 May 1997 (i.e. 4 days after winning), they announced independence for the Bank of England coupled with the creation of an independent Debt Management Office so as to unburden monetary policy from the debt management conflict of interest. On 2 July, in the budget speech, they were cautious in their spending commitments. All these actions were crafted because the second ring of containment impinged upon the political leadership.
   
   
3. Vijay Kelkar has long argued that the stock market crash of 17 May 2004 helped encourage Sonia Gandhi to choose the team of Manmohan Singh, P. Chidambaram and Montek Ahluwalia as the UPA economic policy leadership, which delivered the economic successes of 2004-2011.
   
   
4. James Carville worked for Bill Clinton. A rough analogy into Indian politics would be Amar Singh. He once said: "I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a 400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody." This awareness tempered and shaped the early actions of the Clinton presidency, which worked out as a successful period for the American economy. 
   
   
5. It is starting to work out similarly with the Trump Tariffs. The wheels of global general equilibrium started turning on 2 April, with forward looking forecasts embedded in financial market prices. Financial players everywhere asked: How well will the US economy work? Is the US the safe haven, with sound institutions, that we thought it was?
   
   The 10 year US Treasury went up from 3.9% to 4.5%. The 30 year bond briefly went up to 5%. The S&P 500 dropped 12.1%. Safe haven seekers turned to Germany, and yields on government bonds there fell. Larry Summers said on 9 April:  "We are being treated by global financial markets like a problematic emerging market".
   
   In my column in the Business Standard of 3 March, I had said that in the US, the first ring of containment has broken down --
   

   The US is in a constitutional crisis, with a failure of checks and balances, with the inability of the judiciary, the legislature, the electoral system, the agencies, the special counsel and the press to rein in a strongman.

   and that the second ring of containment would have to do its work --
   

   Market discipline will then impinge upon Trump and the MAGA world, and we hope, atleast partly kick them into shape. Be you ever so high, the markets are always above you.

Market discipline is not perfect. In the field of sovereign risk, we know well that the market tolerates a lot of fiscal misbehaviour for a long time, and then abruptly pulls access. Similarly, I have argued that the Indian equity market fares poorly on macro forecasting while it does well on micro-forecasting. The wrath of the market involves caprice. The key point here is that markets do speak truth to power, over and beyond the checks and balances of the political system.

A development perspective

The yearning for raw power is there in many people. On 9 April 2025, Donald Trump described his decision process: "Instinctively, more than anything else. I mean, you almost can’t take a pencil to paper. It’s really more of an instinct, I think, than anything else".  Montagu Norman, Governor of the Bank of England said in 1930: "I don't have reasons, I have instincts". For a country to have a high level of per capita GDP, this primeval yearning for power needs to be contained.

The first ring of containment is the checks and balances in the political system (e.g. converting the Bank of England into an inflation targeting central bank with dispersed power in the Monetary Policy Committee). A good financial system constitutes the second ring of containment that checks such impulses, that induces better decisions by the political masters.

From an Indian perspective, checks and balances are the essence of the growth journey. The first ring of containment is relatively well accepted (Kelkar & Shah 2022). More attention is required upon the second: a financial markets system that would induce checks and balances, that would matter enough to reduce the incidence of mistakes in public policy.

Consider government borrowing. When government borrowing takes place as a set of acts between consenting adults, where voluntary lenders negotiate a price on the bond market, this creates the checks and balances in the episodes narrated above. In India, about 95% of government borrowing is mobilised coercively (Chitgupi et. al., 2024), which limits the role that the financial markets play in reshaping the incentives of the state. 

Consider the exchange rate. The checks and balances in the episodes narrated above involved a starring role for the exchange rate. When poor countries run a government controlled exchange rate, this channel of influence is limited [EiE Ep67 Floating exchange rate], which sustains poverty.

In India, a disproportionate burden of adjustment falls upon the equity market as other markets adjust less.

In today's mainstream thinking, financial development is seen as integral to the journey of economic development through its allocative function.  `Finance is the brain of the economy', `Wall Street tells Main Street what to do'. The financial system should occupy `the commanding heights of the economy' and make all the detailed allocative decisions about firms, technologies or industries which receive investment [EiE Ep21 The beauty of finance]. A good financial system performs the allocative function better than `industrial policy' can [EiE Ep89 Industrial policy]. 

But finance plays another important function as well: that of reshaping the checks and balances of the state, or being the second ring of containment for power. The second ring of containment matters most when the first ring of containment -- checks and balances of the political system -- falters. These two lines of reasoning encourage us to place financial sector development at the centre of the growth journey [EiE Ep57 How to do development].

There was a time in India when we were making progress in building a financial system. This has faltered (Shah 2023;  EiE Ep71 The Journey of Finance). We need to get back to the knowledge building and community building that began in the early 1990s in this field.