Roger E. A. Farmer is distinguished professor of economics at UCLA and currently Senior Houblon Norman Fellow at the Bank of England. This op-ed appreared in the Financial Times on July 18, 2013.
Ben Bernanke suggested in June that the pace of quantitative easing might slow by the end of the year. Global markets dropped by 4 percent in two days. It has taken several weeks — and carefully reassuring congressional testimony from the U.S. Federal Reserve chairman — to calm them.
Asset price movements of this kind are not unusual — but they are hard to explain with conventional economic theory. Sometimes they turn into financial tsunamis, like the 2008 crisis, which leave devastation and misery in their wake.
The 2008 meltdown led to calls for government intervention in financial markets. This idea is not new; it began with the inception of central banking more than 300 years ago, and was extended during the Depression. Following that crisis, financial regulations such as the U.S. Glass—Steagall Act were brought in to help insulate the economy from the worst effects of market volatility by separating retail and investment banking. In the 1990s, however, many of those regulations were dismantled in response to an idea promoted by Chicago School economists: the efficient markets hypothesis (EMH). According to this idea, unregulated financial markets promote economic efficiency and increase the welfare of all.
The EMH has two parts that are often confused. The first — “no free lunch” — argues that, without insider information, it is not possible to make excess profits by buying and selling stocks, bonds or derivatives. Backed up by extensive research, this is a pretty good characterization of the way the world works.
The second – “the price is right” – asserts that financial markets allocate capital efficiently, in the sense that there is no intervention by government that could improve the welfare of one person without making someone else worse off. In “The Inefficient Markets Hypothesis,” a recent paper, my co-authors and I show why that idea is false.
The effects of financial crises are long-lasting. Most of those affected were unborn when they occurred, or too young to make informed financial trades. This fact is sufficient to explain excess volatility and the human misery it causes.
However, because the Treasury has the power to tax and transfer wealth to future generations, it can make informed financial trades on their behalf. Those trades would, in turn, reduce excess volatility and help prevent crises. A UK sovereign wealth fund, as I argued in recent testimony to parliament, is one way to implement a policy of this kind.
To create such a fund, the Treasury could purchase shares in a stock market fund, which it would pay for by issuing government bonds. By standing ready to buy and sell shares in the fund, at a preannounced price, the Treasury would act to maintain financial stability in much the same way that the Bank of England has historically set short-term interest rates to control inflation.
The BoE has two mandates. The first is to “deliver price stability”; the second is to support government “growth and employment” objectives. It works to achieve those two objectives by using one tool: the interest rate on overnight loans. The ability to buy and sell a stock market fund, in exchange for government bonds, would give the bank a second tool to maintain financial stability and prevent the recurrence of systemic financial panics that are so damaging to economic growth.
In 1997, the BoE was granted political independence. The arguments that guided the creation of an independent Monetary Policy Committee apply to an even greater degree to any body that might operate a financial stabilisation policy. The new Financial Policy Committee is a natural body to take on this task. It is charged with “protecting and enhancing the resilience of the UK financial system.” To achieve this, it will need effective policy instruments. Just as the MPC sets interest rates to maintain price stability, so the FPC should be given the power to regulate share prices to maintain financial stability and promote growth.
The Great Recession originated in the financial markets: it is to the financial markets that we must turn for its solution.