Sunday, September 21, 2014

Financial Policy

John Cochrane supports the case (forcefully made by Anat Admati) for higher capital requirements, citing excellent pieces by Pat Regnier at Time and Peter Coy at Business Week who explain exactly what this does and does not,  mean. I agree: we need banks to hold more capital.  But is that enough?

The following passages are extracts from my recent paper in the Manchester School on the role of the Financial Policy Committee as a guardian of financial stability.  I make the case that financial markets are inefficient because we cannot trade in markets that open before we are born. That fact is an important source of market incompleteness that I call the "absence of prenatal financial markets".
We all agree that financial crises occur. We disagree as to their cause. Some economists argue that markets are not only informationally efficient; they are also Pareto efficient. The boom and the bust are a consequence of the natural flow of knowledge acquisition in a capitalist economy. They are the price of progress. I disagree.

The distinction between informational efficiency and Pareto efficiency is often overlooked. I am quite ready to concede that financial markets are informationally efficient. It is hard to make a living trading stocks and most people don't do a very good job of it. But that does NOT mean that financial markets allocate capital efficiently to competing ends.
If booms and busts were the consequence of waves of innovation, we would expect to see large fluctuations in the earnings of companies. A wave of innovation would generate a wave of profits. But we would also expect to see those earnings capitalized into the market price of companies. The price earnings ratio of the market as a whole should remain approximately constant. That is not what we see and the Price Earnings ratio, in data, has swung between a low of 5 in 1919 and a high of 44 in 1998. 
Large fluctuations in price to earning (PE) ratios are prima fascia evidence that financial markets are inefficient. Those inefficiencies arise as a direct consequence of the absence of prenatal financial markets and they have huge consequences for human welfare. We need not and should not accept unemployment rates of 8% as normal. We can, and should, act to prevent the consequences of financial crashes before they occur.
Like Anat Admati, I support higher capital requirements for institutions that gamble with taxpayer money.  Like Miles Kimball, I do not think that will be enough. One solution that Miles and I have advocated is a Sovereign Wealth Fund that would actively trade a stock market index fund with the goal of stabilizing PE ratios.


  1. Would the sovereign wealth fund short the market at high P/Es or just sell off the shares purchased at market lows?

  2. It would short when high and buy when low. The government is big enough to do this and, by riding the equity premium, it would make money in the process.


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