http://mainlymacro.blogspot.in/2015/03/the-power-of-financial-markets.html
Thursday, 12 March 2015
The power of financial markets
You might imagine that the global financial crisis had reduced
the power and influence of finance and those involved in financial markets.
After all, the excesses shown by participants in those markets had caused the
largest recession since WWII. (Not to mention a constant stream of cases of
illegality and mis-selling.) However I wondered yesterday if the opposite might
be true.
This was during a debate
at the Houses of Parliament, in which Jonathan Portes and I were debating
austerity with Roger Bootle and Doug McWilliams. A constant refrain from our
opponents was that (a) the stock of government debt was very large, (b) you
needed the confidence of markets to be able to maintain this level of debt, (c)
markets were fragile beasts, so best take no chances, and (d) therefore we
needed austerity to reassure those markets.
I immediately thought of one of my better posts, where I suggest too many people view
markets like a vengeful god, and those that are ‘close to the markets’ like
high priests. (I couldn’t quite believe it when a member of the audience asked
our opponents about whether they thought some proposal would ‘pass muster with
the markets’.) Now Roger, who is a sensible guy, did agree that default was not
really an issue for the UK, but the danger was rather inflation, if the deficit
or debt became ‘too large’ and markets refused to fund it, so it had to be
monetised. If it seems odd to you that the markets would start worrying about
the monetisation of debt because a large recession increased deficits, but be
quite unconcerned today about the central bank creating money to buy huge quantities
of government debt as part of Quantitative Easing, then your mistake is to
think that the markets are always rational. If they are both fragile and
febrile, as our opponents and others
close to the markets often suggest, it could happen.
Before the financial crisis, it was in the interests of those
involved with financial markets to emphasise how rational they were. No need
for regulation - these are clever people who knew what they are doing. The
crisis blew that argument apart, but instead it created the idea that the
markets could be dangerously irrational: irrationally exuberant at one point,
and irrationally risk averse the next. It also showed how dependent on these
markets the economy had become. Hence the idea of a vengeful god that could
suddenly turn on you for no good reason and who therefore had to be appeased at
every turn.
This kind of argument has a strong emotional appeal,
particularly when the financial crisis is fresh in peoples’ minds. I suspect
that attempts to show that markets are actually pretty rational most of the
time will not work. Instead I’m afraid we have to focus on the high priests. A
truly irrational market could do anything. The problem comes when the high
priests declare that, by being close to the markets, they can discern some
logic to its tantrums. And by a divine coincidence, this logic just happens to fit macro view of the world that the high
priests hold.
For example, we are told that markets worry about large
deficits and require austerity immediately. Never mind that there is no sign of
worry, and that interest rates are falling: markets are fragile and febrile and
could turn at any moment. The high priests, being close to the markets,
understand that. Strangely the high priests never detect any concern that a
persistent recession brought about by austerity might - through hysteresis
effects - permanently damage productive potential, with potentially greater
impacts on the tax base and long term solvency. I guess the high priests
markets had not read that paper.
We are told that Osborne needed to give a clear demonstration
to the markets that he had the political will to bring the deficit under
control, which is why deficit reduction had to be front loaded. It does not
seemed to have occurred to the high priests markets that, given his
desire to reduce the size of the state and win the next election, front loading
austerity is exactly what he wanted to do, even if he had no particular concern
about the deficit. To show a clear conviction to give top priority to reducing
the deficit required him to do something that was politically costly, like
raising inheritance tax.
And do not forget that Ireland and Portugal were constantly
told by those close to the markets that they needed to embark on acute
austerity to ‘regain the trust of the markets’, when in fact what the markets
were looking for all the time was for the ECB to act as a lender of last
resort. I could see
that from my academic ivory tower, but most of those ‘close to the markets’
did not.
