Let the Market Work

Friday, April 6, 2012

Financial markets are in a precarious place, with European banks and sovereign balance sheets in the crosshairs. Bank regulators are increasingly aggressive, and eurozone borrowing costs are rising as the debts of years past come due.

Policy makers are seeing their authority, credibility, and firepower tested. In turn, they are tempted to pursue “financial repression”—suppressing market prices they don’t like. But this is bad policy, not least because it signals diminished faith in the market economy itself.

Markets are not always efficient, but the market-clearing prices for stocks, bonds, currencies, and other assets (like housing) are critical to informing judgments, in good times and bad. Market-determined asset prices often reveal inconvenient truths. But the sooner the truth is revealed, the sooner judgment can be rendered and action taken.

By contrast, government-induced prices send false signals to users and providers of capital. This upsets economic activity and harms market functioning. Markets that rely on governmental participation will turn out to be less enduring indicators of value.

In environments of financial repression, businesses are keener to retrench than recommit their time, energy, and capital to new projects. Trillions of dollars in private capital remain on the sidelines. And the private-sector engine that drives prosperity sputters.

Consider a few recent examples of this policy in practice.

In Europe, share prices are falling among the largest banks, but these prices are little more than a symptom. European banks suffer from a lack of capital to offset future losses and a lack of transparency that makes it futile to try to judge their financial wherewithal. The bank problem is not some unfounded attack by greedy speculators, so a leading proffered solution—extending the ban on short-selling shares in big banks—obfuscates rather than informs. It also delays the necessary private-sector recapitalization.

Turning to another case, when firms buy insurance to reduce risks in their portfolio, the insurance has to be worth the bargain or else hedging becomes unreliable and risks are exacerbated. That’s what happened with the negotiated settlement in the Greek market for credit-default swaps, when negotiators “voluntarily” agreed on principal reductions. Such policies give rise to default by another name. Counterparties aren’t fooled. Neither should policy makers be. Firms’ exposures to their counterparties require more transparency and better tools for risk reduction.

Then there are the ratings agencies. They have been rightfully criticized for assigning higher ratings to various financial products than were justified by their fundamentals, yet now we see a dangerous irony: governments trying to persuade ratings agencies to assign higher ratings to sovereigns than deserved or justified by market prices. Blaming the ratings agencies for the dysfunction in funding markets will not lower funding costs. After all, the largest global economies do not have debt-rating problems. They have debt problems.

Markets that rely on governmental participation turn out to be less enduring indicators of value.

Financial repression is sometimes the effect of policy even if it is not the intent. It manifests itself, for example, when policy makers react more forcefully to declines in asset prices than to increases. Price increases tend to be treated with benign indifference. But declines often lead policy makers to respond with force, deploying fiscal stimulus and monetary accommodation. Market participants then conclude that governments have their backs.

The fiscal trajectory of the United States is a good example of market distortion. However well-intentioned, the Federal Reserve’s continued purchase of long-term Treasury securities risks camouflaging the country’s true cost of capital. Private investors are crowded out of the market when the Fed shows up as a large, powerful bidder. As a result, the administration and Congress make tax and spending decisions—with huge implications for our standard of living—with heightened risks around future funding costs.

Sinking asset prices often lead policy makers to jump in with remedies. Market participants then conclude that governments have their backs.

As measured against the administration’s budget, every percentage-point increase in interest rates above the current baseline would translate into an additional $1 trillion of debt service over ten years. And with financial repression in play, we risk missing early warning signs from markets that our debt burden is intolerable.

Trying to manage and manipulate asset prices is not new. But history provides little comfort that such practices work. Interfering with market prices occasionally buys time, but rarely do policy makers take advantage of the window of opportunity to enact structural reform. Financial repression embeds the wrong incentives—obfuscation begets delay, and a robust recovery becomes unattainable.

The path to prosperity requires the long road. It requires policy reforms that make the economy less reliant on the preferences of government and more responsive to the market. That means favoring long-term growth over fleeting market stability, and giving precedence to structural reforms over temporary stimulus and market manipulation. Financial repression is a tactic that may help us through the week or month or year. But it will come at a substantial cost to our long-term prosperity.