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Wednesday, June 6, 2018

Understanding Why Governments Cannot Use Stock Prices As A Policy Tool

Professor Roger E. Farmer proposed in his book Prosperity for All (link to my review) that  governments should set up a body to control equity prices as a means to smooth the economic cycle. In this article, I explain why a government could not hope to control the level of stock prices in a meaningful sense.

(This was a discussion that I deferred from my review. I expect to write a final article that explains why that even if the stock market could be controlled, it would not be useful for policy purposes.)

Of course, it might be possible for a government with a large sovereign wealth fund to influence the stock market. However, unless it could convince other investors that it was investing in fashion designed to provide strong returns, other investors would probably ignore the government's attempt to jawbone stock prices. If it wants to engage in economic stabilisation, there is no reason to follow the government's preferences.

No Analogies to Fixed Income


The difficulties with pegging stock prices does not apply to the government bond markets, although some commentators try to blur the distinctions between financial markets.

It is abundantly clear that central banks can pin down short-term risk free rates in their own currency -- assuming that there are no currency peg arrangements. (One can debate special cases, like the euro area -- which short rates?) Occasionally some monetary policy specialist gets greatly excited about 20 basis point gaps between market rates and a policy rate (for whatever technical reason), but no sensible person outside the money markets cares about 20 basis spreads in money market instruments.

Going further out, it is possible to pin down long-term bond yields, as was the case in the United States during and after World War II. (Link to short discussion here.) The reason why pegging government bond yields is feasible is that the government is a monopoly supplier of government bonds; so long as the central bank and Treasury coordinate policies, a price peg can be sustained. (Pinning down private sector yields runs into the same problems as equities, although governments could return to regulating private sector interest rates as well.)

The problem with pegging bond yields is that bonds have a non-zero duration, and so changes result in capital losses/gains (unlike money market instruments, which have a negligible duration). Changes to pegged bond yields instantly hands gains or losses to holders, which is going to cause political issues.

I will now run through the problems with pegging equity prices.

Stopping Equities From Rising is Very Difficult

There is very little the government (or arm of the government) can do to stop equity prices from being pushed up by determined investors (other than by fixing prices by law). The problem is that doing so would require very large short positions -- and it is necessary to borrow shares to go short. (I discuss derivatives in the next section.)

When someone buys a share in a company, someone has to deliver those shares. The only way for a short seller (who owns no shares) to sell is to borrow shares from another holder. The reason why a holder lends the shares is that they are effectively borrowing at an advantageous interest rate that is negotiated as part of the stock borrowing transaction. If they know that the parties that are borrowing desperately need to get their hands on shares, they can squeeze the borrowers by demanding exorbitant amounts to borrow.

A government agency that announced that it wanted to short the stock market in stupendous size is basically putting a giant "Kick Me!" sign on its own back; it would be squeezed unmercifully.

Furthermore, the failure of the policy is self-fulfilling. The financial sector would be reaping windfall profits at the hands of the government agency that is being squeezed -- raising the fair value of equities.

What About Cash-Settled Derivatives?

One might think that the government could get around this with cash-settled derivatives, like futures. (In a cash-settled derivative, the payoff is based on the level of the stock index, and there is no need to borrow shares. This is in distinction to physical delivery, where longs have to deliver the underlying commodity or financial asset to shorts at expiry.)

The use of derivatives will not solve the squeeze problem. If the government agency tried locking down the futures price (which would be contrary to existing rules), all that would happen is that the cash index price would diverge from the futures price. Arbitrageurs might sell cash equities short against futures, but they have limited balance sheet capacity, and need to avoid being squeezed. Even if the futures price is locked down, the government would get creamed on the contract expiry, as it would have to pay out based on the cash index price.

Stopping the Index from Going Down More Plausible, But Poses Other Issues

It would be easier for the government to keep stock prices above some floor level. There is no need to borrow shares, and it can always pay for it. In practice, it would issue bills to counter-balance the equity purchases.

The problem is that once the government puts a floor in place, the tendency will be for stock prices to drift above that floor -- the government has your back! The floor strategy is literally "the put" that bears have been accusing the Fed of providing, and stock market prices would generally be above the strike of that put. The only way prices will bump into the floor level is if fair value is way below it, and investors want to get out.

The problem for the government is that it is a sitting duck for Wall Street and other stock market operators if its holdings get too large. The managers of the equity fund are unlikely to be given too much discretion in stock picking, as they would effectively become central planners for the entire private sector. As a result, they would have to hug some benchmark weights for holdings. However, if the government's minimum holding in a firm is 20%, and a cartel of "hodlers" controls 90% of the firm, they can literally set whatever price they want for their shares.

Of course, if the government pays too much for equities, it could end up with negative returns once the bill financing cost is taken into account. Although the government does not have the same bankruptcy concerns as a private sector entity, the loss represents a transfer of resources to the sellers of equities. Since equity holders are mostly at the top of the income and wealth distribution, this is a regressive policy.

Concluding Remarks

Although the government could conceivably prop up the stock market, it certainly does not have the ability to fine tune its trajectory in the same way as the overnight rate. Furthermore, the policy would create distortions as the private sector learned to game the system.

 (c) Brian Romanchuk 2018

7 comments:

  1. It makes you wonder whether, like "open mouth operations" was supposed to move debt markets, that a public announcement by the government that it was going to buy or sell would have the desired effect without nary the expenditure of a shilling or a dime.

    Henry Rech

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    1. Problem is that the idea is that the government is to move stock prices counter-cyclically, which means that listening to them is a money loser. This is not the case for bonds, where policy is aligned with investor returns.

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    2. I can't see the difference.

      If the market believes that the government can move markets, the market will take heed.

      If you take your point, then you have to argue that just about no amount of government selling or buying will turn a market. Then the discussion is completely moot.

      Henry.

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    3. If someone is a stock guru, and says that the market is over-valued/cheap, people might believe them because the believe that they will get better returns. If the government says that it inconvenient for policy for stocks to go up - which us what Farmer wants - why do I care? All I care about are my returns.

      As for buying/selling, they could credibly buy, but they have limited capacity to short sell. If they had huge holdings most of the time, they would have greater capacity to sell without getting squeezed. The problem is - how can they get those holdings without driving the price to the moon?

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  2. I think the government could effectively control equity prices if it allowed itself the right tools.

    For example, if the government wanted to stop equity prices rising above X, then imposing a 50% per annum wealth tax on the value over X on all holdings would probably do it. A 100% tax definitely would. However, simply the threat of such a tax might be enough.

    I'm not sure how that fits with Farmer's idea though.

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    Replies
    1. I suspect using tax policy to attempt to put a ceiling on stock market capitalization would have similar problems to the proposals for Land Value Taxes. First, taxes are usually paid on liquid events such as capital gain upon sale of the asset; if the value is to be taxed there will never be enough liquidity in the whole system for each individual to actually pay the tax. Second, if everyone knows the capitalization limit there will be no liquidity available at that limit. Why buy stock at the limit price when it can only go down from there? Perhaps dividend policy would evolve to compensate. I think the Alternative Minimum Tax (AMT) raises problems for some share owners who fail to anticipate the tax bill in a situation where a cash sale does not provide the funds to pay the capital gains tax, but I am not aware of the details.

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