The (dubious?) wisdom of financial markets

Euro

These days Italy and several other European countries are embarking upon very ambitious programs of reforming both their domestic economies as well as the way they interact with each other within the Euro area.

Many of these reforms are desirable and long overdue. Interestingly, however, many of these reforms are not being motivated by policymakers as necessary to the long-term success of these countries as much as they are linked to the need to appease financial markets. Just today, Mario Monti, the skilled and highly reputable academic appointed to navigate Italy through these troubled times, explained his latest packet of economic reforms by invoking the need to appease the markets, in particular by labeling them “bestie feroci da domare” (i.e., wild animals to tame).

From my perspective as a financial economist doing research on financial crises, I find this argument curious. Much existing research on financial crises (including my own, so please feel free to shoot the messenger) shows that the quality of financial markets deteriorates considerably in proximity of financial crises, i.e., during the times when politicians, policymakers and the broad citizenry pay the most attention to the markets’ behavior.

In other words, financial markets work at their worst (and the signals they deliver are the least accurate) exactly when we collectively listen to them the most. There is a large body of evidence convincingly showing that on various metrics financial markets perform poorly at their most basic and crucial task, pricing assets correctly, during periods of instability and volatility.

This is not to say that markets’ behavior, however “dislocated” they may be, cannot have real consequences on those economies. Italy is a case in point: its liquidity crisis, driven by a run to Southern European sovereign bonds (which translates as: if you are selling Italian bonds, I better sell them faster than you regardless of why you are doing it), can eventually degenerate into a solvency crisis (read: default) despite less than dramatic economic fundamentals, especially when compared to those of countries for now immune from contagion (e.g., the UK).

Financial economists also suggest that the most effective way to tame markets in turmoil  is not to undertake long-term reforms but to surgically intervene in those markets to remove the sources of observed dislocations. For instance, in the current context, calming a run to Italian sovereign debt can be achieved by declaring that the ECB act as lender of last resort (the way the federal government in the U.S. insures bank deposits against runs). Simply declaring those intentions may be sufficient to stop a sovereign debt run while giving the affected economies time to address their long-term problems.

These observations suggest that policymakers proceed with greater caution when undertaking radical reforms of local and international economic infrastructure under the threat of dislocated market behavior. Acritically accepting markets’ wisdom may be as dangerous as ignoring it.

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About ppasquar

Associate Professor of Finance at the Ross School of Business, and long-term Napoli fan.
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