Should governments prevent market crashes?

Government intervention in the stock market: a way to save the economy or a bail-out programme for failing companies?

In 2015, China’s stock market imploded.

In less than three months, the Shanghai Composite Index fell more than 40% from its peak.

Investors were rapidly losing faith in the financial system. The stock market crash had people running scared and threatened to subdue economic activity.

To prevent worse, the Chinese government tasked a group of state bodies with buying up assets to restore confidence.

This group, known as the “national team”, now buys up stocks whenever a market crash looms. It’s a de facto backstop that’s supposed to make big market crashes a thing of the past.

Communist nonsense, I hear you say? Not necessarily.

A British scholar thinks Western capitalist governments like the UK’s should implement a similar policy to keep market crashes from spilling over to the real economy.

If you think about it, the enormous asset buying programmes central banks introduced in the aftermath of the crisis were policies of a similar kind.

It set a precedent for big government intervention in the markets. It’s not a huge leap from quantitative easing (QE) to what China’s national team is doing.

Could this be a cure to stock market crashes or is it socialism for the rich?

It’s all about confidence

There’s a theory doing the rounds that the stock market will help push the Withdrawal Agreement with the EU through the UK parliament.

According to said theory, the pound will sell off and the market will go into a tailspin if parliament rejects the “best and only deal on the table” on 11 December.

Confidence in the UK economy will drop dramatically and politicians will panic. They won’t dare vote down the superficially renegotiated deal with Brussels in a second vote.

However, unless all hell would break loose politicians aren’t expected to heed the stock markets too much.

One British scholar, however, believes politicians should pay attention to the stock market. He argues the link between the stock market and the real economy is much stronger than most people think.

Roger Farmer, professor at the University of Warwick, advocates government intervention in the stock market. Governments should buy stocks when they plunge as a way to stabilise the financial system.

It’s all about confidence. A market crash doesn’t exactly imply everything’s peachy. After stocks sell off, it’s only a matter of time before confidence in the economy sinks as well.

Farmer explains:

“Low confidence induces low wealth. Low wealth causes low aggregate demand, and low aggregate demand induces a high-unemployment equilibrium in which the lack of confidence becomes self-fulfilling.”

Governments might counter this low confidence by setting up an “asset stabilisation fund” that buys up stocks or takes a big stake in exchange-traded funds (ETFs).

In 2015, China’s national team reportedly had access to three trillion yuan (£340bn). The sheer firepower governments possess can make a big difference in the markets.

Notes Moxy Jing in Bloomberg:

“Market participants say the mere knowledge of a big buyer provides a confidence boost when nerves are jittery.”

Governments would essentially be providing a safety net, which assures investors a soft landing. If investors don’t fear a crash, maybe they’re less likely to panic when the market takes a bit of a tumble. They know they’ll be rescued.

And because confidence in the stock market is closely related to confidence in the economy, it pays to prevent a market stampede. No concerns about the stock market means no concerns about the wider economy, the reasoning goes.

Nationalising the stock market

Farmer’s plea to have governments buy stocks on public markets isn’t necessarily inspired by some obscure paragraph in Karl Marx’s Capital.

There are already plenty of examples in the real world that could hint at a general move in Farmer’s desired direction.

Quantitative easing policies in the aftermath of the global financial crisis already made us familiar with big asset buying programmes from central banks…

And Farmer’s policy proposal isn’t unprecedented. Aside from China’s “national team”, other countries like Japan, Hong Kong, and Taiwan, have intervened in the stock markets in a similar way. South Korea is planning to follow their example.

Would investors object to governments meddling in the markets if it’s in their interest?

The knowledge that government bodies will step in if markets fall by too much, would make investing seem a lot less risky.

There are three big problems with this policy, though.

First, it would create a “too big to fail” policy for the entire economy.

Shares of listed companies that lose investor confidence would be bought up by governments. It wouldn’t take much for these rescue policies to turn into a large scale nationalisation of companies.

Second, if shares are bought with the sole purpose of preventing a market rout, there’s a good chance the government doesn’t get “value for money”.

There are already lots of so-called “zombie companies” around, which can’t pay back their debts and wouldn’t have survived if it weren’t for this unprecedented period of ultra-low interest rates.

Governments buying up stocks when the market crashes might force them to rescue companies that are not worth saving.

Finally, it’s fine in theory for the state to purchase assets when the market is tanking and offload them once the market’s doing well again. In practice that’s a little more complicated.

Once you’re committed, you’re committed. Just look at QE. That was also supposed to be an emergency policy but it took central banks nearly a decade to get out.

Investors were nervous the banks would retreat before confidence was fully restored (which arguably never really happened). Central banks were trapped in a trap of their own making.

Still, Farmer is confident his proposal will turn into a widely adopted policy soon enough.

As he told Bloomberg last week:

“Asset price stabilisation policies are coming to a central bank near you. It’s just a question of when.”

“My best guess is that it will take another stock market crash. That crash will happen, most likely within the next five years, but its timing is unpredictable.”

The next time there’s a crisis, let’s hope governments can think of a less expensive way to save the world.

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