Financial Markets and the State: Price Swings, Risk, and the Scope of Regulation

The paper considers the rationale and scope of state intervention in financial markets. Standard theory gives rise to two extreme views of policy in these markets. The state should leave markets unimpeded, other than ensuring transparency, and eliminating other market failures. Or, it should extinguish asset-price swings as soon as they arise, even if this requires massive intervention. The paper develops an imperfect knowledge economics (IKE) model of fluctuations and risk in asset markets and shows that it provides an intermediate view of policy. The model recognises the inherent dynamism of modern economies; that individuals search for innovative ways to forecast the future and make decisions and that the social context, including institutions and policy, also change in novel ways. The model implies that asset price swings play an indispensible role in guiding society to allocate capital to alternative projects and companies. Although psychological elements and technical trading may play a role, markets undergo swings even if everyone bases their trading solely on fundamental factors. But, if price swings lie at the heart of what markets do, then eliminating them as soon as they appear, as extant bubble models would have us do, makes little sense. Markets, however, are not perfect. As everyone else, participants must cope with imperfect knowledge about how to interpret fundamental factors in forecasting future returns. Consequently, price swings can sometimes become excessive, in the sense that participants may bid prices far from levels that are consistent with the longer-term values of assets. This IKE framework has a number of implications for prudential policy in financial markets. On the one hand it acknowledges that, within a reasonable range, the market would do a far superior job, though not perfect, in setting prices. On the other hand, it recognises that price swings can become excessive and that this excess is socially costly. Consequently, policy officials need to be on guard for excessive swings in asset markets and be ready to dampen them with a set of prudential measures. The framework suggests an array of such measures. It also has important implications for how regulators should measure and manage systemic risk in the financial system.