The Bank of England's financial policy committee should buy low and sell high
Bank of England
Roger E. A. Farmer is a distinguished professor of economics at UCLA and was the Senior Houblon Norman Fellow at the Bank of England in 2013. His book, "How the Economy Works, Confidence Crashes and Self Fulfilling Prophecies," is now available in a 2014 paperback edition with an updated preface on the aftermath of the financial crisis. This op-ed appeared originally on August 12 in The Guardian.
The goals of the Bank of England's financial policy committee, created by 2013's Financial Services Act, are to maintain financial stability and support the government's objectives for growth and employment.
Why do we need a committee to oversee financial stability, and what tools will the FPC need in order to achieve success?
Financial markets experience repeated cycles of boom and bust. A credit boom occurs when borrowers and lenders anticipate that asset prices will increase. Investors borrow money and use the borrowed funds to build factories and machines. Newly created companies hire workers and jobs are created. The economy experiences a boom.
But every boom is followed by a bust. There comes a point when the psychology of the market turns around and, at that point, financial assets fall in value. Companies go bankrupt, workers lose their jobs and home owners lose their houses. The economy experiences a crash.
The fact that every boom is followed by a bust is not a surprise. Although the bust is inevitable, its timing is not. And for that reason, it does not pay for you or I to bet against the market.
The ratio of the stock market price to cyclically adjusted earnings, the PE ratio, is a highly persistent, volatile process. It has been as low as 5 in the 1920s and as high as 45 in the 1990s. When the PE ratio is above its long run average, an investor can profit from selling the market short. When it is below its long run average, a winning strategy is to borrow money and invest it in shares. But although that is sound investment advice in theory, in the real world there is no private investor with a long enough horizon and deep enough pockets to make those trades. As Keynes famously said: "Markets can remain irrational for longer than you can remain solvent."
Economic theory teaches us that free trade in markets leads to efficient allocations.
But a precondition of that doctrine is that everyone who is affected by trade is free to participate in the market. That condition does not hold in the context of the financial markets. We cannot buy insurance over the state of the world into which we are born.
The problem of excess financial volatility is one that cannot be solved by any individual; but it can be solved by government. The Treasury has the power to make commitments on behalf of future generations. The FPC, by exercising that power on behalf of the Treasury, can make trades in the financial markets that capitalise on the inefficient boom-bust financial cycles that are the source of so much human misery. In this way, the FPC will at the same time stabilise volatility in the market and promote financial stability.
Most economists would argue that the FPC should have the power to set minimum capital requirements for banks, pension funds and insurance companies. It should monitor the lending behaviour of banks to prevent imprudent gambling with deposits that are guaranteed by the taxpayer. And it should ensure that our financial institutions retain the required liquidity to weather a storm. These are all important regulatory goals. But they do not get to the systemic root cause of financial crises.
Financial crises occur because willing participants in the financial markets are driven by cycles of optimism and pessimism. These cycles are not damped by trade because there is no private trader with the patience and the resources to profit from market irrationality. The FPC can and should buy shares in the stock market when the PE ratio is low, and sell them when it is high. These trades will be profitable for the Treasury and they have the potential to smooth out the financial cycles that are the consequence of financial market irrationality.
As Keynes said, markets can remain irrational longer than you or I can remain solvent. They can remain irrational for longer than George Soros can remain solvent. They cannot remain irrational for longer than the Treasury can remain solvent. The FPC, backed by the Treasury, has an advantage precisely because it has the power to tax and transfer not just from you and me, not just from our children and our grandchildren, but from our children's, children's grandchildren.
When the next financial crisis occurs, and it will occur, do not blame the members of the FPC. They are guard dogs without teeth. It's time to move beyond empty rhetoric by giving to the FPC the tools that will enable it to deliver what is requested of it. If we truly want financial stability, we must act to stabilize markets.