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