Open market operations – in the stock market

Nice to see some ideas I proposed a good while ago getting a bit more of an airing, namely governments running open market operations in assets other than their own bonds (pdf) in the process of managing the economy. I suggested that governments should purchase equities on a countercyclical basis because it both

  1. made them money
  2. improved macro-economic outcomes

Now the second of these rationales is gaining some support as people think about the role of government as a market maker of last resort.  Note several things about the subsequent discussion on Thoma’s thread.  Firstly the case has been made in terms of ‘targeting’ asset prices, in the way open market operations of the central bank target short term interest rates.  This is a determinate process. I don’t think you can know enough to target share prices.  In fact I think it’s batty when put like that.

But that’s very different to saying that governments can extend their ‘market maker of last resort’ role to leaning against the wind of excessive optimism and pessimism in these markets. That’s pretty much what we do in the foreign exchange market (when we’re not pursuing the occult practice of ‘smoothing and testing’). It makes perfect sense – the government expects to make good money and make the economy less volatile in the process.  Everyone’s a winner except the momentum traders who followed and contributed to the momentum a little too much.    

After five thousand questions Mark Thoma concludes.

Thus, while I certainly think this is a fruitful area to investigate, particularly in light of recent experience with the housing and stock price bubbles, we have more thinking to do and more regressions to run before we are ready to implement this kind of policy.

This is very typical of policy debate in general.  Someone comes along with a proposal to improve something.  To him it seems pretty obvious that things can be (perhaps greatly) improved if we do something a little different. Then people come out of the woodwork and say ‘what exactly do you mean?’ Now inevitably the person suggesting something new won’t know exactly what he means.  He is, after all, observing how things are and suggesting something he regards as a compelling improvement. But rather than say ‘yes, the argument for it is compelling, though it has many implications that we should also be thinking about’ the interlocutor will call for everything to be sorted. Trouble is, that it is in the nature of things – and of human thought – that comprehensive rethinking can rarely if ever be done.  The threshold for action should not be that we’ve got all the details worked out – that’s usually the sign of self delusion more than anything much else.  The threshold is that we have sufficient understanding to believe that the action we are taking can bring substantial benefits, and we don’t believe it will produce to highly undesirable perversities or sideeffects.   

I also think this problem is particularly pronounced in economics where the practitioners think in models and so are highly anxious about aspects of policy about which there is uncertainty. To repeat, there are always plenty of aspects about the future of policies – for governments or for other organisations – that are uncertain and this often applies nearly as much to existing policies as it does to new ones. One needs to manage them as intelligently as one can.  

These words of mine are heartfelt because lots of the things I suggest are subjected to the same kind of death of a thousand details.  Thus when I suggest that fiscal policy is not working that well and could be assisted if it were recast more in the mould of monetary policy, lots of people seem to agree with this proposition, but then want to know a thousand other details – all of which are contentious.  So the best – and a thousand different versions of it – become the enemy of the good. 

Now it’s fine to be thinking about all Thoma’s questions. But we haven’t got a lot of the analogous questions solved for open market operations in the bond market. We muddle along fairly confident (most of the time) that doing what we’re doing is better than the alternative of inaction. When we change interest rates we don’t work out all the implications. We can’t.  We just do the best we can. And the same goes for open market operations in equities. There are obvious gains to be had in extreme situations, and so the policy can be pursued in those circumstances. And we can keep thinking about how far we want to go beyond that and develop our institutions accordingly.

Note however that the proposer of this policy does not argue for the policy in extremis. The way he argues for it, is not as some pragmatic enhancement to what we do, but a fully fledged policy to target equity prices (not individual ones but the price of a basket of equities).  And so the whole discussion goes from the outset to the kinds of academic considerations that I’m arguing are not central to the question of whether it’s a good idea to take some action right now.   

Note for those responding to this that much of the reaction to the policy as if it is in the same family of policies as using monetary policy or short term interest rates to control asset prices. It’s not. It’s using open market operations (the purchase and sale of securities) to influence their price – not to mention as vehicles for profitable investment for the state. So where the central objection to using interest rates to target asset prices is that it’s sending one instrument out to control two variables, here we have two instruments and two variables.

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observa
observa
12 years ago

So basically Nick you’re saying the Govt should have stood in the market buying as the Oz index fell swiftly from 6300 to 3300, albeit they might have made some profits selling into that longer slower rise to 6300? Some smoothing that would be. It certainly knocked out the private investors trying to do the same by all accounts.

Emess
Emess
12 years ago

The situation you describe is a bit like that of the usual distinction between engineers and scientists who are usually deductive and inductive thinkers/method users respectively.

The interaction between them (emphasising that this is a generalisation) is normally that the scientists discover stuff and knowledge, and that engineers are able to then understand that stuff and apply it…with only limited disasters on the way.

When you observe (as I have) the interaction of engineering and scientific teams, you can see the horror of the scientists when they see the engineers going off and doing stuff with only half the knowledge, and the frustration of the engineers when they see the scientists going off in all directions looking at what might turn out as peripheral detail, and yet an outcome is required in a looming time frame.

The classical answer to this is to have the teams and their work objectives split so that scientists/deductive thinkers are looking at the knowledge gaps and the engineers/inductive thinkers are looking at the implementation plans. In a well planned operation, the scientists come to the rescue with the required knowledge when the engineers stumble at some point because they didn’t know enough at that point. However, overall, the project progresses because the engineers will drive it.

So, the suggestion I would put to you is: If you can interest the political powers that be in such a proposal, you corral those that do want to look at the detail into one team and get them to map out the details needed and then crunch at those details, and you get those that want to implement into another team and develop an implementation plan. Once you have the implementation plan and a list of details needing solution, you can almost always massage it into a package that looks achievable. Noting that when you get the implementation plan, always double the time and budget as project optimism is always locked in by now internally, and when you get the ‘details’ plan, go through it critically to isolate the critical details and the nice to know details.

murph the surf
murph the surf
12 years ago

And in HK the public could also buy the “Tracker Fund” as it was called and I’d guess many opted to put their super( called the MPF in Hk ) into it.
Purists all cried that the action was a great shame and a day of infamy but it worked well .

Damian Jeffree
12 years ago

I was impressed to see the Future Fund doing a bit of de facto leaning against the wind by sitting out of over-priced Australian Equities producing an outstanding result for the fund (and the Commonwealth) at the end of the worst year ever for Australian Equities.

A lot of fund managers would have weighed heavily into Aussie Equities wherever they were. Just by not buying they have probably saved the Federal Government and taxpayer $10-$30 B. Shorting stock (really leaning against the wind) would have netted similar gains again, but then we all know that shorting is evil. Gerry Harvey says so.

There is a lot of value in doing as much as we can to discourage booms and ease busts in equities and other asset classes including property. Merely having the government in there indicating that now may not be such a good time to buy stocks by publicly announcing that it was starting to thinking about selling might help cool an overheating market. If played very conservatively and done well this could help reduce market volatility = wins all around.

JM
JM
12 years ago

“The threshold for action should not be that weve got all the details worked out – thats usually the sign of self delusion more than anything much else. The threshold is that we have sufficient understanding to believe that the action we are taking can bring substantial benefits, and we dont believe it will produce to highly undesirable perversities or sideeffects.”

cf. climate change debate. One side always calls for more research until anything at all is even contemplated.

observa
observa
12 years ago

‘Do you think that leaning against the wind of excessive optimism and pessimism in [equity] markets. is described by a process of buying all the way from the top of the market to the bottom? Is that what we do in the foreign exchange market (which the post uses as a model)?’

Nicholas, although I understood where you were coming from I would have thought it’s obvious you are comparing apples with oranges here, or more aptly apples with a basket of every other fruit. In the case of open market money operations the Reserve is the monopoly supplier of AUD but with share trading it is simply a buyer and seller like every other participant, albeit some have the ability to up the supply of the individual fruit on offer(share issues).

With AUD I’d suggest the Reserve has clear insider trading benefits as monopoly provider, but you might like to consider just when they should buy in a stock of shares in order to begin your open market share operations. After all they will need to have a fair stock on hand to lean against the wind like currency. Lean against the wind with AUD and there’s plenty more where they came from but I’m not so sure about ABC Learning shares. They could perhaps avail themselves of insider trading benefits by monopolising share trading information (ie run the trading mechanism), as Madoff tried somewhat, by buying that info from other sharebrokers to add to his own sharebroking firm info. Nice try but I reckon he and Ponzi were short a critical piece of the puzzle to stitch it all together and I can only speculate what they’d have done with that access to a printing press when in a wee spot of bother in the marketplace. You couldnt go far past central bankers’ current form for the obvious answer I’d suggest.

observa
observa
12 years ago

‘If they think the dollar is under/overvalued theyll make a decision when to bet against it, but they wont hold out a blank cheque’
Hmmm… what do they do when that share index is saw-toothing down from 6300 to 3300? Smooth out the saw tooths and where would that leave the taxpayer not to mention the temptation to shore up certain stocks like ABC Learning if their bankers have triggers on lending,etc. When the Rios vary in price from around $150 to $30 there were ‘educated’ buyers and sellers at those prices and in between. I’ll let commenter Carl on JQ’s ‘requiem for the EMH’ say it better than I can-

‘Carl Futia Says:
January 3rd, 2009 at 3:10 am
If you substitute the words no free lunch for efficient markets you typically find much more public acceptance of the hypothesis. After all, its main prediction is that markets rarely make EXPLOITABLE mistakes,i.e. mistakes that can be recognized as such when they occur and that can be exploited via some investment strategy that is spelled out in advance.

As far as I can tell this prediction has enormous empirical support.

The hypothesis that public officials can outguess the financial markets because they know more about the future course of the economy has exactly zero evidence to support it.’

Then there’s the integral question of how central bank regulators got credit creation/money supply so wrong which Spengler nails so succinctly here-
http://www.atimes.com/atimes/Global_Economy/JL25Dj02.html
Essentially they, like financial intermediaries and everyone else, missed the obvious with that credit creation and demographics and guided by relatively benign goods and services inflation fuelled the massive asset boom and set up the inevitable bust. As Spengler in a moment of clarity in the fog wrote back in May 2008-

‘There is nothing complicated about finance. It is based on old people lending to young people. Young people invest in homes and businesses; aging people save to acquire assets on which to retire. The new generation supports the old one, and retirement systems simply apportion rights to income between the generations. Never before in human history, though, has a new generation simply failed to appear.’

But central bankers oblivious to that underlying demographics(just as these planners were with their late Monartos and MFPs in the 70s) kept on printing the fairy dust for the aging Peter Pans to lend and leverage each others’ assets in the belief they’d all keep flying in retirement. Welcome back to earth with a helluva thud now.

The only thing I’d add to Spengler’s clarifying insight into finance is that it’s simply an admin cost of facilitating real savings and investment flows between these demographic cohorts and when 45% of corporate profits in the US come from such administration, something real has to give if you know anything at all about business. No amount of monetary pumping or purchasing shares can alter that painful fact but naturally we’d al like our Govts to kiss it and make it all better for us. Goodbye nasty markets and hello Govt hanky(we are all Keynesians now) but unfortunately there’s a glaring fallacy of composition in there somewhere. On that point I note the US steel industry is now clamouring for assistance after a 50% drop in prices AND output between Sept and Dec. Buy steel, coal and iron ore shares eh Nicholas..he asks rhetorically and grimly.

conrad
conrad
12 years ago

“Another example more germane to this discussion is the purchase of domestic stocks by the Hong Kong Govt”

It’s not clear to me that it is a good example. At the moment Australian stocks are down because the world is down and times are, well, going to presumably become rather average if they aren’t already. Thus the value of shares probably represents a decent prediction of their real value for now. When the HKMA bought stocks in 1998 they did so because their individual was under speculative attack.

Obviously the second of these is important, because you need to work out what are the defining bounds of when and when not to buy things. This is easy for the HKMA for their dollar — they just keep it within prespecified bounds. I notice that the RBA does pretty much the same to a lesser extent, as it starts buying dollars at around 60c to slow the decline when the dollar is declining quickly (and I believe the sell at the top of the cycle a bit too). Buying stocks alternatively is a bigger head-ache, and such predefined strategies are not so obvious, so presumably the only way it can be done is on the fly. It would be nice to know how this might work without giving all power to some random person or organization — obviously this can be done, such as when the HKMA did it, but some exceptional justification would be needed for it to not look like the government playing, possibly corruptly, at the casino. This must be part psychological — people don’t seem to mind the RBA doing it with the dollar (or perhaps saving banks), but would they, say, put up with the government using the Future Fund or something like that to buy BHP shares or some other “Australian Icon” company if it was going bankrupt?

Fred Argy
12 years ago

There is certainly much more interest in the Fed considering variants of quantitative easing. This means expanding its own balance sheet through the purchase of either government bonds or increased loans to the private sector (where a government body owns some of the assets and profits from some of the increase).

At some point there may well need to be some government intervention of this kind, even in your kind of asset markets (shares or mortgages). But

– one would need to pick the kick-off point (a 10 or 20% decline may have seemed enough but it turned out to be a 50% decline);
– the situation is best when it is confined just to one market is it in one single foreign exchange market or an isolated slump in one share market? But what happens if the share slump is universal (across the Globalised world)? One would thus need an integrated, internationally coordinated action?
– there is of course a moral hazard problem (especially as equity owners are fairly high income people);
– and there could be macroeconomic implications

One needs to do some hard thinking before hand. Which shouldn’t stop people like you with your great inventiveness of ideas.

Fred Argy
12 years ago

Well, doesn’t it mean that, early on, we would be “bailing out” equity holders? OK it also implies later on running surpluses (I doubt that the RBA would manage the operation on its own). And doesn’t it mean bigger deficits? I wonder what Turnbull would do with that, especially if it does not work?

And are suggesting co-ordinated international action?

observa
observa
12 years ago

“The government buys into more risk when everyone else is heading for the door. It does so only when it thinks theres a good chance of making money on the deal – by helping to restore fundamental valuations.”

I would have thought that’s what Govt does now at a much higher and less politically messy level by simply printing more money and allowing inflation to restore ‘fundamental valuations’. Austrians are naturally critical of this administrative make-work process as they are of digging holes and filling them in again generally. I’d come back to Spengler’s ‘moment of clarity’ about the overarching demographic problem here and suggest that without fully comprehending it, we’re simply destined to repeat the Japanese disease recently or the folly of our ancestors in the 1930s. I’d include Govts pushing on monetary string along with buying shares, financing car yards, etc in such folly. Depends how we like our remedy now I suppose. Honestly, short, sharp and horrible or delusional, drawn out and very painful.

observa
observa
12 years ago
Patrick
12 years ago

I agree that targetting in the context of equity prices sounds ‘batty’. I would add ‘frightening’.

I appreciate your comments about death by a thousand details. However at the moment I think I need more details just to understand what you mean. I’m sorry to be so obtuse!

Presumably, for example, buying would basically just have to be limited to baskets of shares such as the ASX300 (after all you wouldn’t want to be seen as abandoning 201-299 would you, even at arm’s length?).

When would the decision to invest ‘counter-cyclically’ be made, in very generic terms? Ie would this be something the government did after a ‘crash’, or just whenever it ‘felt’ counter-cyclical? Concomitantly, when would the decision to sell be made?

It appears that you countenance deficit financing this (otherwise it couldn’t be that usefully counter-cyclical). In this case I understand this as a manifestation of your broader belief that the government should be more willing to borrow against its tax collection ability (call it a coercive revenue asset) – is this so?

The key draw-back of the above point is that if the government is properly accounting for things, then the timing of the decision to sell would matter a lot – since the gain in investment needs to offset the interest cost. So whilst certainly the government could probably afford to hold a few tens of billions of equities for an indeterminate time and eventually make a profit, the interest costs will impose significant opportunity costs in the meantime. That is really just background to my final question: do you really think that this would be likely to consistently yield greater revenue than simple tax cuts, programs such as early-childhood intervention and ie (in the context of Australia at least) infrastructure spending?

Or do you just mean (and this kind of wraps up all of the above questions) that this should just be an idea out there that from time to time the Government can reach for, opportunistically?

Tel_
Tel_
12 years ago

The only real detail here is just how the government can price commodities more accurately than the market can. Does the government have:

(a) someone very smart
(b) inside information not available to the general market
(c) access to unlimited funds so they can double their bets when they bet wrong
(d) infinite time to wait if they are left holding commodities which are hard to sell
(e) legislative power to bend the market in their favour

Everyones a winner except the momentum traders who followed and contributed to the momentum a little too much.

Yes I do understand that the market gains momentum and is prone to overshoot, but if there was a simple formula for it, then someone would already be out there working the angle. We know there’s not a simple formula for it so why would government suddenly discover one?

In the foreign exchange market, if the RBA decide that they want to put a ceiling the exchange price of Aussie dollars, they can sell these dollars at zero cost to the country (they are not selling anything real, electronic printing press). They really do have infinitely deep pockets. If the RBA decide they want to push up the price of the Aussie dollar then they are automatically limited by their available foreign currency (BTW: where do the RBA explain this activity on their website? they seem kind of shadowy about their foreign currency trades).

If the federal government wanted to put a ceiling on the price of copper, they would actually have to deliver real copper. If they wanted to put a floor on the price of copper then the money would have to come out of either tax or inflation which would presumably have an immediate effect on either voter’s pockets or foreign exchange rate. Worst case they would be left holding copper that they bought at too high a price and which they must keep holding until the price comes back up again (consider if the electrical industry suddenly discovered a cheap alloy that worked better than copper, people holding copper would be screwed, if fiber optic systems became cheaper with a new design it might also massively change the demand for copper). Also, large foreign governments could bet against our government and use even deeper pockets to manipulate prices.

The EU tried this with butter, just kept buying and buying to stop the price falling. Then they had happy farmers but no idea what to do with the butter. I guess a copper mountain is easier to store than a butter mountain…

JC
JC
12 years ago

If the RBA decide they want to push up the price of the Aussie dollar then they are automatically limited by their available foreign currency (BTW: where do the RBA explain this activity on their website? they seem kind of shadowy about their foreign currency trades).

it’s actually reported every balance sheet period, Tel.

Tel_
Tel_
12 years ago

Yeah, they explain it here:

http://www.rba.gov.au/MarketOperations/International/ex_rate_rba_role_fxm.html

I just couldn’t find my way around their site I guess.