Another pointy-headed post about the issues

by John Quiggin on February 25, 2005

After a longer break than I’d planned, I’m back for the second and final instalment of my series on the efficient markets hypothesis and its implications for Social Security reform and other issues. The first instalment is here.

Last time, I pointed out that, under the strong assumptions needed for the efficient markets hypothesis to hold, the diversion of social security funds to personal accounts makes no difference at all, since everyone can already choose their optimal portfolio, borrowing if necessary to finance equity investments. A more realistic version with borrowing constraints or high borrowing costs implies that either private accounts or diversification of the holdings of the Social Security Fund can be beneficial, and also that a range of other government interventions will be beneficial. (See also Matt Yglesias

In this post I want to look at the case I think is actually relevant, namely, where the efficient markets hypothesis is violated in so many ways as to be a poor guide to economic policy of any kind.

To begin with, why do I think this is the relevant case? Because the efficient markets hypothesis is way out in its predictions of the key variables it is supposed to explain: the relative prices of bonds and equity and the volatility of asset prices. Compared to the EMH, asset prices are several times too volatile, average returns to equity are several times too high and real rates of interest are much lower than they should be.

In addition, even defenders of EMH admit that the vast majority of the markets that would be required for the hypothesis too hold either don’t exist or are subject to large transactions costs. I’ve already mentioned the transactions costs of borrowing, but an equally important factor is the absence of insurance against job loss or business failure caused by recessions. In effect, defenders of the EMH look at the complexity and sophistication of corporate capital markets and assume that all the other risks and contingencies in the economy are irrelevant.

On the assumption that the difference between rates of return to equity and to government debt are largely due to market failure, the immediate implication is that the government should hold more equity, use its tax power to spread the resulting risk, and thereby achieve a massive risk arbitrage. One way to achieve this is for the Social Security Fund to invest in equity, as was proposed under Clinton. Alternatively, if the central bank holds foreign reserves for whatever reason, there’s a case for holding equity as well as debt, and it looks as if this is happening. Finally, the government can own enterprises outright, for example in the infrastructure sector.

Each of these approaches to public holdings of equity has advantages and disadvantages. Holding a diversified portfolio of small shareholdings raises the problems of ethical investment: what if some members of the public object to investments in some particular company. Ted raised this issue a while back in relation to the default portfolio for private accounts, and its equally acute in relation to diversification of the Social Security Fund.

Investments by governments in overseas equity raise a bunch of political issues in both the investing and target countries.

Finally, direct ownership raises all the issues that have been tossed about in debates over nationalisation and privatisation for decades.

All of these points imply that there are limits to the optimal public holding of equity, though there’s no good theory on this (or on the related question of the optimal level, if any, of gearing for the public sector). In any case, as public holdings of equity increase, the rate of return will fall and the rate of interest will rise, ultimately eliminating the equity premium. So we end up with the mixed economy we all know and (some of us) love.

But as long as governments can realise an average return on equity investments that exceeds their cost of debt, adjusted by the (small) cost of risk in an efficient equilibrium, there’s a case for more public investment, either direct or portfolio.

{ 12 comments }

1

Kevin Donoghue 02.25.05 at 2:26 pm

Practically speaking it makes sense to let government do whatever government seems to do best. We can argue that case-by-case. But the collapse of the EMH leaves economic theory in a mess. What do we do, go back to trying to understand Keynes?

2

Consigliere 02.25.05 at 2:59 pm

EMH is not perfect, however it better explains the markets then anything else.

3

P O'Neill 02.25.05 at 5:05 pm

Your closing sentence leads to a related issue of the keenness of some governments for Public-Private Partnerships. If the government having some private sector involvement can be justified on EMH failure grounds, then it’s not immediately obvious why the government would actually want to share some projects along PPP lines. There’s a popular perception that the government gets suckered in these deals, in which the private partner gets the return in all the good states and dumps the losses onto the taxpayer when things go wrong. Which sounds like the exact opposite of the investment strategy your logic leads to (and with which I agree).

4

Sebastian Holsclaw 02.25.05 at 8:57 pm

“In any case, as public holdings of equity increase, the rate of return will fall and the rate of interest will rise, ultimately eliminating the equity premium. So we end up with the mixed economy we all know and (some of us) love.”

Now I’m not an economist, so it is quite possible I’m missing something here but you seem to be assuming a rate of growth ‘X’ which is the same no matter who is investing–whether the government or private investors. In other words you are assuming that for $1,000 of investments you get growth X if it is $500 from the government and $500 from the private sphere and you also get X if it is $900 from the government and $100 from the private sphere. But if we believe that the government is not as good at properly investing in the overall economy as the private sector (which many economists certainly do believe) it seems to me that dramatically increasing the government investment in equities would not only narrow the difference in returns by increasing the governmental return, it would also decrease the overall level of growth–leading to a mixed and weaker economy. Depending on other factors that might be worth it, but it takes a lot of good factors to make even a small decrease in growth worthwhile.

5

John Quiggin 02.25.05 at 9:42 pm

I’m not assuming equal performance Sebastian, which is why you get a mixed economy as the outcome. For most of the activities traditionally undertaken by the private sector, differences in the cost of capital are outweighed by the poorer performance of publicly-owned firms. In infrastructure industries, the reverse is commonly the case.

The test is whether a bond-financed government enterprise can operate profitably either in market competition or under regulatory prices that would yield normal returns to capital for private competitors.

6

Sebastian Holsclaw 02.25.05 at 10:12 pm

“The test is whether a bond-financed government enterprise can operate profitably either in market competition or under regulatory prices that would yield normal returns to capital for private competitors.”

Hmm. I’m not sure I’m understanding this sentence properly. The test for what? Government investment? Let’s say under your model the perfect amount of government investment is 30%. I think you are trying to describe a method by which the investment amount gets to 30% and no more. What stops it from going to 50% and being a drag on the economy? (Actual percentages, clearly should be interpreted as pulled out of my ass). The government businesses won’t be as profitable at first, but surely the government will then create rules to favor its own investments. This will allow the government entities to remain competitive but will seriously deform the market in ways that aren’t good for overall growth. I think you are saying there is a mechanism of incentives for stopping that from happening, but I can’t figure out what it is.

7

John Quiggin 02.25.05 at 10:39 pm

Two possible answers

1. If you are doing an external economic assessment you net out any benefits obtained when governments rig the rules in favour of their own enterprises.

2. If you’re a government, you try to precommit by establishing independent regulators

8

Tom G. 02.25.05 at 11:21 pm

I’m not sure I understand Sebastian’s point if the government investment takes the form of a passive index (as opposed to say starting its own companies). I see there could be problems as government holdings rise, but I don’t see any reason to expect lower growth from the government holding a small % of US equities.

9

john c. halasz 02.26.05 at 11:20 pm

Sebastian’s second comment also seems to miss the case of governments deforming the “rules” of the market to favor the private investment of its backers. It’s also obvious that governments are dependent on the economy, whether public or private, for their tax revenues/budget constraints, so it’s not as if there are no long-run incentives/constraints to their policy preferences/steering performances.

10

Marcus Stanley 02.27.05 at 4:43 pm

Well, yes, Sebastian, if you assume government is bad, then government is bad. But there are many examples of public institutions that have immense control over the actions of private economic actors but do not really abuse that control for the gain of particular constituencies. Prominent among them being the Federal Reserve. It seems to me your argument really amounts to saying that limited government is never possible so long as government undertakes any economic activity at all. Since if there is any mechanism for limiting government abuse of its economic powers you “can’t figure out what it is”.

11

Sebastian Holsclaw 02.28.05 at 6:25 pm

“Prominent among them being the Federal Reserve. It seems to me your argument really amounts to saying that limited government is never possible so long as government undertakes any economic activity at all.”

No, that isn’t what I’m suggesting at all. The Federal Reserve does not exist to make money. Or rather in a more literal sense it does, but not for profit. Once you start setting up a system where government is in business, it is going to deform the rules to favor itself. In a distantly related topic, see US communities with stoplight enforcement cameras. They tend to be placed at intersections with short yellows, and sometimes the intersections shorten the yellows, to make more money on the automatic tickets. The community safety answer to the problem of dangerous intersections would almost certainly be a combination of longer yellows and enforcement cameras. But since the city doesn’t make as much money that way, the longer yellow part of the equation doesn’t play through the system.

12

Cleve Blakemore 03.02.05 at 1:03 am

Hly cw, y gys r gy. w’r tlking FLMING, with tfft strmrs.

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