Should the government peg the S&P 500?

by on December 30, 2008 at 4:26 pm in Economics | Permalink

The very well known macroeconomist Roger Farmer says yes:

It is time for a greatly increased role for monetary policy through
direct intervention of central banks in world stock markets to prevent
bubbles and crashes. Central banks control interest rates by buying and
selling securities on the open market.

A logical extension of this idea is to pick an indexed basket of
securities: one candidate in the US might be the S&P 500, and to
control its price by buying and selling blocks of shares on the open

That is from the FT.  Though he says he is warming to the idea, to my ear Mark Thoma sounds skeptical as am I.  Public choice considerations aside, if the Dow is valued at 7000 in market opinion and the Treasury (Fed?) is propping it up at 8500, a lot of people will sell shares into the hands of the government.  How much are the shares worth then?  How hard will the government try to break the shorts who speculate on lower prices?  Will this work any better than currency pegs?  What are the implications for pursuing other monetary targets, such as the rate of inflation?  If the peg succeeds who would hold other, riskier assets?

Some people might even say that the "Greenspan put" was part of what got us into this hole in the first place.

Farmer is working on a book How the Economy Works and How to Fix it When it Doesn’t.

1 KipEsquire December 30, 2008 at 4:38 pm

Do we really need to go back to high school economics and remind people that the stock market is an atrocious proxy for the economy? For starters, the stock market does not include government, small businesses, or most real estate.

Good grief.

2 DRB December 30, 2008 at 4:56 pm

Worst idea ever. Yea a risk free index fund that makes 6%(or whatever) per year that wont screw things up.

3 Alex December 30, 2008 at 5:07 pm

From time to time I flirt with economistphobia — but mostly I resist it. “Ideas” such as this one makes it harder to reject it, however.

4 Anonymous December 30, 2008 at 5:14 pm

In 1997, the Hong Kong government intervened to support the local stock market… and ended up making a tidy profit as the market recovered. It is far from clear, however, that the conditions are right for pulling this off in the US.

5 MnM December 30, 2008 at 5:31 pm

I agree with John Dewey. Where does it end? If anything, I think the last six or so months have taught us that we need the pricing mechanism to work without interference,rather than with more of it.

Also, is anyone else frightened by the title of Farmer’s book?

6 David Zetland December 30, 2008 at 5:39 pm

That’s the stupidest thing I’ve ever heard.

On the other hand, it *does* make sense to pay attention to S&P appreciation as a proxy for financial wealth inflation — something that can be countered with interest rates, not purchases.

7 Carlton Smith December 30, 2008 at 6:34 pm

Doesn’t this confuse what the stock market is? This might almost make a bit of sense if the stock market dictated the health of the economy, but since stock prices merely reflect the health of the economy the only effect this would have is it would take away aggregate stock prices as a meaningful indicator of that health. However, if one’s goal was to obfuscate normal indicators of national economic health so that one can fool the public into believing that the economy was honky dory as it fell apart around them, then this idea might work swimmingly.

8 nullpointer December 30, 2008 at 6:48 pm

would someone please remove this academic from where he can do real harm.

may i suggest a stint studying migratory patterns or something?

sweet baby jeebus…..

9 RM December 30, 2008 at 7:07 pm

Shoot me now and get it over with. The reason the market works is because there are short sellers.

With government only buying and not short selling, you’ll see a version of the 1929 stock market.

10 Ironman December 30, 2008 at 7:20 pm

Absolutely awful idea. Beyond bad. Better yet, we have a natural experiment to demonstrate just how bad such a strategy would be in execution: the Black Monday Crash of October 1987.

Here’s a quick rundown of what happened. Looking to the future, investors anticipated that the expected growth rate of dividends would accelerate, then briefly stall out, then resume their higher level of acceleration shortly afterward.

In the months preceding the crash, investors had pushed up stock prices in anticipation of higher dividends being paid in future quarters (coinciding with an acceleration in the rate of growth of earnings). But then they ran into a chaotic time conflict. They looked past the coming dip in dividend levels and kept stock prices at their elevated level, focusing instead on the increasing rate of dividend growth that followed the dip. And why not? The dip in the acceleration of the growth rate of dividends would only last for a quarter before resuming its faster growth track.

That’s where things really went wrong. Serious imbalances formed across the markets until stock prices could no longer be sustained at their higher level – the market crashed as it became clear that the growth rate of trailing year dividends per share in the fourth quarter of 1987 was going to be near zero.

More than that, that imbalance of forces helped push stock prices far below where they would have dropped had investors not tried to keep them suspended. Artificially, if you will.

Fortunately, the following acceleration of dividends ensured that the crash would be a short term event. The markets quickly recovered.

As a neat metaphor, the crash itself was a textbook example of cartoon physics – specifically, the kind of physics that are in play when Wile E. Coyote is chasing the Road Runner. Imagine Wile E. chasing the bird off one mesa toward another. They both run off the edge of the first mesa. The Road Runner never looks down and reaches the next mesa, but Wile E. looks down, and per the laws of cartoon physics, plummets to Earth. And also per the laws of cartoon physics, he doesn’t stop when he hits the ground, but continues to make a deep coyote-shaped hole before bottoming out.

Somehow, I don’t think the government is any smarter than Wile E. Coyote, nor would any strategy that defies the basic physics governing the stock market be successful.

11 Bob Murphy December 30, 2008 at 8:46 pm

What’s wrong with the gold standard? It worked very well until the governments decided they wanted to start slaughtering each other’s conscripts.

12 JP White December 30, 2008 at 8:55 pm

There have been a number of horrible ideas put forward recently. This beats them all hands down. How is the market supposed to allocate resources rationally if the government is setting the price of stocks?

13 Cyrus December 30, 2008 at 10:02 pm

If the growth in the amount of goods and services being exchanged outpaces the growth in the gold supply, then a gold standard is inherently deflationary.

14 Grant December 31, 2008 at 12:10 am

Anyone who is writing a book called How the Economy Works and How to Fix it When it Doesn’t could easily be arrogant to the point of gross self-delusion. I’d imagine thats why Tyler mentioned it…

15 Barkley Rosser December 31, 2008 at 12:35 am

Alan Brown and other Gold Bugs,

Before you waste everybody’s time further advocating a return to the gold
standard, especially in the midst of a serious and deepening recession, I
suggest you read Barry Eichengreen’s Golden Fetters; The Gold Standard and
the Great Depression. Not a good idea going back on the “barbrous relic,”
and it has fluctuated very wildly, both against the dollar and against a lot
of other commodities and goods. The idea that it is somehow some super special
standard of value is not even a joke.

16 Andrew December 31, 2008 at 2:00 am

Good lord.

So, bear with me, back when they decided to peg the number of rounds available in handgun magazines at 10, what happened. The rise of the Foaty (.40) and the small concealed 9.

Now, where will the demand flow when the value of businesses is price controlled? Who the freak could know, and isn’t that a problem.

17 Ricardo December 31, 2008 at 3:12 am

I agree this is a horrid idea. But in fairness to Farmer, let’s think about the other alternatives. It is now becoming clearer that even a central bank committed to stable prices is insufficient to guarantee macroeconomic stability. The Greenspan point of view was always that the Fed should fight inflation and otherwise sit back even with clear evidence of a stock market bubble. The Fed takes an active role only when the bubble pops by slashing interest rates to prevent a recession.

This view, needless to say, is rapidly falling out of favor. For those who want the Fed to take a more active role in preventing bubbles, what exactly should the Fed do if not peg the S&P 500? If you don’t advocate an explicit peg, you are basically left arguing the Fed should rely on subjective indicators of asset bubbles and should balance the desire to prevent bubbles against other objectives in some similarly subjective manner. The rules versus discretion dichotomy is dead, in other words.

18 Pavel December 31, 2008 at 6:05 am

Not a good idea. BUT – including Case/Shiller to the CPI core index would make sense. Residential real estate is much more consumer durable rather than investment asset.

19 Adam December 31, 2008 at 7:35 am

No Federal Reserve Chairman or any other authority has the information to determine what is and what isn’t a bubble or a unduly low price. It won’t work and, worse, it will only add additional mistrust into the pricing of assets. The stock market will become a completely rigged game.

Note too that Farmer’s basic argument is that markets, especially the labor market, have too much friction to be allowed to do their allocative work. So Farmer’s solution is to add mistrust and uncertainty? Sounds doubly like a foolish and damaging idea. If friction really is the probably, let’s find ways to reduce it–like reeducation and internet labor markets. Oh, we already have the latter? Maybe there isn’t so much friction as Farmer suggests. Maybe it’s just fear of change.

20 Bill Stepp December 31, 2008 at 9:59 am

Before you waste everybody’s time further advocating a return to the gold
standard, especially in the midst of a serious and deepening recession, I
suggest you read Barry Eichengreen’s Golden Fetters; The Gold Standard and
the Great Depression. Not a good idea going back on the “barbrous relic,”
and it has fluctuated very wildly, both against the dollar and against a lot
of other commodities and goods. The idea that it is somehow some super special
standard of value is not even a joke.


A gold standard is certainly better than a paper standard. The gold exchange standard in the years before the Big D was a “managed” standard, and had some problems as I’m sure you’re aware.
What Eichengreen didn’t point out, if memory serves, is
that a gold standard works better with free banking.
The real problem is not the standard per se, but the State’s money monopoly in the form of central banking.
If we replace central banks and fiat money with free banks and competition in note issue, then we will banish the possibility of another Big D, minimize unemployment, and maximize output and incomes. This would also be the best way to cabine and shackle the mass murder state.
And contrary to Mises, real liberals (not libs, thank you) do spell the State with a capital S.

21 Yancey Ward December 31, 2008 at 1:50 pm

A truly awful idea, but one whose time is not far off now. Seriously, what do people expect politicians to do when the Boomers begin drawing their pensions and liquidating their 401Ks all at the same time? They will, of course, begin providing a high price floor for the selling.

22 John Dewey December 31, 2008 at 3:57 pm

Yancey Ward: “what do people expect politicians to do when the Boomers begin drawing their pensions and liquidating their 401Ks all at the same time?”

I agree the Boomers will strain the system somewhat, but consider that:

1. The peak years Boomers, born in 1956 to 1964, will not begin receiving Medicare benefits for 13 to 21 more years. Plenty of time remains for reforming Medicare.

2. Boomer 401K’s will be liquidated gradually. Liquidation of financial assets will allow Boomers to continue spending levels and thus driving economic growth.

3. Many Boomers will continue working past normal retirement age, contributing to GDP growth.

4. The generation about to move into the workplace, and the generation now in their 20’s, are both as large as the Boomers they are replacing. They will produce at higher levels than did the Boomers (productivity continues to rise). Those younger workers will be ready to buy up all the assets Boomers are liquidating.

Fear of retiring Boomers is way overblown, IMO.

23 Greg December 31, 2008 at 4:16 pm

I like it. As some commenters have noted, we should extend it to all assets rather than unfairly protecting only the S&P 500. I want all my investments to only go up. I think 10% per year is a reasonable number. Let’s get to it. Oh, and please include a voucher for one free lunch.

24 Bill Woolsey January 1, 2009 at 9:11 am

The Fed wouldn’t be “setting the prices of stocks.” Relative stock prices could still provide a signal of market perceptions of the the relative prospects of various firms. If the Fed did this using monetary policy, then how it works is that if the index is below target, then the Fed creates money until the nominal profits generated for production is high enough for stock prices on average to return to target. In the opposite situation, it would contract money, reducing future profits and so the value of stocks. The price level (of final goods and services, and I guess, total spending on final goods and servces) would vary with the aggregate expected profitability of the 500 largest firms.

The more standard approach is for the Fed to target nominal income–total spending on final goods and services. The usual notion is that it should grow with trend productivity (or 1% or 2% faster to generate a planned 1% or 2% inflation rate.) Rather than targetting on portion of income–profits of the 500 largest corporations–the target is for the total of all income.

If the Fed doesn’t use the S&P 500 index for monetary policy, but rather continues to target nominal income and also the S&P 500, with
that being secondary, then it is acting as a hedge fund. If the Fed begins selling its own bonds, it would make it easier to do. Of course, it could go broke too.

I suppose the purpose of the policy is to stop momentum trading on the market as a whole. End this “technical analysis” business. And make it so people trade only on fundamentals or else buy and hold.

25 John Dewey January 2, 2009 at 10:48 am

Bill Woolsey: “Relative stock prices could still provide a signal of market perceptions of the the relative prospects of various firms.”

That may be true for the 500 equities represented by the S&P 500. But how would such “relative stock prices” signal the overpricing or underpricing for those equities relative to the prices for all other equities, domestic and foreign? relative to the prices for real estate? relative to the prices for agriculture commodities? relative to the prices for petroleum futures? relative to the price for any other good in which humans invest?

26 doc holiday January 2, 2009 at 12:57 pm

I thought The PPT was already involved in valuation pegging and helping provide stability (during the last year or two).

In other news:

Compared to 12 months ago, only alternative investments and shares exhibited any increase. Those aged over 65 were the most bullish on shares with more than a third saying it’s a good time to invest in the stock market.

Meanwhile, when people were asked to whom would they go first, when seeking financial advice, 47pc said they would go to either a trusted friend/relative or find the information for themselves. Just 1pc said they would ask a stockbroker.

Older respondents were more likely to use an independent financial adviser.

27 crander January 3, 2009 at 11:47 pm

Yeah sure, central banking isn’t working so well so let’s up the ante and try centralizing equity markets too. After that centralized housing planing and ownership (hey wait) and centralizing food production, automotive and so forth. Pretty soon the whole economy will be optimized right?

p.s. maybe a deflationary period after a GIANT asset bubble is a good thing, a needed thing…

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