Financial Markets and the State: Long Swings, Risk, and the Scope of Regulation

45 Pages Posted: 30 Jan 2013  

Roman Frydman

New York University (NYU) - Department of Economics

Michael D. Goldberg

University of New Hampshire

Abstract

The paper makes use of an Imperfect Knowledge Economics (IKE) approach to examine the rationale and scope of state intervention in asset markets. IKE recognizes that policy officials and market participants must cope with ever-imperfect knowledge of the causal mechanism driving market outcomes. In our IKE-based model of asset markets, price swings arise from participants' diverse interpretations of the effects of fundamentals on outcomes. Under IKE, the market is an imperfect mechanism for setting values. However, the paper argues that, within a range of prices, the market's allocation is superior to the allocation that would result if the state actively intervened into the price-setting mechanism. During periods of non-excessive prices, swings play an indispensible role in helping society to allocate scarce capital and the state should confine its intervention to setting the rules of the game, that is, ensuring transparency and eliminating other market failures. However, price swings can sometimes move far from levels consistent with most perceptions of longer-term fundamental values. If they do, the IKE approach calls for active intervention to dampen excessive movements. The paper proposes the use of official guidance ranges and discusses problems with their estimation. It also proposes an array of other excess countering measures and concludes with ideas on how regulators can better measure and manage systemic risk in the financial system.

Comments on this paper can be found at:
http://ssrn.com/abstract=2209395

Suggested Citation

Frydman, Roman and Goldberg, Michael D., Financial Markets and the State: Long Swings, Risk, and the Scope of Regulation. Capitalism and Society, Vol. 4, Issue 2, Article 2, 2009. Available at SSRN: https://ssrn.com/abstract=2209399

Roman Frydman (Contact Author)

New York University (NYU) - Department of Economics ( email )

19 West 4th Street
New York, NY 10012
United States

Michael D. Goldberg

University of New Hampshire ( email )

Durham, NH 03824
United States
603-862-3385 (Phone)
603-862-3383 (Fax)

HOME PAGE: http://pubpages.unh.edu/~michaelg/

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