Do we need financial markets?

I wrote a MINT column on the header recently. Then, I expanded on it for another article in ‘Swarajya’.

One of my friends was not particularly pleased with this column. We had a constructive engagement via email. He felt that taxes would do the job. He thought that I was advocating a ban on financial markets. A careful reading of the column would show that that was not my core recommendation. At best, it was a negotiating position.

I was happy to find that Dani Rodrik had written on similar lines in November 2015.

And yet financial markets, evidently placing a premium on stability, hailed the outcome. A majority AKP government, investors apparently believed, would be much better than the likely alternative: a period of political uncertainty, followed by a weak and indecisive coalition or minority administration. But, in this case, there was not much wisdom in crowds….

… Financial markets are supposed to be forward-looking, and many economists believe that they allocate resources in a way that reflects all available information. But an accurate comparison of Brazil’s experience with that of other emerging-market economies, where corruption is no less a problem, would, if anything, lead to an upgrade of Brazil’s standing among investors….

… We know from painful experience that financial markets’ short-term focus and herd behavior often lead them to neglect significant economic fundamentals. We should not be surprised that the same characteristics can distort markets’ judgment of countries’ governance and political prospects.

He is right. If they cannot price financial assets correctly, how can we expect them to assess political risk correctly? But then, even the inability to assess political risk should result in a risk premium not only for political risk but also for the inability to assess it correctly. Central banks have, perhaps, erased the ability to consider risk at all. In the final analysis, that could be the biggest damage and the worst legacy of ultra-loose and unconventional monetary policy.

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