Government intervention in the stock market: not actually a crazy idea by mattsteinglass
February 6, 2009, 11:15 am
Filed under: Economics

This paper by Roger Farmer of UCLA wins Brad DeLong’s strong (ecstatic?) approval.

It seems very important to me. The idea is to set up a system for the Federal Reserve to trade in an index of all publicly traded companies in order to stabilize the level of the stock market. The number that would drive the level at which to stabilize the market would be the unemployment figure. Just as the inflation rate currently drives the Fed’s trading in government bonds to set the overall level of interest rates (monetary policy), the unemployment rate would drive the Fed’s trading in index funds to set the overall level of the stock market.

The Fed would not buy individual stocks, so this would involve no picking of winners and no USG ownership of corporations. Individual stocks would rise and fall faster than the overall level of the market, and investors would try to beat the market by investing in companies whose shares they expected to rise faster than the index. But in today’s world, the individual attempt to invest on value is swamped by vast fluctuations in the overall market index — hence the “random walk down Wall Street” problem. The only way to defray risk is to diversify and invest long-term, which actually reduces the market’s efficiency in valuing companies. In Farmer’s world, the market would move gradually up, at a rate consonant with maintaining high employment, and individuals would try to invest on value.

Is he right? I lack the chops. I hope people who have them will take this idea on — it seems big.

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