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Home arrow Business & Finance arrow Money, Markets, and Democracy: Politically Skewed Financial Markets and How to Fix Them

Checking Democracy

It must never be forgotten that the forces impinging on the markets from democracy are propensities, not necessities. These propensities may be a part of democracy’s DNA, yet just like the genetically encoded traits of human beings, the expression of those propensities may be constricted and modulated given the appropriate environment. Not only that, democracy is capable of containing a mix of elements from other regimes and still remain, for all intents and purposes, a democracy. Such a mix was envisioned by America’s founders in setting up a democracy with, to name just one feature, an unelected Supreme Court to judge the constitutional validity of laws passed by the elected representatives of the people. A similar inclusion of a non-democratic ingredient is financially manifest today with the powers allotted to central banks, such as the US Federal Reserve and the ECB. As was noted before, the people who control the levers of money—the linchpin of our entire financial system—are not elected, but appointed. once placed in those offices, central bankers are not easily dislodged during their comparatively long terms. Not to be overlooked either is the large wing of the administrative state made up by the plethora of financial market regulatory bodies. In making and enforcing rules in place of an elected branch of government, what are these regulators but an aristocracy run by tenured bureaucrats?

The difficulty, though, is that these deviations from democracy are themselves the natural outcome of democracy. With everyone influenced by the mores of individualism to rely upon themselves in fending for their interests, with usually only a few friends and family on their little social platoons to help them, people harken to the state to shield them from the commotions and upheavals of commercial life. By this prescient observation made over a century and a half ago, Alexis de Tocqueville perceived how democracy gives way to the administrative state. The same impulse lies behind the existence of a central bank. So too, as was elaborated before, the discretionary authority that the central bank wields is the result of a tax consumer versus taxpayer dialectic in democracies that impels governments to assume control over the money supply. The welfare state, brought about by the class conflict between tax consumers and taxpayers, demands a central bank at the ready to print money in order to help fund the mass of expenditures. Yet the financial regulatory apparatus along with the central bank are precisely what have to be tamed. And that requires measures that do not sit well in democracies.

If only to avoid contradiction, therefore, one cannot simply lay out the ideal set of arrangements between the state and the financial markets— and then call that a fix. As a logical matter, certain polity preferences do narrow the items that can be chosen from the full menu of economic alternatives. Thus, a strong case can be made that the mandated disclosure required of public companies by securities regulators does little to help investors. Better it would be if disclosures were made voluntary in accord with shareholder demands for them. But this policy change is not coming anytime soon to a democracy near us. No doubt, too, that restrictions on short selling impede the market’s ability to correct overpricing in stocks and ferret out corporate wrongdoing. When such restrictions inhibit the naked short selling of CDS, they hinder markets from holding governments accountable for their fiscal mismanagement. Alas, one cannot feasibly propose that democratic governments, or any other governments for that matter, forswear entirely the imposition of short selling constraints. During a sharp downturn in prices, if at no other time, such a measure will look too seductive for politicians to resist as a means of stabilizing the market—or at the very least, as a means of giving the appearance of doing something. It would be preferable as well if governments were to get out of the business of encouraging residential mortgage finance. Bond markets would no longer be the scene of mayhem whenever a mass of people with low credit ratings cannot make their payments. But housing is too important an asset in people’s estimations for anyone to expect democratic governments to exempt it from the imperative of promoting equality.

One can go on listing the compromises that have to be made in a democracy. No group of public officials empowered to oversee the risk being taken by financial players, whether in the form of derivatives or some other chancy instruments, can be expected to spot even a few of the landmines that may be lying in the vast and deep terrain of financial markets, much less disarm them before they explode. Given our ever growing technological prowess, reams of financial data can surely be delivered to the government’s computers. Still, no matter how much data public officials have, they cannot be expected to have the knowledge necessary to preserve market stability. Such knowledge would have to come from connecting all the widely dispersed dots amid the infinitude and intricacy of information generated by our mammoth marts of finance. More critically, those relatively few individuals watching the markets from the commanding heights of the state are not likely to have the fortitude to go against the weight of prevailing opinion during boom periods. William McChesney Martin famously stated that the Fed’s job is to, “take away the punch bowl just when the party gets going”.1 One can certainly debate whether Martin always kept to his own maxim during his tenure at the Fed from 1951 to 1970. What cannot be debated is that party poopers with the requisite timing have been a rare species in government. Yet the prospect of having nobody superintending the financial scene is what no democratic public will permanently brook. We shall have to live with the likes of the SEC and CFTC, as well as the newly formed Financial Stability Oversight Council.[1] [2] And, yes, currency prices managed so as to further the interests of politicians and favored industries get in the FX market’s way of facilitating trade and economic co-operation across borders. Floating exchange rates do not help either in constraining governments from deliberately cheapening their currencies to avoid difficult economic reforms. But a call for fixed exchange rates is like asking for sandals to walk in the snow. It can be done for a while, but it is not bound to last. Politically siding with democracy economically means accepting less than optimal policies in the financial markets.

  • [1] Though this sentence is often attributed to Martin, what he actually said was less pithy:“The Federal Reserve ... is in a position of the chaperone who has ordered the punchbowlremoved just when the party was really warming up”. See William McChesney Martin,“Address of Wm. McC. Martin Jr., Chairman Board of Governors of the Federal ReserveSystem before the New York Group of the Investment Bankers Association of America”,October 19, 1955,
  • [2] US Department of the Treasury, “Financial Stability Oversight Council”,
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