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Outside the Box
"Arguing in My Spare Time" No. 3.13
May 13, 2000
When the Internet bubble pops, there will be calls for reform. My guess is that the result will be too much, too soon. Politicians will have to show that they are "doing something," and a careful, deliberative approach will not be popular.
One idea that I suspect will not work very well is raising margin requirements. Individuals can buy stock on "margin," meaning that they can borrow some of the money needed to buy the stock, using the stock as collateral. In the 1920's, the legal minimum requirement for "margin" was ten percent. After the 1929 crash, the limit was raised to 50 percent. Recently, some people have suggested raising it again.
My guess is that margin requirements are not terribly effective. There are futures markets and options markets, which allow individuals to take leveraged stock market positions without being affected by margin requirements.
I do believe that some reforms are in order. This essay offers some ideas to consider. I am not saying that I am certain that these are valid solutions. I am not suggesting that I have anticipated all of their effects. Right now, they simply represent thinking "outside the box." They should be analyzed to determine whether they would be effective. Their potential for unintended consquences ought to be thought through.
1. The Tobin Tax
The idea is to tax the trading of stocks, as means of discouraging short-term trading. There is a presumption that short-term traders are less rational than long-term investors, so that at the margin the tax would tend to increase the influence of rational investors. The proposal often is attributed to James Tobin, an economist who won the Nobel Prize.
2. Forced Secondary Offerings
This is an idea that I have proposed to eliminate the artificial scarcity of stock that occurs with IPO's. The idea is that within, say, 12 months of its IPO, a company would be required to have at least, say, 40 percent of its stock out in the public market. This would make post-IPO prices more rational. It also would make companies think twice about going public before they can establish a credible record of earnings. You would not want to have to issue a large volume of stock at depressed prices, so you would want to make sure that you have earnings before you take your company public.
3. Government Auditors
In the banking sector, the government conducts audits. It does so because with deposit insurance, taxpayers can be liable for bank failures.
My guess is that when the bubble pops, taxpayers are going to end up liable for a lot of the losses. Pension plans, in particular, are vulnerable, and they are insured by the government.
Government audits of companies could serve as a valuable check on the accounting abuses that so-called "third-party auditors" routinely let slip. Even in the absence of taxpayer risk in the bubble, a case could be made that government audits could have a favorable benefit-cost ratio.
4. Restrictions on the uses of funds from stock offerings
The idea would be to require that funds raised in stock offerings be held in earning assets for at least three years. Of course, these assets could be internal investments on the part of the firm. However, venture capitalists and corporate officers would not be allowed to "cash out" with the proceeds of IPO's.
5. Stabilizing Funds
The government would classify certain mutual funds as "stabilizing," based on their investment rules. For example, a passive index fund would be considered stabilizing. A fund that buys companies with price-earnings ratios below some number and sells when the ratios get above some higher number would be stabilizing. A fund that increases its cash position as the market price-earnings ratio rises would be stabilizing.
Overall, to be classified as "stabilizing," the fund would have to be rule-driven, and the rules would have to be regarded by the appropriate regulatory agency as stabilizing. Funds that achieve this designation would be given tax advantages. In the extreme, the government could allow IRA's and 401(K) plans to invest in stocks only if they invest in stabilizing mutual funds.
The presence of a few stabilizing funds could tend to force other funds to think twice about destabilizing investments. You would know that as price-earnings ratios rise the demand for stocks will fall, due to the impact of the stabilizing funds.
6. Futures markets in dividends (or earnings)
The idea here is to force investors to pay attention to fundamentals. Today, it is possible for stock prices to diverge from the expected present value of future dividends or earnings. It is precisely this divergence that Shiller emphasizes in his book, "Irrational Exuberance." If there were futures markets in dividends, then such a divergence would give rise to arbitrage opportunities. This arbitrage would enforce the relationship between stock prices and expected future dividends.
One important flaw with this concept is that futures markets rarely are liquid for more than a few quarters ahead. Most of the implicit absurdity in bubble stock prices likely has to do with dividends and earnings that are expected several years from now.
Still, I believe that the introduction of futures markets in dividends or earnings could have merit. Compared with a day trader time horizon, a framework that looks at fundamentals even 6 to 9 months ahead has to be an improvement.
7. Fed responding to asset prices
I understand that there is a paper by Stephen Cechetti and others suggesting that the Fed should pay attention to asset prices when it sets monetary policy. Although I have not read the paper, I would bet that it does not argue that monetary policy should have an objective of stabilizing asset prices. My guess is that instead the paper argues that rapid increases in asset prices are indicators of future inflation. Just as some people argue that high gold prices or a depreciating currency are signals of future inflation, one could argue that rising stock prices or real estate prices could be indicators.
The idea of using asset prices as an indicator of future macroeconomic developments would, in the current environment, have led to tighter monetary policy sooner. This probably would have restrained the bubble. The question is whether it would have been good macroeconomic policy.
If inflation accelerates over the next few years, then indeed the Fed should have raised interest rates sooner on the basis of rising asset prices. On the other hand, if inflation remains tame, then there is no reason to believe that from a macroeconomic perspective monetary policy was too loose over the past year or so.
In conclusion, there are policy options available to try to prevent future bubbles. If the current bubble collapses as much as I fear, these policy ideas will deserve study.