Yesterday the Irish government finalised a rescue deal worth €85bn for the country’s beleaguered banks. With all such large financial decisions, the initial test of success was seen to be the reaction of the markets.
To say that they were not convinced would be an understatement. The euro fell against the dollar and the London and German stock markets saw a drop in value. Perhaps more importantly the bond yields on Portuguese, Irish and Spanish government debt stayed worryingly high, as did the cost of insuring such bonds against default.
French Finance Minister Christine Lagarde criticised the markets stating that the bailout was ‘sufficient’ and the markets ‘irrational’, in a similar vein Germany’s finance minister Wolfgang Schaeuble called the markets’ worries about Portugal ‘irrational’.
The problem with lambasting the markets is that by doing so politicians seem to suggest that the markets are treating Irish, Portuguese and Spanish debt unfairly and, more importantly, that they are aware they are doing so.
However, both criticisms seem to conflate two mutually exclusive conceptions of the market. The first, that the market is a fair reflection of value, or that it can be. The second, that the market is simply the collectivisation of various subjective opinions, and that like any subjective opinion it can be, knowingly or unknowingly, incorrect. While the two are mutually exclusive, it would appear that some politicians would like to have it both ways.
One result of the recent financial turmoil is that markets were exposed as being particularly prone to ‘herd-behaviour’ and likely to underestimate the chance of one-off, ‘unique’ events occurring. In this sense the market is not a ‘fair’ indicator of value, but a subjective response based on a number of considerations. Thus the markets should not be lambasted for remaining sceptical about the financial state of some European countries’, or some banks’, finances.
Markets also responded, negatively to indications that, rightly, bondholders will have to absorb some possible losses on European bonds in the future. Market opinion is not infallible; if politicians do not agree with it, then they should say so, but it is juvenile to label it ‘irrational’.
Importantly, politicians have to be honest with themselves, and admit that the more they interfere with the free operation of markets the less markets can be trusted as a source of true value. Every time a bank is bailed out, every time debts are implicitly underwritten, market indicators become less accurate.
That’s not to say that politicians should let countries default on their debts, or allow banks to fail to pay their creditors, but they must realise that when they do intervene, investors will take note, and adjust their behaviour accordingly.
Thus decisions made by market participants will not only reflect their opinion of a good deal in light of the possible risk, but also in light of the possible action, or inaction, of government.
If this is accepted, then maybe politicians will stop suggesting that market opinions are perfectly rational, but they’ll also have to stop labelling those opinions ‘irrational’ when they don’t like them.
Stephen Clarke is a research fellow at Civitas. This post first appeared on the Civitas blog
