Volatility and the market

[Paul Davidson <pdavidson@xxxxxxx>]

Trond and David's concerns has to do with volatility in financial markets.
Trond's bond would not necessarily solve the problem.  There have been
periods when price fluctuations in bond markets clearly were much larger
than in equity markets-- e.g., during the early Volker years.

The question is how to stabilize the movement of financial assets whether
they be stocks, bonds, foreign exchange, etc.  (What Trond and David forget
is that in an open economy even if you restrict the domestic price of
securities to plus or minus 20 %, the exchange rate permits wider
fluctations in the value of these stocks in terms of another currency.)

In April I gave an invited lecture to a plenary session of the Royal
Economic Society annual conference entitled "Volatile Financial Markets and
The Speculator" which I think provides some guidelines to understanding the
problem.(And also the difference between arbitrage and speculation.)This
lecture has been just published in the English journal ECONOMIC ISSUES, vol
3, September 1998. Peter Reynolds of Stratfordshire University UK is the
Editor of this journal and I am sure he will be glad to tell you how to get
your university library to order it. His email address is
p.j.reynolds@xxxxxxxxxxxx

In London last month I gave a paper at the Social Market Foundation as part
of a debate on International financial market volatility. I gave a paper
entitled "The Case For Regulating Internsational Capital Flows" (the only
one on this side of the debate). Those on the other side were Nigel Lawson
(Mrs. Thatcher's financial minister),  John Flemming of Oxford and Lord
Megned Desai (who was a student of mine in macroeconomics when he got his
Ph. D from the Univ. of Pennsylvania).  The Social Market Foundation will
be publishing this debate in January 1999.

The crux of my argument in the debate paper is that the interpretation of
the role that financial markets play in the economy depends on the theory
one, implicitly or explicitly, relies on.

There are two alternative theories (1) the classical efficient market
theory and (2) Keynes's liquidity theory of financial markets.  The first
theory logically leads to a laissez-faire policy for otherwise policy
prevents efficiency (with asymetric information the only policy is
transparency so information becomes close to costless to obtain). Keynes's
theory, on the other hand, logically leads to the argument that
transparency wouldn't do it and that there is a role for government in
developing an institution to stabilize the financial market prices.

I then go through the various policy suggestions on the public discssion
table, to indicate how these meet the theories criteria.  [I also rely on,
and use, some recent writings of Peter L. Bernstein author of the best
selling book AGAINST THE GODS, a treatise on risk, probability theory, and
financial management.  Peter argues (correctly in my view) that a liquid
market cannot be an efficient market.  Efficiency requires the absence of
liquidity.]

David's plus or minus 20% policy is a take off on John Williamson's target
zone exchange rate (or FEER) policy . For thosde interested in the debate
of whether a FEER folicyy works oor not see the Wintyer 1992-3 issue of the
JPKE (vol. 15) for a debate between John and myself on Reforming The Worlds
Money.  In my view, to paraphrase Franklin Roosevelt, the only thing we
have to FEAR is FEER itself!

Paul
Paul Davidson
Holly Chair of Excellence in Political Economy
Editor, JOURNAL OF POST KEYNESIAN ECONOMICS [JPKE]
Economics Department -- 523 SMC
University of Tennessee
Knoxville, Tennessee 37996-0550
email: Pdavidson@xxxxxxx;   phone: (423)974-4221;    fax: (423) 974-1686
http://econ.bus.utk.edu/Davidson.html