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Financial Markets and the State: Long Swings, Risk, and the Scope of Regulation

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  • Frydman Roman

    (New York University)

  • Goldberg Michael D.

    (University of New Hampshire)

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    Abstract

    The paper makes use of an Imperfect Knowledge Economics (IKE) approach to examine the rationale and scope of state intervention in asset markets. IKE recognizes that policy officials and market participants must cope with ever-imperfect knowledge of the causal mechanism driving market outcomes. In our IKE-based model of asset markets, price swings arise from participants' diverse interpretations of the effects of fundamentals on outcomes. Under IKE, the market is an imperfect mechanism for setting values. However, the paper argues that, within a range of prices, the market's allocation is superior to the allocation that would result if the state actively intervened into the price-setting mechanism. During periods of non-excessive prices, swings play an indispensible role in helping society to allocate scarce capital and the state should confine its intervention to setting the rules of the game, that is, ensuring transparency and eliminating other market failures. However, price swings can sometimes move far from levels consistent with most perceptions of longer-term fundamental values. If they do, the IKE approach calls for active intervention to dampen excessive movements. The paper proposes the use of official "guidance ranges" and discusses problems with their estimation. It also proposes an array of other excess-countering measures and concludes with ideas on how regulators can better measure and manage systemic risk in the financial system.

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    Bibliographic Info

    Article provided by De Gruyter in its journal Capitalism and Society.

    Volume (Year): 4 (2009)
    Issue (Month): 2 (October)
    Pages: 1-45

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    Handle: RePEc:bpj:capsoc:v:4:y:2009:i:2:n:2

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    Web page: http://www.degruyter.com

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    Web: http://www.degruyter.com/view/j/cas

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    Cited by:
    1. Koppl, Roger, 2010. "Some epistemological implications of economic complexity," Journal of Economic Behavior & Organization, Elsevier, vol. 76(3), pages 859-872, December.
    2. Roger Koppl & William Luther, 2012. "Hayek, Keynes, and modern macroeconomics," The Review of Austrian Economics, Springer, vol. 25(3), pages 223-241, September.

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