Here's a piece I missed when it first appeared. Henry Hu, University of Texas, Austin, Law School, published "Faith and Magic: Investor Beliefs and Government Neutrality," at 78 Texas Law Review 777 (2000). Here is the abstract.
This article analyzes investor beliefs as to stocks, the inadvertent role government plays in shaping those beliefs and thereby contributes to a rise in stock prices, and the need for government "neutrality" among investor belief systems. It suggests that, contrary to conventional wisdom, there is no inherent conflict between respecting market primacy and dealing with investor demand for equities. Concerned policymakers are offered an end-run around having to determine if a bubble exists. This article has three key themes:
First, most investors have faith in the superiority of stocks as an asset class and the magic of time in dealing with the risks of stock ownership. The article shows that, in their simple strong forms, the core beliefs of the current stock-based investor "religion" are not axiomatic. Long term historical statistics, the equity premium puzzle, time diversification, current valuations, and related issues are examined, relying in small part on a hypothetical new derivative ("fountain of youth swap").
Second, the Federal Reserve Board and the Securities and Exchange Commission have acted in ways that further this religion. In departing from neutrality, they play a role in the very stock market ascent they are concerned about. At issue are SEC mutual fund performance disclosure rules and the moral hazard of Federal Reserve actions in the bailout of the hedge fund Long Term Capital Management and of use of the Exchange Stabilization Fund in international crises.
Third, regardless of whether there is "irrational exuberance," government should move toward neutrality. The SEC can consider changing mutual fund disclosure to more of an asset class focus and enhancing disclosure of liquidity risks linked to mutual fund shareholder redemptions. The Federal Reserve can consider pre-announcing policies precluding it from bailing out mutual funds and from buying equities and equity derivatives.
The article concludes, "Some magic stores offer a small prop known as a "money maker." Be it a fancy version with metal rollers or a version in cheap plastic, the prop works the same way. You insert a dollar bill, the machine whirls about, and a five dollar bill comes out. A five can be turned into a ten. No skill is required. It would be caricature to suggest that many investors think the stock market is such a "money maker." If it were, an individual would invest, wait for the stock market to process that investment, and watch a larger amount emerge. The stock market is different. Although there may be rational reasons to suspect that a desirable outcome should generally occur, such an outcome is not guaranteed. Nevertheless, the investment religion subscribed to by most ordinary investors today holds that a desirable outcome is indeed virtually guaranteed. Faith in common stocks will almost certainly be rewarded if a broad portfolio of stocks is held for the long run and the magic of time diversification is allowed to do its work. Little judgment is required. This equity-celebratory religion is not the only belief system. Whether stocks are the asset class of choice may well depend on arcane statistical assumptions, even when one assumes a frictionless world of no transaction costs or aberrant investor behavior. Some observers believe, for instance, that whether stock returns are "mean reverting" may be important in making rational asset allocation decisions. The case for stocks may also depend on assumptions about the size of the equity premium in the future. Despite a generation of work, there is little agreement on the far easier issue of explaining what the equity premium has been in the past. Moreover, the equity premium issue turns out to be inextricably linked with questions about the nature of American exceptionalism. Were the extraordinary historical returns from American stocks the result of lucky throws of ordinary dice - extraordinary realizations of a perfectly ordinary probability distribution - or did those returns flow from dice loaded in America's favor? Will the financial market god be malicious and change the dice? All equity premium studies ultimately rest on the statistical dissection of year-by-year stock market returns: what if, as a playful "counterfactual" historian may be tempted to suggest, America's entire past constitutes but one data point? The SEC and the Federal Reserve have helped establish this equity-celebratory religion. The SEC, through its own pronouncements about stocks and, more importantly, through its stock fund disclosure requirements, promotes the superiority of equities and downplays their price and liquidity risks. The Federal Reserve's impact on investor beliefs is more subtle. Through its demonstrated interest in stock price movements and its actions with respect to Long Term Capital Management, the Federal Reserve has led many investors to believe that it can and would prevent a stock market crash or ameliorate the effects of a crash. I have sketched some steps that the SEC and the Federal Reserve can take to reduce their own distortive impact on the stock market, principled steps of an incremental nature that I hope would be robust and unexpected enough to have an effect. Government has no business promoting one particular religion in a world where alternative religions also deserve consideration. Government has contributed directly to the very ascent in stock market prices that it is worried about. By intervening in the marketplace for investment belief systems, government is, in effect, tampering with the paradigmatic mechanism for resource allocation in free economies. Regardless of whether we are in a bubble, regardless of our faith, it is a dangerous game to play with loaded dice."
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