Government Intervention and Information Aggregation by Prices

• Author: PHILIP BOND,ITAY GOLDSTEIN
• DOI: http://doi.org/10.1111/jofi.12303
• Published date: 01 December 2015
• Date: 01 December 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 6 •DECEMBER 2015

Government Intervention and Information

Aggregation by Prices

PHILIP BOND and ITAY GOLDSTEIN∗

ABSTRACT

Governments intervene in firms’ lives in a variety of ways. Toenhance the efficiency of

government intervention, many researchers and policy makers call for governments

to make use of information contained in stock market prices. However, price informa-

tiveness is endogenous to government policy. We analyze government policy in light

of this endogeneity.In some cases, it is optimal for a government to commit to limit its

reliance on market prices to avoid harming the aggregation of information into mar-

ket prices. For similar reasons, it is optimal for a government to limit transparency

in some dimensions.

OUR PAPER IS MOTIVATED BY TWO key observations. First, governments play an

important role in the lives of firms and financial institutions, and take actions

that have significant implications for these firms’ cash flows and stock prices.

Second, government actions often follow financial market movements; and,

closely related, many government officials view market prices as a useful source

of information, and a number of policy proposals advocate making more explicit

use of this information.

In this paper we analyze the implications of a government’s use of market

information in light of a key economic force: market prices reflect not only

∗Bond is with the Foster School, University of Washington.Goldstein is with the Wharton School,

University of Pennsylvania. We thank Campbell Harvey (the Editor); an anonymous referee; an

Associate Editor; along with Viral Acharya; Michael Fishman; William Fuchs; Qi Liu; Vincent

Maurin; Adriano Rampini; Jean-Charles Rochet; Duane Seppi; Laura Veldkamp; and seminar

audiences at the Bank of Israel, Dartmouth College, the Federal Reserve Banks of Chicago, Min-

neapolis, and New York, the International Monetary Fund, MIT, Michigan State University,New

York University, the University of California at Berkeley, the University of California at Irvine,

the University of Delaware, the University of Illinois at Chicago, the University of Maryland,

the University of North Carolina at Chapel Hill, the University of Waterloo, the University of

Wisconsin, Washington University in St Louis, York University, the Financial Crisis Workshop at

Wharton, the American Economic Association meetings, the EUI Economic Policy after the Fi-

nancial Crisis Workshop, the FIRS Conference, the NBER Summer Institute on Capital Markets

and the Economy,the Chicago-Minnesota Accounting Theory Conference, the Theory Workshop on

Corporate Finance and Financial Markets, the American Finance Association meetings, the NY

Fed-NYU Financial Intermediation Conference, the University of Washington Summer Finance

conference, the Society for Economic Dynamics conference, and the IDC Summer Workshop for

helpful comments. Bond thanks the Cynthia and Bennett Golub Endowed Faculty Scholar Award

Fund for financial support. All errors are our own.

DOI: 10.1111/jofi.12303

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2778 The Journal of Finance R

the fundamentals about which a government may wish to learn, but also ex-

pected government actions. Consequently, when governments make decisions

based on information they glean from market prices, this affects the amount

of information the government can ultimately obtain from the market. We first

analyze the equilibrium effect of these forces, and derive cross-sectional impli-

cations. Second, we analyze whether a government should increase or decrease

its reliance on the market. Third, we develop implications for other issues—

in particular, whether a government should reveal its own information to the

market (i.e., transparency).

Before detailing our findings, we expand upon our two opening observations.

The first observation is well illustrated by the course of the recent financial

crisis, during which government bailouts of leading financial institutions (e.g.,

AIG and Citigroup) and other firms (such as in the auto industry) constituted

critical events for these firms. Government actions remain important follow-

ing the crisis, as exemplified by recent penalties and regulations for financial

institutions.

These government actions—especially transfers made during the crisis—

have attracted much controversy in both policy and academic circles. Critics of

government transfers argue that they waste taxpayer funds, unfairly reward

banks and their shareholders, and increase future moral hazard problems. On

the other side, proponents of government transfers argue that they help to

soften the negative externalities that would flow from weak balance sheets,

notably reduced lending and financial contagion.1

Regardless of the balance between the costs and benefits of government

intervention, however, there is little debate that it is desirable that a govern-

ment be in a position to make an informed decision. The concern is that the

government conducts major interventions without having precise information

about the costs and benefits of doing so.2For example, prior to the collapse

of Lehman Brothers, the U.S. government had to quickly decide whether to

bail out Lehman. Ideally, this decision would be based on information about

the state of Lehman, the implications of its failure for the financial system,

and the potential moral hazard that a bailout might create for future episodes,

but obtaining and analyzing all this information in a short amount of time is

impossible.

1For example, government programs to stimulate bank lending (e.g., Troubled Asset Relief

Program (TARP) and TermAsset-Backed Securities Loan Facility (TALF)) were motivated by con-

cerns that a decrease in lending would hurt firms and deepen the recession. The bailouts of large

financial institutions, such as AIG and Bear Stearns, were driven by fears that the failure of these

institutions would bring down the financial system due to the connections across different insti-

tutions. The intervention in the auto industry was motivated by fears that bankruptcies of large

automakers, such as General Motors, would have devastating implications for their employees,

suppliers, and customers.

2In a striking example, in order to determine the size of the bailout needed to save Anglo Irish

Bank, the Irish government asked the bank’s executives for an estimate of losses. Recently exposed

internal tape recordings reveal that the bank’s top executives lied to the government about the

true extent of losses.

Government Intervention and Information Aggregation by Prices 2779

This concern leads to the second key observation mentioned above. The chal-

lenge of making intervention decisions under limited information is well under-

stood by policy makers themselves, and one often proposed solution is to base

intervention decisions on market prices. To illustrate, consider the following

excerpt from a 2004 speech of Ben Bernanke:

Central bankers naturally pay close attention to interest rates and asset

prices, in large part because these variables are the principal conduits

through which monetary policy affects real activity and inflation. But pol-

icy makers watch financial markets carefully for another reason, which

is that asset prices and yields are potentially valuable sources of timely

information about economic and financial conditions. Because the future

returns on most financial assets depend sensitively on economic condi-

tions, asset prices—if determined in sufficiently liquid markets—should

embody a great deal of investors’ collective information and beliefs about

the future course of the economy.3

Other senior Federal Reserve officials—for example, Minneapolis Federal Re-

serve Bank presidents Gary Stern and Narayana Kocherlakota—have voiced

similar opinions. These views are in line with the basic tenet of financial eco-

nomics that market prices aggregate information from many different market

participants (Hayek (1945), Grossman (1976), Roll (1984)), and hence provide

valuable guidance.

Inspection of government actions in the recent crisis suggests that policy

makers do indeed watch prices closely,and often use price movements to justify

their actions. For example, the 2011 report of the Special Inspector General

for the Troubled Asset Relief Program states that “short sellers were attacking

[Citigroup] . . . Citigroup’s share price fell from around $13.99 at the market’s

close on November 3, 2008, to $3.05 per share on November 21, 2008, before

closing that day at $3.77. In the week leading up to the decision to extend

Citigroup extraordinary assistance, Citigroup’s stock decreased far more than

that of its peers.”4Beyond anecdotal evidence, empirical studies from before the

crisis establish that government actions are significantly affected by market

prices.5

In addition to existing government responses to financial markets, a range

of policy proposals call for governments to make (more) use of market prices,

particularly in the realm of bank supervision (e.g., Evanoff and Wall (2004)and

Herring (2004)). Such policy proposals are increasingly prominent in the wake

of the recent crisis and the perceived failure of financial regulation prior to it

(e.g., Hart and Zingales (2011)).

In light of these observations, in this paper we study a model of information

aggregation in financial markets, where information aggregated in prices is

3Availableat http://federalreserve.gov/BOARDDOCS/SPEECTTES/2004/20040415/default.htm.

4Available at http://online.usj.com/public/resource/documents/CitiOIG.pdf.

5See Feldman and Schmidt (2003), Krainer and Lopez (2004), Piazzesi (2005), and Furlong and

Williams (2006).