The power of markets

James Carville, an advisor to President Clinton, once famously said that he would like to be reincarnated as the bond trader because of their ability to intimidate. That statement was an expression of resentment at the ability of financial markets to frustrate the political objectives of elected governments. At the start of his presidency, Clinton wanted to increase government spending in a big way, but was instead persuaded to opt for deficit cutting. Higher spending could have increased inflationary expectations and bond traders, known as inflation hawks, would respond by driving interest rates higher. That would hurt economic growth, blocking the President’s objectives. A textbook example of this sort of tension between markets and government was demonstrated by the Thai Central Bank’s botched attempt to impose capital controls last week. The central bank, which wanted to discourage foreign inflows because it was driving up the baht, said that 30% of deposits would have to be held in interest-free accounts. Premature withdrawal, i.e., in less than a year, would mean penalties. It was a spectacular mistake. Currency and stock markets crashed all over Asia at the imposition of capital controls, demonstrating that investors hate restrictions on their freedom to move money around. Faced with the prospect of being blamed for triggering a world-wide meltdown, the Thai government partially backtracked. It was a brutal display of the awesome power of financial markets — a kind of ‘shock and awe’ if you will. A similar episode, though not on such a scale, has taken place in India. In January 2005 a speech by RBI governor Y V Reddy at an academic forum, which seemed to contain a reference to taxing or more generally discouraging short-term portfolio inflows led to panic in the market, a denial from the finance ministry and eventually a late-evening clarification from Dr Reddy. The travails of the Thai central bank ought to serve as a salutary warning to Indian policymakers, who sometimes tend to muse in public on the desirability of banning P-notes or of scrapping the Indo-Mauritius tax treaty. The broader point is that markets are not passive recipients of policy. Instead, there is a dynamic interface, because of their ability to react rapidly.