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Should Japan Spend Public Funds To Prop Up Stocks?

Posted by: Kenji Hall on March 3, 2009

Tokyo stocks are down this morning, hovering again near a 26-year low. So it’s no surprise that the Japanese politicians are wringing their hands and considering the prospect of a government-led stock-buying scheme. Calls for these so-called price-keeping operations tend to crop up whenever the stock market sinks alarmingly low.

One option that ruling Liberal Democratic Party bigwigs are considering: Expand the role of the Banks’ Shareholdings Purchase Corp., a government-funded entity that buys up shares in Japanese companies to help the country’s struggling banks repair their balance sheets.

The fact that Japanese officials are talking about a PKO shows a belief in government action over market forces. But should the government try to prop up stocks?

Opinions are split.

One advocate for government-led stock-buying is UCLA economics professor, Roger Farmer. In a letter to the Financial Times published on Feb. 27, Farmer called on governments to live up to their “collective responsibility” and collaborate on engineering “a soft landing by directly intervening in national stock markets.”

His argument is straightforward: Boost stocks and you reassure consumers that their savings and investments won’t evaporate in the downturn. “By putting wealth back into the hands of savers, central banks have the power to restore confidence, increase aggregate demand and maintain employment,” Farmer wrote. And unlike government spending packages that can run up public debt and lead to higher taxes, “price-keeping operations need not cost the taxpayer a penny and, in my view, have a much better chance of success,” he said in his letter.

But historical precedent and the details of carrying out a stock-buying program are what give Barclays Capital economists pause. In a report today, Kyohei Morita and Yuichiro Nagai argue that a PKO might not be as helpful as politicians think.

There are a few possible downsides. Investors might see the PKO as a chance to cut their losses and flee the market, rather than staying put to let their investments rebound. Another possibility: Businesses that report earnings under Japanese guidelines (which feature less rigorous mark-to-market accounting standards than U.S. rules) might not sell shares to the government. It’s also unclear how transparent the government buying would be, how it would decide which companies’ stocks to buy, or how much it would ultimately spend.

The duo looked back at what happened when Japan purchased huge sums worth of stocks in the 1960s. Sure, the two government-funded bodies that were in charge of the buying ended up profiting once the market swung higher. But in their view, the actual benefits from the scheme were minimal.

One problem the government buying created was that there were fewer market trades. “This drop in liquidity led to sharp price disparities between the issues that were purchased and those that were not,” Morita and Nagai wrote.

And when the government started trimming its stockholdings, it fueled concerns about a market sell-off. To assuage these worries, the government sold a sizable portion of its portfolio back to companies. That led to companies owning equity in each other (known as cross-shareholdings), which shut out individual investors from the market. Without shareholders to agitate for better corporate governance or higher shareholder value, companies had few incentives to change their old habits and much-needed reforms were put off.

In a 1992 Nikkei editorial, Tsuneyoshi Sakano, a former Finance Ministry official who was on the frontlines of the government’s stock-buying in the 1960s, wrote: “The biggest lesson we learned was the economic principle that no matter how much money you try to pour into the stock market, you cannot maintain prices and control the market if the economy itself is in bad shape.”Spoken like a true believer in Adam Smith's free-market principles.

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