half regulation of securities markets home

If securities markets are totally unregulated, some people will commit frauds, and the prevalence of frauds will cause many people to avoid the securities markets. So the government should make and enforce laws against securities fraud. I am not in favor of total deregulation of securities markets.

Securities markets sometimes have bubbles. Some type of security may be profitable. Since that security is profitable, more people buy that security, which causes the price to rise, which makes it more profitable, etc. The security becomes overpriced. Investors sell the security, which causes the price to fall, which makes the security less profitable, which causes more investors to sell the security, etc.

Investors who bought the security when it appeared profitable discover that the security was not as profitable as it appeared. This causes investors to become more skeptical of all their investments. Investors are less willing to pay high prices for any security, so the prices of most securities fall. Investors feel poorer and spend less money. Companies whose stock prices fall reduce wages and other expenses. The result is a recession.

So should the government try prevent bubbles from forming and bursting through regulation of the securities markets? Preventing recessions seems like a good idea.

The obvious solution is for the government to deflate during the bubble and inflate during the bust. But this will not work unless the government can detect booms and busts in advance. In reality, governments usually fail to detect booms and busts until after they have occurred. It is not possible to prevent recessions after they have already occurred. People who think it is easy to detect booms and busts should ask themselves why investors fail to detect booms and busts. An investor who detects booms and busts in advance can make vast amounts of money by selling at the peak and buying at the bottom. Many investors try to do this, and most fail.

The stock market may rise because of a bubble, or because the economy is good. Most politicians have an inflated ego. So if the politicians who run the government see that the stock market is rising, they will probably assume that all of the rise is because of their wise management of the economy, and none of the rise is because of a bubble. Meanwhile the opposition will say that all of the rise is because of a bubble and none is because of the government's unwise management of the economy. The government is likely to be in denial about a bubble until is is too late to prevent the bubble.

The best the government can do is to maintain stable prices. In a bubble, prices of most thing will probably rise. In a bust, prices of most things will probably fall. So a policy of stable prices will cause the government to deflate during a bubble and inflate during a bust. This will make bubbles and busts less severe. But hindsight will probably show that the inflation and deflation did not occur at the right time or in the right amount. A policy of stable prices will not eliminate bubbles and busts.

Contrarian investors make bubbles and busts less severe. But suppose that the government tries to prevent bubbles and busts by imposing regulations which restrict risky investment strategies. But how does the government determine which investment strategies are too risky? A person will not use an investment strategy which that persion thinks is too risky. So if a person is using and investment strategy, that person does not think that investment strategy is too risky. If many people are using the same investment strategy, then many people think the investment strategy is safe, and they will oppose an attempt by the government to restrict that investment strategy. The government will be unable to restrict an investment strategy unless there is a consensus that that investment strategy is too risky. The government will not be able to restrict investment strategies used by the majority of investors. The government will be able to restrict investment strategies which are used by a minority of investors but rejected by the majority of investors. But these minority investors are contrarian investors. So if the government tries to prevent bubbles and busts by restricting risky investments, the policy will transmogrify into a policy of restricting contrarian investing, which will makes bubbles and busts worse. You cannot stop a fad by punishing the people who refuse to participate in the fad.

Major stockbroking companies often trade stocks for both themselves and for other people. But if a stockbroker loses money trading for himself and goes bankrupt, then the stockbroker's customers are hurt. The customers have deposited their savings with the stockbroker, but the customers cannot withdraw their saving from the bankrupt stockbroker or transfer their securities to another stockbroker until the bankruptcy is settled.

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