I’m a pro-marketeer, but ‘the market’ does not always know best

Liz Truss
The markets didn't like Liz Truss's tax cuts. That says nothing about whether they were good policy or not

One peculiar side-effect of Liz Truss’s short-lived premiership has been the exposure of the idea that people who self-identify as “pro-market” believe government policy should be dictated by the “verdict of markets” and that the “verdict of markets” can be identified by talking to a few financial traders about why they are buying or selling today. Stranger yet, on the centre-Left of politics, some appear to have sympathy with this bizarre notion, as reflecting a pragmatic reality governments have to engage with, given the way the world works, even if they do not regard that as ideal.

Thus, it is said one of the key side-effects of Truss’s downfall is that Starmer’s incoming government will need to be cautious, to begin with, rather than seeking to raise spending or borrowing significantly. Perhaps this is a helpful thing for Starmer’s supporters to say to protect him from political pressure. But, whether helpful or not, it isn’t remotely true.

First, I have literally never heard of anyone “pro-market” who believed that meant economic policy should be determined by financial market reactions. For a start, the “market” in “pro-market” is typically nothing to do with financial markets at all. The “market” in question is the processes of competition and innovation, pricing revealing information, and incentives created by profit-seeking that exist in the markets for socks, IT equipment, food, business services and thousands of other “markets”.

Next, why on Earth would “listening to markets” be a good basis for setting economic policy even if one could infer accurately what they had to “say”. If a government thinks some reform to regulation, to planning law or to taxes will lead to faster growth, but on the day the policy is announced financial market prices fall, why would any government accept that meant its beliefs about the pro-growth nature of its policies were wrong? Why would financial markets be expected to know better? And, especially, why would their instant response be expected to be the underlying truth?

An even more astonishing version of this wrong-think was central to stories about Truss’s demise. It appears senior officials went to her and told her financial markets were demanding she reverse her corporation tax cuts. Presumably that must have meant some officials had made a few calls and asked some financial market pals why there was debt market turbulence, and those they spoke to said they didn’t like the corporation tax policy.

But the UK is a multi-trillion pound economy, selling our debt into markets that almost the entire global capital stock has access to. It isn’t that there are only three traders who are going to buy our debt, so we need to find out what they need to close the deal, like we were doing a merger. That kind of “consulting the debt markets to see what they need” is what tiny developing economies without any serious financial markets need to do. It’s embarrassing if anyone genuinely thought that was the way to conduct policy in the UK.

Financial market prices, particularly in markets for government debt and currencies, reflect a complex of factors from thousands of traders with access to trillions upon trillions in funds. Movements on one day reflect focal point trading, salience and other guesses as to the immediate market reaction to events.

Longer-term investors have different objectives from short-term investors and different objectives from each other. There are lagged effects, complex cascades of effects from things that happen in completely different financial markets thousands of miles away. Traders can guess why other people are reacting as they are, but they don’t know – and if they did know they certainly wouldn’t tell government officials.

The exact reasons for movements – especially short-term movements – are poorly understood, particularly of crashes and booms. And there are powerful economic theorems that demonstrate that, if markets are working properly, it is in principle impossible to understand them fully.

No-one should seek to make policy decisions on the basis of “the verdict of markets”. We can never know what that verdict is with any confidence, and even if we did know there is no good reason to believe it would be right or better than the beliefs of policymakers themselves.

If you want policies to create growth, set policies you believe will create growth and see, after a few years, whether growth has resulted. If you want to sell debt, offer a higher coupon (interest rate) for it. Financial markets don’t know better. Only the desperately economically naïve would believe that they did.

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