Listen to the market, hear the best policy decision, but don’t always choose it
Economics Discussion Paper Series
University of Essex, Department of Economics
Real-world policymakers want to extract investors' private information about a policy's likely effects by 'listening to' asset markets. However, this brings the risk that investors will profitably 'manipulate' prices to steer policy. We model the interaction between a policymaker and an informed (profit-seeking) investor who can buy/short-sell an asset from uninformed traders. We characterize when the investor's incentives do not align with the policymaker's, implying that to induce truth-telling behavior the policymaker must commit to sometimes ignoring the signal (as revealed by the investor's behavior driving the asset's price). This implies a commitment to executing the policy with a probability depending on the asset's price. We develop a taxonomy for the full set of relationships between private signals, asset values, and policymaker welfare, characterizing the optimal indirect mechanism for each case. We find that where the policymaker is ex-ante indifferent, she commits to sometimes/never executing after a bad signal, but always executes after a good signal. Generically, this 'listening' mechanism leads to higher (policymaker) welfare then ignoring the signals. We discuss real-world evidence, implications for legislative processes, and phenomena such as 'trial balloons' and 'committing political capital'.
No. 748 February 2014