Listen to the market, hear the best policy decision, but don't always choose it

Abstract

Policymakers often consider policies with (a) uncertain social benefits and (b) uncertain impacts on the value of private assets; we characterize six ways (a) and (b) may be inter-related. Where investors have private information over (b), policymakers may attempt to learn this through the response of asset markets to proposed policies. However, where this information is concentrated, an informed trader may profitably hide his information and “manipulate” the market. We show that it is nonetheless generically optimal for policymakers to listen and respond to asset markets, but under specified conditions they must commit (e.g., through “political capital”) to sometimes pursuing a policy even when the expected welfare effects are negative. Surprisingly, allowing traders to short-sell can make it easier for policymakers to induce truth-telling actions.