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Recommendations by the dean of a leading US business school that governments should look to stock markets for guidance may sound controversial during a period of sustained public outrage at Wall Street and its international counterparts. The economist Peter Blair Henry, dean of NYU Stern School of Business, however is making the case that market responses to economic reforms provide a valuable predictor of government policy’s success.

At the core of Prof Henry’s research is historical analysis of stock market reactions to government reforms in emerging economies. He concludes that decisive and transparent plans to implement market-friendly policies repeatedly inspired market optimism in future growth. Given that stock prices take a predictive approach, considering whether given factors will create or destroy value, Prof Henry sees them as a powerful bellwether of policy effectiveness.

He highlights the particular relevance of stock market responses to fiscal austerity among emerging economies in his analysis. Amid high inflation, the announcement of austerity programmes heralded very positive market responses in expectation that economic conditions were to improve. Markets fell however when restrictive policies were implemented in countries with only moderate inflation.

These lessons, Prof Henry asserts, are of utmost significance to today’s policy makers across Europe and in the US. Given low inflation in these countries, their governments should caution against excessive fiscal austerity that removes demand from the economy, thus exacerbating their economic malaise.

Prof Henry also concludes that historical stock market responses suggest that the best way to resolve the Eurozone debt crisis is conditional debt forgiveness. In expectation of debt relief, stock markets in both debtor and creditor countries rose, according to his analysis. Importantly, debt forgiveness only restores market confidence and economic growth when accompanied by by structural reforms that encourage investment, Prof Henry argues.

Such structural adjustment policies - as prescribed to developing countries for decades through IMF and World Bank loan programmes - must now be embraced by troubled European countries to improve their global competitiveness. Their creditors must meanwhile share the burden of this adjustment through debt relief. It is the aversion of US and European governments to make difficult reforms that leads to continued stock market volatility, Prof Henry argues, rather than the market mechanisms themselves.

“The wisdom of the market”, was published in Foreign Policy journal on 8 February 2013. “Turnaround: third world lessons for first world growth”, will be published on 12 March 2013.

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