In the last one week, even as the world was captivated by both real and imagined nuclear radiation risks from Japan, important developments were afoot elsewhere. The Federal Reserve held its policy meeting and discussed the inflation outlook in its press release. True to form, it said that core inflation (the one that excludes rise in prices of what we eat and what we put in our cars) was contained just as the subprime mortgage crisis had been contained. It promised to keep interest rates exceptionally low for an extended period of time.
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Unlike the Great Depression, which triggered a complete re-examination and overhaul of the financial system, the current crisis seems to have had little lasting impact on policy framework. In particular, there has been little critical thinking about the Fed’s role. The Fed’s attempt to fine-tune the economy and smooth out every minor bump in the financial markets with a finely calibrated interest rate move makes it a de facto central planner. Its policy of smoothing out moderate fluctuations created an illusion of success—the so-called Great Moderation—even as it vastly increased systemic instability. The economy is a complex adaptive system. As any student of system dynamics knows, the sort of activism practised by the Fed interferes with normal adjustment processes, perpetuates imbalances, and vastly increases the risks of a catastrophe.
The Fed was originally conceived as a lender of last resort, a crisis manager, not the conductor of a finely choreographed ballet. Reorienting the Fed’s policy framework to its original purpose would be the first step towards a more robust and, more importantly, a fairer system. Two respected economists reinforce these arguments. Raghuram Rajan wrote in his blog that policymakers in democracies are doomed to ignore moral hazards when crises strike. Hence, he wanted them to act more decisively when there was no crisis—like not keeping interest rates too low for too long, as it led to excessive risk-taking.
Mervyn King, governor of the Bank of England, was in California last week, and said that solutions to all economic crises did not begin and end with providing more liquidity to financial markets. He said it was acceptable only if it was an intermediate solution on the way to structural reforms. But he warned that not only had the problems of “too big to fail” and “too important to fail” financial institutions remained with us, but global imbalances had also begun to rise.
These financial institutions led the stock market rally on Friday in the US by announcing higher dividends even as Anat Admati kept up her admirable campaign for structural reforms in the financial industry. In a letter to the Financial Times, she and 16 other eminent finance professors argued that only recapitalized US banks should be allowed to make dividend payments (http://www.gsb.stanford.edu/news/research/isaacletter.html).
The director of the documentary, Inside Job, which won the Oscar in its category, said in his acceptance speech: “…three years after our horrific financial crisis… not a single financial executive has gone to jail, and that’s wrong.” Whether there was criminal culpability or not, there should have been accountability. Yet many of the people and institutions that wrought the worst financial disaster since the Great Depression remain well ensconced. Worse still, many of the egregious practices of the pre-crisis era are making a comeback. FT recently reported not just an increasing incidence of covenant-lite debt, but also growing demand for synthetic junk bonds, which resemble synthetic mortgage-backed collateralized debt obligations that mushroomed during the credit bubble. Meanwhile, banks are offering their hedge fund clients increasingly easy financing and leverage on securities, such as non-agency residential mortgage-backed security, where the market had been given up for dead until recently.
Even as banks are ratcheting up the risk, regulators appear to be practising forbearance, not just in letting these risky practices proliferate but also in turning a blind eye to accounting obfuscation. Mark-to-market requirements that were eased during the crisis continue to be relaxed even as markets have ostensibly returned to normal. That the four major banks are carrying their disproportionately large second-lien home loan portfolio at unrealistically high valuations, which were used in the stress tests, is well documented. Another accounting shenanigan is the so-called “extend and pretend” strategy, wherein banks have been extending the maturity and reducing the interest rate when borrowers cannot repay loans coming due. This practice has been especially notable in commercial mortgages, where delinquencies remain sky-high. Many banks are also reportedly carrying delinquent home equity loans at full value on their books and booking accrued interest on them.
It is striking that the US dollar did not strengthen during the financial market turmoil last week. The world is learning to avoid something that has inflation radiation written all over it. Sensible investors would flee the hubris radiating from New York and not Tokyo.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. This piece was co-authored with Srinivas Thiruvadanthai of the Levy Forecasting Institute. These are their personal views. Your comments are welcome at firstname.lastname@example.org