While gains are private goods, capitalists have increasingly resorted to making pain a public good. In other words, capitalists prefer to see policymakers adopt a hands-off policy and let markets work when the markets are producing gains for them, but at the first sign of trouble, they would like the state to step in and bail them out, so the pain is widely distributed.
Such poignant appeals from the financial sector are packaged intelligently as public-spirited recommendations to avoid harmful declines in output and employment in the broader economy. The onus is on the policymakers to see through the bluff. Right now, Ben Bernanke is under pressure to lower the federal funds rate as the panacea for the troubles plaguing the American financial institutions. So far, he has resisted well, notwithstanding a surprise discount rate cut on Friday. In case he is thinking hard on emulating his predecessor in other aspects, a small tale that I happened to read in a research report of a stockbroker might help stiffen him further.
Imagine a train station in a small village that has two railway tracks. One is not in use, the other an active track. A lone child is playing on the disused track knowing fully well she is safe. Several other children are, however, playing on the active track. The stationmaster periodically reminds them that the train is due to pass. The reminders go unheeded. The train appears on the horizon. It is too late to stop it and it is too late for the children to move to safety. What should the stationmaster do to save the many children playing on the active track? The easy answer is that the stationmaster should divert the train to the disused track and sacrifice one child to save the lives of many children. Well, that would be a folly.
The child playing on the unused track was behaving responsibly. The children playing on the active track were not. So, sacrificing the lone child to protect others would be to punish responsible behaviour and to reward irresponsible behaviour. If policymakers keep bailing out market participants who have behaved irresponsibly, they would be sacrificing the responsible child. Those who played by the rules and were prudent, would suffer competitive loss and go out of business. There is no substitute to combining free markets with effective regulation and consequences for those who fail to comply and cause systemic risk. The expectation that financial market participants or investors would regulate themselves has repeatedly failed the test of empirical reality.
Of course, some argue that policymakers should not be concerned with moral considerations but with the real economic consequences of their action or inaction. Surely, if output and employment in the nation were going to be hurt, policymakers can’t remain unmoved just to punish the errant behaviour of the few. Deeper examination reveals that the trade-off, so presented, is largely illusory. The real trade-off is whether the policymaker wishes to prevent damage to output and employment in the short term or in the long term, rather than a false choice between punishing a few or saving many. Framing the decision wrongly runs the risk that even bigger mistakes are committed with more deleterious consequences for output and employment at a later date. Thus, short-term action delays the damage, only to set up a bigger one later.
Unfortunately, no system of governance has figured out how to hold decision makers accountable for the net present value (NPV) of their decisions over a reasonably long horizon. By the time the true NPV comes into view, the protagonists are gone and cannot be called to justice. This is a natural spur for higher weightage to short-term horizons and popular pressure.
Thus, if there is an impact on the underlying economy in the next few months, Bernanke would lower the federal funds rate aggressively, as he signalled on Friday. Financial markets would cheer such a move as signalling the end of their woes. Whether that is really the case or not, it would signal the resumption of woes for the US dollar, for sure. Gold would shed its diffidence then. It would also arrest the recent slide in the price of crude oil.
Such monetary policy measures combined with more effective regulation and supervision might avoid bloodletting and lay the foundation for more sustainable business cycle upswings wherein the financial sector plays second fiddle to the real sector. But such neat and moderate solutions are more likely to appear in newspaper columns than in reality. One of the following two scenarios would unfold in the next few months: Either the damage already done to trust and confidence is too much for interest rate therapies to work, or “risk-ignored” returns make a comeback. For the next few months, investors would be smart to bet on the latter and wise to look out for the former.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org