Heading for another great recession?

| January 28, 2010

As I predicted in earlier posts, governments are reacting to the financial crisis by indulging in populist reforms that are intended to punish the culprits – banks and financial institutions – and to stop them from doing again whatever they did that caused the US and global economies to crash in 2008-9. The form and character of what President Obama has said he wants to do – if Congress allows him to do it – is a typical example (this is what the President said, in part):

"That’s why we are seeking reforms to protect consumers; we intend to close loopholes that allowed big financial firms to trade risky financial products like credit defaults swaps and other derivatives without oversight; to identify system-wide risks that could cause a meltdown; to strengthen capital and liquidity requirements to make the system more stable; and to ensure that the failure of any large firm does not take the entire economy down with it. Never again will the American taxpayer be held hostage by a bank that is "too big to fail."
 
The diagnosis is largely correct, as is the prognosis, but the suggested cure is way off the mark. It seems that the President wants to stop banks becoming too big – on the assumption that having banks that are too big to be allowed to fail creates a risk for the financial system – and he is proposing to strengthen capital and liquidity requirements and to limit the banks capacity to hedge risk. The President and his advisers have obviously missed the point. The point is that the system failed because of the lack of transparency, not because people took unwarranted risk. The latter is not a cause, but a trigger, firing a gun that was already loaded and would have gone off sooner or later, for one reason or another.
 
As the GLG Group points out – and I have made the same point before this in my blogs and in my 2008 book, which I wrote in 2006-07,
 
The current crisis was not caused by one or more banks being too big to fail. Rather it was caused by a collective failure of confidence amongst all credit institutions, such that none were willing to extend credit to any other.
 
How is making banks smaller and limiting their capacity to hedge risk – as well as taking money out of circulation by keeping more bank funds locked up as “security” – going to prevent this from happening again? The answer is that it won’t, but it will keep the tabloid press happy and it will allow the government to claim that it has done something the public has been asking for: retribution, punishment for the guilty.
 
While in the recent crisis the proximate cause of the systemic failure of confidence was the securitisation of real estate mortgages, which should be dealt with, as I explain in my new book, the fundamental cause of the crisis was the inadequate state of regulatory frameworks, the inability of the system to manage systemic risk. Restricting what any one player or groups of players can do is not going to remove this fundamental risk. Actually, it may make thing worse. In that new book, by the way, I propose how to fix this fundamental problem once and for all – and the solution is not more regulation.
 
This is because the likely if unintended consequences of what President Obama wants to do will be these: 
  • the capacity of the system to manage risk will be diminished if hedge funds cannot play their role, which is to assist in placing risk where it can best be handled and to punish those who take unwarranted risks with other people’s money; and
  • the flow of money through the US economy and, consequently, through the global economy, and the speed of that flow will be reduced, perhaps quite substantially.
In turn, these impacts on the US and global financial systems will impair the capacity of the economy to grow at a pace rapid enough to take the US out of recession and to push Europe and Japan towards meaningful growth rates. Furthermore, this chain of events might eventually cause China to re-consider where it parks its billions, most of which are in the USA now, which would contribute to a possibly terminal downward spiral in US economic activity.
 
What I am saying here is that there is a real probability that what Obama wants to do may give the US the opportunity to experience the Great Depression all over again, having narrowly escaped an opportunity to do so in the last two years, thanks to Bernanke, the Chinese and quite a bit of luck.
 
Let’s hope I am wrong.
  

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Patrick Callioni is a former senior public servant, with the Queensland and Australian Governments, and is now the Managing Director of consulting company, Enterprise Intelligence Pty Ltd, which specialises in helping business to do business with government and vice-versa. www.enterpriseintelligence.net.au His book Compliance Regulation and Financial Services is available at Amazon

 
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One Comment

  1. Bradley J

    February 10, 2010 at 10:31 am

    Inflation




    The global financial crisis has resulted to many predicaments. Despite the downturn, many remain optimistic. However, perhaps one of the biggest economic issues that don’t get discussed is problems with a wage decrease  over the last several decades.  Wages for most workers have declined, but CEO compensation hasn’t.  Now people do deserve reward for effort – but something is wrong with this picture.   You see, the thing is that wages overall have increased in dollar amount, but increases in wages (such as minimum wage increases) don’t increase entirely relatively to inflation.  Several states peg wages to inflation (and dollar amount) but not to dollar value.  The costs of health care, energy, and other goods and services have risen above the rate of inflation – ever wonder why so many people run for payday loans.