Financial Markets, and the Next 90 Days

The next ninety days will be the most eventful in US financial markets since Ronald Reagan was inaugurated. The response by Washington to the market failure induced by the unwise risk management of mortgage backed securities will put in place a policy matrix that will dictate the regulatory framework for the next decade.

The breakdown in financial intermediation has already caused the Federal Reserve to push up against the edge of its mandate. The forced liquidation of assets at Bear Stearns to avoid a systemic meltdown of the domestic financial architecture creates the impression that concerns over moral hazard have been thrown out the window, and that price stability will be subordinated to an election year calendar.

In the past six months the central bank has reduced the policy rate by 300 basis points, and has also set up three separate facilities to provide liquidity to banks and securities firms in distress. The Office of Federal Housing Enterprise Oversight recently reduced the capital requirement for Fannie Mae and Freddie Mac from 30% to 20%, which should result in the injection of $200 billion into the market for mortgage-backed securities. Moreover, it is quite plausible that the Federal Government will take the final step and provide an explicit guarantee for Fannie and Freddie, thus in effect socializing the up to 80% of the mortgage market over the coming year.

What awaits the market going forward is equally unpleasant. The talks underway in Washington between Senate Finance Chairman Chris Dodd (D-CT) and House Financial Services Chairman Rep. Barney Frank (D-MA) appear to be organized around a bailout of both banks and homeowners to the tune of $400 billion. Had enough? No wait, it gets worse.

Over the horizon, the quid pro quo for the bailout of the domestic financial industry will be a significant step up in regulatory oversight by the Federal and State governments. The return of the regulators to domestic financial markets will stifle financial innovation and discourage reasonable assumptions of risk concomitant with globally active investment institutions. If little is done over the next few months, the era of unfettered freedom by U.S. financials will come to an end. Policy entrepreneurs in Washington already smell blood in the water and will be putting together an aggressive agenda that will seek to put real constraints on financial firms.

How far can it go? Perhaps, one should begin to think about the unthinkable. Want to see a return of Glass-Steagall? Seem far-fetched? Just wait till the backbenchers in Congress and the public gets a whiff of what the true price of the bailout will be. What may seem a bit outlandish today may not seem that far off the mark tomorrow.

The collapse of Bear Stearns and the response by Washington if not implemented properly may signal a turning point in the relationship between the market and the state. Twenty-five years of progress towards building a market based society where adjustments in prices and wages are the primary driver of changes in behavior is now at risk. The efficient allocation of scarce resources and capital in the pursuit of profits and prosperity will take a back seat to income redistribution. The late political scientist David Easton once defined politics as the “authoritative allocation of resources.” For many in our political establishment, that is an ideal state of not only political interaction, but also economic policy.

The Austrian political-economist Joseph Shumpeter often made the point that the public response to private financial crises was often worse than that which caused the conflagrations the first place. The more than one trillion dollars that our public institutions will put forward to stabilize the domestic financial system will require the Fed to push rates much higher in the aftermath of the crises to hedge against the inflation risks that will linger for years. Just as important, our political class will seek to satiate the current populist economic fad by re-instituting inefficient government mandates to quash risk-taking activity by banks and other financial institutions; mandates that will in turn diminish prospect for growth in the aftermath of the crises.

Our financial and public elite who otherwise might put up a vigorous intellectual and political struggle to preserve the progress made over the last quarter century are lost in an increasingly vain Beltway culture more concerned with ratings of an insignificant preacher and sex scandals rather than the first order concerns of the day. The primary question facing the country at this critical juncture is how to preserve the incentive to take risks in a context where market participants will be compelled to redistribute a static quantity of capital in a more equitable fashion rather than engage in the dynamic creation of wealth.

By the time Congress adjourns for its summer break roughly 90 days from now, much of what makes our domestic financial markets and the economy so attractive, may be put at risk. The initiatives favoring free trade, free capital flows and flexible currencies could be lost. One would have thought that the real risks over the horizon, in a tired and long election season, would have stimulated at least a modicum of debate about where all of this is leading. That is, if anybody is paying attention…. anyone?

Joseph Brusuelas is the Chief US Economist at IDEAglobal in Manhattan. The ideas expressed in the article are his own and do not represent those of the firm.