It looks very likely that Obama will win and Democrats will gain additional seats. Political preferences aside, history says that a unified government is bad for markets. And the impact will be dramatically worse than historical precedent if Obama’s “21st-century regulatory framework” is applied. In his view, the global financial crisis is the result of US deregulation and Wall Street greed. This diagnosis is dangerously wrong.
The root causes are properly traced to the 1997-98 financial crisis, after which Asian policy makers decided to manage currencies (lower) to promote export growth and build dollar reserves. Asian current account surpluses exploded, and excess savings were funneled into the safe haven of US fixed income. Of course the capital influx lowered US borrowing yields and promoted a severe mis-allocation of global resources to consumption / homeownership / financial assets. This distortion grew with Greenspan’s refusal to normalize rates faster as asset bubbles grew. His “measured pace of policy accommodation removal” (remember that phrase?!) was predictable to a fault. Asset volatility plummeted. Leverage appeared much safer — to finance homes, buy cars, securitize loans, speculate on commodities, or launch hedge funds. In fact, banks and hedge funds were swiftly punished by investors if they used too little leverage.
Why? Investors in leveraged vehicles faced real problems — ageing demographics, rising health care costs, inflation — that were made worse by lower yields. Pension funds, for example, saw their present value of future liabilities swell as real rates (ie, discount factors) went lower. Liabilities would have swelled anyways given the aging demographics of the rich world. Insurance companies, university endowments, and charitable foundations all faced similar problems. So hedge fund assets quadrupled as investors desperately sought a source of ‘above-market’ returns. And securitization surged as investors enhanced asset yields to match growing liabilities.
The world became leveraged — and vulnerable — to financial assets. Subprime debt insolvency was the trigger for the de-leveraging tsunami that followed. But predatory lending and Wall Street greed were hardly the root cause. This crisis is mostly a story of global resource misallocation and lax monetary policy. It’s also a story of financial innovation (a close cousin of greed) being applied to real problems: an ageing populace, rising health care / education costs, broken social security system, etc. The world needs more innovation, not less. Incentives matter in finance no less than they do in pharma or high-tech. If we dull innovation in America, then Asia will happily take the lead. Choking the finance industry with regulation would be the death knell for the US Dollar and further destabilize global markets.
So tighten the supervision of lending standards. Monitor financial leverage and systemic risk more closely. Prick asset bubbles with monetary policy before they grow too large. Discourage Asian governments from using mercantilist currency policy. Reform our health care system. Make university education more affordable. Recapitalize our social security system. These are complex problems with difficult solutions. You have the intellectual strength to social problems to our financial mess. Don’t reduce it to Wall Street greed.
You’re better than that, Obama.
This post is based on an email I received from a subscriber of this blog. I receive a few of these a week, but this one was especially interesting, well written and had some thoughtful analysis. I know it made me look at the financial crisis in a different light. The sender was kind enough to grant me permission to anonymously publish the content with some minor edits.