A recent Intelligence Squared debate put the major blame on Washington over Wall Street for the financial crisis. Nouriel Roubini sided – together with Niall Ferguson and John Gordon Steele – with the view that Washington was the real culprit even if many bankers and investors were greedy, incompetent and taking excessive risk. If bad political policies are the mother of the crisis, politics will determine the outcome. There is considerable slippage between effective economic policies and political expedience in the crisis management and major risks lie ahead.
Due the current political lock-up in cleansing the financial system, the US government is effectively subsidizing with capital injections the larger lame duck financial institutions as 'too big to fail'. They fear the domestic dislocation but also the negative repercussions from foreign creditors if their holdings are wiped out by bankruptcy court. So they have short-circuited the traditional institutional means to deal with insolvency and reorganization of failed corporations.
The financial sector is busy setting up arrangements in which employees are guaranteed high levels of compensation if they stay on through the difficult days ahead. These retention-type payments allow firms to survive in their existing form, pursue business as-usual, and gamble for resurrection, i.e., make further risky investments. This is the mildest form of moral hazard stemming from the subsidies. This could degenerate into even worse distortions as the US governments starts to play a stronger hand credit allocation for political ends. Distorted credit allocation and encouragement of securitization from Washington politicians played a major role in creation of the subprime mess in the first place.
These same payment schemes, e.g., Goldman Sachs’ loans-or-employees deal, are a form of poison pill with regard to further bailouts, Whilst the Administration seems to prefer keeping these firms on life support for the reasons above, this kind of tunneling is leading Congress to knee-jerk legislation like the recent 'bill of attainder' taxation on executive compensation. 'No New Bailout Money' is a slogan reaching from here to the midterm congressional elections.
Unless the economy turns around, somewhat miraculously, we are in for a big slump or even for a Great Depression as demonstrated by the words and body language in Bernanke’s interview on '60 Minutes.' As he sees the world, there is only one course of action remaining: print money and hope for a moderate degree of inflation. The money part was, of course, the announcement yesterday from the FED.
The Obama stimulus plan - Bernanke endorsed Obama and this plan of action prior November elections - and ambitious social agenda add to the risks of future inflationary pressures. This expands already over-bloated federal deficits from the bailouts and is leading to record levels of US public debt. So far the financing cost of this has been low with the flight to US government securities from higher risk assets in the financial crisis. The recent FED move to expand its balance sheet and buy US treasuries and agency bonds has brought down longer term interest rates. In effect, the FED is creating another subsidy in the form of artificially low interest rates. Is this situation sustainable?
Here we are come full circle because this is being financed by US treasury auctions to foreign governments. Particularly, the Middle East with its oil surpluses and the Far East (Chinese) with the trade surpluses from their export oriented economies. These surpluses no longer seem sustainable with the fall in oil prices and collapsing export markets as well as rising domestic needs to support their domestic economies and provide stimulus.
Foreign creditors like China are beginning publicly to express their concerns about sovereign debt in the US. Already China seems to have lost confidence in the implicit guarantee that backs the Agency bond market. The recent FED move to expand its balance sheet serves to substitute China and other central banks in this market. Foreign central banks never bought anything close to a trillion dollars of Treasuries and Agencies in a single year. A half trillion or so of annual purchases was more than enough to have an impact.
The inflation part is the potential fly in the ointment for this self-perpetuating FED money machine. If inflation is driven by the so-called “output gap,” i.e., how far the US economy is below potential output, then prices will not increase much, the yield curve steepens moderately, and banks make out like bandits (reflected in the current optimism of lame-duck banks like Citibank in their recent earnings forecasts and stock market rally). But if the whole world is moving more into an emerging market-type situation then (a) inflation expectations become danger (central bank jargon for “really scary”), (b) potential output falls as we massively deleverage, and (b) people move increasingly into alternative assets - storable commodities spring to mind - and we get some serious inflation. If oil prices jump, then we have an even bigger inflation problem. Oil is not storable, supposedly.
A potential run on the US dollar and skyrocketing commodities prices would bring down like a house of cards all this Bernanke financial engineering and the consequences of the public debt pyramiding would come to roost. The killer would be rising interest levels. This would make US public debt very difficult to service much less pay down. It would create a new era of stagflation (stagdeflation?) with sluggish economic growth and high unemployment that may take decades to sort out depending on the political will. Certainly this scenario would serve as a 'cold shower' to the present US administration with its deficit financing and income redistribution policies.
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