From the January 27, 2008 Sunday Times
January 28, 2008
by Irwin Stelzer
One thing is certain in this uncertain world: when the roiled financial waters have calmed, the world of finance will not be as it was before the storm broke.
John Maynard Keynes's famous statement, "In the long run we are all dead", was followed by the less famous "Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again." Keynes was right. Fortunately, we economists can tell everyone more than that - we can reveal that in addition to a flat ocean, there will be new rules governing the use of the seas.
The first drafts of new regulations are already on the drawing boards of legislators in America. The sub-prime fiasco has revealed an important market failure – those who grant the mortgages sell them on so quickly that they can be casual about the borrowers' ability to repay the loans, or even hand over the first interest payments. Soon mortgage brokers will have to retain some of the risk they have created. This will be forced on them by new regulations or by the insistence of the investors who ended up holding toxic mortgages. We have probably seen the last of Ninja loans – no income, no job, no assets.
More fundamentally, for better or worse, it will be a long time before the presumption in favour of deregulation reasserts itself. For decades now the vast majority of economists have argued that deregulation of financial markets has contributed to economic growth and to increased stability of the American economy and other leading economies. That they are broadly right is no longer relevant. The hunt is now on for regulatory fixes – expanding the power exercised by the Federal Reserve and, in Britain, the Financial Services Authority, to supervise banks and intervene in their affairs if necessary; more power for regulators to limit the ability of banks to conceal risks with a variety of off-balance-sheet gimmicks; limitations on the ability of rating agencies to, in effect, "sell" AAA ratings in a system under which they are paid by those they are rating. Defenders of light-handed regulation will not be able to dismiss the new regulations with the usual, "If it ain't broke, don't fix it". Instead, they will have to fight for the least counter-productive fixes.
Nor will the leading financial institutions emerge from their current troubles unchanged. For one thing, their desperate need for new equity to offset the write-downs they have taken has thrown them into the arms of sovereign wealth funds, nontransparent investment vehicles of national governments that might have other than purely commercial motives for intervening in companies in which they are substantial shareholders.
This is making the American government sufficiently nervous that even President George Bush, who has welcomed what he calls the return of our money, felt compelled to act. Late last week he issued an executive order requiring tighter review of the national-security implications of foreign investments, and empowering the secretary of commerce to "compile and evaluate data on significant transactions involving foreign investment in the United States". It is the thin edge of what will become a rather large wedge.
As a consequence, the sovereign wealth funds will find that the short-term problems the economies of the West now face will produce a long-term change in how they do business. At the gathering of the great and good in Davos, executives from western institutions are urging the governments that control these funds to change the way they do business – to make their governance procedures and investment goals more transparent so as to avoid a political backlash.
My guess is that as long as American and other banks badly need capital infusions from the sovereign wealth funds, they will not be in a position to insist on changes. But once balance sheets are in order, and the need for cash becomes less urgent, pressure on these funds will become irresistible, and at least token bows made to the demands of countries that accept their money.
The rules governing monetary policy will also change. In recent years there has been a debate over whether central bankers should focus solely on inflation in the prices of goods and services, or consider also the prices of assets such as shares and houses. Those who object to basing monetary policy on share-price and house-price movements argue that it is impossible to tell when there is a bubble that needs pricking, and that it is better to leave it to the market to make any corrections that are needed.
They have lost. The fact that the bursting of the so-called house-price bubble is complicit in the current, spreading problems means that, in the future, attention will be paid to house and share prices. Central bankers, now convinced that movements in asset prices affect consumer spending, job creation and inflationary expectations, won't stand by while asset prices reach levels they consider unsustainable, but will raise interest rates or restrict credit to bring prices off the boil.
How they will know when investors have had too much of a good thing, I am not certain. But having been asked to clean up the debris left by the recent share-price collapse, and watching the social and economic consequences of the housing bubble's collapse, they will feel justified in intervening to dampen price rises.
Robert Brand, a banker friend of Keynes, warned the great economist against relying "on the skill and economic knowledge of bankers harassed by politicians". Substitute "regulators" for "bankers" before cheering the new round of regulations that is in our future.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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