Bad Policies Create Market Distortion
November 3rd, 2008 - The newsflow in America, Europe and Japan is dominated by talk about recession and government action to counter its severity. All indications are that the downturn will be sharp, particularly in those countries such as the US and Britain that had the biggest housing bubbles.
The same policymakers who previously fed the frenzy of excessive risk-taking by providing plentiful liquidity, and overlooking the necessity of regulating the shadow banking system, are now posing as the champions that will save the economy and financial system from ruin. Naturally, the public’s trust in many of these officials is low.
What a sorry history of monetary, regulatory and fiscal mismanagement! For non-Wall-Streeters, the Fed’s record on monetary policy is too awful to need any further comment. Of course, if you had been reading Wall Street’s view of Federal Reserve policymaking over the past many years you would have had to look hard to find any criticism among the panegyrics. As beneficiaries, why would they want to criticise an institution that was artificially boosting asset prices and giving them the means to make loads of money?
With regard to fiscal policy, many governments have been abusing Keynesian demand management. The idea behind economic stabilization based on Keynes’s theory, is to conduct a counter-cyclical policy. In other words, when there is aggregate-demand deficiency and the economy is facing a recession, the government is supposed to run a deficit, compensating for lower private-sector spending. But when the economy is booming, authorities should aim for a fiscal surplus.
Fiscal policy, conducted in this manner, would smooth economic fluctuations and keep government finances in balance. But many governments have been tempted to keep on spending even during the good times. The result is a pro-cyclical fiscal policy that exaggerates the boom and leaves the government with a gaping deficit in a slump. Gordon Brown, current PM and former chancellor - - among others - - is guilty of this error. The problem is that politicians have a short-term horizon and in their eagerness to gain public approval may ignore longer-term problems created by their policies.
Some observers have called for the need to let market forces play out their role in this recession and allow a correction of the asset mispricing, economic distortions and imbalances that have been built up over many years. Unfortunately, this would mean a severe global recession that would be politically unacceptable. So, realistically, massive government intervention is inevitable.
And this is likely to create more distortions, mispricing and volatility in the future. The idea that we will come out of the current recession with a balanced economy and financial system ready for a period of rapid non-inflationary growth is a nice thought, but unlikely to be realised. However, those countries with better government finances, stronger household and corporate balance sheets, a robust financial system and low external debt will be in an advantageous position.
The process of deleveraging has accelerated recently. Hedge funds have been failing in large numbers and many developing countries have been pushed to the brink. We should expect the unwinding to continue. The earlier buildup of leveraged positions was so large that the reversal will take some time to complete.
Banks in the US, UK and elsewhere are being buttressed by every means at the authorities’ disposal. Many of them are effectively insolvent, with awful balance sheets and bad management. The partial nationalisation of these banks side-steps the issue of overcapacity in the sector. There is a need to rationalise the banking sector by allowing a good many entities to fail.
The market would have dealt with the problem efficiently, but brutally. Now with bureaucrats acting in concert with bad managers, we should not expect an optimal solution. As for the outlook, with recessionary forces taking hold, banks are likely to face more loan losses, asset write-downs and the need for additional capital injection.
