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The Bank for International Settlements released its Annual Report today, which was comprised largely of "how we got here" narrative that cited the usual economic imbalances (US/European debt agglomeration). The report also touches on the failure to identify systemic risk, a predicament the BIS attributes to the existence of a global financial system that exhibits a degree of complexity and interconnectivity beyond what any single market participant is able comprehend. Although the backward-looking statements are worth reading, we were far more intrigued by the BIS's commentary on what it perceives to be the major risks to a recovery going forward. Below are two selected excerpts that deal with both fiscal and monetary policy risks going forward:

"Fiscal policy is at serious risk of overshooting even in the economies with the most room for debt expansion. A fundamental reason is that, while the programmes most likely to be highly effective and low risk are timely, targeted and temporary, those attributes of fiscal action are notoriously rare in representative democracies."

"And once the recovery materialises, how can central banks begin to tighten policy interest rates and unwind their vast monetary interventions? The technical issues are much less challenging than the political ones."

On a multiple choice test, we would be inclined to check the box next to "strongly agree" with respect to each of these statements. The two premises above would be very valuable if inserted into the discourse that surrounds a number of questions today, namely: Is inflation on the horizon? When will we see a recovery in the broader economy? How and when can the government unwind it's various market-supporting programs in a responsible manner?

The ability of politics to distort and interfere with certain aspects of business and the financial markets can be more readily identified within the smaller (relatively) microcosms of intervention - GM being the prime example. Even a completely disinterested layman would likely be able to offer a vague description of what that Company needs to do in order to become profitable again: Reduce it's union obligations, reduce it's debt, close half of it's dealerships, and shut down inefficient/unprofitable plants (You would probably also be told something to the effect of "build better cars") Unfortunately, certain politicians have taken to abusing their direct line to Fritz Henderson, and proceeded to micromanage plant closure decisions.

In terms of broader economic policy, it is easy to envision several scenarios that could lead to politically motivated tampering with programs currently in place. If you believe that we face an inevitable bout of inflation, you must ask yourself whether the political will exists to combat rising prices with Paul Volcker-like methods. Additionally, what will happen once the population of those who have exhausted unemployment benefits grows large enough, and subsequently loud enough to catch the attention of politicians in Washington? It might be difficult for Congress, mindful of the upcoming 2010 elections, not to scramble to find a way to increase the length of time one may receive benefits.

This speaks to the "temporary" aspect of an effective program as cited by BIS, and underscores the reality that as a program moves from temporary to permanent status, it must be funded somehow. That "somehow" tends to be through the fiscal lever labeled "tax increases"; the pulling of which most would agree is not conducive to an economic recovery.

The BIS, in its own tactful way, did not directly identify politicians as being the looming "problem", instead referring to "representative democracies" as the confounding factor. The message is clear though: The greatest risk to a sustainable recovery is politically motivated interference that pulls either too hard or too long on the various levers of fiscal and monetary policy.

Disclosure: No positions

Source: Bank for International Settlements: Politics May Stand in Way of Recovery