Unresolved Financial Troubles: Three More Warning Shots

There are three articles at ft.com this morning warning about financial system troubles that remain unresolved. They are discussing distinctly different aspects of difficulties that could derail recovery. They are different, but for me they rhyme.

Loose Ends or Fundamental Change

Clive Cook (here) argues that the U.S. Congress is trying to define financial system legislation to enact reform without first defining what process they will actually follow. It is the old cart before the horse argument. As a result, Cook represents the likely form of resulting legislation to be full of holes, like the paper boat drawing that accompanies his article.

Cook raises questions about the advisability of tax policies that encourage increased debt. He gives as an example the mortgage interest deductibility provisions in the U.S. code. That doesn't sound like a politically viable option, but, theoretically it does give one pause. How can we avoid credit bubbles when we institutionalize the inflation mechanisms? Cook writes:

Too many US households and financial institutions got too deeply in debt. Housing-related debt was especially implicated in the mess. And it just so happens that debt in general, and housing-related debt in particular, attracts enormous implicit subsidy, especially in the US. Before one starts to tinker with complex evadable mandates on this and that – cranking up the regulatory machinery with all the unintended consequences this would doubtless have – one surely ought to look hard at the tax policies that actively encourage indebtedness.

Talk about attacking sacred cows? There isn't a more divine bovine than home mortgage interest deductibility. But Cook's arguments can not be ignored. His contention that we are blathering away about tying up loose ends and controlling the financial system through regulation without addressing fundamental structural forces should get some attention. But, getting down to fundamentals is not the easy way to proceed. And the easy way is the Washington way.

Bubbles, Bubbles Everywhere

Next, Prof. Nouriel Roubini of New York University (here) writes that the massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes is the mother of all carry trades. Roubini admits that some of the market advances have resulted from the beginning improvements in economic activity. The bulk, however, is liquidity driven, not valuation driven, and a super bubble is forming. Roubini says:

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

The Interest Rate Question

A third article by Wolfgang Munchau (here) argues that central banks around the world must not be too late to take away the low/zero interest high liquidity punch bowl. Munchau says that there are preliminary steps that must occur before serious tightening of monetary policy can start. He writes:

There is plenty else to do before raising rates. So it will take time. Given the bubbles that are already building up in several markets, this may well be too late. Ronald McKinnon*, professor of international economics at Stanford University, recently made a convincing case for a moderate increase in US interest rates. He argued that this would help the money markets to return to normal, put a floor underneath the dollar, and help China stabilise its economy. His arguments appear sensible to me. His advice will not be heeded.

Munchau cites bond market bubbles and sovereign debt expansions as reasons why tightening will be monetarily necessary. He is not suggesting sharply changing interest rates, because the recovery is too fragile. He mentions a short-term interest rate of 2% as a prudent, but non-damaging possibility. One has to wonder, though, if that would be enough to put a serious dent in the bubble that Roubini sees. And would it be too much for U.S. banks that are milking every basis point they can out of a steep yield curve in an effort to earn their way back to solvency?

Summary

What we see here are three cannon shots across the bow of the good ship recovery. They represent three separate views of pitfalls that could have a negative impact on the economy in the coming quarters and years. Can we have a recovery and a stable economy if we simply patch up the system that brought the world to its knees? Can we succeed elsewhere if we don't succeed in establishing a reformed and stable financial system? Can we manipulate monetary policy to diminish the "bubble-ation" of assets without stalling out a fragile recovery? Can the sovereign debt burdens building in the world be sustained?

In the 1930s recoveries were started and squashed as monetary policies were mismanaged. It could happen again.

Comments

[Clive Corcoran:]

The implication that I see from all three themes is that the Fed is walking a very tight rope on the US dollar/zero interest rate dilemma and it is very delicately balanced.... too delicately in my opinion.

Nov 02 08:11 AM

[bartpr:]

in the thirties both hoover and frd screwed up the economy. both initiated high interest rates and the results were bad.

Nov 02 08:12 AM

[buyitcheap:]

Are the current policies anticipating the damage that will be wrought by the coming tax increases?

Nov 02 08:40 AM

[john s. gordon:]

it has been suggested by others that mortgage interest deductibility (on 2 homes?) needs to be capped @ a lower level.
most of us do not have annual mortgage interest exceeding 100K.
> jack

Nov 02 08:48 AM

[Dave Wrixon:]

Even the UK does not have mortgage interest rate deductibility. It was stopped on new mortgages from 1984 and abolished in 2000.

Nov 02 08:58 AM

[Zmartmoney:]

Mortgage interest deductibility has the job of encouraging home ownership - someone who is more fully invested in the community in which they live, pay attention more closely (not always) to what's happening in that community, and are more involved with the activities of their local government. Renters don't particularly have the ties that bind to care about what local politicians are doing to raid the public treasury. Those local politicians can then go on to become our national leaders, with almost no one knowing where they came from or what they're about. My God! they could be common community organizers or other such grime.

Anyway, I digress. Home ownership isn't what caused the sordid mess of the last decade or two. Policies of the Fed, Countrywide, AIG, Fannie, Freddie, Goldman, Treasury, and stupid policiticans are what have put us onto the rocks. Individuals legally filing their taxes and taking an exemption for taking on a serious responsibility are NOT the cause of what has happened. Let's not shoot everyone on the street because one of them is known to be a pickpocket.

Nov 02 09:35 AM

[Graham and ...:]

We really need to eliminate mortgage deductability going forward. OK, "grandfather" existing mortgages so as not to disrupt the system.

Nov 02 09:56 AM

[Pat C:]

How about just limiting mortgage deduction to a percentage of AGI for the sheeple (say 20%) and entirely for the well to do or quicker phase out of itemized deductions.

Nov 02 10:38 AM

[Steven Hansen:]

john, consider that we may may be in a situation where all solutions have a negative result.

Nov 02 11:39 AM

[BRUCE E. W.:]

People like to say that the "lost decade" for the Asian Economic Crisis was due to this theory or that one; claiming their own bias. The Japanese, however, claim that they begged the world community to halt the short selling of their Yen which was mechanically exploited in the carry trading markets. They claimed it subverted every surge of recovery as the Yen got stronger it would be brought right back down by global currency trading in shark infested waters; feeding frenzyon the Yen.
I can't find the link but I read a warning well before Roubini wrote his analysis ft.com/cms/s/0/9a5...
(in fact it was still 2008 by a currency trader) that warned of this happening to the dollar with global consequences and repercussions that were unmeasurable. Unfortunately, the world community did not seem to have the will to intercede in the Japanese predicament (the Japanese are resentful and rightfully so). While the gloom and doom on the market is potentially a bit of a herd hysteria (along with hunters and scavengers standing by), the dire warnings about shorting the dollar is not a passing gust of wind. As Jim Morrison might have sang:
This is the End...and this is no impartial jury. Since the entire currency is a fiction float, if you pop this bubble...

Nov 02 06:55 PM

[Old Trader:]

Steven,

I strongly suspect that you're correct. It appears to me, at least, that we're stuck with hoping the "least bad" solution(s) are the ones that will be implemented. Definitely, a case of "pick your poison".

One thing that has struck me, is that Congress and the current administration seem hell-bent on reinventing the wheel. While there's absolutely no question that certain aspects of the old system failed to work "as advertised", other things worked fine. It seems that it would be easier and faster to focus on the failed aspects, than starting from scratch.


On Nov 02 11:39 AM Steven Hansen wrote:

> john, consider that we may may be in a situation where all solutions
> have a negative result.

Nov 02 07:59 PM

[untrusting ...:]

There were many many factors other than just interest rates that caused the Great Depression. And quite a few of them were a lot more important than interest rates.

Besides, what is your rationale for "penalizing the savers" with effective interest rates of 0% and rewarding the incompetent risk takers who lost hundreds of billions/trillons of dollars via excessive risk, gambling, and fraud? Many would argue that the Fed's policy and financial institution compliance with effective interest rates of 0% for savers is tantamount to practically legalized theft from other segments of the population.

Further, the effective 0% interest rate being provided to large financial instutions and large financial speculators is NOT being passed on to the real economy such as consumers and small business. Banks get funds a near 0%, but want to charge 15, 20, 30% interest on credit cards, small business loans, revolving credit, etc. The only benefit of ultra low interest rates to the real economy is for that segment of consumers that may be able to refinance mortgages at lower interest rates .... but even that is somewhat limited as: plenty of mortgages are underwater thus can't refinance (estimtes we have seen indicate as much as 50% of all mortgages are or soon will be underwater) , job losses and income reductions prevent many from refinancing, and quite a large amount (30% of all homes have no mortgage if we recall correctly). And even if consumers can refinance, the financial instutions are hugh beneficaries via the excessive refinance costs and fees.


On Nov 02 08:12 AM bartpr wrote:

> in the thirties both hoover and frd screwed up the economy. both
> initiated high interest rates and the results were bad.

Nov 02 09:31 PM