Simon Smelt's  Instablog

Beyond the immediate, investment in building productive capacity must occur if the U.S. is to prosper and if higher national debt levels are to be serviced. Three forces that have built up in recent months and that will interact ferociously now make this almost impossible.

Let's be optimistic and assume that any new debt default problems (e.g. from commercial real estate) can be absorbed by the reformed and refinanced financial sector.  Yet, the cards are now stacked against sustained recovery, because:

First, the rule of law has been abandoned for swathes of financial contracts. International research has found that successful economies are those that have well established property rights and law.  This gives investors confidence to invest and, if things go wrong, they know the path to follow in seeking redress or unwinding positions.  This is what distinguishes the U.S. from Venezuela and Russia.  Or used to.

With the crisis, the U.S. rule of law has eroded for investors.  Because of the housing loan crisis, there were various proposals for mortgage cram-downs and the like.  Whilst the need was and is to help stranded homeowners, and force lenders to ease off or contribute, the effect is also to undermine confidence in the basic mortgage contract. The legal deal between lender and borrower, with the property as security, is now subject to third party intervention by the government with the lender having uncertain recourse to the property.  Perhaps all this is just for a short time for certain mortgages, or perhaps not. The sanctity of the contract is gone.

Similarly, the Chrysler deal saw bond holders’ legal position in the queue of claimants overturned. Bond holders were forced by the government to give up part of their entitlements to the union, and castigated by Obama for resisting.  So, now in the U.S. bond holders cannot rely on their legal position in the queue in the event of default or bankruptcy.  This makes loans to large unionised firms much riskier than hitherto.

Of course, there were good reasons in these cases. Maybe it won't happen again.  But at the end of the day, lenders’ legal entitlements have effectively been cancelled by the government in an ad hoc fashion. 

Of course, it all depends who you are. As I've <a href="simonsmelt.com/musings...;>commented before</a>, the very protective treatment that bond holders in the big banks have received may be connected to the large bond holdings in the banks by some major overseas sovereign wealth funds.  By contrast, the hedge funds lambasted by Obama over Chrysler will predominantly have been representing domestic savers and pension funds.

This first factor interacts ferociously with a second, moral hazard.  There's been much discussion over the zombie banks and their recovery.  Being too big to fail, they have received both directly and via AIG large sums of public money.  They have been allowed to renegotiate their stress test results and now can deduct any profits they make (e.g. from AIG handouts) from the stress test requirements.  

In a May 7 interview with Charlie Rose, Geithner speaking of the stress tests on the big banks said: "all Americans should be confident that these institutions are going to be viable institutions going forward…. So it's like precautionary insurance against the risk of a deeper recession. That'll help make recovery more likely, because then banks won't have to keep behaving against the possibility that they have to protect themselves against things getting worse."  

So, Secretary Geithner wants to assure all Americans that the big banks are safe.  Which means they are.  Ordinary financial institutions – banks or otherwise – might have to worry about mortgage lending or buying corporate bonds.  But not the big banks because they have a total government guarantee.

Smaller but sound financial institutions will face risks from the government regardless of their legal protections.  But the big banks, funded by taxpayers will receive only protections from the government. The inevitable result will be that the big banks gain market share not because of any superiority of performance but because of who they know.  Returns on investment will necessarily be secondary to nurturing the relationship with the government.

The third force contributing to the perfect storm is government borrowing and spending.  Set aside worries (well founded in my view) about the future of the $ and inflation.  Again, let’s be optimistic and assume all that can be handled. 

Government debt and government spend as a share of GDP will rise.  The compensatory savings proposed by the administration were so small as to be derisory – the government is scarcely even concerned to appear to be looking to save money.  And if you believe in the mega savings promised from health try and get your doctor or hospital to undertake to reduce or freeze the real costs of your health care in the future.

There will be massive Treasury bond issues by governments worldwide and a likely reducing Chinese trade surplus and taste for U.S. $.  Hence, domestic purchases of bonds will be far more important to fund rising U.S. government debt.

But that may be OK as U.S. households are expected to save more.  Setting aside, the consequent drag on consumption, consider the dynamic created.

Financial institutions outside the big banks are subject to extra risk from government confiscation of their loans if the debtor is in difficulty.  This curtails their lending.  The big banks have no such problem as they are supported by the government.  They will respond to government preferences in their lending.  And the government soaks up household savings into Treasury bonds which can then be used to fund or partner with the big banks’ lending.

In short, a corporatist approach.  So much for the markets and Anglo-Saxon type capitalism.  Some might say good riddance, but this removes the strengths of the U.S. economy and hence its growth potential.  And consider who will benefit from the change.