Ever since Chairman Bernanke favored horticulturists this spring with his perspicacious observation of the "green shoots" of recovery, the financial media have been focused on when and how the Federal Reserve would formulate its exit strategy from the near-zero interest rate environment. The bond market has been particularly keen on divining the timing of such an action.
Lost in the discussion of the interest rate exit strategy is the quandary facing the Fed and Treasury of finding the other exit strategy. As discussed on December 23rd and December 26th of last year, the government has been quite active implementing emergency measures to stabilize the financial system and to prevent a disastrous economic decline. By and large, that appears to have been somewhat successful. We have not entered Great Depression II.
However, the economy and financial system are not functioning very well. U.S. unemployment crashed through previously anticipated ceilings and many fear that it will go much higher and persist longer than when the stress tests were devised. Moreover, the U6 data, which counts those who are unemployed and looking, those who are no longer looking for work and those who are temporarily employed and want permanent work, is now about 16.5%!
The importance and difficulty in devising a credible exit strategy from the plethora of government guarantees and market stabilizing programs is beginning to permeate the collective consciousness of investors.
PIMCO has recently been observing in its reports and media interviews (source: Bloomberg News) that
The U.S. recovery scenario is weak because the economy can’t grow now without support from the government and Federal Reserve.
As Tony Crescenzi of PIMCO told Bloomberg television,
The economy can’t reach a self-sustaining condition without this support . . ..
Left unsaid is whether the economy can reach a self-sustaining condition of economic growth without the government delineating an exit strategy from the emergency guarantees. Furthermore, there is the question of how to get the economy to a self-sustaining condition so that the guarantees can be withdrawn.
The answer isn't readily available. Indeed, that appears to be the question posed by Paul Volcker back in January when he and Jacob Frenkel wrote:
Difficult questions of weaning markets and financial institutions from official life support are sure to arise.
Certainly government have been creative in devising these emergency measures. Creativity was central to policy makers as the playbook was thrown out and the players drew up new routes as the game progressed. Considering the severity of the credit crisis, there was likely little other option.
However, the government position that creative solutions will be devised to exit these guarantees is problematic at best. How will private market confidence be restored? Certainly increased regulation of the financial services sector is coming. Nevertheless, economic growth requires that private industry and investors make credit judgments and that the allocation of capital be handled through the workings of the marketplace.
As the G-20 report states:
We will eventually need an exit strategy that preserves the government’s essential roles in effective regulatory oversight and prevention of systemic risks but leaves in place incentives for innovation, risk-taking and private monitoring of ﬁnancial ﬁrms.
Private monitoring of financial firms is a nice way of saying that capital needs to be able to assess balance sheet strength. But, it is precisely the current difficulty to accomplish this private monitoring (e.g., credit assessment of bank balance sheets by other banks and investors) that led to the implementation of government guarantees and emergency measures to bring down interest rates.
It is also doubtful that the recent change to financial accounting standards will result in an increase of confidence as to the credibility of balance sheet strength. Without the restoration of confidence in financial reporting, creativity alone may be insufficient to formulate an exit strategy and set the economy on a self-sustaining recovery.
As PIMCO's El-Erian so succinctly stated in a recent Financial Times piece,
[T]he economy will continue to struggle, navigating both the adverse implications of last year’s financial crisis and the unintended consequences of the experimental policy responses.
Without an effective exit strategy from the plethora of government guarantees and the unintended consequences of substituting guarantees for confidence and trust, El-Erian's conclusion may well be correct.