The Case for a New Normal

by: Promod Radhakrishnan

Market movements and the direction of key economic indicators over the last 2-3 months clearly points to a tempering of the current downturn and possibly a quick uptick in activity across most sectors. Though the market's over-exuberance is not supported by any facts pointing to a drastic return to growth and profits, there are many economists who support this view. Last week, James Glassman at JP Morgan opined that 'Whenever we have plunged off a cliff and fallen into a deep hole in the past, for a while the economy has a tendency to bounce back very quickly' - a view supported by some others including Laurence Meyer, former Fed Governor.

This view is contradicted by several others who predict a slower uptick also leading to a 'new normal' where we would see higher savings rates, reduced consumer spending and tempered growth. I would sincerely hope the latter is true, despite all the immediate benefits and gains from the former trajectory.

As compared to what have been traditionally decade-long recession-boom cycles, we are probably seeing a series of heightened, but faster cycles during this decade. Without too much doubt, we can say that the US central government responses to both the 2000-'01 downturn and the 2008-'09 downturn has been led/driven by monetary policy. Not often have we seen Fed rates fall, rise and then fall so drastically in a span of 8-9 years. This fact coupled with a consistently loose fiscal policy has perhaps exacerbated the speed of economic cycles.

I am not saying that one should find fault with the Fed's rapid response to the current downturn - in fact, I agree with the view that nothing short of such a response would have helped push the economy out of a recession spiral faster this time around. To understand this, we have to compare the Fed's response to the Japanese central bank's response to their down-turn which started in January 1990. The Bank of Japan took 17 months to make its first interest rate cut, and even after that, it relied more on fiscal policy and government funded projects rather than using monetary policy as a tool to steer the economy. The success/failure of such a strategy is known to all of us - it created a prolonged period of stagnation, though it did manage to avoid a full-blown recession. Having said that, should we say the current direction of US monetary and fiscal policy would take the economy in the right direction long-term? This is doubtful to say the least.

In the Fed's last rate-setting meeting, the board of governors almost unanimously supported a dovish monetary policy - this essentially means an unwritten commitment from the Fed to keep rates near sub-zero levels, helping a rapid pick up in the credit cycle - assuming inflation stays within 'acceptable limits'. On the fiscal policy front, though there has been quite a lot of lip-service to fiscal discipline from the current government, we haven't yet seen any concrete action/plan. The latest in a series of 'government-funded' initiatives, the health care plan, sees an additional 2 trillion USD of spend over the next 10 years - and apart from either a possible drop in service/care levels or a rise in taxes, the only 'funding' mechanism we have seen is a piddly USD 80 billion deal that the White House supposedly has ironed out with the big pharma manufacturers.

If we combine the above stands on monetary and fiscal policy, we have the stage set for another cycle of unreasonable growth backed by high fiscal deficits and loose credit standards. Based on advances in distressed bonds, corporate bonds and munis over the last quarter, it already seems that the financial sector has picked on the thread. Add to that an agonizingly slow pace of regulatory reform - and there is a significant risk of a too-rapid turn around before we fix some of the fundamental ills inherent in the current system.

Why can the Fed not set an internal target for economic and market activity (economic growth, market indicators, etc.) and rigidly follow a monetary policy which can control expansionary cycles and curtail market booms? Instead of using inflation as the sole leading indicator for monetary policy, the Fed should play a more active role in tracking key indicators and not restrain itself from pulling the trigger if it sees unreasonable moves. Pure free market advocates would disdain such a Fed avatar, but we have already seen what happens if the Fed stays in its Greenspan mode. It's amply clear that the current market culture driven by quarterly results, bloated profits and huge bonuses can never be self-correcting or self-regulated. Uni-directional Fed policies targeted at avoiding recessions and fueling growth cycles can only lead to unbridled activity in one or more of the asset markets. We probably need a more 'range-bound', directional fed policy for the next bunch of years to help temper cycles and avoid asset bubbles.

On the fiscal front, an ever-expanding government reach is definitely not the solution to all ills. When comparing government-run programs in other countries, we often forget the size and nature of the beast here - most markets are too big in size and volume for the government to play an active role without compromising fiscal responsibility. Government-run programs are fine provided they are targeted only at the weakest links in society and provided there are clear stakeholders who fund the plan. Otherwise, rising deficits would soon push external debt to over half of the national GDP and threaten the credibility of US treasuries.

Many would point to an intermediate uptick in interest in treasuries and opine that foreign economies would continue pumping back money into the US given clear signs of economic revival. However, we cannot expect this to be sustainable if central authorities continue with a loose monetary policy and a fiscal policy which promotes deficit spending without a clear plan of future curtailment. This can only yield one result long-term - a gradual move away from the dollar as the world's reserve currency and subsequent struggle in funding deficits through foreign money. It's difficult to ever assume that consumer savings would rise to a level that can fund such gargantuan deficits.

Regulatory reform is the third pillar which needs the government's utmost attention. Among the broad outline of financial services regulatory reform moves that the Treasury Secretary announced months back, very few have seen implementation yet. A few of these are critical to be implemented before any serious market/economic uptick occurs:

  • Disclosure and regulatory guidelines for credit rating agencies
  • Market governance framework for OTC instruments, especially credit default swaps
  • Increased disclosure norms for non-bank financial services entities like hedge funds and private equity funds
  • Continued monitoring and regulation of financial services practices as related to consumer products/services (the only area we have seen some concrete action so far)
  • Policy outlining broad principles and limits for compensation policies at financial services firms (going beyond Ken Feinstein)

Among the above suggestions, the last one would see the highest amount of debate and opposition. But unless there is either a central regulatory or self-regulatory control of compensation principles, top management and trader (key profit-driving), financial sector compensation will continue to be driven by immediate profits, which would in turn force minimal alignment between risk management principles and corporate reward/compensation norms. Because irrespective of the nature and volume of regulatory overhaul and international guidelines like Basel II, there is enough ingenuity in the financial system to unearth loopholes and drive short-term profit and compensation maximization. And that combined with loose federal monetary/fiscal oversight would prevent any sustainability of economic growth long-term.

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