Sunday, July 01, 2007

The Coming Credit Crisis: Common Sense from Some of the Usual--and Some Unusual--Corners

As usual, Doug Noland hits the nerve in this article about the state of our global credit surge. Doug is worried; and so am I. I have posted my concerns here and here, and written articles about them here and here.

And he and I are not alone. We're even getting some common sense from an unusual quarter: an international organization, believe it or not, called the BIS (Bank for International Settlements).

Tower1
[Thanks to bis.org for the photo.]

The history of this group is interesting. They have gone from a Holland-based banking overseer of war debt reparations payments, to a Swiss-based overseeing think tank of the world's central bankers, where they discuss things like their collective macroeconomic policies. (For the uninitiated, "macroeconomic policy" refers here to the efforts of central bankers to stabilize and optimize their country's economy.)

Unlike some other international organizations I can think of, this one seems to be useful. In their latest opus, they give us a perspicacious review of the global economy's present precarious position. Quoting from their press release:

"BIS General Manager Malcolm Knight highlighted the uncertainties currently facing markets and policymakers. They include the possible resurgence of global inflation, the evolution of current account imbalances, and potential vulnerabilities in financial markets and financial institutions. He noted that behind each set of concerns lurks the common factor of highly accommodative financial conditions. A further tightening of monetary policy might then be needed, as well as action to reduce still high government deficits and debt in many countries. Countries that, in principle, have floating exchange rate regimes should allow their currencies to adjust more freely. Regarding financial sector developments, there could perhaps be more scepticism about the purported benefits of having new players, new instruments and new business models searching aggressively for increased yield."
...
"The consensus economic forecast expects the recent excellent global performance to continue. Yet at least four sets of concerns can be raised, even if our capacity to calculate both their likelihood and possible interdependence remains limited. First, a rise in global inflation pressures cannot be ruled out. Second, the current slowdown in the United States might prove more significant than expected and the global implications greater. Third, global current account imbalances, together with large and volatile capital flows, indicate an exposure to disruptive exchange rate changes with potential implications for financial markets as well as asset prices. And finally, with most asset markets already “priced to perfection”, any unwelcome shock might have unexpected consequences."

Food for thought.

Back to our more typical sources of common sense, we have this recent Wall Street Journal blog post by Grg Ip, referring to my favorite economics school, the Austrians, and suming up the BIS report this way:

'What does the BIS say central bankers should do? Essentially, relax their single-minded focus on price stability, and tighten monetary policy when “a number of indicators — not just asset prices but also credit growth and spending patterns — are simultaneously behaving in a manner that indicates increasing exposures.” In other words, when easy credit is fueling excesses, raise interest rates to end the party, even if inflation is quiescent.'

(I would add, "and refrain from creating non-market-initiated credit to start with", but no one asked me, in spite of my plethora of common sense.)

And then we have George Soros. Now, I hate to say he's even partially right about anything, but I'm going to give credit where credit is due. According to Wikipedia, Soros and other critics of capitalism "argue that there is no will to enforce any significant regulation in the present competitive financial industry, where nations effectively compete to offer less regulation."

I would agree with this, if not with the nature of the problem and the identity of the culprit. It is true that the central bankers have misperceived their real utility. They could be a private watchdog for consumers, helping the banking industry to undo all of the existing counterproductive regulations and install more basic and reasonable ones. Lack of financial-sector regulation is not the problem, although it will be the remedy that government will apply when the current leveraging imbalances tip over. (Again, for the uninitiated, leveraging is borrowing or lending on the basis of little or unverified collateral.)

No, in fact it is not under-regulation that has caused this problem; it is over-regulation that has created this monster we call our federal and state banking systems. No wonder financing has found a way around them and is now running wild.

And why does Soros pounce on capitalism, and not on pure human shortsightedness? How can he carry a torch for the totalitarian centralism he deserted back in his native country? He should know better than to throw out the free-market infant with the bath water. It is not capitalism that is at fault, because under normal conditions, sooner or later, if left alone, capitalist forces would see to it that the unwise actions of bankers will fail. The problems occur when governments decide to intervene to prevent this failure from taking place, through the politicians' natural supervisory instincts and their creation of the moral hazard of Lender-Of-Last Resort. (For the uninitiated, this LOLR principle works on the same idea as the FDIC only widens it to include any large financial institution or other entity whose failure, in the politicians' and central bankers' imperfect opinion, could cause a country's economy to falter.)

If our politicians had never created a centralized banking system, unwise bank lending would be increasingly rare, and would only be undertaken by speculative bankers who were incapable of learning from the difficult experiences of their less-wise colleagues. As it stands today, bank failures for poor management are simply blended into stronger banks, so what penalty is there for failing? And there is so much regulation of viable banks that over the last 30 years financial credit transactions have expanded outside the industry to places where no one has gone before, and where therefore there are no regulators, and of course no predecessors, no precedent failures, and even no naturally-evolved rules of the game.

This is not the fault of the free market; on the contrary, this is the fault of a lethal combination of the over-regimented market and the market's underlying distaste for slavery and talent for freedom. It can be channeled, but it will not be dammed. If you try to stop its flow, it will flow around you, perhaps doing damage along the way. And flow it did, until now we have trillions-worth of unsecured credit leveraging endangering the system, much of it outside the regulated banks.

I am not saying that banks would not profit from a little oversight, i.e. encouragement from outside consumer-based watchdogs to force them to regulate themselves. We could even give those watchdogs the name "Federal Reserve Board." After all, proper free-market functioning is not free-market anarchy. Freedom is not license, and there is a huge difference. But to say that capitalism or the free market needs regulation by politicians is insane. Just look at the mess we're in today.

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