What to do now that the panic has ended

It seems that the financial panic is over. Stock markets are finding a floor, inter-bank credit is thawing, medium term leading indicators are improving, and all of the likely bad news is generally anticipated. Therefore, now is the time to carefully consider the policy lessons that have arisen from this market disruption, especially in the context of the G20 meeting and the driving political imperative to be seen to be taking action.

As evidence of market calming, global stock market indices have been progressively creating a base since their lows on October 27 and seemingly everyone buys (I think incorrectly) into a deep and prolonged two year recession, allowing the markets to climb a wall of worry.

Banks may not be lending robustly to their clients but the benchmark inter-bank interest rate, at just over 2 per cent, is more than a month beyond its peak level of 4.8 per cent and all those cries about frozen credit markets. Banks are also steadily withdrawing funds from fortress Federal Reserve and the European Central Bank and debt auctions show a declining interest from bankers to taking additional liquidity.

As positive factors, yield curves are steeply positive, energy price retrenchment is boosting purchasing power, inflation is abating and monetary (and less so fiscal) stimulus is pervasive and meaningful.

Finally, we have been made aware of calamities from emerging market defaults (witness Iceland to Russia) to the bankruptcy of large industrial concerns (like the American auto assemblers). First the US, then the OECD, then China and the rest of the developing world have fallen into recession. What unknown fundamental news could possibly drive the market significantly lower?

This is not to say that there will not be a rise in unemployment and bankruptcies and financial failure, and a drop in consumption and investment, over coming months. But there are high odds that we will not see a continuation of the emotional downswing in prices of all financial assets (save the US dollar and treasury bonds) that have so unnerved investors and main street citizens alike since mid-September.

The end to this crisis, just like the 50 or so other crises that preceded it over the three hundred year history of financial markets, owes most of its resolution to the natural dynamic of the downswing. Simply put, markets have fully reflected a shift in investor preferences for significantly less risk and the exit of capital from risky situations is essentially complete. The pain has played out. We have also been saved by the actions of central bankers, who massively expanded their balance sheets by $2 trillion so far this year, on Walter Bagehot’s century old maxim to “lend without limit at penalty rates” to stem a financial panic.

So, given that the financial market pain is mainly behind us, and with the likelihood that we are now facing nothing more prosaic than a global business cycle downturn, what is the policy advice to policy makers now returning home from the G-20 meeting in Washington?

First, do no harm, as there is an overwhelming temptation at times like this to “do something”. Investors are understandably unnerved and wish to repeal history to reverse their losses. The man in the street is also demanding retribution for those who should be held responsible for the economic damage.

Out of this emotional starting place come calls for government ownership and direction of credit markets, micro-level interventions into pay and governance conditions within financial firms, and a restructuring of the financial system that puts political leadership in the driver’s seat rather than market forces and commercial interest. None of these policy changes will make markets rise, improve financial conditions, grow the economy or enhance economic freedom to create wealth. Rather, they will act as a dead weight in the recovery period and reduce the potential for regaining the market and economic losses.

A second recommendation is to rebalance regulation of the markets. It was notable through the most unnerving period of the panic that investors and certain financial firms were not fully aware of the market sensitivity of their holdings, nor could they accurately assess the value of those same impaired assets.

Therefore, we need more information and transparency, both as a prophylactic to price risky behavior ahead of time and as a means to better price risk and reduce uncertainty at times of market disruption. Suggestions to publish data on over-the-counter derivatives, to migrate those peer-to-peer transactions to a tradable and public market, and to introduce minimum capital requirements that cover all financial assets and organizations are welcome.

At the same time, though it is not likely in this politicized climate, we need a reduction in existing regulations for financial transactions, which have grown dramatically in the aftermath of Sarbanes Oxley and the crusading antics of various New York public prosecutors.

There is apparently no limit to the scope creep of financial regulators and so there should be a principles-based approach to regulation that focuses on accurate and fulsome information provision to investors, minimum risk-based capital requirements, equal treatment of investors – and not much else. The current focus on process, and the arbitrariness and uncertainty involved in enforcement, are adding to the risks and cost of financial transactions and are subtracting from potential wealth creation. More competition between regulators, along with mutual recognition of standards, would also be a superior reform to the current calls for a “one-world” regulatory approach.

Finally, there is the financial crisis itself and the role of central banks in staunching the panic. It is a Sisyphean task to assume, as some must be doing, that we can prevent another financial panic from occurring. That, like the current misguided efforts to “fight the recession” with fiscal policy, is simply not going to succeed. The capitalist system that has created the greatest prosperity and quality of life in history is inherently cyclical and emotional, as the players are only too human and the recent crisis was as much psychological as financial.

A better approach would be to attempt to moderate the degree of the next financial disruption by market means. One approach would be to introduce market insurance, backstopped by central banks and paid for by financial firms and investors in a competitive market, with premiums based on the riskiness of the entity being insured against systemic risk (i.e., using measures of leverage, asset-liability mismatches, volatility of investments, etc.).

Central banks worldwide have provided an unpriced service as lender of last resort through the crisis, and one way to discourage excessively risky behavior in the future, and reduce the negative impact of financial failure, is to price the activity as it occurs. History shows quite clearly that we will not eliminate financial panics but we can move some distance to moderating their impact. Further, the service of central banking should not be free anyway, as this inadvertently encourages moral hazard issues regarding the demand for risk.

A reasoned approach to dealing with the financial crisis should start with an approach that works with market forces, rather than displacing them or pretending that they do not exist or function properly. Unfortunately, the current anti-market rhetoric is not conducive to such dispassionate analysis and we risk magnifying the next crisis and reducing economic growth prospects as a result. Such is the price to be paid from politicizing public policy.