| Bubbles and Reform: the Delicate Balance |
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| Friday, 15 January 2010 05:15 | |
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We've posted a lot about this lately, but it's clear that the subject of bubbles isn't going away any time soon. Just this week The World Economic Forum released its annual report, Global Risks 2010. The report makes some stunning predictions saying that there is more than a one-in-five chance that another asset price bubble is looming on the horizon. And when it bursts it could be as devastating to the world's economies as the last one and become one gigantic tsunami of a financial crisis. Not a rosy picture, but let's push back for a moment and focus on the nearly four-in-five chance that it won't happen. We prefer those odds, even though finding a workable solution to our current financial crisis appears to be a slow-moving long shot. In the US, we're witnessing a delicate balancing act—or should we say, a tug of war—as economists and lawmakers weigh the pros and cons of keeping interest rates low to help a stumbling economy, but avoiding runaway inflation, while simultaneously eyeing the possibility of inviting a situation that could become the next asset bubble. Some argue that the potential bubble problem lies in the record low interest rates held fast by the Fed for the past 12 months. With cheaper money, it could become too tempting for speculators to rush back in and snap up everything that appears to glitter—never mind that they might not understand what they're doing. It's that kind of irresponsible exuberance that pushes asset prices to unsustainable levels . . . and we all know how that ends. Now, please don't misunderstand us. We're all for intelligent speculating. Our book, The Big Gamble: Are You Investing or Speculating? makes our position pretty clear. As we point out, it's the speculators and the well reasoned and seasoned risk takers that have always sparked the imagination and fueled innovation and job creation for many. The big concern is when speculators, and we refer to those on Main Street as well as Wall Street, are either ill-informed, out of control, or blatant rule breakers. That's the toxic mixture that gives consumers tunnel-vision and lures them into herd mentality to buy what everybody else is buying. Some argue that financial reform is the only way to prevent another bubble, or at least to cushion against the chaos that follows when a bubble bursts. We agree that a new Consumer Financial Protection Agency could put the breaks on deceptive lending practices that created the subprime debacle. But could reform have prevented the rising default rate in conventional mortgages or the boom and bust we've witnessed in commercial real estate? Can reform prevent future bad loans and bubbles? Not likely, nor is it likely to stem Wall Street's appetite for high-risk taking. Risk, after all, is what greases their wheels. Creating those impossible to understand packages like credit default swaps (see our reportWall Street's Shadow Market) allowed banks to make short-term profits with borrowed money and to pay out obscene bonuses to executives while the economy crumbled around us. This week those same executives were called before the Financial Crisis Inquiry Commission in Washington. They were expected to come clean about their role in creating the worst financial disaster since the Great Depression. But what was revealed is this: either these executives are dumb as foxes and are pretending that they can't wrap their heads around the enormity of the crisis they've created, or else they really don't get it. Frankly, we don't know which is the bigger problem. In either case, they claim to have accepted the meme that housing prices had a limitless ceiling therefore it was OK to give money to folks who obviously had no visible means to repay it. It was a mindset that bloated profits for the financial industry as housing prices continued to accelerate, but which eventually teetered on the brink of collapse when the bubble burst. Immense government bailouts saved the industry from going off the cliff and, it seems, there's even more where that came from. So, now bankers want us to believe they didn't see it coming? Sorry, we aren't buying it. If these high rollers truly don't understand what they've created, our recommendation is to keep them out of the decision-making loop on any future financial reforms. Oddly enough, they do display a certain level of understanding as evidenced by the fact that they continue spending bail out money (our money) to lobby against financial reforms. Keep watching for news updates as these hearings continue. If and when financial reform does come, look for specific language that mandates limits on the banks' ability to create high-risk leveraged investment vehicles. Without that, reform won’t have the necessary bite to prevent meaningful change. Meanwhile, there are other issues to balance, such as the role that interest rates play in the big picture. We recently posted about the startling fact that economists actually have no viable model for determining how much interest rates should be hiked to offset the excessive asset prices that create bubbles. When the Fed meets in a few weeks, word has it that they plan to keep the key bank lending rate at a record near zero low. Stay tuned to find out whether there will be any news about the need to start raising rates in order to prevent inflation from taking off. |
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