Future of Finance Conference
The
Who’s Who
of finance descended upon Washington, D.C. Monday for 24 hours of policyanalysis, complete with presentations from Treasury Secretary Tim Geithner, Kevin Rudd(Prime Minister of Australia), Meredith Whitney (the bank analyst who first called thedemise of Citigroup), Professor Robert Shiller, Larry Summers (Assistant to the President forEconomic policy), Nobel Laureate Myron Scholes, CEO of TIAA-CREF and former FedGovernor Roger Ferguson, and former Fed Chairman Paul Volcker, among many others.Assembled were senior leaders in investment banking, commercial banking, hedge funds,pension funds, derivatives trading, market exchanges and so on.
The Wall Street Journal
,sponsor of the by-invitation-only forum, is covering the formal proceedings of the meetingsso I will share some of the informal discussions. Having the opportunity to just chat withGeorge Soros or Nassim Taleb (of
Black Swan
fame) as well as with my friend and formerboss, Paul Volcker was fascinating. The cocktail and table chatter confirmed what many ofus are thinking, that no one really knows how and when the crisis will end, but many arenow looking over the valley to the economic and financial risks in the recovery period.My overall impression is just how concerned many leaders are about the
prospects of forthcoming inflation and a plunge in the dollar.
Volcker commented that his hard-won battle against inflation is at risk if the current Fed is willing to accept inflation ratesthat “best foster economic growth and price stability in the longer term”. This is a quotefrom the March 18 FOMC press release, taken out of context, that the former FedChairman fears might indicate that the current FOMC is less committed to inflation controlthan he feels they should be. The fear is that the Fed would tolerate some inflation to getthe economy going and the debt repaid.To be sure, the Fed is flooding the system with liquidity; M2 has been growing at a 15%annual rate in the past three months, and once the velocity of money picks up, the reboundin economic activity (sooner or later) will lead to inflation. This worry presumes that the Fedwill not or can not reverse the growth in money in sufficient time to preclude this fromhappening. Chairman Bernanke, on the other hand, points out that many of the measureshe is currently taking to boost the flow of credit are short-term in nature and that the Fedcan drain reserves when necessary. As well, the Treasury and the Fed believe they cansterilize their actions (use open-market operations to counteract the effects of loans tofinancial institutions or capital injections on the country’s monetary base). Some have evensuggested that the Fed could issue its own bonds to drain liquidity when necessary.
March 25, 2009Dr. Sherry Cooper
Executive VicePresident,Chief Economist
1-800-613-0205
PAGE 2
The counter argument is that the Fed will err on the side of easing (for too long) formacroeconomic reasons, and that with the budget deficit rising explosively, running theprinting presses and allowing a “bit of inflation” makes it easier to repay the debt. Manypoint out that it is a natural tendency of over-spending governments to shy away fromsufficiently tight monetary policy to avert or reduce inflation as we saw in the ‘60s and ‘70s.This is why Volcker is so concerned that if we let the inflation genie out of the bottle, thedegree of tightness required to reverse the process could well be political untenable. It wasVolcker who took the political heat in 1979 through 1982 for driving the economy intorecession to break the back of inflation. (Remember 15% Treasury bills?)The
issue of the dollar is very troubling
and is highlighted by China and Russia raisingthe prospects of reduced Treasury buying and substitute reserve currencies. Volcker wentas far as to say that we are in a
dollar crisis
, as well as a credit crisis, banking crisis,economic crisis, and so on. (However, he also suggested that other currencies are in crisisas well.)
There is a crisis of confidence, and the shocking development that thefinancial system is government dependent
. The U.S. dollar is falling, undoubtedlyreflecting, at least in part, the excessive spending and borrowing of the government. Thefeared inability of the U.S. to finance the debt without much higher interest rates isunderlined by today’s weak five-year Treasury note auction, with a lack of foreign investorscoming to the table. This came after a sale of U.K. government debt Thursday failed. It wasthe first failed auction of conventional U.K. government bonds since 1995. If the Treasurycontinues to have difficulty funding the deficit, rates will rise returns will fall; evenquantitative easing by the Fed cannot fully offset reduced foreign demand.Clearly, no one forces China to buy Treasuries, they do so to keep a lid on their owncurrency. If they remain unwilling to revalue the renminbi, then they are forced to buy U.S.-dollar assets. Those purchases could shift more towards real assets, equities or otherdollar-denominated investments. No wonder the Chinese would like to see their currencypegged to SDRs or another synthetic currency, reducing their need to buy dollars,presuming the hegemony of the dollar is declining. The Treasury and the Fed are wellaware of these risks. Tim Geithner asserts his belief that the dollar will remain the globalreserve currency.Judging from these concerns, many of the financial participants seem to take economicrecovery for granted even though they have their doubts about the current bank bailoutprograms. I was surprised by an informal vote that showed that most participants (by far)believe the Public-Private Investment Program (PPIP) to buy legacy assets from troubledbanks will not work as currently devised because banks won’t sell enough of these toxicassets at prices that private purchasers would offer; these prices, presumably belowcurrent marks, would lead to further write-downs, which require banks to go into the TARP
PAGE 3
for more capital. Some suggested the amortization of the loss or some other capital relieffor banks.Another issue,
the cleavage of Wall Street and Main Street
and the resulting rush to judgment by the House to tax bonuses is a concern. Lynch-mob populism is dangerous.Larry Summers suggested that the U.S. middle class feels squeezed. They are losing their jobs, their homes and their wealth and they are angry. In the past, they have directed theiranger downward, resenting that welfare and social assistance programs were available forthe poor but not for them. Ronald Reagan tapped into this sentiment in 1980. Some of thatstill exists manifested in the immigration debate. But now, the middle class is also directingits anger upward, hence the executive compensation furor. There will be a continuingfirestorm towards Wall Street (in its broadest sense) and towards the business elite ingeneral. (Just last night the home of the CEO of RBS was vandalized.) President Obamasuccessfully tapped into that sentiment in his campaign. Seeing the danger of the mob, thePresident now is quieting his rhetoric. The Senate will provide the sober second look.House bills often die in the Senate and the recent House bill on an executive compensationclaw back of 90% will likely die a quiet death. One Goldman Sachs executive at theconference quipped that being paid in stock was claw back enough.
There is no returning to the norm of the past 30 years.
While the goal is the returnto fully functioning private credit markets, we are never going back to the credit andspending excesses of ‘03 and ‘04.The
global imbalances created unsustainable U.S. overspending andundersaving
, financed in large measure by China and the petro-countries of the MiddleEast. America is now painfully deleveraging, which portends slower average growth andlower rates of return in the future. Ultimately, the 30%-to-40% household savings rates inChina will wind down creating a more buoyant domestic buying market there.Meanwhile, in the U.S. banks must return to banking the old-fashioned way: knowing theircustomer, strengthening their underwriting standards and limiting leverage. More lendingwill be financed by deposits and fewer loans will be securitized. Nonbank financialinstitutions will come under more scrutiny and there will be greater price and volumetransparency and capital and collateral requirements on credit default swaps and otherderivative products. Financial regulatory oversight will be consolidated and reformed.Consideration will be given to reducing the procyclicality of capital requirements. It lookslike the Fed will be tapped as the Systemic Risk Regulator, although what exactly thatmeans is uncertain. Paul Volcker believes there should be a commercial-bank centredapproach to regulation and supervision. Commercial banks have a fiduciary responsibility toserve the public, business and government. Their deposits are guaranteed. The rest of thefinancial system falls into the category of capital market institutions, which don’t need as
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