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 © Boeckh Investments Inc., 1750-1002 Sherbrooke Street West, Montreal, Quebec. H3A 3L6 Tel. 514-904-0551, info@bccl.ca
V
OLUME
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7,
 
2010
Government 
 
Policy
 
and
 
the
 
Markets:
 
Prepare
 
For
 
Some
 
Big
 
Changes
 
When markets don’t perform the way politicians want, you can count on them tobypass, manipulate or manage these markets. All too frequently these attempts aremotivated by short-term political needs where appearances take priority over substance.Currently market distortions in housing, credit and the financial system are huge anddangerously unstable. We are now beginning to pay the price. There is a critical shortageof political will to tackle the underlying problems and band-aid solutions will likely keep uslurching from one crisis to the next over the coming years.As we discussed in
The Great Reflation 
the steady increase in credit during the debtsupercycle hid a multitude of sins. Distortions in both the domestic and global economygrew virtually unchecked behind a veil of prosperity. Such a facade was supported by theexpansion of private debt relative to income or GDP–choose your yardstick. The distinctionbetween wealth and credit became clear in the aftermath of the financial crisis. Peeringbehind the veil reveals an ugly, distorted picture: unsupportable private debt levels,spiraling public sector debt, massive trade imbalances with the accumulation of reserveassets of a few countries, and a flawed international monetary system. All of these issuesimply economic stagnation and high structural unemployment in the U.S. and otherdeveloped countries.
 
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In his recent book,
Fault Lines 
,
1
Professor Rajan eloquently argues that the U.S.’spolitical predisposition toward stimulating consumption, particularly when attempting toforce an unwilling private sector to create jobs, tends to warp incentives especially in thefinancial sector. Minimal unemployment benefits and a health care system tied to jobscreate enormous pressure that “enables politicians to run roughshod over the usual checksand balances on government policy. Long-term policies are enacted under the shadow ofan emergency, with the party that happens to be in power … getting to push its petagenda.”
2
We can see the pressure mounting with widespread riots and demonstrationsthroughout Europe, a shifting political landscape in the U.S., and currency wars.Political pressures are combining to push countries toward non-market solutions,and when a few countries move in this direction, it puts a domino-like pressure on others tofollow. This trend must be watched closely as it is starting to take a few pages from the1920’s and 1930’s playbook, a period when intractable economic problems led tonationalist economic policy reactions and a rise of state capitalism (wherein the productiveforces were increasingly influenced by state policies). This is a trend that is on theascendency everywhere. Investors should pay attention as financial markets will beaffected in ways that are not particularly clear at the moment.Fault lines, to use Professor Rajan’s term, can be loosely interpreted in a geologicalcontext as fractures or discontinuities in the earth’s surface. Energy from active faults canbe released suddenly and cause earthquakes. Similarly, energy from the disequilibriumand distortions in the world monetary and economic systems can also cause financial
1
 
Rajan,
 
Raghuram.
 
Fault 
 
Lines:
 
How 
 
Hidden
 
Fractures
 
Still 
 
Threaten
 
the
 
World 
 
Economy 
.
 
Princeton
 
University
 
Press,
 
2010.
 
2
 
Ibid,
 
p.15.
 
 
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earthquakes. We barely escaped from one in 2008-2009. Another is headed our way if themounting array of global and domestic problems is not resolved.
The
 
Fault 
 
Lines
 
and
 
Government 
 
Intervention
 
Economics used to be labeled “political economy” for the good reason thatpoliticians and governments rarely trust the market to deliver the results they want. Eventhe19th and early 20th century laissez-faire English and U.S. economies had thefingerprints of government all over them when markets didn’t work as they desired. SinceWorld War II, full employment commitments in most countries have legitimized suchintervention, particularly when jobs and living standards are threatened. Presently it is nosurprise to see a rising intrusion of government into markets, the economy and the financialsystem. This is just as true of democracies as totalitarian governments, whose legitimacyis also heavily based on job creation and improving living conditions. It shows up in avariety of ways, including exchange rate manipulations, import restrictions, exportsubsidies, direct bailouts of banks and corporations and a multitude of non-market bilateraldeals on capital investment, lending and trade. A number of surplus countries have built uphuge sovereign wealth funds which they increasingly use to bypass transparent markets.It would be wrong to think that it is just the developing (actual or quasi) totalitariancountries that rig the markets with what is loosely referred to as state capitalism. It occursequally in democracies, although it is often less obvious. A case in point is the long-standing trend in the U.S. to rig the housing market to push below market credit into thehands of low income borrowers so they “can own a piece of America.” Much of the rise inthe private sector debt supercycle since 1980 reflects this inordinate expansion of credit to
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