From the September 30, 2007 Sunday Times (London)
October 1, 2007
by Irwin Stelzer
The turmoil of the past months has had one advantage: we now have a clearer picture of where the US, UK and world economies are headed – and how monetary and regulatory policies are likely to change.
World economies are going to slow. In the US home sales and prices are down, inventories of unsold homes and foreclosures are up, and new construction has slowed, resulting in layoffs of building workers. The mortgage business is in the doldrums, meaning layoffs, too, of the paperwork creators attached to the building industry.
The problems in the sub-prime mortgage market have affected financial markets from Germany to Britain, with the latter facing the humiliation of the first run on a bank in some 150 years. The reputation of the governor of the Bank of England, Mervyn King, is in tatters.
Business confidence in France, Germany, Italy, Belgium and the Netherlands is declining, and France’s finance minister says her country is bankrupt.
Federal Reserve Board chairman Ben Bernanke, who cut interest rates sooner and by more than other central bankers, is a hero – at least to stock traders and investment bankers. Which tells us a great deal about what is to come. Among other goodies in store for rattled investors will be a decision by several central bankers to lower interest rates.
Bernanke’s experience proves to all central bankers that in balancing the risks of a financial meltdown against the risks of encouraging more improvident lending by bailing out those caught in the credit crunch, their reputations are safer if they opt for the stimulative effect of lower interest rates. Besides, with the economies of many countries slowing, and inflation relatively tame, further reductions in rates can be justified as needed to prevent a downturn in the real economy from turning into a serious recession. That justification will be even more appropriate when China really steps on the brakes to contain inflation, an event the regime will delay until after the Beijing Olympics so as not to stir up any unrest that might result from rising unemployment.
We also know something else: that the regulatory systems of several countries will be revised.
In America, mortgage brokers have encouraged uninformed borrowers to stretch for loans they have little or no hope of repaying, often falsifying application forms in order to collect fees for originating these loans. Those activities will be more closely regulated in the future. So will the rating agencies that gave the coveted AAA rating to securities so opaque – and backed by assets so dicey – that they were closer to junk status. As rating agencies earn their fees from the issuers of these securities, their incentive to “just say no”, as Nancy Reagan once advised youngsters who were offered drugs, was virtually nonexistent. So they contributed to the debt-addiction of otherwise sober investors and borrowers. That will probably change.
Finally, there is the problem of “nontransparency”. It seems that the nature of the very complicated financial instruments developed in recent years is opaque – neither borrower nor lender fully understood the terms or the value of the collateral behind these securities. Rules requiring greater clarity – transparency – are in the industry’s future.
So is increased participation by the US government in the mortgage market, both directly and indirectly. The regulators are about to expand the authority of the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association (commonly known as Freddie Mac and Fannie Mae), which are privately owned corporations authorised to make loans and loan guarantees, to take on more and larger mortgages, and of other agencies to increase the range of mortgages they will insure.
On a less formal level, Treasury secretary Hank Paulson is working with – urging or coercing, depending on your point of view – lenders to persuade them to work out the problems of hard-pressed mortgagees, rather than foreclose on their properties, many of which are in the key electoral states of Ohio and Michigan. Since the resale value of foreclosed properties is often less than half the amount of the mortgage, lenders have every incentive to cooperate.
In Britain, the regulatory structure is also under review. It is clear that the division of responsibility among three different regulators, crafted by Gordon Brown when he was chancellor, has attracted sufficient criticism to force a rethink by politicians eager to avoid another embarrassment after the Northern Rock bank run.
We also know another important thing – that the markets are more on the side of Mervyn King than are the politicians. Long-term interest rates are rising, as investors anticipate that the actions of the Fed will unleash at least a bit of inflation. For the same reason, the price of gold, which some investors believe is an inflation hedge, is rising. These inflation hawks have some reason to worry. In the US, the consensus calls for a slowdown to 2% growth, not a recession. Unit labour costs are rising. Around the world, food prices are soaring, as acreage once devoted to growing food is shifted to growing fuels. Oil prices are high and likely to go higher as the Opec oil cartel refuses to increase output in response to rising demand. Couple rising inflation with declining growth, and the dreaded word “stag-flation” is heard again in the land.
The danger in all of this is that politicians overreact. The development of innovative credit instruments contributed to a major expansion of home ownership from Manhattan to Manchester. Those instruments also permitted risk to be shared among many lenders with varying appetites for such risk.
Regulations might need tweaking, but they must not be crafted so as to return credit markets to the bad old days of overregulation.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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