The financial turmoil of the past several months has had one advantage: We now have a clearer picture of where the U.S. and world economies are headed. And how monetary and regulatory policies are likely to change.
The world economies are going to slow. The problems in the U.S. subprime mortgage market have affected financial markets throughout the world. Business confidence in France, Germany, Italy, Belgium and the Netherlands is declining.
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. The experience of Bernanke 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 our regulatory system will be revised. 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 that were closer to junk status. Since the 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 somewhere between minimal and nonexistent. So they contributed to the debt addiction of otherwise sober investors and borrowers. That will probably change.
Finally, 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 American government in the mortgage market, both directly and indirectly. The regulators are about to expand the authority of Freddie and Fannie Mac to take on more and larger mortgages, and of other agencies to increase the variety of mortgages they will insure.
Also, Treasury Secretary Hank Paulson is trying to persuade lenders 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.
We also know another important thing — that skeptical markets are starting to look Bernanke’s gift horse in the mouth. 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 for some reason believe is an inflation hedge, is rising.
These inflation hawks have some reason to worry. In the United States, the consensus calls for a slowdown to 2-plus percent growth, not a recession.
Unit labor 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.
The danger in all of this, of course, is that politicians over-react. The development of innovative credit instruments contributed to a major expansion of home ownership from Manhattan to Madrid to Melbourne.
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 over-regulation.
Examiner Columnist Irwin Stelzer is a senior fellow and director of the Hudson Institute’s Center for Economic Policy.
