Economists call them exogenous shocks. Then-Prime Minister Harold Macmillan called them “Events, dear boy, events.” Former U.S. secretary of defense Donald Rumsfeld called them “unknown unknowns.” Investors care less about the precise label than the fact that the world seems a scary place. Never mind that almost all of the economic news in America is good: corporate profits are up and mortgage rates are down; retailers can be heard humming a happy tune as first quarter profits clock in at 26 percent above last year’s level, and bankers try to stay below the radar but have difficulty concealing their glee at the best quarterly profit performance in two years; home sales and building are up and property developers are snapping up land that has infrastructure in place in anticipation of new construction; inflation is at a 44-year low; and the Chinese are again buying U.S. government IOUs.
Yet all is not for the best in this best of all possible worlds. The happy economic news is accompanied by disturbing news on a variety of fronts. Israel is increasingly nervous at the inability of America and its partners to contain Iran’s nuclear weapons program, and is considering the feasibility of an attack that would delay the regime’s acquisition of the bomb it has promised to use to destroy “the Zionist entity.” South Korea has responded to North Korea’s torpedoing of one its vessels by blocking passage of that regime’s ships through its waters, a decision that might trigger a war with an increasingly bellicose and emboldened North: hostilities would certainly involve the U.S. troops stationed on the border — unless President Obama pulls them out as part of his plan to “engage” the North Koreans. The war on terror goes on, with New York and its financial center certainly among the leading targets, and sheer luck so far preventing a disaster. Worst of all, America now seems so impotent that its former allies, Turkey and Brazil, feel they had better sign up with what Osama bin Laden calls “the strong horse,” which seems to include anti-Americans from Hugo Chávez to Mahmoud Ahmadinejad. The picture of the leaders of Turkey, Brazil, and Iran holding grasped hands aloft in triumph at a deal aimed at derailing sanctions is, to put it mildly, unsettling.
In short, now that the world’s policeman has left the international beat, there is no telling what might happen. Worse still, that cop has decided to patrol the domestic beat, without too much regard for the possible consequences of his inability to distinguish the good guys from the bad.
The financial overhaul bill wending its way to the president’s desk, whatever its virtues, and there are several, will likely lower bank profits and their credit ratings, forcing them to be even stingier with potential borrowers. The Securities and Exchange Commission has adopted new rules that will make it more difficult for money market funds to continue providing about one-third of European bank’s wholesale funding lest they run afoul of a plethora of new regulatory investment criteria.
Congress is about to take up the cap-and-trade bill that will drive up energy costs, and is planning to impose new taxes on multinational businesses, investment managers, and hedge fund operators. Markets loathe uncertainty, and these laws and regulations provide more uncertainty than investors can comfortably confront. No on can predict their effect, least of all the congressmen who vote for them and freely admit they haven’t read them — these bills typically run close to 2,000 pages, and their advocate, House Speaker Nancy Pelosi, says you can’t know what’s in them until we pass them.
Then there are the problems in euroland. We have known since the financial crisis hit that some institutions are too big to fail. When Greece was (at least for now) bailed out by a combination of its eurozone colleagues, the European Central Bank, and the International Monetary Fund, we found that there are countries too small to fail. With Spain experiencing difficulties, we are told that medium-size countries are, well, too medium-sized to fail. Allan Meltzer, economics professor at Carnegie Mellon University in Pittsburgh, famously said, “Capitalism without failure is like religion without sin.” He was right: There is now every reason for governments and big banks to believe they can spend and take risks, failure no longer being a possible penalty. It’s called moral hazard, a problem so far ignored by a panicked eurocracy and uncorrected in the massive financial reform bill before the U.S. congress.
Adding to uncertainty is the possibility that U.S. banks are more exposed to the trials and tribulations of Europe’s banks than has heretofore been realized. Indeed, our banks are now so nervous about the possible weakness of so called counterparties that they are demanding somewhat higher interest rates on interbank lending.
Of course, investors who value a good night’s sleep above all else can flee to the dollar, as many are doing. But as they nod off they just might have a nightmare or two. They might have heard on the late news that this or that expert says the U.S. recovery remains “fragile,” never mind the cheery economic data. The Federal Deposit Insurance Corporation’s (FDIC) list of “problem” banks now runs to 775 institutions, some 10 percent of the U.S. industry, compared with 252 at the end of 2008. This is in addition to the 72 banks regulators have closed down so far this year, and the 237 that have failed since the beginning of 2008. These mostly smaller banks have taken on property loans that are unlikely to be repaid in full.
More important, there is no end in sight to the deficits the government is piling up. The president is determined to continue spending, despite the ocean of red ink splattered across the nation’s books. Indeed, earlier this week presidential adviser Larry Summers urged Congress to pass a second stimulus package, or risk aborting the recovery. With Democrats determined to continue spending, and Republicans opposed to new taxes, with the bill for health care and other entitlements set to soar as the population ages, only a series of victories by candidates backed by the Tea Party movement has any real prospect of bringing the growth of government, and associated deficits, under control. Meanwhile, the printing presses keep churning out dollars, as the Federal Reserve Board hunts for just the perfect exit strategy and just the right time to implement it.
Which means that inflation is one of the nightmares that those fleeing to the safety of U.S. government bonds will have. Some waken in a sweat and rush to the telephone to buy $1,200 gold, or other commodities. Others give up, and decide that since they can’t really protect themselves against exogenous shocks, events, or unknown unknowns, all they can do is fret. Or forget about it all, dust off the old barbecue, and enjoy the long holiday weekend.
