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FRONT PAGE CONTRIBUTOR

Shifting The Tone In Financial Markets

Turning From Crisis To Weakness

I’ll go out on a ledge and say that the financial world has taken a step back from the ledge.

A semblance of non-insanity has been apparent in capital and bond markets this week. Now that governments across the world have made credible commitments to prevent financial meltdown (defined broadly as chains of insolvencies among tightly-interconnected counterparties), the violent panic attacks of last week have been damped out.

Term LIBOR, which is a complex of interest rate benchmarks that has been seized upon by mainstream press people as an indicator of the health of the crucial interbank-lending market, has stopped rising. Most of the LIBOR rates have been inching (or millimetering) back from the insane, nonfunctional levels they reached last week. Three-month dollar LIBOR is down about nine basis points from yesterday.

This is still insane and nonfunctional, but at least we’re moving in the right direction.

The US Treasury yield curve is still very, very steep, although we’re in the middle of a hefty bond rally this morning. There is now so much central-bank liquidity out there, simply fantastic amounts of it, that overnight interest rates (such as Treasury-bill repo) are practically zero.

There are very faint signs that capital markets are coming back to life. There’s a tiny amount of term lending now being reported. Capital markets are still frozen solid, but they don’t appear to be getting worse.

But let’s take a look at the real reason why people who aren’t bankers or Wall Streeters even care about financial crises: the Main Street economy. And it doesn’t look good, people.

So we’re all facing one near-term risk (the economy) and two long-term risks (excessive risk-aversion, and overzealous regulation). All are things you need to be concerned about, and that financial markets have begun to focus on.

There is abundant anecdotal evidence that the global economy hit the wall in late September, as the capital-markets lockup directly affected the cost of producing, marketing, and delivering real-world goods and services.

It will take months for capital markets to return to some facsimile of normal functioning. In fact, they may never return to normal, as the heroin of government-guaranteed counterparty performance eliminates the need for efficient credit intermediation.

All of that will prove to be a large headwind against economic growth for quarters, maybe years, maybe longer. Get set for an ugly recession and a weak recovery.

The long-term risks to global economic health are rooted in the natural way that humans react to disasters: they correct excessively in the other direction, and they clamor for revenge.

I can guarantee you that it will be a very long time, decades, before the financial world ever lets itself get as overextended as it did in the runup to this crash.

In the simplest possible terms, the root of the crash was in the systematic underpricing of risk. Now the world will lurch too far in the other direction, and overprice risk, which will diminish the returns to capital, and depress economic activity well below sustainable levels. That’s actually very bad news, but there’s no avoiding it.

And there’s really nothing you can do about it. Watch for stories over the coming years that the balance sheets of the world’s financial institutions will become far stronger than they have been in a long time. That sounds pretty good, but it actually means that they’re hoarding capital received from governments, and holding capital out of the productive economy.

Why is that rational? Because bankers are a very cautious bunch, and none of them wants to get burned in the next crash.

The other thing humans do in bad times is they look for someone to hang.

That’s going to be the financial profession in general, and Wall Street in particular.

One of the reasons that financial markets have gotten so weak is that they’re pricing in the anticipated effects of a huge pulse of vindictive, punitive regulation from the Democrats who seem poised to consolidate their political power next month.

We’re not going to be stopping at capping executive pay (thereby diluting the incentives for success). Democrats are actively looking at bringing back all kinds of structures and processes from the New Deal.

This will all be sold as a way to make the economy “fairer,” and less prone to shocks. Fair enough, I guess you have to expect the pendulum to shift.

But putting the shackles on the financial world will necessarily make it harder for the real economy to produce jobs and prosperity.

That’s the real problem with revenge, as Shakespeare could have told you. You usually end up shooting yourself in the head.

-Francis Cianfrocca

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