Thursday, November 5, 2009

Is the Federal Government Tempted by Moral Hazard?

The British government recently announced that it is thinking of breaking up the big British banks in order to avoid having institutions that are too big to fail. The U.S. government, by contrast, contemplates maintaining its de facto too-big-to-fail policy and building regulatory reform around it.

The British approach has the beauty of simplicity and the sensibility of placing limits. Smaller institutions, with effective controls over the amount of leverage and derivatives exposure they can take on, would be less likely to blow up counterparties. They would probably be less complex, engaging in fewer types of activities, and would therefore be easier to regulate. The system as a whole would be healthier. British taxpayers would sleep better.

In America, however, size and complexity remain. Regulators mostly believe that they can effectively oversee the behemoths they in part helped to create through mergers they strongly encouraged of failing firms with stronger ones. Perhaps they've also been subtly influenced by the industry's belief that size confers competitive advantages.

But the size advantage of America's big banks is meaningful only because the federal government backs them up. If there were no too-big-to-fail doctrine, the size of these institutions might frighten counterparties concerned about unseen exposures. The sheer complexity of the big banks on an operational level, something that not all their chief executives could master, would heighten counterparty fears of another AIG, where risks of its credit default swap operations weren't apparent to most market participants (and perhaps its executive management) until too late.

The U.S. government is able to back up America's big banks to a large degree because of the dollar's unique position among currencies as the world's reserve currency. Much and perhaps most of the world sees the dollar as a reservoir of value, and it's still used in international transactions far more than any other currency. In order to support the banking system, the U.S. government (primarily the Federal Reserve) has driven short term interest rates to zero while printing trillions of dollars. If any other country had taken these steps, its currency would have collapsed. But the dollar is special and the U.S. government can pull sh . . . stuff that no other government can pull.

That's a concern. On Halloween, when children have unusually easy access to candy, it's hardly surprising that they go on sugar binges. Wall Street banks were no different when they thought they could make money underwriting mortgage-backed securities based on loans to borrowers who had no verified income, employment, or assets, because they supposedly could pass the credit default risk onto investors. The banks, too, went on a binge--and we've all got a hangover from that one.

Federal officials are human, and it wouldn't be surprising if they've been tempted by the dollar's reserve status to push the edge of the envelope. The idea behind monetary and fiscal stimulus is that it triggers consumption and investment, which in turn spur more economic activity, which then pushes the virtuous circle farther along with new rounds of consumption and investment, etc. But the fiscal stimulus has been slow and spotty, and the monetary intervention seems to have put a lot of money in the big banks' reserves instead of being loaned out, or to have been sent overseas via the carry trade to stimulate the economies (or at least the investment assets) of foreign nations. The credit crunch hasn't gone away; it's simply shifted from Wall Street to Main Street.

Sugar binges ultimately have bad consequences, as do binges of poor mortgage underwriting. A federal monetary and fiscal binge isn't likely to be any different. If things fall apart, it's likely to have really, really bad consequences, because the U.S. government may have taken advantage of the dollar's reserve currency status to binge more merrily than a government that knew its limits.

The British learned prudence after World War II, when the United States deliberately displaced the pound sterling as the world's reserve currency with the dollar. The British government's 1992 attempt to intervene against hedge fund speculation in the pound was a dismal failure, reinforcing the lesson that currencies, like all other things economic, are subject to the laws of supply and demand. The U.S. government, triumphant after victories in World War II and the Cold War, acts as if the sun will never set on the all mighty greenback. The Fed, in its statement yesterday, continued to forecast zero interest rates over an extended period of time, in effect promising its print shop employees oodles of overtime pay for the foreseeable future. This enthusiastic wallowing in moral hazard is reminiscent of the British government's eagerness to borrow from America to pay for World War II. The Lend Lease Program, which gave the Brits multiple dollars for each dollar they actually repaid, was perhaps the biggest "wink and nod" ever in government-to-government lending. But that only ensured British insolvency at the end of the war, and when Britain asked for yet another loan after Japan's surrender, America's terms, in essence, probably accelerated the dissolution of the British empire. Britain had no choice but to agree (and repay this loan in full as well, with payment completed in 2006).

America's foreign creditors--China, Japan, oil producing nations and others--can do little in the near term about the federal government's profligacy other than preach and make subtle threats. They, indeed, have an interest in America's prosperity. But the more chits they hold, the more leverage they will have. At some point, they'll pull the plug on America, just as America pulled the plug on Britain. Not because of animosity--even today, Britain remains America's closest ally--but simply because it's in their interests to do so. America's system of national accounting doesn't very clearly balance assets against liabilities--indeed, it mostly focuses on national income (as measured by GDP) without much consideration of the costs, risks and liabilities connected with producing that income. There are no federal reserves to tide us over hard times (like many states' rainy day funds). We are in deep yogurt, but there is scant federal data revealing that problem.

The essential, unstated premise of federal economic policy today seems to be that by using the relatively painless process of printing money, we can get something for . . . well . . . basically, nothing. With the indulgence in moral hazard that the dollar's role as reserve currency allows, it's easy for the federal government, almost unconsciously, to reach this conclusion. The big banks on Wall Street now understand that they have to beware of the risks of moral hazard. If only this understanding extended to the government . . . because not every day can be Halloween.

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