Free marketeers are applauding Washington's hands-off approach to the latest financial crisis. It's been a sharp contrast with the interventionist approach on Fannie Mae, Freddie Mac, Bear Stearns and the numerous Fed facilities in previous months.
It's clear that form of Washington activism wasn't working. With each collapse of a financial firm, the benefits of government intervention have weakened--it brought a few weeks of respite in the case of Bear Stearns, but just a few days in the case of Fannie Mae.
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But I don't think the hands-off approach being applied to Lehman Brothers and AIG will work either. Treasury should have a broader plan to try to stop the write-down spiral. Instead, it seems to have created a Catch-22--companies must attract more equity capital, but Washington will only get involved after a company's share price goes near zero (which prevents it from attracting equity capital).
Meanwhile, more and more profits are being made on the short side with each payout (on Bear, Lehman, AIG). The Securities & Exchange Commission is reportedly planning to stiffen its rules against manipulative short-selling. This would be a good step, and is overdue. But by itself it won't be enough to stop the sequential collapse of financial firms.
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More at the core of the problem is the new mark-to-market accounting process. Even if a company has huge cash reserves, the new accounting techniques create a capital shortage by valuing assets as cautiously (meaning low) as possible, without a reasonableness test. The mark-to-market rules discourage takeovers by forcing prices for post-merger assets to be lowered overnight--when reasonableness would argue that their value would increase due to the deeper pockets of the acquirer.
Washington should clarify the new mark-to-market rules toward a reasonableness test, not just a lowest-possible-price test. In more general terms, Treasury and the SEC should take more of the crisis-fighting burden from the Fed, which has done enough (some would say too much.)
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In addition to lowering the Fed funds rate to 2 per cent from 5.25 per cent, the Fed has substantially changed the composition of its balance sheet over the last year. By dramatically expanding its lending to banks, its holdings of Treasury securities has fallen from $780 billion a year ago to $480 billion. This only makes sense as a temporary response to the crisis. In the absence of explicit Fed support for a strong and stable dollar, the riskier composition of its balance sheet risks further debasing the value of the dollar.
It will be hard to judge the full damage from the financial crisis until there's a pause in the mark-to-market spiral. With no sign of a pause yet, we have to assume ever more damage.
If the insurance industry is dragged further into the accounting crisis, I would analyze it along the lines of my August 2007 global downgrade based on the breakdown of the securitization process--a major one-time hit to gross domestic product from the disruption of jobs, transactions and future earnings.
I disagree with the view that the U.S. is destined for a long-term malaise like Japan's in the 1990s. In sharp contrast with current US problems, Japan's malaise was caused by a strong, deflationary yen (81 yen to the dollar in April 1995) combined with generally positive real interest rates.
While the latest U.S. financial crisis is a big negative, growth in many other parts of the economy will help cushion the blow. Mortgage rates declined sharply in September. US export strength continued into the third quarter, supporting modest US GDP expectations. Many of the financial losses are double-counting within a zero-sum game. For example, one institution's loss on a credit default swap is a gain for another institution. A lower price for an existing home hurts the seller and favors the buyer.
The near-term issues are whether Washington will dig deeper into the crisis, reconsidering the accounting rules and rewriting the weak dollar policy that have contributed substantially to the malaise.
David Malpass is president of Encima Global, an economic research and consulting firm, and was chief economist of Bear Stearns.
