President Bush turned up on Wall Street, last week, and gave his standard sheriff talk about standing up for law and order and putting miscreants in jail. Tough speech, but very vague on details. And the reference to a "few bad apples" brought on howls of laughter in certain quarters - - given the evidence on the widespread incidence of corruption. Even schoolboys now recognise that there are systemic problems that have to be addressed by regulatory measures.
Proponents of competitive markets obviously dislike more laws and regulations, but have to admit that some reform is necessary for the sake of preserving the long-run viability of the system. Unregulated capitalism has a strong tendency to self-destruct, and it is occasionally necessary to tweak and optimise existing regulations. Adam Smith got it just right. In the "Wealth of Nations" he said that greed is OK, and in the "Theory of Moral Sentiments" he said that unrestricted greed leads to the breakdown of civil society. Society has to have an adequate and viable framework for free and fair exchange; otherwise we end up in a free-for-all between Mafia gangs. Right now, we need to have more transparency and accountability to rebuild lost trust. Bush has to try harder.
The past decade was notable for its excesses and the scale of bad behaviour. But it was nothing compared with what transpired in the 1920’s - - the last great bubble period in the United States. In the twenties corporations released scant and often distorted information, and accounting standards varied widely among firms. Investment practices included widespread fraud, price manipulation, insider trading and secret investment pools - - to a far greater extent than anything we have witnessed recently. The stock market was essentially a casino, and for the average outsider, investment was largely a gamble.
The 1929 crash led, subsequently, to the establishment of the SEC and the passing of the Glass-Steagall Act (since, followed by the Financial Services Modernisation Act) that previously created a barrier between commercial banks and the securities business. A system was established that relied crucially on the self-regulatory actions of corporations, investment banks, lawyers and accountants. It wasn't a perfect system, and stumbled occasionally, but it functioned quite well until the widespread breakdown of standards of behaviour in the past decade. In recent times, the incentives and the temptation to cheat have increased. Trust has been abused and the self-regulatory mechanism has failed.
Don’t over-regulate
How much regulation is optimal is always a question of striking a delicate balance between the need to protect investors from abuses, and the danger of squelching innovative and entrepreneurial behaviour. If the current financial situation worsens it is possible that populist political pressure will force policymakers into over-regulation. We will then pay the economic price in the form of less efficiency and lower growth prospects. In order to prevent the bad boys from misbehaving again, legitimate activity may also end up by being constrained. There may be official or self-imposed limits put on risk-taking behaviour. In consequence, returns will also suffer. We have already had inefficiencies and extra costs introduced into the economy as a result of the measures taken, and policies implemented, to counter terrorism. In addition, don’t forget the restrained animal spirits, resulting in subdued venture-capital financing and lower capital-spending growth and we can guess the impact on productivity growth. Also important in this context are rising government budget deficits and a tendency towards greater protectionism.
Bush’s talk did little to instil confidence in the stock market and there are indications that individual investors are beginning to fundamentally reassess their expectations regarding equities. Cracks are appearing in the buy-and-hold ideology that has dominated thinking up to now. What’s more, the performance of the economy is obviously not divorced from the fortunes of the stock market. Further slides in the market will inevitably affect economic growth prospects. The risks have increased on the downside.
The attraction of Treasuries
In a flight to safety, some investors have been piling into Treasuries, which are now very richly priced. With the Fed very much on hold, inflation low and the risk premium on corporate debt edging higher, government securities have increased in attraction. This outcome is being viewed favourably by policymakers, keen to keep the housing boom fired up. Mortgage rates, which earlier in the year threatened to rise, have now crept lower.
Treasury yields much lower than present ones, would be signalling a deflationary outcome for the economy. Currently, inflation is at a very low level and a look at its broad components shows the dichotomy between the goods and services sectors of the economy. Core service-sector inflation has edged higher this year and is running at a substantial annual rate of about 4.0%. In contrast, the goods sector has been suffering from deflation. As the dollar depreciates, it is not unreasonable to expect some reversal of the pricing trend in the goods sector.
The benchmark ten year Treasury may be heading for a yield of 4.5%. With core inflation running at about 2.5%, this gives a real return of just 2.0%. The question is whether this is an adequate return for the risks assumed. Comparisons with earlier low-inflation periods may be misleading. Bond markets were more stable then, whereas volatility has been the rule in more recent times.
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