Thursday, September 18, 2008

A Terrible Week For Small Government

Once as tragedy, once as...

OK, there's no denying it. This has turned into a terrible week.

Not only is it a terrible week for bankers and their shareholders, it's a terrible week for those of us who believe in small government. The US government has nationalised its biggest private sector insurer, its legislators are drawing up tough new financial market regulations, and the supporters of Big Government -including most of the British broadcast media - are in full cry.

John Snow wants to see the evil men of greed brought to heel, Will Hutton wants hard man Mervyn King sacked and commercial bank liabilities nationalised, Paul Mason wants an FDR style ban on investment banks, etc etc.

So what to do?

As a very subdued Irwin Stelzer said on Newsnight, we have to accept the urgent need for changes in financial market regulation. Tougher capitalisation ratios for sure, greater oversight of liquidity management, and in this country, that long delayed Darling package on special bank resolution and better depositor protection.

But we also need to take a cue from George - yes that George. Last night he resolutely refused to blame the markets. Accepting that it wasn't edifying to watch short sellers making money out of misery (cf Black Wednesday), he pointed out that the real root of today's problem was the huge debt bubble that built up over the last decade or so. That was what fueled the property boom, and the excesses in the financial markets.

So why did that happen?

At the end of the day the world's central bankers have to take a big slice of the blame. They provided the cheap money which underpinned the growth of debt.

In particular, the famous "Greenspan put", which saw 20 years of the US Federal Reserve moving to cut interest rates aggressively every time financial market turmoil seemed to threaten the long economic boom. The 1987 stock market crash, the Mexican crisis, the Asian crisis, the LTCM debacle, and the bursting internet bubble - after each, US rates were slashed. For long periods, US short-term interest rates were actually lower than the inflation rate (ie real interest rates were negative). It was cheap cheap money.

Now we face the consequences.

As we've been blogging all week, we think much of of the commentary on this crisis is hysteria - this is not the end of the world. But it's certainly confirmed that we now we face a recession, followed by a prolonged period of jobless joyless 1970s style recovery. It may not be quite as bad as the last two decades in Japan, but we're going to have a pretty grim time.

Events this week have surely sealed a Tory landslide. So let's hope George remembers the lessons of the past: the only sustainable way back to economic health is to downsize government and trust the markets.

But there's no denying that the last week has made that a much tougher sell.


PS When Tyler worked in the City, he used to think a lot about risk and return. In particular, he recalls reams of stats showing that for decades low grade high yield debt had produced fantastic returns combined with extraordinarily low risks. Better than equities, better than government bonds - a no brainer. Really? You mean you can have your cake and eat it? Yes. Absolutely. Well... strictly speaking, if you go all the way back to the 1930s, the stats do show there were some losses - some quite big. But of course, the 1930s were a very unusual period, and since then central banks and governments have got a lot better at heading off disaster. It's extremely unlikely to happen again...

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