So Many Genies So Little Time

GeniesOver the past year, as the global economic crisis went from bad to worse and the federal government announced one hastily-conceived emergency intervention after another, the proximate cause of all this carnage was generally agreed to be financial models that essentially failed to contemplate all possible variables of risk and therefore failed, with disastrous consequences. When investment banks across the globe used 30 – 50x leverage to buy debt instruments tied to mortgages that were generally assumed relatively safe, they did so only because they had modeled these decisions and concluded that the risk that accompanies using that much debt to purchase financial assets was manageable under almost any conceivable circumstance. However, as we all now know, those models missed the circumstance that began in 2007 with the collapse of the domestic, sub-prime mortgage market. This little ripple spread and eventually developed into a tsunami that now has swamped all major global economies.

Over the past few months, all relevant instruments of federal economic policy have been brought to bear to contain this tsunami and stave off a global depression. To their credit, so far, it appears that such an outcome has been avoided. And make no mistake, the world does not need to endure a depression at this point in time. However, as the government ponders rescuing yet another industry (domestic automakers) and is even going so far as to now dictate interest rate terms to mortgage lenders, one has to wonder where this all ends?

In almost every part of our economy, market forces are being pushed aside by heavy-handed and—seemingly desperate—measures. While most observers don’t disagree that desperate times call for desperate measures and virtually all acknowledge that avoiding a depression is essential, one cannot help but wonder how we are going to undo all of this and when? Also, one has to wonder at how much forethought and back-testing is going into some of these programs.

I would doubt that the same amount of computer and brain power that went into risk models for the investment banks and hedge funds that bought mortgage debt with leverage is being used right now to assess the costs, benefits and potential pitfalls of current government interventions. In some cases, you almost get the impression that things are being hammered out on the back of a napkin at three a.m. in some board room in Washington or New York. Given the probable lack of full risk assessments for many of these emergency measures, should we not consider what could possibly go wrong and what steps might be necessary at some point in the future to undo the damage?

For instance, with government now in greater control of the U.S. economy than at any time in its history, at what point down the road will it be a good time for it to step back? Governments are not particularly good at ceding power. Is it realistic to expect both an Administration and Congress controlled by a party which openly advocates greater governmental control and oversight to willingly step back once this economic crisis has passed? I mean, if the federal government can actually dictate the interest rate that can be charged on a conventional home mortgage, when will it ever be politically astute to let that rate rise to a level determined by actual market forces?

How and when is the federal government going to start unwinding all of this? If we are in an economic recovery in late 2009 and surviving banks are starting to restore their balance sheets, will they be able to return their TARP investment and regain full control of their own destiny? When will corporate boards in rescued industries be able to establish their own pay policies without deferring to Washington? I assume that would occur after all government money has been repaid, but what if not?

Lastly, the actions of our own government, as well as that of virtually every other major economy on earth are all quite inflationary right now. In the midst of creeping deflation, that is a good thing. However, at some point in the not too distant future, inflation is going to become a very bad thing and it will require economic pain as severe if not worse than what we are experiencing now. Will the government—run by politicians interested in the next election—have the will to deal with it? It is funny that the recession that analysts keep comparing the current one to is the recession of 1981-1982. It was a 16 month barn-burner as Fed Chairman Paul Volker raised interest rates to choke off double-digit inflation and President Reagan’s tax policies just began to kick in. In the end, the recession did come to a conclusion and the nation began a long period of economic prosperity. However, with an incoming Administration that is on record as wanting to undo some of the Reagan-era tax code changes and Congressional approval ratings at very low levels, will there be enough courage on Capitol Hill to fix the problems that current emergency measures will surely create?

It is hard to see how Washington is going to put this genie back in its bottle. That thought is keeping a lot of people up at night.

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