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Reasons for Economic Optimism Despite G20 Summit Failure

Economics / Global Economy Nov 19, 2008 - 11:31 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleMartin Hutchinson writes: The gathering of 20 largest industrial countries in Washington this past weekend – billed as a crucial G20 summit – turned out to be a rather dull scrum.

There were promises of a coordinated approach to bank regulation, additional economic stimulus packages, and increased allocations for the International Monetary Fund (IMF) –one of the five “ aftershock-investing ” opportunities Money Morning has counseled readers to watch for. But none of the G20 meeting proposals seemed even remotely likely to make a difference in the here and now.

Even so, when you consider the kind of mischief the world's 20 largest governments are capable of getting into, it's best to just breathe a sigh of relief.

The G20 communiqué starts by getting the cause of the crisis wrong. It blames banks that “sought higher yields without an adequate appreciation of the risks” as the primary cause of the crisis, while government was to blame only for inadequate supervision. That begs the question: What made banks – which for decades had been model citizens, leading perfectly blameless lives – suddenly go off the reservation in this way?

The answer, of course, is sloppy monetary policy.

These slapdash policies, pursued by the U.S. Federal Reserve since 1995 and by other central banks since 2002, have translated into very low interest rates, and asset bubbles that over-inflated the value of stocks, real estate and commodities throughout world markets.  Naturally, since borrowing was cheap and asset prices always went up, bankers, acting like the well-trained economic men they are, leveraged too much and stuffed their balance sheets with all sorts of snoozy assets.

But central banks' misdeeds are not failures of the private sector; indeed, central banks are government institutions.

Likewise, the misdeeds in the housing market – while perpetrated by private-sector wheeler-dealers among the mortgage brokers and asset securitizers – were initially prompted by Fannie Mae ( FNM ) and Freddie Mac ( FRE ), two government-based enterprises (even though these companies tried to masquerade as private-sector ventures, so they could pay their top brass like Pharaohs, instead of the civil servants that they actually were). They were spurred on by the Community Reinvestment Act , which positively forced banks to lend large sums of money to impoverished unfortunates who couldn't pay it back – creating the subprime-mortgage market . 

The G20 's refusal to admit that government bears a large part of the responsibility for the crisis is important. Public beliefs about the cause of disasters can affect policy for decades. This happened during the 1930s. For decades the public was convinced that the Wall Street Crash of 1929 caused the Great Depression . Indeed, it was two other factors – the Fed's inability to expand the money supply during the banking crisis of 1931-33 (identified as a big problem by Milton Friedman and Anna Schwarz in 1963), and the highly protectionist 1930 Smoot-Hawley Tariff Act (not really blamed until the late 1970s) – were much more centrally responsible.

Only when another almost identical crash happened in 1987 – and no “Depression” followed – was this long-held misnomer finally put to rest.

But this long-held misdiagnosis caused U.S. policymakers to devote much effort to preventing another Wall Street Crash, in order to avoid another Depression. In doing so, they made matters much worse in some respects, notably by splitting commercial and investment banking by the 1933 Glass-Steagall Act . That legislation almost shut down the U.S. capital markets in the late 1930s, because the tiny new investment banks, split off from their commercial bank parents, could not afford to underwrite large, risky stock-and-bond offerings.

With its mistaken assessment of the market's current backdrop, the G20 will focus mainly on bank regulation, tightening down so that banks will be forced to keep more capital on hand to sustain their balance sheets – therefore unable to make as many risky investments or high-risk loans.

We're already seeing the fallout from this assessment. First, banks are de-leveraging as fast as they can, forcing down asset prices and helping fuel the whipsaw volatility that's become the market norm of late (hedge funds and other institutional players are de-leveraging, too, which is contributing to the chaos). Second, credit has tightened throughout the world economy, and we're now watching as one market after another is succumbing to recessionary forces .

Controlling the salaries of bank executives will also have a modest economic effect, probably in increasing the number of hedge fund and other speculators that infest the financial system – not a good recipe for stability in the long run.

What won't happen is a proper reform of the government policies that went wrong. There will be no tightening of monetary policy – until rapidly rising inflation forces it to happen, probably about a year from now, once the economy has touched bottom. There will be no reform of the housing market – we are unfortunately unlikely to return to the sepia-toned days when local savings-and-loan companies run by “It's a Wonderful Life's” George Bailey (Jimmy Stewart) made home loans directly to customers they deal with on a first-name basis. This failure to reform will make housing finance a source of future instability, and increase the bureaucratic cost and hassle of getting a mortgage. 

Despite these many missteps, however, there's reason to be very thankful.

For all its mistakes, the G20 avoided the biggest blunder of all, the misstep that touched off the Great Depression – a move toward protectionism that could devastate world trade. Indeed, the group specifically pledged to avoid trade-inhibiting moves for the next 12 months and to work towards a Doha global trade agreement . I'll believe the reality of the latter when I see it , but if the world's statesmen are negotiating Doha, even unsuccessfully, they're not passing Smoot-Hawley.

Simply having the world's leaders meeting frequently keeps them from moving in this specific wrong direction – passing protectionist legislation is unpopular with leaders who know they will have lunch with their country's trading partners soon, meaning they'll do all they can to avoid that embarrassment!

With world trade unaffected, even this very unpleasant downturn is likely to be fairly short and nothing at all like the Great Depression. Twelve months from now, the world economy will be starting to emerge from a recession, stock prices will be rising and the major problem facing us will be rapidly accelerating inflation.

But at least we'll have inflation-hawk Paul Volcker around, advising President-elect Barack Obama on the moves to make to tackle that problem. That's one problem that won't be misdiagnosed.

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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