G-20 Economic Summit – The Finger of Blame Points at Them ~ Steve Blitz Morning Notes
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Monday, March 30, 2009

G-20 Economic Summit – The Finger of Blame Points at Them

Those that failed to see the current crisis coming are going to London to cobble together regulations to prevent the next one. These architects of the new financial world seem to have forgotten that today’s hodge-podge of financial instruments developed out of past regulations that road-blocked capital from earning its highest return. If Regulation Q hadn’t capped rates paid on bank deposits the money market mutual fund industry never would have formed and the whole shape of the capital markets and the role of banking would have been different. Regulations work best when needed least.

In the Korea Times a few days ago Ken Rogoff laid out the regulatory issues to be debated and the positions being staked by the major players in an excellent article "Brave New Financial World." Today’s policymakers can say what they want about international coordination and sustaining a responsible and robust financial system, but new rules always sow the seeds for the next crisis and that will be true this time as well. In fairness, some of the proposed regulations make sense and are necessary but the focus is on keeping the financial “scoundrels” from getting drunk at the punchbowl with scant mention of who spiked the punchbowl in the first place and how to keep it from happening again.

The current maelstrom is a financial market failure of historic proportions but the Federal Reserve and other central banks spiked the punch bowl by hewing policy to inflation indexes of dubious value while ignoring the burgeoning foreign capital inflows ramping up credit growth. The financial sector did what it does best in that environment -- manufacture the yields that these funds were searching for on the presumption that the demand for these instruments will be greater tomorrow.

Bill White, former Chief Economist of the BIS had long been warning of the catastrophic impact from central banks ignoring rapid credit growth because inflation was low. He was right the Fed was wrong and the solution lies less in re-regulating the financial system than it does in resolving the structural imbalances in global trade.

Martin Wolf writes with the usual intelligence and clarity in the FT today (“Why G20 leaders will fail to deal with the big challenge”) --

“. . . next to no adjustment in underlying structural imbalances is occurring. In particular, the non-fiscal sectors of the three big surplus countries are expected to continue to run huge surpluses. The change – temporary, the surplus countries surely hope – is that domestic fiscal expansion is modestly offsetting the decline in demand coming from deficit countries with over-leveraged private sectors. But that decline in private demand is also offset by massive fiscal boosts in deficit countries.

This is not a path towards a durable exit from the crisis. It is a path on which the fiscal deficits needed to offset persistent current account deficits, and collapsing private spending in external deficit countries, continue indefinitely. Unless and until surplus countries recognize that this cannot continue, no durable escape from the crisis will be achieved. Understandably, but foolishly, they are unwilling to do so.

So what is to be done? That must be a central agenda item of the next G20 summit. The world economy cannot be safely balanced by encouraging a relatively small number of countries to spend themselves into bankruptcy. The answer lies partly in changing the policies of surplus countries. But it lies as much in rethinking the international monetary system. . . . “

There is an answer in the existing international monetary system, let all currencies float freely in the market. The Fed and others have been conducting policy as if this were true. It isn’t. Any fair reading of the Japanese Yen and China’s Yuan against the dollar suggests manipulation on their part to keep their currencies cheap and the export orders flowing. For China to have spent the past decade selling yuan against the dollar despite a massively growing trade surplus to now complain that they own too much dollar debt and the U.S. should do something about it is ludicrous. They should reap the consequences of their policies.

Either the structural imbalance between the trade surplus nations and the trade deficit countries is allowed to resolve itself through freely floating exchange rates and international capital flows or it gets resolved by domestic policies that effectively do the same.

If the G-20 builds a new structure for the financial sector and fails to build new rules for foreign exchange and capital flows we can be sure that global trade imbalances will also collapse the next upturn. At that time the financial sector will present a new set of challenges that the to-be-adopted regulations will have missed and government will be too leveraged to step in and replace private credit.

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