POINTS OF INTEREST IN THE WEEK AHEAD
- The financial reform debate is in the final innings with much at stake.
- The low level of economic literacy exposed in last week’s hearings before the Senate’s Permanent Subcommittee on Investigations offered an unnerving insight into much that is driving the financial reform effort.
- Financial reform legislation in its present form devotes a great deal of attention to issues that had little to do with the housing debacle and does little to put to rest the Too-Big-to-Fail issue.
- The crisis exposed flaws in the financial architecture that need attention. Done right, financial reform will allow failing institutions to be wound down without holding the entire financial system hostage. Done wrong and financial reform will produce many adverse unintended consequences, making credit more expensive and difficult to get and forcing businesses to live with risks they don’t want and have, with the aid of financial derivatives, been able to shed.
- Meanwhile, the economy is in recovery and is likely to accelerate this spring. This will translate into an improving job market, easing anxieties about the economic outlook.
It usually works out best if we understand the problem before we try to solve it …
From the perspective of economic literacy, last week’s hearings before the Senate’s Permanent Subcommittee on Investigations had to be, well, not memorable, or inmemorable (as infamous is to famous). The hearings exposed an unnerving ignorance of fundamental principles of market economics by folks who have a hand in remapping rules of finance that will be with us for a while. Flip assertions about what is and is not socially valuable reflect a confusion about our market economy that is as fundamental as knowing that George Washington was the first president of the United States.
Maybe it’s human nature to get self righteous about the mistakes others make when there are even worse problems in our own back yard that we should be tending to. Where are the hearings about the shameful story in the figure below. We can’t blame this one on financial derivatives, sir. Michigan’s problems began long before the first swap transaction was introduced in 1981. Bad luck? Sure, manufacturing comprises 20-25% of Michigan’s economy. Except, wait a minute … that’s true for a bunch of other states as well, including Alabama, Arkansas, Idaho, Indiana, Iowa, Kentucky, Louisiana, North Carolina, Ohio, Oregon, South Carolina, and Wisconsin. And it isn’t much different for Texas either. Many things are out of our control. But why has Michigan’s economy been allowed to evaporate, while its business, labor and political leaders stand idly by, even as others with similar challenges, especially Wisconsin and Indiana, are getting Most-Improved-Player awards? Michigan must overcome a deeply held perception that it is genetically anti-business. Fair or not, no amount of advertising dollars can change that perception. This story is tragically ironic, because the Wolverine State once was the icon of business energy. The Tristate area is going to face the same future as Michigan, if it only knows how to raise taxes but not how to shrink its public-sector cost structure.
The low level of economic literacy is plaguing financial reform. Reform is dangerous—it produces unintended consequences—if we don’t understand the connection between incentives and economic behavior. Folks may like to hear that someone else is to blame for the mistakes they made, but everyone knows—including those who bought houses far beyond what they could afford and then walked when the promise of endless capital gains died and including the investors who bought funky financial instruments that enabled the housing bubble out west and in Florida to inflate—that Wall Street isn’t the only culprit in the housing debacle. Sir, Goldman was no more culpable in the housing debacle than Congress. Because Washington is mostly focused on appeasing (or stoking) political outrage, the financial reform legislation in its present form seems likely to do little to fix the flaws and is heavily focused on changing things that had little to do with the housing debacle.
What flaws need fixing? The financial system is highly interconnected. The bankruptcy laws need to be modified to allow for an orderly unwinding of a failing financial institution (for example, ending the exemption given derivatives has attracted some attention). No institution should be too big to fail. Public funds should not be relied on to resolve failing financial institutions.
Now that the financial reform debate is in the final innings, it’s time for the grownups to step in. In its present form, financial reform will make credit more expensive and more difficult to obtain and businesses will find it more difficult to shed risk, harming the very people we are trying to help. Done right, reform will increase transparency, allow failing institutions to fail, and not stand in the way of financial innovation that has allowed those who want to shed risk to pass it to those who seek it, an evolution that has contributed to the US economy’s robust performance in the past.
Key focus for this week …
- March real consumer spending likely rose a solid 0.6%. Real consumer spending is already reported to have increased at a 3.6% annualized rate in the first quarter.
- The survey of purchasing managers is expected to continue to indicate that industrial activity is expanding at a brisk rate.
- March construction likely picked up from February’s weather-depressed levels, but remains very weak.
- Upbeat anecdotes from the motor vehicle industry suggest that April vehicle sales may not have faded much from March’s 11.8 million unit annualized pace.
- Purchasing managers at non-manufacturing companies likely will stay up in the “growing” range.
- Labor productivity growth slowed a bit in the first quarter, taking cues from the slower rate of real GDP growth.
- The early Easter this year is distorting trends at chain stores, but sales at national chains remained on the slow-ascent path.
- Nonfarm payrolls probably rose 200,000-300,000 in April and the unemployment rate probably edged down. Only 72,000 temporary census workers have been hired so far this year of the 500,000- 800,000 expected to be hired in total at the peak of the effort, so a substantial number will be added over the next couple of months. These Census jobs will terminate by mid to late summer.
James E. Glassman
jglassman@jpmorgan.com