Is It Over Yet, Mom?

A few years ago when we were in the basement of our Minnesota home hunkering down against an oncoming tornado, our son uttered these words; unfortunately, the storm hadn't hit yet. (In this case, it did some damage, but was not devastating)

Simon Johnson, of MIT and the Peterson Institute for International Economics gave an interesting presentation on the current crisis to an East Asian audience. He notes that confidence, in some sense, is returning to the markets, as evidenced by the earlier runup in stock indices, which have retraced. Johnson notes that Jamie Dimon, the CEO of JP Morgan Chase described their past year as "our best year ever." How can that be if things aren't getting better? Getting better today depends on where you sit.

Being an economist by training, Johnson notes that the costs of higher unemployment, lost output and wealth have not been truly felt yet. In his opinion, we face "greater danger" from what he cleverly describes as the "Super Sized" U.S. financial sector. We've talked about this phenomenon before, notably yesterday. According to Federal Reserve data in Johnson's slides, the financial sector's share of U.S. domestic profits was more than 42% in 2002 and now hovers at around 28%. Tail wagging the dog?

The current U.S. regulatory strategy, in his words, is to put large, unconditional subsidies into the banking system in order to support financial intermediation, and this is justified by the need to lower the risk of bank runs and a loss in confidence. Incidentally, he notes that it helps stock prices in the near term, and provides job security for banking industry insiders.

Like us, he berates the "false" financial innovation trumpeted by U.S. market apologists which results in consumers overpaying for what should be commodity financial products.

He uses a very interesting terminology for the surviving entities in the current U.S. financial system, calling them "oligarchs," which is the term used for those hand-picked individuals to whom were transferred all the tangible assets of the former Soviet Union as it was collapsing under the inept leadership of Yeltsin. Johnson notes, for example, that the top 3 U.S. banks currently hold 30% of all deposits, up from 20% pre-crisis. When in doubt, fly to safety, which means fly to those banks who have shaken hands with the government, which describes all the Super Sized banks.

It's not a pretty picture, but it reflects our political system's inability to drive any real change beyond a Most Favored Nation approach of anointing a select group of actors and calling it a day. There are potential coalitions of unlikely bedfellows that could object to the current scenario, and Johnson identifies some of the players.

A parallel discussion has been going at the Peterson Institute, led by my former tutor in international economics Professor John H. Williamson. He introduced me long ago to his concept of Fundamental Equilibrium Exchange Rates (FEERs). It has proven to be a very useful policy tool for international banking and foreign exchange management. Bottom line from this discussion is that the dollar exchange rate vis-a-vis most currencies is overvalued, driven mostly by fear and a flight to what people think is safety. The fundamental outlook might not sustain this current situation.

Finally, investment gurus are advising investors to diversify away from U.S. markets and to overweight towards emerging markets. In theory, and in a vacuum, this sounds sensible. In fact, it would seem to follow from a lot what I've written myself. However, I just read about Satyam, the poster child for corrupt and incompetent Indian public company management, being renamed Mahindra Satyam and moving forward. Unfortunately for risk averse investors, besides the new name and new executives, what has changed? Why should risk averse investors have confidence in Indian securities regulation and in Indian affiliates of U.S. accounting firms? Why should anyone believe in the tone at the top, the controls, and integrity of financial statements under a new, unknown regime? Hard to figure, but it makes good copy.