Incoming US presidents often face significant financial headwinds. Barack Obama is facing a force-five hurricane. The world economy has swiftly transitioned from a position of reckless financial risk-taking to a situation that may be even worse – no financial risk-taking. To add to these difficulties, the emerging challenge is deflation. By David Smick.

Since the outbreak of the crisis, policymakers have engaged in financial firefighting, not fire prevention. In the US, policymakers have been fixated on the mortgage market and declining housing prices. Yet the credit crisis reflects a problem more fundamental than mortgage defaults. Global markets have declared a buyers’ strike against the industrialised world’s financial architecture – the sophisticated paper assets, including securitisation, which financial institutions use to measure risk and deploy capital. The housing crisis was a mere trigger for a collapse in trust of paper, followed by a deleveraging of the entire bloated global financial system.

Besides putting out fires, global policymakers must define a new financial architecture. Mr Obama should be thinking the problem is not that the world lacks capital – more than $20,000 of capital is sitting on the sidelines.

It is time to go where the money is. The faster that policymakers can fashion financial reforms and a credible system of regulatory oversight, the sooner sidelined capital will re-engage. Financial markets crave certainty; what they lack is the certainty that global leadership has a credible model for a new financial architecture.

Complicated task ahead

Fashioning such a model will be complicated. By late 2008, Ben Bernanke’s US Federal Reserve – after drowning the financial system in liquidity – still found itself frustrated with widening spreads between shorter-term market interest rates and longer-term rates. The Fed engaged in quantitative easing, pushing market rates down by intervening directly in both the Treasury and non-Treasury credit markets, under a framework of transparency. The Fed’s balance sheet expanded dramatically even as Congress increased the fiscal deficit to unheard-of levels. This begs the question: once the economy begins to recover will the Fed be forced to monetise today’s exploding debt? It seems likely.

Yet despite the Fed’s anti-deflation binge of money printing, matched by an explosion in fiscal stimulus, the asset-backed securities market and other credit markets remain largely frozen. Now the government must confront several questions: Can the debt securitisation process be revived simply by printing or spending money? And if not, what reforms would restore global investor confidence in a securitised debt market greatly amplified by a host of layered derivatives products?

Global regulators need to find a way to standardise the securitised debt market – perhaps by treating new securitised debt such as publicly listed securities, clearly labelling the identity of the issuer and contents (as well as the liability, in the event that such labelling is untruthful). Unless the securitised debt market is reformed, the financial sector, particularly in the US, will lack credibility. As a subset of this reform process, a clear plan is needed, showing how banks globally will deal with their still considerable off-balance sheet risk. Ultimately, effective financial reform requires a global solution – an international oversight mechanism. However, unless the G10 heads of state directly intervene, the challenging differences in individual nation regulatory regimes will likely make reform painfully slow.

Export dependence

What is also becoming clear is that the global emerging market export model of recent decades is cracking up. In that model, developing economies tied their currencies in one form or another to the US dollar and became dangerously export-dependent while building up huge excess savings to be recycled back to the industrialised world. The resultant global ocean of excess savings became dangerously unmanageable – a hot-bed for the creation of dangerous financial bubbles.

As global demand has plummeted, the export-dependent emerging markets are in trouble, and the sad fact is that the International Monetary Fund lacks the resources to mount much of an effective rescue operation in the event of widespread credit defaults. European financial institutions are at particular risk.

We are about to see an earthquake in the relationship between governments and financial markets. Washington, DC, is America’s new financial centre.

The great uncertainty is whether governments have the power to rescue the financial system if the crisis worsens significantly. It seems doubtful. That is why policymakers desperately need to think boldly about a set of reforms that lay out a future financial doctrine.

David Smick is chairman and ceo of global advisory firm Johnson Smick International Inc, and founder/editor of The International Economy magazine.

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