"Government is the ultimate crowd; every decision being made by committee. It is always acting on the last trend, the one that is already over. (For example, the Federal government passed securities laws to prevent the 1929-1932 crash...in 1934.)"
-- The Elliott Wave Financial Forecast, July 2007.
Politicians worldwide have historically proven themselves poor architects of fiscal policy. The Glass-Steagall Act of 1932 was a reaction to the persistent deflation following the stock market crash of 1929. The soon-followed Banking Act of 1933 was a reaction to the U.S. banking system collapse.
Sixty-six years later, the Banking Act was repealed -- in reaction to an expanding economy and financial engineered products that promised to lower systemic risks. We all know how that worked out.
Now we are promised a new set of financial reforms that will control systemic risks once and for all. Somehow, I believe that history will prove this legislation has missed the mark, as well.
U.S. banks have decided that hoarding cash is a better bet than loaning money; excess reserves at the Federal Reserve remain stubbornly high. The Fed has kept interest rate near zero, but we do not suffer from "a liquidity flood" or inflation; on the contrary, deflation is a concern. Now Europe's banks are hoarding cash, too: The European Central Bank reports that its overnight deposits are surging well above the historical average.
To solve the liquidity crisis, Europe looks to the Fed and U.S. banks, but the new financial regulations are at odds with such lending. Banks are now required to maintain improved capital ratios and limit “risky” loans and activities with depositors' money. And short of some emerging market debt, few things are priced more “risky” right now than European sovereign and bank debt.
That means that European companies are forced to pay punitive rates in the open market -- and borrow less as a result. In other words, this is an engineered liquidity crisis: Tighter regulations are stimulating deflation, the opposite of what regulators intended.
Politicians assume there is some "magical" interest rate at which lending will resume. But just like the misguided policies to support real estate values (which will only recover when prices have declined enough to represent a reasonable multiple of average income, rather than the fantasy valuations created by low interest rates and a lax lending regulations), supporting overleveraged banks or creating new debt to support the old debt won't solve Europe's credit crunch.
Zero interest rates are not a panacea for too much debt; central banks are pushing on a string. Corporations bemoan higher open market rates -- but, like declining housing values, those rates are true and real. We have all gotten used to low interest rates, but deflation is persistent, and it cannot be stimulated or legislated away, or all we end up with is more debt and nothing learned.
Bill Fox is EWI's Senior Bonds Analyst. He has been involved in the markets since graduating in 1988 from Vanderbilt University. He joined EWI in 1994. NEW! Bill's Interest Rates Specialty Service now covers ETFs: IShares Barclays 20+ Treasury Trust (TLT) and the ProShares Ultrashort 20+ Treasury Fund (TBT), the most liquid ETFs in the FI sector.