Economics of moral hazard

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Renewed US slowdown, Europe’s peripheral debt and default concerns, and inflationary pressures on Chinese growth sound the death knell for the Fed-led recession response, which gambled on large monetary steroids to stimulate investment and consumerism. Inherently, assurances that the Fed wouldn’t allow a stock market decline while ECB guaranteed a timely Greece-solution not only contradicted basic neoliberal ethos, but also encouraged the phenomenon that prompted market collapse in the first place – moral hazard.
The initial success of increased liquidity in propping up asset prices (US stocks, European banks, Chinese real estate) insulated institutional ‘irrational exuberance’ from market risk. It set another self-contradictory precedent that central banks, governments and printing presses stood ready for indefinite intervention to cover losses. So, global financial authorities in effect encouraged speculation as part and parcel of a policy aimed at curbing speculatory imbalances that fuel bubbles.
Now that the stimulus approach has been exposed as unproductive, mr market is beginning to price in low volumes stemming from loss of faith in financial authorities. By nature, moral hazard is counter-productive, discouraging punters with long-term investment viewpoints contrary to central bank manipulations. As things stand now, not only has three years of quantitative easing failed to kick-start growth, it has also driven the dollar down, the only thing delaying collapse being a different kind of uncertainty haunting the euro region.
And while the euro-dollar zig-zag tries to figure the lesser ugly currency, international markets seem convinced that the world’s largest economy is sleepwalking into a debt time-bomb that will destroy its reserve currency status. Government intervention in the bond market is debasing the dollar, signaling an inevitable rise in interest rates and discouraging long-term treasury bond investments by turning yields negative.
China has been accumulating US bonds for a long time to push US rates lower and bolster its export market. That Beijing has finally initiated a visible shift away from the dollar into other currencies and real assets, buying oil wells and gold mines, is indicative of serious bankruptcy concerns for the American economy.
A falling dollar, of course, translates into immediate inflationary tendencies in commodities, whose price rush in the last year means few market participants hold long term hopes with the greenback. What we are witnessing now is what resulting inflation expectations do to consumer psychology. As businesses and households around the world come to the realisation that increased utility spending is the result of a faulty recession-policy in the US, they rein in spending, delivering the proverbial kiss of death to consumerism and faith in the American economy’s ability to lead a coordinated bottoming out.
Deliberate dollar weakness also amounts to ‘exporting inflation’ to emerging economies. Unable to intervene in commodity markets, they are enduring debilitating food and energy inflation that retards growth and adds to unemployment. In effect, the US is causing the economic south to spend disproportionately more so it can continue borrowing to finance its unprecedented deficit.
The point when these economies respond by devaluations of their own cannot be pushed forward indefinitely, resurrecting ghosts from the ’29 great depression when currency devaluations were engineered far and wide. Ironically, the strategy aiming at increased growth and avoiding a repeating the depression has led to a situation where unemployment and inflation are rising, with the international setting increasingly resembling the collapse of 60 years ago.
In Europe, too, the Greece bailout drama clearly focuses at saving German and French banks with large exposure in the struggling country than its economic fundamentals.
But massive spending cuts and austerity that came with the 110b euro package last year have already wrecked living standards and increased unemployment, reducing tax revenues and driving the economy further lower. Just why collective Union wisdom has banked on more of the same to deliver strikingly different results is only making the market more certain that the focus is on saving large financial institutions, not the working class population.
It is strange that despite dismal economic outlook on both sides of the Atlantic, authorities continue to advocate the irresponsible model that empowered the same institutions to lead the way to recovery that caused the massive collapse. By continuing to inflate debt in the US and bailing out European banks, governments are only delaying the inevitable. America must eventually stop financing its debt and enter prolonged recession, while Europe has little choice but to let the periphery default where it must, or prepare of an unprecedented Lehman effect on entire economies. Moral hazard makes for bad policy.

The writer is Business Editor, Pakistan Today

1 COMMENT

  1. Nice read. But the title of the article reminded me of the movie Wall Street: Money Never Sleeps. It used the same ‘Moral/Ethical Hazard’ term on multiple occassions on how speculation and capital markets make and ruin lives. And how the financial institutions have exploited ordinary people’s investments. Appreciated.

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