THE TURMOIL OF THE past several months has had one advantage: we now have a clearer picture of where the U.S. and world economies are headed. And how monetary and regulatory policies are likely to change.
The world economies are going to slow. Here in the United States home sales are down and inventories of unsold homes are at levels not seen in decades. Prices are expected to fall 7 percent this year, and another 7 percent in 2009. Foreclosures are rising. New construction is down, resulting in layoffs of building workers. The mortgage business is in the doldrums, resulting in layoffs of the desk-bound, paperwork creators attached to the home-building industry.
The problems in our subprime mortgage market have affected financial markets from Australia to Germany to Britain, with the latter facing the humiliation of the first run on a bank in some 150 years. Business confidence in France, Germany, Italy, Belgium, and the Netherlands is declining, and France's finance minister says her country is bankrupt. Federal Reserve Board chairman Ben Bernanke, who cut interest rates sooner and by more than other central bankers, is a hero--at least to stock traders and investment bankers.
Which tells us a great deal about what is to come. Among other goodies in store for rattled investors will be a decision by several central bankers to lower interest rates. The experience of Bernanke proves to all central bankers that in balancing the risks of a financial meltdown against the risks of encouraging more improvident lending by bailing out those caught in the credit crunch, their reputations are safer if they opt for the stimulative effect of lower interest rates. Besides, with the economies of many countries slowing, and inflation relatively tame, further reductions in rates can be justified as needed to prevent a downturn in the real economy from turning into a serious recession. No bail-out, just good anti-cyclical monetary policy. That justification will be even more appropriate when China really steps on the brakes to contain inflation, an event the regime will delay until after the Beijing Olympics so as not to stir up any unrest that might result from rising unemployment.
We also know something else: that the regulatory systems of several countries will be revised. In America, mortgage brokers have encouraged uninformed borrowers to stretch for loans they have little or no hope of repaying, often falsifying application forms in order to collect fees for originating these loans. Those activities will be more closely regulated in the future.
So will the rating agencies that gave the coveted AAA rating to securities so opaque, and backed by assets so dicey, that they were closer to junk status. Since the rating agencies earn their fees from the issuers of these securities, their incentive to "just say no," as Nancy Reagan once advised youngsters who were offered drugs, was somewhere between minimal and non-existent. So they contributed to the debt-addiction of otherwise sober investors and borrowers. That will probably change.
Finally, there is the problem of what has come to be called "non-transparency." It seems that the nature of the very complicated financial instruments developed in recent years is opaque--neither borrower nor lender fully understood the terms or the value of the collateral behind these securities. Rules requiring greater clarity--transparency--are in the industry's future.
So is increased participation by the government in the mortgage market, both directly and indirectly. The regulators are about to expand the authority of Freddie and Fannie Mac to take on more and larger mortgages, and of other agencies to increase the range of mortgages they will insure. Also, on a less formal level, Treasury secretary Hank Paulson is working with--urging or coercing, depending on your point of view--lenders to persuade them to work out the problems of hard-pressed mortgagees, rather than foreclose on their properties, many of which are in the key electoral states of Ohio and Michigan. Since the resale value of foreclosed properties is often less than half the amount of the mortgage, lenders have every incentive to cooperate.
In Britain, the regulatory structure is also under review. It is clear that the division of responsibility among three different regulators, crafted by Prime Minister Gordon Brown when he was chancellor, has attracted sufficient criticism to force a re-think by politicians eager to avoid another embarrassment after the Northern Rock bank run, which saw frightened depositors queuing up in orderly British fashion to reclaim their money. Only when the Treasury guaranteed that no depositor would lose money did the lines you saw in the photos in your newspapers disappear. Plans being discussed include replacing the current insurance limits and system--₤2,000 ($4,000) and 90 percent of the next ₤30,000 are guaranteed, with payment far from immediate--with a system modeled on ours.
We also know another important thing--that the markets are more on the side of Bank of England governor Mervyn King, who at first refused to follow Bernanke's lead, than are the politicians, who favor easing and more easing. The Bernanke cut triggered fears of inflation, as a consequence of which long-term interest rates are rising. For the same reason, the price of gold, which some investors believe is an inflation hedge, is rising. These inflation hawks have some reason to worry. In the United States even the pessimists generally only expect a slowdown from the 3.8 percent growth rate of the second quarter to a bit less than 2 percent growth, rather than a recession. Durable goods orders are running 5 percent ahead of last year, and sales of back-to-school items have been brisk. Unit labor costs are rising. Around the world, food prices are soaring, as acreage once devoted to growing food is shifted to growing fuels. Oil prices are high and likely to go higher as the OPEC oil cartel refuses to increase output in response to rising demand.
The danger in all of this, of course, is that politicians over-react. The development of innovative credit instruments contributed to a major expansion of home ownership from Manhattan to Manchester to Madrid to Melbourne. Those instruments also permitted risk to be shared among many lenders with varying appetites for such risk. Regulations might need tweaking, but they must not be crafted so as to return credit markets to the bad old days of over-regulation.
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD , director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).