Rapid deregulation, complacency and the next financial crisis
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Despite the usual, ever-present economic, political and geopolitical concerns, is there anything else to suggest that the world could spiral into another financial meltdown?

In the aftermath of the 2007-2008 crisis, authorities in many countries took regulatory steps to reduce the risk that the system could again unravel and bring the global economy to its knees. In addition to regulatory safeguards, coordinated action was taken through the G-20, the Bank for International Settlements and other institutions to reduce regulatory arbitrage.

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Measures also were taken to stimulate economic activity and restore confidence. Financial markets recently have hit record highs as consumer confidence and business survey indicators registered solid gains. Economic activity in most countries picked up, although, on balance, it continues to lag previous recoveries.

 

With the world economy — and the U.S. economy in particular — seemingly on the mend, the question is, what might derail the recovery and trigger another collapse? Here is one scenario worth exploring: a combination of investor complacency plus a major sudden rollback of U.S. financial regulations, carried out in an environment of rising interest rates and fears of protectionism, could send a shockwave through the markets and trigger a sharp economic contraction.

You could add to this one more cause for unease — the market volatility prompted by rising tensions over North Korea and Syria.

The Trump administration includes a number of senior officials who believe that tighter regulations enacted during the Obama administration are holding the economy back. However, there is little research to support this view. An argument can be made that a sudden, deep rollback in regulations could destabilize markets because banks and investors are still interpreting and adapting to the Dodd-Frank Act.

The risk of turmoil is even greater given that markets already are trying to absorb a technological revolution that includes enhanced algorithmic trading, the proliferation of electronic bond trading platforms and increased reliance on exchange-traded funds (ETFs).

Market participants’ complacency only adds to concern that few are keeping an eye out for the reappearance of systemic risk or, at a minimum, a significant price correction in one or more asset classes. “Priced to perfection” is often heard these days in discussions of financial markets with value metrics in a number of asset classes hovering several standard deviations above the norm.

Conventional wisdom is that economic growth will improve and rising inflation will be well managed and contained by central banks. This has led many equity investors to believe that company earnings will improve this year following two years of disappointment.

However, this interpretation could become frustrated quickly, particularly if the Trump administration’s promise of tax reform and infrastructure spending collapse as healthcare reform did. Already much of the positive news on the economy comes more from survey data than hard economic data.

The most recent estimate of annual first-quarter real GDP growth by the Atlanta Federal Reserve is 0.6 percent. Such anemic activity could trigger a reassessment of earnings growth for the year.

With economic forecasts showing little upward momentum, the monetary tightening by the Federal Reserve could create problems both for the real economy and financial markets.

If market participants get nervous about rising rates, coming as they are on the heels of a prolonged period of exceptional monetary stimulus and unprecedented low yields, it is not hard to imagine the possibility of a sharp reassessment that could send asset prices tumbling. The risk of rising market tensions and volatility, notably in exchanges rates, could lead to wider instability.

At this juncture, the Federal Reserve should be extremely cautious about raising policy interest rates. While the desire to normalize rates is understandable after years of outsized monetary accommodation, the likelihood of success is doubtful given the central banks’ track record.

Similarly, for those who believe that the regulatory pendulum has swung too far toward oversight, a gradual and prudent adjustment first requires a thorough consideration of the effectiveness of regulations. Substantial changes in Dodd-Frank could prompt market participants to reassess the likelihood of future systemic risk, putting downward pressure on asset prices.

In addition, any effort to turn back the clock by re-imposing old regulations, like Glass-Stegall, could quickly turn into a disaster. Financial markets have changed significantly since the repeal of Glass-Stegall. Even since the global financial crisis, the operation of markets has evolved to the point where regulators are wrestling with how to deal with liquidity risk, contagion and a host of ancillary issues.

All the effort that has gone into reducing the risk of another financial meltdown could be jeopardized if the administration rushes to deregulate in order to fulfill campaign promises despite not enough time spent on rigorous analysis, open discussion and simple patience.

Failure to recognize the disconnect between financial markets and economic fundamentals in an environment of low asset price volatility and policy uncertainty could be an accident in the making.     

 

Keith Savard is a fellow at the Milken Institute, an independent economic think tank based in Santa Monica, Calif. He is an expert in evaluating the interrelationship between economic fundamentals and activity in global financial and commodity markets. He also held positions at Zurich Investments, The Institute of International Finance, the U.S. Department of State and the Board of Governors of the Federal Reserve System.


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