Merk Market Outlook: Coming Wave of Regulation and the Risk to the Dollar

Over the past several months it has become clear that there is a cauldron of regulation brewing in Washington. The bursting of the subprime bubble and dislocation in the financial sector has brought with it, in its aftermath, the risk of overregulation. Members of the political class are brimming with confidence that the political, economic and social considerations have aligned to finally tame the market. Serious consideration is being given to policies that would curb the ability of investors to hedge against future instability in markets, engage in financial innovation and even determine the pay of senior managers, much less corporate executives. What is beginning to take shape is not a necessary bout of reform, but a wave of regulation that will stem that necessary flow of investment into the US and put the dollar at greater risk.

Over the past several months it has become clear that there is a cauldron of regulation brewing in Washington. The bursting of the subprime bubble and dislocation in the financial sector has brought with it, in its aftermath, the risk of overregulation. Members of the political class are brimming with confidence that the political, economic and social considerations have aligned to finally tame the market. Serious consideration is being given to policies that would curb the ability of investors to hedge against future instability in markets, engage in financial innovation and even determine the pay of senior managers, much less corporate executives. What is beginning to take shape is not a necessary bout of reform, but a wave of regulation that will stem that necessary flow of investment into the US and put the dollar at greater risk.

 

At this late stage in the game, one does not get the impression that our political elite has given proper consideration to the costs and benefits of returning to 1970’s style regulation. On one hand the cry out of Washington is that the grabbing hand of the government must return to the marketplace to protect society and ensure the proper functioning of markets. Yet, those same political actors who bemoan the power of the market are the same ones considering the implementation of regulations that would create incentives for the necessary flow of capital to fund their earmarks and out of control spending.

 

The simple truth is that due to the deficit in the US current account, the country must import $1.9 billion per day to cover the shortfall in savings and investment that it needs. Unlike some of the economically ill-informed in our political class, we are not under the impression that foreigners invest in the US to provide leverage over our way of life or our foreign policy. What drives the flow of funds from abroad is the return on investment from parking capital in an efficient, deep and liquid market. An increase in regulation that would limit speculative activity to give the public the impression that Washington is doing something to curb the excess of the market, would in the end create inefficiencies in domestic markets, increase the cost of doing business, drive up interest rates and send the value of the dollar plummeting.

 

For example, the Congress is seriously considering curbing speculation in the oil markets. While this would provide a transitory measure of satisfaction to a certain political constituencies, but is it economically prudent? After all for markets to function properly it is essential that market participants are able to derive future prices. Put another way, current expectations of supply and demand over the next several months or years, out to be embedded in futures prices. This provides market players with a signal of future costs and guides investment, exploration and development in the industry. Perhaps, the members of Congress think that they can do a better job of allocating resources and setting prices. But it is doubtful.

 

Those that support a significant increase in regulatory activity on the part of Washington, suggest that it is the government and the government only that can enact the necessary steps that can save us from ourselves. They believe that without government intervention in the marketplace that financial institutions will not adopt sufficient risk practices to avoid another sub-prime type debacle. These would be reformers believe that speculative activity in the oil market will continue to drive up the price of gasoline, as if, China and India do not exist or that supply and demand do not matter in election years. Moreover, many make a straightforward argument that if public funds are used to bailout financial concerns such as Bear Stearns, that the federal government should dictate the how and what type of risks firms should take.

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Such a step up in regulatory activity would be unwise on two accounts. First, the thinly disguised series of efforts currently underway have more to do with addressing what many in Washington view as a structural imbalance in the power between the market and the state. A move at this time to tilt the equation of power back towards the state would risk undoing many of the absolutely positive innovations in the market that have been accomplished over the past three decades.

 

A set of policies that would give the power to unelected bureaucrats in Washington the ability to set the parameters of risk taking inside the business community and create a series of incentives for potential foreign investors to send their capital elsewhere would be precisely the wrong direction to take. Just as the emerging world is adopting open economic policies that will provide the margin of comfort to get the US through what will be a very difficult transition, it would be unwise to adopt a set of policies that drives capital elsewhere. After years of lecturing other nations on the necessity and virtue open markets and flexible exchange rates, the irony will not be lost on an emerging world that is striving to construct exactly the type of futures markets that the Congress is considering regulating. After all, imagine what current levels of gross economic output and the interest rates would be if it were not for free trade, the flow of foreign funds into the country or the ability of firms to hedge against future uncertainty.

 

Second, the structural adjustment in the value of the dollar has yet to run its course. It is in both the interests of the US and the global economy that this process occurs in an orderly fashion. Any regulatory regime that has more to do with domestic political considerations of power and are not in the interests of maintaining an open and efficient market should be forthrightly opposed. While there is little that can be done to prevent the long term redressing of global imbalances, it is imperative that in this election year that a discussion take place that ensures a carefully considered and thought through regulatory regime. If this is not the case, the risk to the dollar is enormous and we would expect a downward spiral in the greenback should Congress wield too heavy of a hammer on the banking community and financial markets.

 

Joseph Brusuelas
Chief Economist
Merk Investments