By Steven K. Beckner
Bullard acknowledged the concerns of some observers that “the
European sovereign debt crisis is occurring against the backdrop of a
weakened financial system in Europe and the US, and that to the extent
the holders of troubled debt are these very same weakened firms, there
may be some prospect for contagion to reignite the type of financial
shock last seen in the fall of 2008.”
But he said that “while this is certainly possible, I do not think
this is a likely scenario.”
Bullard noted that credit default swap prices for major U.S. and
European banks “have moved sharply higher in recent weeks, but not to
the extreme levels seen during parts of late 2008 and the first half of
2009.”
He attributed to the less violent response of prices in good part
to government guarantees.
“Governments have made it very clear over the course of the last
two years that they will not allow major financial institutions to fail
outright at this juncture,” he said. “Because these too-big-to-fail
guarantees are in place, the contagion effects are much less likely to
occur.”
“‘Too big to fail’ is a controversial policy, but it does have its
upside in the current situation,” he added.
Bullard also stressed that “the current agreement in Europe does
buy substantial time for European governments to enact fiscal
retrenchment programs.”
“It will take time for those programs to be enacted and to gain
credibility with financial markets,” he said. “This is a process that
will probably play out over years, not weeks. Certainly, governments
have to act now to gain credibility with markets in the near term, but
continuing vigilance is then also needed to keep the consolidation
moving.”
“If fiscal consolidation does not work, then debt restructuring may
become the only alternative, but, if necessary, that can be accomplished
in an orderly way over time and with minimal damage to global markets,”
he said.
But Bullard said that “even in an extreme case, I do not see any
necessary impediments to the successful operation of a common currency.”
Going beyond the immediate economic impact of the latest crisis,
Bullard foresaw “the possibility that a new, more volatile macroeconomic
era is upon us.”
“Just such an era may be unfolding, for two reasons,” he said. “One
is that governments have now taken numerous unprecedented actions, and
so it will take time to transition back toward the types of credible,
rules-based policies we know will deliver higher quality macroeconomic
outcomes in the long run. The other is that there are clear limits to
what can be accomplished through regulatory reform.”
In an obvious reference to the extraordinary lending, asset
purchases and bail-outs of major firms and markets which the Fed
undertook in cooperation with the Treasury during the financial crisis,
Bullard said “this nontraditional policy has eroded some of the
credibility for stable, rules-based policy that had been built up over
the last 25 years.”
He said the effect of emergency government actions has been to
“make the private sector keenly aware of the possibility that
governments may make very aggressive and unusual policy moves. Exactly
how governments will behave going forward is a question loaded with
uncertainty in the aftermath of this crisis.”
Bullard said “re-establishing credibility for the type of
successful rules-based policy we were previously accustomed to will be a
key challenge over the next several years” and said that could “take a
long time.”
“While the crisis remains fresh, it may not be possible to attain
first-best, full-commitment outcomes for the macroeconomy,” he said.
“Instead, policies may for a time be less effective than otherwise and
private-sector actors may remain overly sensitive to the prospect of
unusual, aggressive policy actions.”
“This means that macroeconomic volatility may be higher than normal
for a period of time,” he added.
The inability of regulatory reform to address certain issues could
also heighten volatility, said Bullard, who in the past has complained
bitterly about Congress’s unwillingness to come to grips with the
government sponsored enterprises.
“The debate has shown that while some issues can be addressed
legislatively, many problems cannot be addressed effectively either
because of political constraints or, more likely, because it is simply
not that clear which changes in current law might support the best
economic outcomes,” he said. “This suggests that some of the problems we
have faced over the last three years will simply remain with us, and so
will the volatility that was associated with those problems.”
“One example is the issue of runs on non-bank financial firms,” he
elaborated. “Non-bank financial firms accounted for about 2/3 of the top
80% of the assets in the S&P Financials for the U.S. in late 2007. These
were names such as Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie
Mac, Hartford Insurance, American International Group, as well as
thrifts like Washington Mutual and Countrywide.”
“It is a hallmark of the crisis in the US that these firms turned
out to be susceptible to run-like phenomena,” said Bullard, adding that
“additional capital requirements do not solve this problem.”
“Since this problem is central to the financial crisis, and since
we do not have a good solution at hand, I expect the problem of runs on
non-bank financial firms to remain part of the macroeconomic landscape
for the foreseeable future,” he added.
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** Market News International **
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