May 27, 2015

Center for Financial Stability President Discusses the Era of "Never Befores" (with Lofchie Comment)

Steven Lofchie Commentary by Steven Lofchie

At the annual Capital Markets Credit Analysts Society dinner, President of the Center for Financial Stability Lawrence Goodman delivered remarks on future challenges facing global markets.

Mr. Goodman explained how a series of "never before" challenges will impact markets. "Never before," he said, has there been such:

  • large-scale intervention by central banks;
  • growth in the financial regulator apparatus and in the labyrinth of rules governing markets; and
  • distortion across a wide range of financial markets.

Mr. Goodman sees "three potential pathways for the future": (i) a growth solution, (ii) a "game remains the same" scenario, and (iii) an unwind scenario. He stated that global markets are likely to migrate from the "game remains the same" into the "unwind" scenario within the next 12 to 18 months. A series of early warning indicators will help to navigate which scenario unfolds over time, he stated.

Commentary

The 2015 FSOC Annual Report suggested significant dangers ahead including: (1) very low interest rates that are making it impossible for retirement funds, particularly government retirement funds, to meet their future obligations, and (2) quick rises in interest rates that could lead to fire sales in markets where broker-dealers will have no incentive or ability to provide any liquidity. (See, FSOC Releases 2015 Annual Report (with Lofchie Comment).) That raises a challenge for monetary policy: keep interest rates low and pension plans fail; raise interest rates and markets could crash."

Mr. Goodman's analysis is consistent with this view. (Also, even FSOC seems to concede that at least some of the danger caused by extremely low interest rates is created by the government, even where the low rates are justified as risks worth taking to stimulate the economy.)

The additional risk that Mr. Goodman points out is this: new government regulations discourage market intermediaries from taking risk positions or accumulating inventory. While the banking regulators driving these regulatory changes may believe that discouraging risk-taking behavior makes markets safer, a more pessimistic view is that the absence of risk takers makes markets more susceptible to crashes when there are no buyers in a downturn. As Mr. Goodman observes: "Regulatory changes have unequivocally impacted the functioning of markets and the economy. For instance, since Dodd-Frank, there has been a collapse in available market liquidity despite the more than ample central bank liquidity."

To put it differently: a market in which no one is willing to take a risk is a market that is very risky.

See: "The Unwind: What's Next for Global Markets," by Lawrence Goodman.

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