The Financial Crisis: Risks of Investing in Government Policy

After a weekend of solemn pronouncements of vigorous, coordinated action by numerous governments around the globe, stock markets everywhere rediscovered exuberance. The Dow Jones Industrial Average was among the most joyous, rising 936 points, or 11%, today. That was the Dow's largest point gain in a single day ever. The S&P 500 and the Nasdaq were similarly rapturous. Problems solved?

Hardly. The government pronouncements were long on apparent sincerity, but short on specifics. It helps, at least momentarily, that all these national leaders linked hands and sang Kumbaya. The One World, interconnected nature of the world's financial system today necessitates joint action. No nation can go it alone.

However, it is also clear that each nation will choose its own policies and protective measures. The argument here is that each nation's financial system is different from others, and its policies should be tailored to its specific needs. That sounds good. But underneath, it reflects a desire not to subsidize another nation's bailouts. This Balkanization of bailout policies may undercut the recent pledges of international coordination. There are differences of opinion among the world's economic powers as to which policies are best. For example, unlimited deposit guarantees in one country could attract badly needed liquidity from other nations' banks. When there's a credit crunch on (and there still is), that triggers international resentment. The same could be said of proposals to inject government capital into ailing banks. When one nation's banking system is backed by its government, its apparent strength would be improved and it would attract credit away from banks in other nations. Thus, the other nations are forced to inject government capital themselves; they can't wait to see if other measures might lead to private sector recapitalization of their banks. This may well be what's happening to the U.S. government's $700 billion bailout plan. The proposal for the government to buy toxic assets is taking a back seat to a plan for direct U.S. government investments in the largest American banks, which they won't have the option to decline.

The truth is that all of the governments involved in the financial crisis are winging it, scribbling out policy measures on cocktail napkins as they go along. After a year and a half of turmoil, we still don't have anything approaching a clear picture of the losses from the mortgage mess and other problem areas. One suspects that the governments themselves don't know where all the bodies are buried. That, if true, is deeply troubling. You can't make good policy if you don't understand the scope of the problem.

By all appearances, the policies announced in the last few days only amount to a large injection of methadone. They focus on loosening up the flow of credit, which is kind of like a taste of the hair of the dog that bit ya. The stock market's exuberance is likely to be a temporary high, because the underlying problems remain. The world's financial system doesn't merely need to be recapitalized. It needs to be reconstituted, with the bad assets writedown fully. A new, more extensive and effective regulatory scheme must be instituted. Bankers must adopt an ethic of prudence and responsibility, not recklessness tempered with greed. Government regulators must adopt an ethic of vigilance, not somnolence.

Has the market bottomed? Should you start buying stocks again? There's no way to tell based on traditional criteria. We're in a brave new world where stock values are determined by that most unpredictable of factors: politics. The financial markets are being nationalized worldwide, not excluding the United States. How effective this will be remains to be seen. The slowdown in the real economy has been virtually ignored by government policymakers. That slowdown--surely a recession even if it hasn't been officially acknowledged as such--and the eventual recovery from it will dictate the timing and pace of the stock market's true revival. By the time policy makers figure out that they need to stop being mesmerized by the gyrations of the Dow, you'll probably know that today's action was just a dead cat bounce.