Those who believe that Wall St investors inhabit the same planet as everyone else should look at what happened last week. On Tuesday, the International Monetary Fund's managing director Dominiqaue Strauss-Kahn — previously an optimist — announced that the world has entered a "Great Recession" that will be worst than anything since 1945. Two days earlier, the World Bank said that trade was suffering its biggest fall for 80 years.
What did Wall St do? The grim news counted for nought. On Wednesday, the Dow Jones industrial average recorded one of its strongest gains since 1945, rising by 5.7 per cent. The Standard & Poor’s index rose by 6.3 per cent and the Nasdaq by 7.07 percent. The indices ended the week even higher. The traders’ exuberance was sparked by a report that Citigroup had made a profit in the first two months of 2009, thanks to an injection of taxpayer funds.
Share markets are supposed to be forward looking, but it would be extremely surprising if Wall St has got it right on his occasion. Eventually, share prices have to bear some relationship to overall earnings. But no recovery is in sight for the US economy where unemployment is rising alarmingly.
The sharp rise in share prices occurred at a time when Wall St is desperate for the good times to roll again. Most Wall St players show no sign of accepting that anything needs to change. Many reject calls for shareholders and bondholders to be left without a cent before corporate basket cases in the financial sector gobble up taxpayers’ money. Instead, they insist on being the exception to the rule that capitalism only operates efficiently by culling the weak.
On Wall St, calls for cuts to corporate bonuses are met with outrage. But there is fervent support for the making taxpayers buy overpriced "toxic" assets clogging up bank balance sheets. It's a different story with companies like General Motors. Wall St does not seems overly bothered if GM goes bankrupt, with the loss of hundreds of thousands of jobs.
Already American taxpayers have poured $US180 billion into the recklessly managed American International Group. The US Federal Reserve chairman Ben Bernanke told Congress recently that AIG "exploited a huge gap in the regulatory system" to operate more like a hedge fund than the stable insurance company it claimed to be. Bernanke said that rescuing AIG made him "more angry" than anything else during the financial crisis.
Despite wildly irresponsible, debt-fuelled, speculation in derivatives markets, AIG succeeded in holding a gun to the head of policy makers. Most other firms would have been sent to the corporate knackery, but AIG insisted that it was "too big to fail". We'll never know if that was true, but it worked. Although AIG made a world record loss of $US62 billion in the last quarter, it survives because of a massive injection of government money that is helping to drive the US budget deficit into perilous territory.
It's anybody's guess what would have happened if AIG and other tottering firms, such as Citicorp, had not been rescued. What we do know, however, is that the rescue has not had the promised effect of stopping unemployment racing towards double-digit figures. Unsurprisingly, some American commentators complain that pouring vast sums into Wall St is a pointless transfer of wealth from the American public to the shareholders of companies that caused the disaster in the first place.
Bernanke is now trying to establish much tighter regulations to prevent another catastrophe after the economy recovers. He wants tough regulations for companies regarded as "too big to fail", including strict limits on debt and constant surveillance of risk levels. But many of the proposals, including "stress testing" of banks, presume that it is possible to measure risk accurately in a radically uncertain world.
Critics such as Nassim Taleb say that standard risk assessment tools, relied upon by the Federal Reserve (and the Reserve Bank of Australia), are seriously flawed. Taleb, the author a well regarded book, The Black Swan: The impact of the highly improbable, says standard risk models don’t recognise the limits of probability theory. He sees the banks' support for these models as "a particularly worrisome case of epistemic arrogance [involving] the use of 'science' to measure the risk of rare events, making society dependent on very spurious measurements".
Bernanke wants to "ring fence" the financial firms that will quality for government bail-outs in future. Those inside the fence will be strictly regulated; those outside will be allowed to collapse. It sounds fine. But it’s hard to believe that big companies outside the fence won’t create complex new financial products that get them into trouble. Once again, they'll threaten governments that the entire system will collapse it they aren't rescued. Don't bet on governments letting them sink.
The reckless behaviour of US and European banks is causing tremendous pain around the globe. There are serious warnings of social dislocation worst than anything al Qaeda could dream of achieving. As part of the response, Kevin Rudd will attend a meeting of the G2O group of nations in early April to try to agree on concerted action to tighten regulation. Rudd is keen to support measures to curtail what he calls "capitalism out of control".
Ultimately, the RBA governor Glenn Stevens argues that a lasting solution requires the financial sector to shrink closer to its former role of merely being a "handmaiden to industry". That may be a bridge too far for Rudd, let alone Bernanke.
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