The Uptick’s Downside

Nouriel Roubini


RIO DE JANEIRO – Since late last year, a series of positive developments has boosted investor confidence and led to a sharp rally in risky assets, starting with global equities and commodities. Macroeconomic data from the United States improved; blue-chip companies in advanced economies remained highly profitable; China and emerging markets slowed only moderately; and the risk of a disorderly default and/or exit by some members of the eurozone declined.

Moreover, under its new president, Mario Draghi, the European Central Bank appears willing to do anything necessary to reduce stress on the eurozone’s banking system and governments, as well as to lower interest rates. Central banks in both advanced and emerging economies have provided massive injections of liquidity. Volatility is down, confidence is up, and risk aversion is much lower – for now.

But at least four downside risks are likely to materialize this year, undermining global growth and eventually negatively affecting investor confidence and market valuations of risky assets.

First, the eurozone is in deep recession, especially in the periphery, but now also in the core economies, as the latest data show an output contraction in Germany and France. The credit crunch in the banking system is becoming more severe as banks deleverage by selling assets and rationing credit, exacerbating the downturn.

Meanwhile, not only is fiscal austerity pushing the eurozone periphery into economic free-fall, but the loss of competitiveness there will persist as relief at the waning prospect of disorderly defaults strengthens the euro’s value. To restore competitiveness and growth in these countries, the euro needs to fall towards parity with the US dollar. And, while the risk of a disorderly Greek collapse is now receding, it will re-emerge this year as political instability, civil unrest, and more fiscal austerity turn the Greek recession into a depression.

Second, there is now evidence of weakening performance in China and the rest of Asia. In China, the economic slowdown underway is unmistakable. Export growth is down sharply, turning negative vis-à-vis the eurozone’s periphery.

Import growth, a sign of future exports, has also fallen. Similarly, Chinese residential investment and commercial real-estate activity are slowing sharply as home prices start to fall. Infrastructure investment is down as well, with many high-speed railway projects on hold and local governments and special-purpose vehicles struggling to obtain financing amid tightening credit conditions and lower revenues from land sales.

Elsewhere in Asia, Singapore’s economy shrank for the second time in three quarters at the end of 2011. India’s government predicts 6.9% annual GDP growth in 2012, which would be the lowest rate since 2009. Taiwan’s economy fell into a technical recession in the fourth quarter of 2011. South Korea’s economy grew at a mere 0.4% in the same period – the slowest pace in two years – while Japan’s GDP contracted at a larger-than-expected 2.3%, as the yen’s strength weighed down exports.

Third, while US data have been surprisingly encouraging, America’s growth momentum appears to be peaking. Fiscal tightening will escalate in 2012 and 2013, contributing to a slowdown, as will the expiration of tax benefits that boosted capital spending in 2011. Moreover, given continuing malaise in credit and housing markets, private consumption will remain subdued; indeed, two percentage points of the 2.8% expansion in the last quarter of 2011 reflected rising inventories rather than final sales. And, as for external demand, the generally strong dollar, together with the global and eurozone slowdown, will weaken US exports, while still-elevated oil prices will increase the energy import bill, further impeding growth.

Finally, geopolitical risks in the Middle East are rising, owing to the possibility of an Israeli military response to Iran’s nuclear ambitions. While the risk of armed conflict remains low, the current war of words is escalating, as is the covert war in which Israel and the US are engaged with Iran; and now Iran is lashing back with terrorist attacks against Israeli diplomats. The Islamic Republic, with its back to the wall as sanctions bite, could also react by sinking a few ships to block the Strait of Hormuz, or by unleashing its proxies in the region – the pro-Iranian Shia in Iraq, Bahrain, Kuwait, and Saudi Arabia, as well as Hezbollah in Lebanon and Hamas in Gaza.

Moreover, there are broader geopolitical tensions in the Middle East that will not ease – and that might intensify. The Arab Spring has produced a relatively favorable outcome in Tunisia, where it started, but developments in Egypt, Libya, and Yemen remain far more uncertain, while Syria is on the brink of civil war. In addition, there are substantial concerns about political stability in Bahrain and Saudi Arabia’s oil-rich Eastern Province, and potentially even in Kuwait and Jordanall areas with substantial Shia or other restless populations.

Beyond the countries affected by the Arab Spring, rising tensions between Shia, Kurdish, and Sunni factions in Iraq since the US withdrawal do not bode well for a boost in oil production. There is also the ongoing conflict between the Israelis and the Palestinians, as well as strains between Israel and Turkey.

In other words, there are many things that could go wrong in the Middle East, any combination of which might stoke fear in markets and lead to much higher oil prices. Despite weak economic growth in advanced economies and a slowdown in many emerging markets, oil is already at around $100 per barrel. But the fear premium could push it significantly higher, with predictably negative effects on the global economy.

With so many risks in so many places, investors, not surprisingly, will eventually prize liquidity in their portfolios, while shunning riskier fixed assets again when these tail risks materialize. That is yet another reason to believe that the global economy remains far from achieving a balanced and sustainable recovery.

Nouriel Roubini is Chairman of Roubini Global Economics, Professor of Economics at the Stern School of Business, New York University, and co-author of the book Crisis Economics.

The Dodd-Frank act
Too big not to fail
Flaws in the confused, bloated law passed in the aftermath of America’s financial crisis become ever more apparent
Feb 18th 2012

SECTIONS 404 and 406 of the Dodd-Frank law of July 2010 add up to just a couple of pages. On October 31st last year two of the agencies overseeing America’s financial system turned those few pages into a form to be filled out by hedge funds and some other firms; that form ran to 192 pages. The cost of filling it out, according to an informal survey of hedge-fund managers, will be $100,000-150,000 for each firm the first time it does it. After having done it once, those costs might drop to $40,000 in every later year.

Hedge funds command little pity these days. But their bureaucratic task is but one example of the demands for fees and paperwork with which Dodd-Frank will blanket a vast segment of America’s economy. After the crisis of 2008, finance plainly needed better regulation. Lots of institutions had turned out to enjoy the backing of the taxpayer because they were too big to fail. Huge derivatives exposures had gone unnoticed. Supervisory responsibilities were too fragmented. Dodd-Frank, named after its co-sponsors, Senator Chris Dodd and Congressman Barney Frank, attempted to address these issues (section 404 is one of those aimed at excessive risk exposure). But there is an ever-more-apparent risk that the harm done by the massive cost and complexity of its regulations, and the effects of its internal inconsistencies, will outweigh what good may yet come from it.

The law that set up America’s banking system in 1864 ran to 29 pages; the Federal Reserve Act of 1913 went to 32 pages; the Banking Act that transformed American finance after the Wall Street Crash, commonly known as the Glass-Steagall act, spread out to 37 pages. Dodd-Frank is 848 pages long. Voracious Chinese officials, who pay close attention to regulatory developments elsewhere, have remarked that the mammoth law, let alone its appended rules, seems to have been fully read by no one outside Beijing (your correspondent is a tired-eyed exception to this rule). And the size is only the beginning. The scope and structure of Dodd-Frank are fundamentally different to those of its precursor laws, notes Jonathan Macey of Yale Law School: “Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies.” Like the Hydra of Greek myth, Dodd-Frank can grow new heads as needed.

Take the transformation of 11 pages of Dodd-Frank into the so-calledVolcker rule”, which is intended to reduce banks’ ability to take excessive risks by restricting proprietary trading and investments in hedge funds and private equity (Paul Volcker, a former chairman of the Federal Reserve, has argued that such activity contributed to the crisis). In November four of the five federal agencies charged with enacting this rule jointly put forward a 298-page proposal which is, in the words of a banker publicly supportive of Dodd-Frank, “unintelligible any way you read it”. It includes 383 explicit questions for firms which, if read closely, break down into 1,420 subquestions, according to Davis Polk, a law firm. The interactive Volckerrule mapDavis Polk has produced for its clients has 355 distinct steps.

Boom time for lawyers

“I fear that the recently proposed regulation to implement the Volcker rule is extraordinarily complex and tries too hard,” Sheila Bair, a former head of the Federal Deposit Insurance Company (FDIC), told Congress in December. A notable pre-crisis critic of regulatory gaps, she now believes that in this caseregulators should think hard about starting over again with a simple rule.” Her comments were made before the Commodity Futures Trading Commission (CFTC), the fifth federal agency involved, issued its own proposal on proprietary trading on January 17th. That one is 489 pages long.

When Dodd-Frank was passed, its supporters suggested that tying up its loose ends would take 12-18 months. Eighteen months on, those predictions look hopelessly naive. Politicians and officials responsible for Dodd-Frank are upbeat about their progress and the system’s prospects, at least when speaking publicly. But one banker immersed in the issue speaks for many when he predicts a decade of grind, with constant disputes in courts and legislatures, finally producing a regime riddled with exceptions and nuances that may, because of its complexity, exacerbate systemic risks rather than mitigate them.

For the same reasons that bankers are worried, lawyers are rubbing their hands. For many of America’s most prominent law firms helping companies to cope with Dodd-Frank is a vital service to clients, a lubricant for the American economy and a great new business. Daily updates on Dodd-Frank from Davis Polk and Morrison & Foerster have become as important to many on Wall Street as newspapers.

Their popularity looks set to endure: according to Davis Polk only 93 of the 400 rule-making requirements mandated by Dodd-Frank have been finalised. Deadlines have been missed for 164 (see chart 1). And litigation is just beginning.

On July 22nd 2011 the United States Court of Appeals for the District of Columbia upheld a challenge by two trade groups to a Dodd-Frank-related rule on shareholder voting put forward by the Securities and Exchange Commission (SEC); the court found that the rule was backed by insufficient or faulty economic analysis of costs and benefits. On December 2nd, another case on similar grounds was filed in a Washington, DC, district court by two securities-industry trade groups, this time against the CFTC, concerning restrictions on derivative holdings. If that court, too, finds for the plaintiffs expect a deluge of further suits.

Along with requiring oodles of contestable rules, Dodd-Frank mandates 87 studies on big and small issues, ranging from the impact of drywall on mortgage defaults to the causes of the financial crisis. Once again, deadlines have been missed and progress is limited: 37 studies have yet to be completed. The ones that have been finished have received little public attention; trying to drink from the rule-making fire hose leaves little time for absorbing the output of the reporting one. Some of the reports seem to reach odd conclusions. A report from the FDIC contends that had Dodd-Frank been in effect four years ago, Lehman Brothers’ creditors would have received 97 cents on the dollar; one expert on the case calls this ludicrous. The problem is not that the reports are necessarily wrong, but that no one is scrutinising them.

Another product of Dodd-Frank is a plethora of new government powers and agencies (see chart 2) with authority over areas of the American financial system and economy affecting veterans, students, the elderly, minorities, investor advocacy and education, whistle-blowers, credit-rating agencies, municipal securities, the entire commodity supply chain of industrial companies, and more. Quite a lot have tasks already done by others—frustrating the act’s worthwhile objective of consolidating fragmented pre-crisis supervision. A new office within the Treasury department is intended to forecast and head off disasters—already a goal of research groups at the 12 regional Federal Reserve Banks, the Federal Reserve Board, the president’s Council of Economic Advisers and numerous federal agencies, not to mention universities, think-tanks and private firms.

If the roles of many of these Dodd-Frank entities are overly familiar, their funding—which often skirts constitutional requirements for congressional approval—is more exotic. The new research bureau in the Treasury will be entitled to the proceeds of a new tax on banks. The new Consumer Financial Protection Bureau (CFPB) will be funded by the Fed.

But the really big issue that Dodd-Frank raises isn’t about the institutions it creates, how they operate, how much they cost or how they are funded. It is the risk that they and other parts of the Dodd-Frank apparatus will smother financial institutions in so much red tape that innovation is stifled and America’s economy suffers. Officials are being given the power to regulate more intrusively and to make arbitrary or capricious rulings. The lack of clarity which follows from the sheer complexity of the scheme will sometimes, perhaps often, provide cover for such capriciousness.

For example, the new CFPB will have latitude to determine what type of financial products can be provided to which consumers and at what cost, as well as the right to pursue institutions for acting in an “abusive fashion (a term with no legal definition). Requirements for “living wills” that encompass hypothetical business plans have to be pored over by regulators; “stress testsinsert government assumptions deep into the decisions banks make about their capital. Such tests are not new to Dodd Frank. But the befuddling form the act gives such ideas unintentionally opens a path to much more state interference.

Dodd-Frankenstein’s monsters

Another problem with complexity is that it encourages efforts to game the system by exploiting the loopholes it inevitably creates. Take the simple matter of nomenclature. Anticipating the Volcker rule, bank departments previously using the wordproprietary” have been dropped, renamed or quietly shifted to sheltered corners. The shadow banking system existed before the crisis, but expect it to grow as some financiers decamp to companies that evade Dodd-Frank’s definitions.

The fees banks can charge for debit cards are being sharply reduced, but other retailers with similar products have received a waiver, courtesy of the so-called Durbin amendment (named after a Democratic senator, Dick Durbin). Consequently the payment industry may be in the early stages of a rule-driven and otherwise unlooked-for transformation with no rationale in efficiency or safety. The bank-remittance business, which was also selectively hit with new rules, is facing a similar shake-up.

The governments of Japan, Canada and the European Union have had their hackles raised by the fact that American federal and municipal bonds will be exempt from the Volcker rule, however it is put into practice, whereas their own bonds will not. Goldman Sachs’s chief financial officer, David Viniar, has said that inefficiencies in the market resulting from Volcker could make trading more profitable—which was hardly the point.

Paying up

There could well be unintended consequences at the level of the employee, too. Last August the SEC opened an office mandated by Dodd-Frank that is dedicated to examining whistle-blower complaints. It collected 334 reports in its first seven weeks; no one will say how many have come forth since, but many more are expected the better known the office gets. This may sound welcome. But Dodd-Frank’s provisions for massive payments to the whistle-blowers—of up to 30% of any monetary sanctions collected on the basis of their report—will make the SEC route more attractive than using companies’ own processes, and may thus make corporate governance less effective.

For their part manufacturers seem largely unaware that a provision in Dodd-Frank concerning the extraction of minerals from in and around the Congo will mean that they will have to begin filing information on their entire supply chain to the SEC. This is officially estimated to affect 1,000-5,000 companies at a cost of $71m. The US Chamber of Commerce thinks it will affect hundreds of thousands. The National Association of Manufacturers estimates it will cost $9 billion-16 billion.

Conflict minerals are a disturbing issue. They were not one of the causes of the global financial crisis.

The overall cost of all this—both directly to public and private institutions and indirectly to the markets—is staggering. At the same time as banks are sacking employees in operating roles, they are adding swarms to cope with various requests from government agencies and other new filings, all to avoid violating rules that may never come into existence and temporary measures that may be rescinded. That is without looking at losses in terms of business not done. Loans that might not fit into a category favoured by regulators are being trimmed or withdrawn.

Jamie Dimon, JPMorgan Chase’s boss, reckons the direct costs to his bank, America’s largest, will be $400 billion-600 billion annually. Additional regulations resulting from the Dodd-Frank act may materially adversely affect BB&T’s business, financial condition or results of operations,” said one regional bank in its recent annual filing to the SEC. Other institutions are said to be in the process of drafting similar statements, or, at the least, planning to acknowledge the costs in the conference calls that surround quarterly earnings.

Banks are trading below book value. Low valuations make it hard for banks to raise the capital that would allow them to lend more, as politicians would like. This state of affairs is in part due to the condition of the economy. And the reasonable goal of restricting banks from taking private risks with socialised consequences may in some cases reduce their value. But it is hard to find a banker or analyst who doesn’t privately attribute a lot of the low valuation to the unnecessarily harsh impact of current regulations.

Inevitably, banks themselves are adding to the costs with a vast lobbying effort. SIFMA, a financial industry trade association, says it has 5,490 people dealing with various subcommittees, almost all devoted to Dodd-Frankery. And there are quieter attempts to blunt the act’s provisions or redirect them to the advantage of one set of financial institutions or another. The Occupy Wall Street crowd, with its emphasis on government-business collusion, would be enraged if it knew.

But most bankers are reluctant to discuss the law in public, and will do anything to avoid commenting on regulators. This is in part due to the risk that, given the industry’s low public esteem, complaining would be inflammatory and counterproductive, perhaps also bringing with it regulatory retribution. A few also see the possibility of gaining an edge: some well established banks consider themselves better able to handle the costs than smaller or newer ones, particularly those that don’t have cushy relationships with regulators. Others, according to the head of one large bank, are quiet only because they do not understand the scope of the changes.

Back to the drawing board

All of which leads to the question of what Dodd-Frank has actually achieved. More information on America’s derivatives markets will be available to regulators than was previously the case, though how much will be useful is debatable. A new (untested) insolvency procedure is now in place for firms like AIG, which lacked an alternative to bankruptcy or bail-out before the crisis. But the heavy lifting on higher capital requirements for banks is being done internationally via the Basel 3 process. And Dodd-Frank has hardly touched Fannie Mae and Freddie Mac, the two big government-sponsored lending entities that received the largest bail-outs in 2008, and which are more important in the housing markets than ever.

.The muddle stands in sharp contrast to the aftermath of earlier legislation. The banking-reform act of 1864 consolidated America’s fragmented currency system and enabled Abraham Lincoln to finance the civil war. The period of reregulation between 1933 and 1940 reserved a safe harbour for commercial banks, which were backed by federal deposit insurance but didn’t attract speculative capital because of caps on the rate of interest that could be paid. Risk was left to investment banks and asset-management firms, tempered by abundant requirements for disclosure and a shift in where the burden of proof lay in litigation, from plaintiffs to defendants.

Even Dodd-Frank’s creators can bring no similar clarity to its intentions. In 2009 Mr Frank attempted to frame the new law’s goals under four heads: securitisation, compensation, liquidation and systemic risk. But in a single speech his ambitions overflowed to consumer protection and the reform of ratings agencies, too. Ambition is often welcome; but in this case it is leaving the roots of the financial crisis under-addressed—and more or less everything else in finance overwhelmed.

United States' economy

Over-regulated America

The home of laissez-faire is being suffocated by excessive and badly written regulation

Feb 18th 2012                  

AMERICANS love to laugh at ridiculous regulations. A Florida law requires vending-machine labels to urge the public to file a report if the label is not there. The Federal Railroad Administration insists that all trains must be painted with an “F” at the front, so you can tell which end is which. Bureaucratic busybodies in Bethesda, Maryland, have shut down children’s lemonade stands because the enterprising young moppets did not have trading licences. The list goes hilariously on.

But red tape in America is no laughing matter. The problem is not the rules that are self-evidently absurd. It is the ones that sound reasonable on their own but impose a huge burden collectively. America is meant to be the home of laissez-faire. Unlike Europeans, whose lives have long been circumscribed by meddling governments and diktats from Brussels, Americans are supposed to be free to choose, for better or for worse. Yet for some time America has been straying from this ideal.

Hardly anyone has actually read Dodd-Frank, besides the Chinese government and our correspondent in New York (see article). Those who have struggle to make sense of it, not least because so much detail has yet to be filled in: of the 400 rules it mandates, only 93 have been finalised. So financial firms in America must prepare to comply with a law that is partly unintelligible and partly unknowable.

Flaming water-skis

Dodd-Frank is part of a wider trend. Governments of both parties keep adding stacks of rules, few of which are ever rescinded.

Republicans write rules to thwart terrorists, which make flying in America an ordeal and prompt legions of brainy migrants to move to Canada instead. Democrats write rules to expand the welfare state.

Barack Obama’s health-care reform of 2010 had many virtues, especially its attempt to make health insurance universal. But it does little to reduce the system’s staggering and increasing complexity. Every hour spent treating a patient in America creates at least 30 minutes of paperwork, and often a whole hour.

Next year the number of federally mandated categories of illness and injury for which hospitals may claim reimbursement will rise from 18,000 to 140,000. There are nine codes relating to injuries caused by parrots, and three relating to burns from flaming water-skis.

Two forces make American laws too complex. One is hubris. Many lawmakers seem to believe that they can lay down rules to govern every eventuality. Examples range from the merely annoying (eg, a proposed code for nurseries in Colorado that specifies how many crayons each box must contain) to the delusional (eg, the conceit of Dodd-Frank that you can anticipate and ban every nasty trick financiers will dream up in the future). Far from preventing abuses, complexity creates loopholes that the shrewd can abuse with impunity.

The other force that makes American laws complex is lobbying. The government’s drive to micromanage so many activities creates a huge incentive for interest groups to push for special favours. When a bill is hundreds of pages long, it is not hard for congressmen to slip in clauses that benefit their chums and campaign donors. The health-care bill included tons of favours for the pushy. Congress’s last, failed attempt to regulate greenhouse gases was even worse.

Complexity costs money. Sarbanes-Oxley, a law aimed at preventing Enron-style frauds, has made it so difficult to list shares on an American stockmarket that firms increasingly look elsewhere or stay private. America’s share of initial public offerings fell from 67% in 2002 (when Sarbox passed) to 16% last year, despite some benign tweaks to the law. A study for the Small Business Administration, a government body, found that regulations in general add $10,585 in costs per employee. It’s a wonder the jobless rate isn’t even higher than it is.

A plea for simplicity

Democrats pay lip service to the need to slim the rulebookMr Obama’s regulations tsar is supposed to ensure that new rules are cost-effective. But the administration has a bias towards overstating benefits and underestimating costs (see article). Republicans bluster that they will repeal Obamacare and Dodd-Frank and abolish whole government agencies, but give only a sketchy idea of what should replace them.

America needs a smarter approach to regulation. First, all important rules should be subjected to cost-benefit analysis by an independent watchdog. The results should be made public before the rule is enacted. All big regulations should also come with sunset clauses, so that they expire after, say, ten years unless Congress explicitly re-authorises them.

More important, rules need to be much simpler. When regulators try to write an all-purpose instruction manual, the truly important dos and don’ts are lost in an ocean of verbiage. Far better to lay down broad goals and prescribe only what is strictly necessary to achieve them. Legislators should pass simple rules, and leave regulators to enforce them.

Would this hand too much power to unelected bureaucrats? Not if they are made more accountable. Unreasonable judgments should be subject to swift appeal.

Regulators who make bad decisions should be easily sackable. None of this will resolve the inevitable difficulties of regulating a complex modern society. But it would mitigate a real danger: that regulation may crush the life out of America’s economy.