Don’t ignore the ticking time bombs

 
Allister Heath
THERE are always two sides to every story. In the main, as I have long been arguing, the global economy has bounced back. Friday’s strong job figures in the US – payrolls are up 400,000 in the past three months – severely embarrassed the bears and supporters of QE2, as did most of last week’s global economic indicators. Growth has returned, as increasingly are jobs, something we should all be cheering. But four major flash points are starting to worry me. The recovery would almost certainly be derailed were any of these to turn into full-blown crises. So they are worth watching closely.

The first is that the latest leg of the US housing crisis is spiralling out of control and could inflict real damage to Wall Street, just when it seemed that the worst was over. Having one’s home repossessed is among the most awful things that can happen to anybody; but it is vital that the market be allowed to clear as speedily as possible and that those who cannot meet their contracted obligations be forced to move on. Lenders’ balance sheets need to be cleaned up speedily; losses must be taken and not drag on. Yet the opposite is now happening, with the robosigning scandal, caused by lenders’ sloppiness, triggering mass litigation and slowing things down.

Bank of America is a worrying case in point: its share price is down by over a quarter in the past six months. The firm has been hit by lawsuits, with a group of bondholders demanding it repurchases $375bn in soured mortgages. This kind of punitive litigation is the last thing the financial system needs right now. It means that the US banking industry is facing renewed question marks, not least given that nobody really fully understands the new regulatory framework.

The Republican seizure of the House of Representatives ought to suggest a welcome return towards free-market principles and a rupture with the big government interventionism of the Bush and Obama years. But what is now needed is a clear message from Congress about what would happen were another top financial institution to fail. Would it be bailed out – or would a proper, rational procedure be put into place to wipe out shareholders, hit bondholders and wind the firm down, as the Dodd-Frank financial reform bill is meant to ensure? The problem is that the bill is a giant muddle. Those who voted for it didn’t even read or understand most of it. It’s a nightmare of confusion and potential chaos. We need clarity on this – and fast.

The second major risk is the possibility that one or several of the weaker Eurozone member states might fail. Yields on Club Med bonds have rocketed again; Germany and the European Central Bank are arguing over plans to create a resolution procedure for bust countries. Bailouts are no longer the answer; but global institutions would find it hard to cope with any proper haircut on their holdings. The legacy of moral hazard lives on.

Then there is the prospect of a trade war and of increased capital controls all over the world, with the G20 summit in Seoul set to be marred by a row over QE2 and the weak greenback. Last but not least, flawed monetary policies are fuelling fresh bubbles in bonds, gold and commodities. At some point – perhaps in a few years’ time – these will burst.

The economy is recovering strongly, but there are numerous ticking time bombs beneath all of us. Only a fool would ignore them.
allister.heath@cityam.com