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Black Monday

September 15, 2008

Washington DC – It was a black Monday on Wall Street, with the Dow Jones that dropped 500 points – the worst loss in seven years – after a series of dramatic events that hit the US financial system over the weekend. Major investment bank Lehman Brothers went bankrupt; Bank of America abruptly bought off failing Merrill Lynch; and insurance group AIG says it is in desperate need of new cash injections. All of this came only weeks after the government-led bailout of mortgage giants Freddie Mac and Fannie Mae, and of investment firm Bear Sterns.

Benn Steil and Sebastian Mallaby, from the Council on Foreign Relations, held a media conference call in the afternoon to explain the significance of this chain of events. “The stakes of this current crisis go well beyond just a few financial institutions,” said Mr. Mallaby, Director of the Maurice R. Greenberg Center for Geo-economics. According to the former Washington Post columnist, the US role on the global stage is at risk. The world is watching the American model of free-standing investment banking and innovative financial engineering taking a serious hit and being outperformed by the more conservative European approach. While some of the most important financial institutions in the world collapse under the weight of debt they don’t have the cash to repay, “New York’s position as the pre-eminent go to place for ambitious young financiers is at risk.” As a longer-term result, the US might be losing economic competitiveness if highly innovative industries such as software and finance start migrating elsewhere.

According to Benn Steil, Director of the International Economics Council on Foreign Relations, the biggest concern for the US Department of the Treasury and the Federal Reserve is to salvage the credibility of dollar-denominated assets and prevent flight of capital abroad. “We do need to be concerned about the future of the Fed and Treasury, especially as they keep expanding their lending activities and last resort interventions,” Mr. Steil said. Inflation spurred by the need of the Federal Reserve to guarantee an excessive number of bad assets – by injecting increasing liquidity into the market — could motivate investors to abandon the US and pour their money onto Europe, for example. And, not coincidentally, the European Central Bank is already imposing much stricter restrictions on the kind of assets it takes as collaterals for its loans. In this sense, the decision by the US Government to refrain from intervening in the case of Lehman Brothers tried to send the message that the American financial system is still on solid footing with the exception of a few bad apples: “It was the right decision of the Fed and the Treasury not to step in with any sort of financial guarantees for Lehman Brothers and to let them go if that needed to be the case,” Mr. Steil commented.

The current financial crisis could potentially have a distressing effect on the already dwindling value of the dollar. High-level Chinese officials are among those concerned, especially over the exceptionally loose US monetary policy. China is particularly affected by it, since it continues buying US Treasury bonds in order to keep the value of the Yuan stable while the demand for Chinese exports increases. Benn Steil explained that the bailout of Freddie Mac and Fannie Mae stemmed from precisely this consideration. The main appeal of US Government bonds for foreign investors is that those assets are some of the most risk-free, since the Federal Reserve will always have the money to guarantee them, “at least in the sense that they can print the dollars needed to back those liabilities,” Mr. Steil noted. Worried that letting go of those investments could seriously damage the reputation of dollar-denominated assets, hampering capital inflows to the US from abroad, the government had no choice but to intervene in the case of Freddie and Fannie – which were always partially government owned.

In any case, it is expected that foreign governments will be careful in abandoning the US market, since many of them hold the majority of their national reserves in dollar-denominated assets. It would be counterproductive for them to diversify at a rate that would contribute to a sudden crash of the dollar and hence undermine the value of their own reserves. However, because foreign governments have accumulated enormous stocks of US assets in the past, “the threat of selling them does have the potential of becoming an important leverage in foreign policy,” Mr. Mallaby explained, since they could threat to disrupt the US financial markets at any time.

News of the financial meltdown, of course, reached the campaign trail and both Barack Obama and John McCain made the economy the centerpiece of their stump speeches on Monday. However, according to Mr. Mallaby, it would be unreasonable to ask them to introduce specific solutions in these remaining two months of the campaign, when it becomes very hard to talk about real policy issues and even more so about technicalities such as derivatives and collateralized securities: “They don’t want to look like they are indifferent but at the same time they don’t want voters to roll their eyes,” Mr. Mallaby said. As a result we should expect both candidates to focus on the more easily understood consequences that the financial turmoil will have on the real economy.

Finally, it remains to be seen whether the American electorate will hold the Bush Administration at all responsible for the turmoil on the financial markets. Although Mr. Mallaby and Mr. Beil said this would not be entirely fair, since the roots of the crisis are much deeper than whatever regulatory stance taken by George W. Bush in the past eight years, they acknowledged that this could very well happen. “I would think that there is always a risk for an incumbent party, especially for one that has been in office for two terms,” Mr. Mallaby concluded.

Originally reported and written for Washington Prism

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