Why Larry Summers shouldn’t run the Fed

Phhhhew, we got through the summer. So often, certainly in recent years, August has been a wicked month when it comes to financial markets. Back in August 2010, the Dow Jones index of leading American stocks lost a hefty 4.5pc. In 2011, the August sell-off was bigger, as US equities fell 5.1pc.

Last summer, of course, throughout August sovereign bond yields spiraled across the Eurozone periphery. Numerous well-manicured nails were bitten to the quick as investors fretted about one or more nations crashing out of the single currency.

During August 2013, though, while stock and bond prices have been volatile, with the Dow showing a typical 4.2pc August drop, this has reflected disinterest rather foreboding. Trading volumes have been remarkably thin. Investors seem to have spent this August on the beach. Financial markets, in the Western world at least, have had a relatively “chilled” summer.

Yet summer is about to be over. America’s “Labor day” holiday, which falls tomorrow, is when the silly season ends. I’d expect trading volumes to escalate this week, as the markets begin to engage with “heavy news-flow”. And with valuations still rather elevated – the Dow is up 13pc this year and the FTSE-100 9pc higher, despite both losing ground in August – market denizens could well concentrate on the negatives.

In three weeks’ time, we’ll see pivotal German elections. Angela Merkel should retain the Chancellorship but will she, once re-elected and less vulnerable to voter protest, allow the European Central Bank to spend more freely on the Eurozone profligates, so tempering meltdown concerns? Or will she, no longer so scared of volatility, squeeze even harder, so re-igniting bond market fears?

Merkel’s eventual post-election moves could be heavily influenced by the upstart Alternative for Deutschland party, a kind of German UKIP. Were AfD to achieve the 5pc of votes necessary to enter the Bundestag, that would seriously complicate the Parliamentary arithmetic. Germany’s bail-out skepticism could then harden, so tying Merkel’s hands.

On top of inevitable Eurozone jitters, traders will also now be mindful of the near-time prospect of military strike on Syria. Even if this diplomatic stand-off is defused, and cooler heads prevail, between now and then markets will still be seriously unsettled, at the very least, by the slew of belligerent rhetoric.

September will also mark the start of Washington’s “gridlock” season, as Democrats and Republicans indulge in their now seemingly annual game of “pass the grenade”. This involves arguing very publicly, and in ever more fatuous terms, about whether or not America’s debt ceiling should be increased, so raising the spectre of what would be a systemically-disastrous US sovereign default. Investors won’t like that either.

So after a relatively relaxed summer, September is indeed set to be busy and bumpy on financial markets. The big event over the coming month, though, has nothing to do with economic growth in America or elsewhere, Middle Eastern politics or any other “real world” outcome.

As far as most financial investors are concerned, the subject that trumps all others, all others combined in fact, is the US Federal Reserve. That’s because, we’re likely soon to discover how quickly America’s central bank plans to start reducing, or “tapering”, its $85bn of monthly bond purchases under so-called quantitative easing.

Since May, when Fed Chairman Ben Bernanke firstly hinted that QE could soon end, or at least begin to end, yields on 10-year US Treasuries have risen sharply, from around 1.5pc to almost 2.9pc in the third week of August. Prior to that, central banks across the Western world, led by the Fed, had kept a firm lid on borrowing costs by printing virtual money at a rate of knots and using it to buy government bonds.

By suppressing interest rates in this way, QE has of course encouraged investors to pile-in to risky assets. That has bid up equity valuations, of course, doing a lot to help the debt-soaked balance sheets of many otherwise busted Western banks. Yet now such “unconventional measures” may soon be ending, or at least slowing down, financial markets could easily take fright.

Already, in a kind of proxy move, as a direct result of Bernanke’s “tapering” overtures, Western investors have lately pulled assets out of some emerging markets, causing their often shallow and flow-sensitive equity indices to pull back. There are likely to be further such indications of a general shift to “risk-off” in the run-up to the Fed’s next meeting on 17-18 September. It is then that Bernanke is expected to give his verdict on when, and crucially how fast, QE is likely to end.

The first big milepost on the path to that meeting will be the August US employment data, to be released this coming Friday. If the job numbers are strong then, paradoxically, the markets could well take umbrage. That’s because signs of a US recovery mean Bernanke could take away the QE candy faster, reducing the Fed’s bond purchases incrementally by around $20bn per month, rather than the currently assumed rate of $10bn-$15bn.

Into this mix we must then throw the on-going battle to run the Fed. And a battle it most certainly is. With Bernanke’s term due to end in January 2014, the White House must soon appoint his replacement. President Obama is to disclose his choice sometime this month – the announcement is already late, and any further delay would be deeply damaging. The only real candidates are current Fed Deputy Janet Yellen and the Former Treasury Secretary Larry Summers.

I find neither candidate particularly inspiring. Both are “doves”, being far less concerned about stemming inflation than they are about stimulating the economy. I think that’s wrong. It is the cardinal responsibility of any central banker to keep inflation under wraps, not least as myopic politicians can’t be trusted to do so. Solve inflation, and the investment and jobs will come. That may be an unfashionable view these days, but it’s the axiomatic lesson of history.

On balance, and given that it really does seem to be a choice only between these two, Yellen gets my vote, if only to stop her opponent. This is despite the fact that Summers is highly-experienced, having been close to the policy-making action during pretty much every market meltdown since the Mexican “tequila” crisis back in 1994.

Summers would be a bad Fed Chairman partly due to his boorish personality – which is the polar opposite of Bernanke’s collegiate approach. That could certainly spook the markets. But my main objection is his track record in government.

As Deputy Treasury Secretary, Summers was more responsible than perhaps anyone else, with the possible exception of his then Treasury boss Robert Rubin, for the repeal of the Glass-Steagall split between investment and commercial banking back in 1999. That was done at the behest of massive lobbying by Wall Street, and has been an unalloyed disaster. No other single act did more to land the Western world in its current financial predicament.

And then there was Summers’ treatment of a brave lady called Brooksley Born. A distinguished financial lawyer, Born was appointed by President Clinton in 1996 to run America’s Commodity Futures Trading Commission. Admirably independent, she issued warnings about the systemic dangers posed by America’s vast and entirely unregulated “over-the-counter” derivatives market.

As a result, and again pleasing his Wall Street friends, Summers led the charge against Born. Thanks to him, Congress passed legislation forbidding the CFTC from bring derivatives under regulatory control. The rest is history – as should be Summers’ application to run the Federal Reserve.


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