There’s an upside to the too-big-to-fail problem, believe it or not.
Do rising credit spreads and tumbling stock prices signal that the U.S. is in for another shock like the one that sent the economy into free fall in 2008?
Don’t bet on it. While there are problems all over the globe and stocks could easily head still lower after a recent correction, there are signs the domestic economy is strong enough to weather the storm.
“People are completely ignoring any good news domestically,” said Matthew Keator, a partner at the Keator Group wealth management firm in Lenox, Mass. “We’ve been here before, in 1994 and 1997-1998. We can handle an international crisis.”
While the United States faces serious problems, ranging from a persistent trade gap and bloated government spending, to painfully high unemployment, there are signs that conditions are improving. The Philadelphia Fed said Tuesday its coincident indicators of state economic activity — tracking jobs, wages and hours worked — rose in 43 states over the past three months, while falling in four and staying flat in three.
What’s more, Keator said, corporate balance sheets are in good shape after big companies slashed spending and boosted productivity. That should help the biggest corporations to keep growing, even as small businesses struggle to get financing and compete for penny-pinching customers.
Keator concedes that there are plenty of problems around the world for investors to consider, from a double-dip in real estate, to the problems in European banks, to the fiscal health of the United States and other rich countries.
But he says that stocks rallied so sharply from their March 2009 lows that “everyone has been looking for some bad news” that would justify a decision to cut equity exposure. As troubling as the European banking problems are, he believes policymakers will sooner or later devise a response that will stamp out the current political rancor among euro zone members and stabilize the situation.
Ironically, a further source of strength against European contagion may come from a failure to resolve the question of how to deal with too-big-to-fail financial firms.
St. Louis Fed President James Bullard (above), who has previously called the existence of too big to fail firms “intolerable,” said in a speech Tuesday that, for now, regulators’ most vexing problem is actually a plus.
“Governments have made it very clear over the course of the last two years that they will not allow major financial institutions to fail outright at this juncture,” Bullard said. “Because these too-big-to-fail guarantees are in place, the contagion effects are much less likely to occur.”
Naturally, taxpayers enraged at having to pick up the tab as reckless bankers visit their vacation houses in the south of France may not find this comment uplifting. And it’s far from clear how a bank rescue now would be received in the market for sovereign debt, which, like other markets, has been shaken in recent weeks by volatility.
The price of insuring against a default on Spanish government debt surged 22% Tuesday, according to CMA, while the price of credit default swaps on Irish debt rose 16%. Banks in both countries were among the losers Tuesday as investors fled risky trades.
Nonetheless, Bullard sees even creaky government backstops as better than nothing, which is what was in place before the failure of Lehman Brothers pushed the global economy off a cliff.
“‘Too big to fail’ is a controversial policy, but it does have its upside in the current situation,” Bullard said.
