© James B. Thomson
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Sadly, in the post great recession world not only is too-big-to-fail alive and well, it is likely a far greater problem than it has ever been. The lesson we should take from the Lehman bankruptcy is not that large financial institutions cannot be allowed to fail, rather that frustrating market expectations can produce instability. The preponderance of evidence from the Lehman episode is that markets and even Lehman management did not believe the U.S. government and financial system supervisors (in particular the Federal Reserve) would allow Lehman to enter bankruptcy. The perceived shift in policy, allowing Lehman to file bankruptcy, created vast policy uncertainty and much of the ensuing financial turmoil; and an explicit return to too-big-to-fail as the prevailing policy.
There is nothing that has occurred post financial crisis that would cause market participants to discount the possibility that all creditors of a large, and/or highly complex, and/or interconnected financial firm will be rescued if that systemically important firm becomes insolvent. Classifying certain financial firms as systemically important before the fact has the unintended consequence of reinforcing the expectation these firms will not be allowed to fail. Despite the living wills provisions of the Dodd Frank Act (2010) and the (misnamed) orderly resolution authority given to the FDIC, on net too big to fail is far from being solved.
To put an end to too-big-to-fail we have to be willing to do two things. First allow a systemic company to either enter bankruptcy or be placed into an FDIC receivership. Second, allow uninsured creditors of that company to suffer losses.
China, the biggest foreign buyer of US government debt, held $1.27 trillion in US government debt as of the end of August. How risky is it for China to hold U.S. debt currently taking into account that the recent budget deal has offered only temporary relief to political tensions in Washington? What actions if any do you see from China in case the U.S. once again faces political deadlock and when the Fed will finally start tapering QE?
It is not clear that China's holdings, and continued acquisition, of US Treasury debt will change much in the near term. To move away from US Treasuries they would have to either relax their capital controls, allow the Renminbi to float freely, or shift away from their export-driven growth strategy (reducing their current account surpluses with the US). However, should the country level debt problems in the Eurozone be less of a concern – note, Ireland is emerging from it is international rescue programs – the Euro may become more attractive to the Chinese and they might hold more of their official reserve in Euro-denominated assets.
The tapering of QE by the Fed should be the bigger concern for China. With the Fed's balance sheet approaching 4 trillion dollars and the US fiscal deficit remaining at unsustainable levels, the tapering of QE promises to put upward pressure on interest rates and hence, produce capital losses on China's holdings of US debt. Of more concern is whether the Fed can unwind its balance sheet, which is more than four times the size it was before the financial crisis, in an orderly fashion and contain inflationary pressures as the nearly $2.4 trillion of excess reserves becomes monetized. Concerns about secularly rising inflation in the US would incent China to diversity it foreign currency reserves away from dollars, reducing its holding of US debt and putting further upward pressure on US interest rates.
As soon as economies start to show sustainable growth, central banks in developed countries will start winding down its massive monetary stimulus. What impact would it have on the financial markets around the world?
The bigger concern is that the central banks in developed countries will wait too long to wind down the stimulus programs. One thing we learned from the run-up to the financial crisis is that excessive monetary stimulus does not necessarily manifest itself in goods prices. To the extent that central banks look to signs of inflationary pressures in goods prices they may stay too long with the stimulus with the consequence of asset price bubbles. The massive downsizing of the central bank balance sheets that will be required is something we have no experience with and will be difficult to execute without impacting economic growth and financial markets. Certainly the upward pressure on interest rates from the balance sheet unwinding will put downward pressure on stock markets and on real investment. If central banks fail to pre-commit to a path for unwinding their balance sheets and fail to follow the pre-committed policy there is a danger of dislocation in financial markets, increased market fragility and volatility.