We have seen a significant shift in the underlying economic philosophy governing the conduct of policy makers in the G8 since the onset of the financial crisis in July 2007. Before the fateful unwinding of two hedge funds in July 2007, which triggered the chain of momentous events, most G8 policy makers believed in some form of liberal management of economic activities in general, and financial markets in particular.
Now, the liberal thinking has totally vanished from mainstream policy makers. Micromanagement of interest rates (Fed Operation Twist), of credit risk premiums (ECB’s “OMT”), of quantity of bank reserves in the system (each and every central bank worth mentioning), and of exchange rates (SNB’s floor) are in vogue, and spoken of proudly by policy-makers. All of these micro-meddling efforts are carried out in the grand background of ultra-loose fiscal policies and implicit underwriting of losses of too-big-to-fail financial institutions.
More than five years have now passed since the start of the current crisis. On the one hand, there is no end in sight yet, as measured by real economic activity and on the other, things look quite pretty as indicated by recent financial market performance.
However, one important ingredient is still missing in action. When one tries to micromanage financial market variables, one quickly realizes that money is fiendishly slippery and flows in unpredictable directions. Soon, we believe, this property of money will be seen as a big restraining factor contributing to ineffectiveness of the heroic efforts of policymakers in reviving economic activity. To this end, we believe that efforts will soon start to restrain the outflow of financial resources from certain key economies of the world. We think this change in policy environment has a non-trivial chance of happening within planning horizons of most investors. If certain key economies indeed put capital controls in place, most of the established relationships in the current global financial markets will undergo significant and permanent changes. While, investors, and asset allocators can ill afford to ignore the fallout from possible capital controls, the index huggers can go about their lives as usual, because this will be surely be one more once-in-a-life-time ten sigma event.
It would not be out of place to remember that we have seen this movie before. The grand effort of micromanaging economic activity was carried out in the erstwhile Soviet Block and we already know the end of that endeavour.