Political India: Engaging America

Written on July 15, 2009 ; there have been some interesting developments since then

Two financial results were revealed in the United States recently, one that suggests prosperity for a few and another that hints at distress for many. Goldman Sachs beat analyst expectations when it disclosed that its second-quarter profits were $3.44 billion, up 64.5% over profits during the same period last year, and its share price has risen about 77% this year. Simultaneously the U.S. Treasury made a bleak admission that the budget deficit had, for the first time in its history, crossed the $1 trillion mark. In a country that has prided itself on being the bastion of laissez-faire capitalism, especially in financial markets, the two results must evoke mixed feelings.

On the one hand the Goldman Sachs results represent the triumph of the relatively unfettered risk-reward relationship that underpins America’s material success in recent decades. The firm is reported to have benefited significantly from taking on higher levels of risk in its fixed income, currency and commodities trading at a time when even its closest rivals, such as Morgan Stanley, have been reluctant to return to the risky behaviour of the pre-credit crunch years. However even Goldman Sachs employees seem to be aware of the awkward timing of their unexpected profits, with Goldman’s Chief Financial Officer saying about the recession, “We are cognizant of it… We understand that we are living in a very uncertain world where a lot of people are out of work.”

On the other, the ballooning budget deficit, rising on the back of a breathtaking $11.5 trillion debt owed by the American people is a harbinger of fiscal, inflationary, currency and tax woes that are likely to depress the economic lives or ordinary Americans for years to come. America has some serious issues of public conscience to iron out.

At the heart of the issues that the country will have to grapple with are fundamental questions about the rules of the game and the architecture of financial regulation. Reforms revealed last month by the Obama administration took some significant steps forward with regards to the latter – it has clarified the role of some agencies, for example by making the Federal Reserve directly responsible for overseeing institutions deemed to be “too large to fail” and by creating the Consumer Financial Protection Agency.

However financial regulation in the U.S. still remains a complex maze of cross-cutting responsibility and authority spread out over multiple agencies – five for banks, one each for securities, derivatives and government-backed mortgage issuers and over 50 other state and consumer protection agencies.

Reform is also incomplete in the areas of monitoring and restriction of the risk that large financial institutions like Goldman Sachs take onto their balance sheets. For example minimum capital and liquidity requirements for such companies have been raised and the infamous practice of mortgage securitisation has been redressed by requiring the underwriter to hold at least 5% of any deal they structure.

Yet, clearer proposals are required for identifying and curbing systemic risks by, for example, limiting the acceptable levels of value at risk (a measure of risk based on the amount, theoretically, that a firm could lose in a single trading day). Goldman Sachs’ VAR rose 20% in the first quarter of 2009 and is likely to have risen further since.

Challenging though it may be to get such reform past Capitol Hill, the price of inaction may be higher still for the Obama regime. It faces the possibility of a political backlash by the American public which is staring down the barrel of higher taxes, higher inflation, lower spending on social services and the unrelenting onslaught of recessionary unemployment and mortgage debt.