A global financial panic arrived this week, sparked by the effective collapse of liquidity at major brokerage firms. As the crisis touches all corners of the globe, politicians are reflexively pointing fingers at Wall Street. But few observers are offering concrete recommendations to stem this crisis and to avert a snowball effect in the weeks and months ahead.
Lehman Brothers declares bankruptcy. Merrill Lynch is forced to sell itself to Bank of America. AIG is backstopped by the government to the tune of $85 billion. I could go on for pages describing these historic events. But with forty years of experience in this business I will instead offer some suggestions for quickly curtailing the panic.
At this writing global central banks are making available enormous amounts of credit and cash to buoy the markets. In addition, the Securities and Exchange Commission, albeit very late, has introduced regulations to inhibit speculators from shorting securities without having the securities to short. But a bit more needs to be done.
To begin, financial markets should close for at least three days to allow for changes in the rules governing financial speculators and to introduce new measures to prevent this crisis from doing irreversible damage. Following the terrorist attacks in 2001 stock markets in the U.S. closed for days without any long-term negative effects.
Next, the Treasury and the Federal Reserve need to make the most of the hand they’ve been dealt.
A rapid flight to quality by investors has driven short-term interest rates on government securities to zero, an event that hasn’t occurred since the Great Depression. In other words, there is a massive shortage of Treasury bills and other government notes and bonds. But the Treasury is the beneficiary of this market panic since it can now raise enormous amounts of liquidity at virtually no cost.
The Treasury should do just that, setting a target interest rate at, say, 1.75 percent on 3-month Treasury bills and raising liquidity until that interest rate is reached. There are two benefits to this action: First, investors will have a safe-haven investment that provides some yield and produces some income. Second, revenues received by the Treasury can be used to support ailing financial markets.
The Treasury, in concert with the Fed, should use this money specifically to buy stocks and other financial instruments that are now under speculative pressure. We all know that stocks are underpriced as a result of this financial panic. So the government’s support at this point in time will ultimately be a boon to the Treasury, which can sell these stocks when the panic is over at substantially higher prices.
Such an operation will cost virtually nothing and will provide stability to a tottering equity market. Even if the Treasury doesn’t take the step of selling more government securities to finance this operation, it will still have the ability to write checks to pay for any intervention into the financial markets that can provide price supports until the crisis passes.
The time also has come to chase speculators out of the markets once and for all. The last major financial panic to grip the U.S. came in 1987, a result of the implementation of portfolio insurance, which was just another speculative investment strategy. This time around, speculative hedge funds — supposedly superior investment vehicles for hedging risk — proliferated to the extent that they became major offenders in the market meltdown. In other words, speculation replaced investment as a driving force in financial markets.
Here’s where the SEC can do a bit more. By implementing more stringent trading rules it can help dampen the urge to speculate in stocks and the fixed-income markets. While I am a free-market advocate, I am also for creating regulations that eliminate speculators who destroy the value of individual stocks and bonds.
In conjunction with these steps, IRS rules should be changed such that the taxation of short-term trading profits reaches prohibitive levels. We already have one such rule: Trading under one-year shifts capital-gains income to ordinary income. However, this graduated tax rate is not prohibitive. Rather, a 90 percent tax rate on trades under one month and a 75 percent tax rate on trading profits acquired within three months, while disallowing deductions for losses on such trades, would truncate a lot of the day trading that distorts normal market volatility.
Once these and other changes are put in place the tactics that have turned the investment markets into casinos will no longer be viable. Confidence will return to all public markets, legitimate fundamentals will drive the long-term uptrend in common stocks, and liquidity will again flow through the financial system.