(James Saft is a Reuters columnist. The opinions expressed are his own)

Easy money in the United States, a falling dollar and growing flows of funds seeking better returns in emerging markets are touching off a new round of capital controls in hot emerging markets, a trend that could accelerate and will at the very least increase market volatility.

It shouldn’t be a surprise, really; loose money in the developed world is helping to spur investment into emerging markets, driving currencies up and making local exports less competitive for countries which, unlike China, aren’t hitching a free ride as the dollar declines.

Inflation may be a threat for many of these, but with the global economy still struggling, it certainly won’t feel that way to policy makers.

Russia on Wednesday joined the list of countries eyeing new measures to stem currency speculation and appreciation. Moscow was careful to say it would not impose actual capital controls, which seek to regulate flows of funds into or out of an economy, but the measures they are considering would have exactly that effect, making it tougher or more expensive for money borrowed abroad to be brought into Russia.

Kazakhstan, which has been intervening actively to slow the ascent of its tenge currency, has introduced legislation allowing capital controls, but so far has not used them.

Indonesia said this week it will consider curbs on foreign holdings of short-term official debt, sending its rupiah into a brief swoon until central banker Hartadi Sarwono damped things down by saying currency moves based on such flows were so far manageable.

Elsewhere all across developing Asia central banks have been intervening to cap gains in the value of their currencies, with Taiwan going so far as to ban foreign funds from investing in local time deposits.

Brazil last month announced a 2 percent tax on foreign investment in stocks and fixed-income securities to limit the strengthening of the real.

International Monetary Fund chief Dominique Strauss-Kahn gave the fund’s standard line to the Financial Times: “The IMF would not recommend them as a standard prescription … as they carried costs and were usually ineffective”.

FIGHTING OVER SCRAPS

Ineffective over the long run they may be, but tempting they are in the short term. The very fact that India and China have emerged relatively well from the crisis and have resumed growth in strong fashion gives courage to those considering their own measures. And really, the very idea of an orthodox allegiance to free flowing markets ensuring the best outcome for all now looks pretty 1999. Malaysia attracted a firestorm of criticism when it imposed controls in the wake of the Asian crisis in the 1990s. There was much talk of how investors would go away and not come back, how development would be retarded and Malaysia ultimately would rue the day. None of that has come to pass, and those same investors proved quite willing to come back if the returns looked good enough, as indeed they did.

But Malaysia, along with Chile, were outliers when they imposed capital controls. What will it mean if it becomes not a tool of desperation but a standard policy when hot money flows? There must be a risk that capital controls become part of an escalating series of beggar-thy-neighbor steps taken by countries fighting over the scraps of a diminished U.S. and European appetite for imported goods.

If, in other words, these controls are a temporary phase to ease the transition to stronger currencies, the risks might not be that high. I’d worry that developed market interest rates are going to stay low for a very long time. That means that the grand emerging markets carry trade of borrowing in dollar to speculate for appreciation elsewhere will, as it did in Japan, build and build.

At the same time you have to look at why interest rates will stay so low for so long. My bet is that it is because consumption in the developed world will be under structural pressure as debts are repaid. So the money flows into emerging markets and drives up currencies, but unless domestic consumption in China and India really takes off there will not be a very good market for exports. That will make newly strong emerging market currencies all the harder for those countries to tolerate, economically and politically. If China does not do its part and allow its currency to appreciate, the argument will be all the more stark.

It may or may not be a good idea, but one thing I would not count on is coordinated and globally sanctioned capital controls, as espoused by Arvind Subramanian, a senior fellow of the Peterson Institute.

The U.S. simply won’t wear it.

Look then for more unilateral controls and more volatility as speculation of all kinds grows.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

With just a few short weeks until the end of the year, look for many fund managers to take on more risk in an effort to salvage their annual return figures.

This is not about fundamentals, this is about something far more important: career risk.

Hedge Fund Research’s Global Hedge Fund index, which is broadly representative of the industry, is up just 11.9 percent year to date, while its Equity Hedge index is scarcely doing better, up 12.6 percent. The HFR Macro Fund index is actually down 8 percent, indicating the best paid minds in the business did not see the astounding emerging markets rally and dollar fall coming.

Given that global emerging markets are up something on the order of 60 percent this year, that all global shares are up 30 percent and even the S&P 500 is up 22 percent, we can conclude that a lot of managers are heading into the year-end reporting season with a lot of ground to make up.

There are also lifeboats full of institutional fund managers and mutual fund managers in the same position.

What all who have missed the rally have in common is not a common failure of analysis — there are lots of different ways to get it wrong — but a collective vulnerability to finding themselves waving their clients goodbye. Letters detailing 2009 performance will have to be posted, ranking lists of funds will be published and there will be consequences.

It must be hugely tempting for managers who are behind — and remember a lot of these people are not committed bears — to pile in and hope the momentum trade can bring their returns back to respectability.

It all adds up to a supportive background for risky assets through the new year. There can be no assurances that fundamentals, which are pretty poor, won’t reassert themselves. There is no telling too that policy makers might put a foot wrong and scare the markets, though I doubt it. They have a very large interest in a merry year end. Even if they didn’t, inflation is not an issue and unemployment is, so don’t look for any telegraphs from Washington, London or Frankfurt bearing tidings of rising rates.

COME BACK CHUCK PRINCE, ALL IS FORGIVEN
Individual investors who missed the rally are less likely to pile in right now. Their temptation will be to pass over the business headlines and go straight to sports. And besides, the holidays provide distractions of their own and you are highly unlikely to be fired by yourself as your own investment manager, now matter how richly you deserve the boot.

Professionals however are usually not so lucky as to be related to the client.

Of course, there must be many managers who are ahead of the market. Why won’t they trim their sails and protect their gains? I don’t know the answer to that but in my experience it just doesn’t work that way. People tend to think of gifts as entitlements and it’s a rare, and valuable, manager who having been aggressive when most were timid now gives up the habits of a lifetime.

It is all very reminiscent of good old Charles Prince, the former Citigroup chief who said about the leveraged buyout market, “As long as the music is playing, you’ve got to get up and dance,” just as the world began to unravel. Prince wasn’t a fool, he was expressing a core truth. If you are head of a bank or a mutual fund and you sit out a boom which you see as too risky you are taking on another, perhaps more persuasive risk; that the very clients you seek to protect will call you a stick-in-the-mud and take their business elsewhere.

This is not a specious argument about “cash on the sidelines” or money market funds. Numbers showing huge cash in money market funds are misleading; most of it will never end up in equity markets. This is simply about the self-fulfilling psychology and mechanics of rallies, especially rallies with official support.

The authorities, in their wisdom, have broken the circuit of a crash by flooding the market with enough money to drive up asset prices. This is intended to bring money out from under mattresses and force people to take risks again, to make them dance even if they feel like a fool.

That is unlikely to last forever or to work forever, but a reversal is less likely before January 1 than after.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(Editing by James Dalgleish)

(James Saft is a Reuters columnist. The opinions expressed are his own)

New studies from the Federal Reserve and European Central Bank show that, whatever else, a recovery in the economy is not being supported by a resumption in bank lending, raising concerns about how exactly growth will become self-sustaining when official stimulus ebbs.

The ECB last week released its loan survey showing banks tightened credit yet again for businesses and consumers, though at a less severe rate than in the previous quarter. Much was made of the fact that banks said they expected to ease terms to businesses, but not individuals, slightly in the last three months of the year.

Days later the Fed was out with its own survey, and again the news is getting worse more slowly, which must mean it is time to pop open the tap water. Banks are tightening terms and conditions to large firms, though fewer are doing so than before. Of course we should be thankful for small mercies, but the fact remains that this is a relative rather than an absolute survey, which means that even if fewer are being tougher the vast majority are being just as tight with money as they were three months ago when things were very tight indeed.

But wait, I can almost hear you ask, banks are making money again. If not making loans, what are they doing with it? Funny you should ask, they are lending it to the government. According to Fed data October marked the first time in years that banks held the same amount in Treasuries and Fannie Mae and Freddie Mac bonds as they did in commercial and industrial loans. Business loans have plunged 18 percent in a year, while Treasury and agency bonds are up 8 percent.

Banks are choosing to lend to the government and to government-backstopped mortgage firms because they see it as the best way to survive: hunker down, take fewer risks and content yourself with the thin gruel and thin margins of taking deposits and lending to the entity insuring those deposits. It’s a good way to get solvent but it will take a terribly long time.

Falling demand for credit is a factor too. Firms are concentrating on expanding margins by cutting back on costs, rather than positioning themselves for an upswing in demand. That means they want fewer loans to support capital expenditure. It also sadly means that they are not yet hiring.

OF JOB GROWTH AND SMALL FIRMS

The question becomes will the loans be there when companies do decide that it is time to tool up and hire again. There can be no certainty. Banks are still in pretty poor shape, more will fail and few look likely to expand.

If you believed in markets you would believe that this is simply setting the stage for new entrants to come in and make loans that the banks won’t. I’d like to believe this, but here we run into one of the terrible side effects of too-big and too-connected to fail. Who on earth wants to set themselves up in competition with government-backed firms? Some will do extremely well in making loans opportunistically to commercial real estate and industry over the next two years, but fewer than would be the case if there was a truly level playing field.

Two groups are doing reasonably well, but only because they don’t have to rely on bank credit: large credit-worthy borrowers and house buyers. Fannie and Freddie are still cranking out mortgages, and loans backed by the Federal Housing Authority have boomed. Rates are low, and though fees are high and terms tighter it has to be said that the decision to officially support the housing market by tax breaks and subsidized lending is making a difference. It may not be good policy, but it is effective poor policy.

Small firms seem to be getting particularly tough treatment; the Fed survey shows that terms, conditions, pricing and availability were all deteriorating more rapidly for the small than the large and medium-sized companies. Annaly Capital points out that while middle market firms paid only a slight premium in the loans market in 2007 and 2008, the difference between benchmark loans and middle market is now almost 6 full percentage points, meaning they pay nearly double.

A prepackaged bankruptcy for CIT Group and a chastened GE Capital will not improve things.

Two possibilities suggest themselves for how things play out. Banks may get their balance sheets in order and begin to lend again in force next year, meeting a need for investment as economic growth takes root, if indeed it does.

If demand rises and banks can’t meet it, look for more official arm-twisting, more ritual abasement by bankers called before Congress and, ultimately, more official interference in the process, probably in the form of insurance or even mandates.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

Stocks and other risky assets are rallying around the world this week because the Group of 20 nations said on the weekend they would keep the economic stimulus flowing, a state of events which illustrates where we are and what a very strange place it is.

The G20, the only group of big hitters that matters because it is the only group which includes the Chinese, met in Scotland over the weekend and, as is the way of these things, did very little with immediate consequences for anybody.

In the communique they issued, the Group of 20 finance ministers, after congratulating themselves on the recovery, more or less admitted that the measures we once thought of as heroic are in the process of becoming commonplace.

“However, the recovery is uneven and remains dependent on policy support, and high unemployment is a major concern,” the statement said. “To restore the global economy and financial system to health, we agreed to maintain support for the recovery until it is assured.”

Let me put that in human terms for you:

“We’ve spent untold trillions saving the economy, but, er, we’ve really only saved the financial system and that only to the extent that we keep on saving it. Jobs, well, not so much. We therefore pledge to continue doing this thing that may or may not be working until we are sure that it is.”

Global stock markets then went off on a stonking rally on Monday, which major media attributed to the pledge of continued stimulus. I suppose we shouldn’t dismiss the possibility that the financial media was, as we often do, mistaking coincidence for causation, but professionals were citing it too.

So, what are they promising to do? Will they be able to do it? And why do the risk markets like it so much?

There are at least two aspects to the stimulus - continued easy money from central banks and actual government spending.

The easy money part - low interest rates and unconventional measures - clearly will continue. It will be politically very difficult to raise interest rates while unemployment is still so high, and given the wan nature of the recovery, unemployment will take a long time to fall.

The actual government spending part is a lot harder to bank on, as it were. One reading of the Japanese experience in the 1990s is that their stimulative measures worked but they lost heart and withdrew them for mostly political reasons, thereby bringing on a relapse from which they never really properly recovered.

The politics of another stimulative spending binge will not be easy, especially in the U.S. and especially given populist backlash. That’s not to say more stimulus won’t be needed, it very likely will, but you can’t count on it arriving. Deleveraging takes a long time and we very likely would have been better off just writing the debt down in the first place.

MARKETS LOVE CERTAINTY

Investors have decided, and I think they are probably right, that so long as the authorities are hell bent on reflation it is foolish to get in the way.

As analyst David Merkel has pointed out, the statement of the Federal Reserve meeting, released last week, characterized financial markets as “roughly unchanged” since they last met in September, revealing that they pay far more attention to equity markets than debt markets.

Because of course equity markets were going more or less sideways in October but many of the riskier parts of the debt markets were rallying strongly. Wasn’t this whole crisis, and its expensive fix, supposed to be about “unfreezing credit markets”? Not anymore, apparently.

That is because the Fed realize that they have got to keep equity markets up, indeed have got to force them to rise. It is the only way to float the equity above the debt, make the banks and the holders of debt whole, and allow the financial system to weather the crisis.

There were other options - default, temporary nationalization - but that is not the route we went down. So, within this context the rally makes great sense.

Notice how equity markets have been on a huge tear since last week, going up on news that implied that the Fed would remain on hold for a long time, going up on unemployment rising through 10 percent in the U.S. and, funnily enough, going up on faith that the G20 would stick with stimulus measures.

This brings us to the crazy part. While it may be individually rational for everyone to hitch a ride on the policy train and follow asset prices higher, I would argue that the project is collective folly.

The risks are inflation and a rapidly falling U.S. dollar which leave banks and debtors solvent in nominal terms but not better off. Those risks are best observed now through the dollar, which is falling, and gold, which is at record highs.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

Emerging markets could be the first to suffer destabilizing inflation, courtesy of a strong economic rebound, a weak dollar and extremely loose monetary policy in the developed world.

Inflation, in faster growing emerging markets, was not high on the list of worries even months ago, but the speed and strength of the rebound and red-hot asset markets in some places show that it may be a rising threat.

“The surprise could be that inflation in emerging markets really takes off,” Amer Bisat of hedge fund Traxis Partners said on Tuesday at a Euromoney foreign exchange conference in New York.

It is not yet a central case, but should price pressures in countries like China, Korea and Brazil take hold, it will leave policy makers in a bind and would roil financial markets.

Interest rate hikes might only attract more hot capital and may be only partially effective. Rising currencies can be self-fulfilling and higher interest rates in emerging markets make carry trades — borrowing in dollars, for example, and reinvesting in something like Korean won — all the more attractive.

Other methods of stemming currency appreciation, which stokes inflation, may also become more popular; Brazil in October imposed a 2 percent tax on foreign inflows into equities and fixed-income instruments designed to keep the real from appreciating too quickly.

Emerging market central bankers can expect no help from colleagues in the developed world any time soon. The Federal Reserve will find it economically and politically difficult to hike with unemployment near 10 percent.

“Inflation in emerging markets will be U.S. inflation exported,” said Maxime Tessier of Canadian state asset manager Caisse de Depot et Placement du Quebec.

This might actually argue for China to acquiesce to U.S. calls for it to increase the value of the yuan, which will fight inflation at home and would win it friends and influence abroad. It would not be a surprise for China to return to a “crawling peg” under which the yuan is allowed to appreciate upward slowly. That won’t happen immediately; a negotiation and wooing period will allow China to extract maximum value from the United States for implementing a policy it may well need anyway.

And of course, with significant spare capacity, the decision will not be easy as inflation in the Chinese economy will not be evenly distributed.

RED HOT

While the data on inflation is still fairly tame, asset markets in many emerging markets are now red hot.

The World Bank this week raised its growth forecast for developing east Asia to 6.7 percent this year from 5.3 percent, but said the strong recovery brought with it new dangers in booming asset prices.

“As liquidity is working its way through the system, and demand is relatively low, the credit is finding its way to stock exchanges and real estate markets. It’s a danger,” said Vikram Nehru, the World Bank’s chief economist for East Asia and the Pacific. The IMF chimed in, citing surging property prices in Hong Kong and “a risk that prices could become driven more by short-term liquidity conditions, divorced from fundamental forces of supply and demand.”

Authorities in South Korea have also reacted to a surge in real estate price in and around Seoul, imposing regulations to tighten access to mortgage finance.

Officials have taken some steps to slow the flood of loans they unleashed via Chinese banks this year, but not entirely effectively. Loans by Chinese banks have disproportionately found their way into property and financial speculation, but moves over the summer to limit lending sent the stock market into a tailspin which may have scared off officials. China’s  four largest banks extended about 136 billion yuan ($20 billion) in yuan-denominated new loans in October, up 23.6 percent from September’s 110.4 billion yuan, the China Securities Journal reported on Tuesday.

And it’s not just property — the MSCI Emerging Markets Index is up more than 60 percent this year and currencies in many emerging markets have recorded strong returns.

All of this comes with one very large caveat; if, as is very possible, the recovery in the United States and Europe falters in the new year, then the risk of actual inflation in emerging markets will recede along with their exports to the West. A relapse lower too might bring with it a recovery in the dollar, which would inflict huge pain on speculators who are running dollar carry trades and investing in emerging markets assets and property.

Taking a very long view, strong emerging markets make good sense. Capital should flow to emerging markets. Returns there over the long run will be better, at least if the rule of law prevails. Unless policies can tread a very narrow path, that growth will bring with it inflation and rising volatility.

(Editing by James Dalgleish)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

So it can be done after all.

Britain is poised to take tough steps to break up the large banks it rescued, setting it in stark contrast to the United States, which seems set on a policy of shoring up the unfair advantages it grants its too-big-to-fail banks while regulating around the edges.

It is quite a change for Britain, which has a sorry history of self-serving self-regulation in financial services combined with limp and outgunned official control.

Chancellor of the Exchequer Alistair Darling on Sunday told the BBC that Lloyds, RBS and Northern Rock would be partly broken up and assets sold to new entrants into the banking market. Large existing competitors such as HSBC are expected to be blocked from making bids for the assets.

Britain took over Northern Rock after a run on the bank and its rescue of Lloyds and RBS left it with stakes of 43 and 70 percent, respectively.

It is worth noting that if anything Britain is more dependent on its financial services sector than the United States.

Could it be that Britain has determined that a level playing field, strong competition and a lower risk of a crisis might actually make it more competitive internationally? I certainly think so.

It will without doubt improve the situation for the small businesses and individuals that can’t access international capital markets and depend on the banks for access to credit and other financial services.

Before we get all excited and expect the United States to follow suit with Citibank and Bank of America, it is important to recall that Britain’s Labour government is more or less on its death bed and faces an election in 2010 which the bookies and almost everyone else think it is highly unlikely to win.

There is also the matter of the European Union, which has a say over subsidies such as the ones Britain has showered on the banks. RBS said on Monday that it may be forced by the EU to sell more assets than it had planned. Lloyds is also seen likely to raise additional new capital to allow it to stay outside of an asset insurance scheme Britain is running for the banks and which would involve the government taking yet more equity in the participants.

OH WHAT A CONTRAST

The fact remains that Britain and the EU are saying that more competition is needed and taking steps to ensure that the banks which ended up needing state care are broken up. This must have an impact on how other big banks are ultimately treated, even if they did not receive the same level of direct state aid.

The equity buffer that is being required is also remarkable; the banks should end up with core tier one equity of about 10 percent, four times what they were expected to hold before the crisis.

Contrast all of this with the hopefully named Financial Stability Improvement Act of 2009, now wending its way through Congress. As Harvard Business School professor David Moss points out, as currently drafted this bill won’t even allow the systemically important banks it is designed to control be named, a real Monty Python-esque touch.

Think about it: we won’t even be allowed to know the identities of the firms we are potentially on the hook for. Moss points out that this neatly side-steps the idea of taxing too-whatever-to-fail status as a means of encouraging the behemoths to sell up and avoid the costs. The costs remain with the taxpayer, or potentially with a group of big firms after the fact.

The argument the U.S. administration is making, more or less, is that our complex global economy somehow demands that we have complex huge banks. If we don’t allow huge banks to persist, we’ll choke off growth. If we think we can go back to mom and pop banking, we are simply kidding ourselves. And anyway, if the U.S. doesn’t allow it, foreign banks will just scoop up the cream. With Britain and the European Union taking strong steps, that argument is losing traction. And as for complexity, well I’d have to say that the record of complexity in banking is mixed, to be kind, as far as the deal it gives to taxpayers and consumers of banking services. It would be one thing to argue for huge economies of scale for plain vanilla banking processes like clearing, but it is hard to see why that needs to be combined with derivatives and trading.

It would be nice to think the winds are blowing west across the Atlantic, but this is not usually the case.

(Editing by James Dalgleish)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

Don’t expect the year-long rally in risky assets to be undermined any time soon by the Federal Reserve becoming concerned about inflation.

The old metaphor — that the Fed’s job is to take away the punchbowl just when the party starts getting good — just doesn’t apply in the current circumstances. That’s not to say inflation isn’t a threat in the medium term — it is virtually a promise.

But punchbowl thinking dates from a time when firstly the Fed was presumed to have a degree of control over events we now know is not true and secondly to an era when asset prices were the caboose rather than the engine of the economic train.

Even with an economy that is now growing, the risk of a self-reinforcing de-leveraging spiral is enough to ensure that the Fed will not pull the trigger on tightening any time soon.

“Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up, economies don’t do well, and when they go down, the economy can be horrid,” Pimco bond chief Bill Gross writes in his most recent letter to investors.

Gross argues that leverage inflated the price of assets even as investment in the U.S. real economy flagged. As this happened the U.S. economy became ever more dependent on asset prices and on the sectors, such as finance, which intermediated the borrowing. When the debt and asset bubble is pinched, the whole edifice is threatened, leading to a response like the one we’ve seen: massive and overwhelming aid trained on markets irrespective of the costs.

Pimco data shows that the prices of assets in the United States over the past 50 years have gone up 1.3 percent a year more than would have been expected given nominal growth in the economy, leading to a putative 100 percent overvaluation if you reason that the assets which depend on the economy for income shouldn’t outgrow it.

Unsurprisingly, the real outperformance of asset prices against economic growth has come in the past 30 years, since when debt growth has accelerated.

There are other explanations for why asset prices have outpaced economic growth. For one thing, off-shoring and outsourcing have both suppressed wages in the United States, leading to higher returns on capital, and increased the income that U.S. assets receive from overseas.

It’s obvious that the past 25 years have not been kind to labor, and as its share of GDP has declined the share going to asset owners has increased. In that sense increasing asset prices make economic sense, though there seems to be every chance that workers start to recapture some of what they have lost.

GROWTH, DEFAULT OR INFLATION?

Taxes on capital and profits have also fallen in the United States, and, like wages, this is a trend that could easily be reversed in coming years, especially given the huge amount of public debt that will have to be paid back.

This brings us to the other very strong reason the Fed may have for not pulling away the punchbowl — or water bowl as perhaps we had better see it — even when the party turns inflationary: public debt.

Since the United States have taken a decision to not allow too much of the private debt to default, it has taken on a corresponding increase in public debt which will have to be repaid ultimately. U.S. debt as a percentage of GDP will exceed 60 percent, a level not seen since World War II.

But unlike the post-war period, Europe doesn’t need  rebuilding and though Asia will grow hugely those profits won’t flow to U.S. coffers.

So, if growth doesn’t allow the United States to repay debts, there are two options, neither pretty; default or inflation.

“No policymaker in the developed world — and, by now, few in the developing world — would want to countenance default as an option,” writes economist Spyros Andreopoulos of Morgan Stanley in London in a note to clients.

“This leaves inflation.”

To be sure, the Federal Reserve takes its mandate to control inflation and its independence seriously, but it is going to find itself in a very difficult squeeze, partly of its own making. The debt is high, growth will be poor and the time for private defaults is past. Threats to its independence will only grow.

Given that, and the dependence of the economy on asset prices, it’s not hard to bet that the evil we will be left with is inflation. Whether it is engineered or just kind of happens is less interesting than the reasonably high likelihood that it will happen at all.

For a time at least, that would argue that risky assets, particularly real assets and emerging markets, do well.

Longer term, things get stickier and stickier.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

There are encouraging signs that shareholders are becoming more assertive in defending their interests.

The Financial Times reported on Monday that some of Britain’s largest institutional shareholders - including Standard Life, Legal & General and M&G - are working on a plan to bypass investment banks by creating a club to underwrite new issues of equity by small and medium-sized British companies, a move that could save hugely on fees.

What, you may wonder, took them so long?

Second only to taxpayers, investors have been the great patsies of the financial crisis, paying massive costs to a financial services industry which has, to put it mildly, not served them well.

Activist shareholders and investors could be a key force in fixing what is wrong with the financial system. Unleashing their power to act in their own best interests should be a main thrust of new regulation.

The British investor group, reportedly being assisted by mergers and acquisition advisors Lazards, would effectively cut out the middle men by agreeing to take up any unwanted new shares in an offering. This is an idea which if successful could save companies and their owners huge amounts in fees and at the same time deal a blow to investment banking profitability.

Fees charged by banks for equity underwriting in Britain have more or less doubled in the aftermath of the crisis to 3.5-4.0 percent of the amount being raised, with the lions share going to banks rather than to the institutional investors who sub-underwrite.

While banks may argue, and in part be correct, that this is because the past two years have demonstrated the risks of capital market underwriting, it is also patently because there are now fewer banks competing for this business.

To be sure, a club approach is better suited for small and medium sized underwritings and would face huge difficulties for a major share issue involving global investors. But if a test run proves successful it would place pressure on fees for transactions of all sizes.

Even before the crisis hit, fees for investment banking services seemed not to follow with the same fidelity the laws of economics which hold such sway in microchips, steel or even tax preparation.

And it’s not just investors, who consume investment banking products, who have been ill-served. Shareholders in companies, particularly in banks, have provided the capital but have not had their fair share of the fruits.

FOR WHOSE BENEFIT IS THIS ZOO BEING RUN?

That has led to bad decisions, decisions often designed to maximize the benefit to employees at the expense of the shareholders who run disproportionate risk.

Paul Myners, a British Treasury official with special responsibility for financial services, gave an absolutely scathing address last week to the Worshipful Company of International Bankers, assembled for dinner in the Mansion House in the City of London.

Myners, who is reported to be considering holding a competition inquiry into banking fees, took aim at the bonus and compensation culture in the industry.

“It could be argued that some shareholders in banks have been left holding not the ordinary shares they originally purchased, but a new form of subordinated, participating, non-cumulative equity that ranks behind rewards for the senior management, and executives of the firm in which they invested have a prior claim. This cannot be right,” Myners said.

“In case anyone needs reminding, the profits of banks belong to their owners; not their managers and traders.”

I imagine that the bankers were a little less worshipful on their way out then they were on the way in.

I would also argue that what Myners said about banking also holds true - to a lesser extent - in other publicly traded companies, where management is able to extract compensation out of proportion to their likely contribution.

Shareholders, and we are really talking about institutional shareholders, have allowed management to get away with it for years because they thought what they were supposed to be doing was outperforming the market by picking winners.

Much of what passed for skilled investment over the last 20 years has been little more than riding the waves of a debt-fueled economy which seemed capable of providing six to ten percent returns on an unleveraged basis.

Adding value too often meant little more than adding leverage to increase returns. When the current rally ends, as it surely will, investors should take a long look at their long term returns. What they will usually see is that they are poor.

A better strategy for the next 10 years may be to spend as much effort protecting your economic interest in what you own as you do in choosing what to own.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

- James Saft is a Reuters columnist. The views expressed are his own –

Even putting aside the spectacular but hard-to-measure risks of a financing crisis or the loss of its special status, the dollar faces really serious headwinds from boring old fundamentals.

The dollar has been weak for months and markets have been fretting over a host of big picture worries.

Perhaps the world’s oil exporters will stop using the dollar as the medium for petroleum trade. Or maybe the so-far patient and docile buyers of Treasuries will finally turn jittery. Either could be a disaster for the dollar, but you don’t need conspiracies or crises to be bearish on a currency from a country which on some measures has run the largest-ever deficit between what it imports and what it sells abroad.

One of the most interesting side effects of the first part of the financial crisis was that the dollar actually rose despite being the locus of the credit bubble and despite the U.S. consistently importing far more than it exports. That strength, which has now been reversed in part, was largely because the freezing up of markets set off a scramble for dollars.

The acute phase of the crisis is over and a return to something approaching normalcy is not treating the dollar kindly; from its peak this year the dollar has fallen more than 13 percent against a trade-weighted basket of currencies. The current account deficit — the balance of exports to imports — has also been reduced greatly, from a peak north of 6 percent of GDP to below 3 percent at the end of June, with further narrowing in the months since. That is because a weaker dollar makes U.S. products more competitive, but also because the price of oil, of which the U.S. is a net importer, has dropped, and consumption at home is flagging.

It is far too early, however, to say that the dollar adjustment has done its work and the deficit will now close.

“The U.S. current account shortfall was primarily driven by a consumption surge rather than an acceleration of investment on the back of productivity growth and high profitability,” Citigroup currency strategist Michael Hart wrote in a note to clients.
THINGS THAT CAN’T GO ON FOREVER DON’T

That is bad news for the dollar and bad news for the outlook for U.S. growth. A 2005 paper by Caroline Freund of the World Bank and Frank Warnock at the University of Virginia <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=875699> found worse outcomes for the countries that ran current account deficits to finance consumption as opposed to those which ran deficits in aid of investment.

Industrialized countries which, like the U.S., run current account deficits for consumption, find that the currency depreciation that follows tends to be deeper. What’s more, the adjustment in the deficit lasts longer and is often twinned with lower growth. It is not, I suppose, a big surprise that importing more than you export and then consuming it leads to depressed growth. The real wonder is the way in which the U.S.’s special status and the generous financing terms offered by its trade partners made this possible without more immediate damage to the dollar.

There is also the possibility that globalization has permanently raised the “natural” level of the U.S. current account deficit. Huge swaths of the U.S. manufacturing base and a growing wedge of the country’s service sector have been offshored or simply moved out of the U.S. Many of these goods and services are still consumed by the U.S., but now much of the money generated by those sales will be the result of dollars being sold to buy pesos, ringgits or yuan.

This may place more structural pressure on the dollar to fall over time.

Australia’s decision to raise interest rates last week hurt the dollar and for good reason. It demonstrated that as a recovery happens the action will not be in the U.S., but in resource-based economies and in places, mostly in Asia, where the best prospects for productive investment lie. The U.S., where the Federal Reserve will likely need to keep rates low for a very long time, will have a hard time capturing the imagination of investors.

For policymakers, and not just U.S. ones, the puzzle is how to allow the dollar to fall gently without precipitating trade friction or a disastrous loss of confidence. Because it’s more or less in everyone’s interest, it will probably more or less be avoided. A weaker dollar, though, is simply consistent with the outlook for the U.S.

A long shamble downwards rather than a fall off a cliff looks to be in the dollar’s future.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

–James Saft is a Reuters columnist. The opinions expressed are his own.–

When the U.S. dollar ultimately loses its status as the world’s premier reserve currency it will be painful for all involved, almost certainly disorganized, and very possibly a very good thing.

World Bank President Robert Zoellick outlined the risks to the dollar’s status in a speech in Washington on Monday.

“The United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency. Looking forward, there will increasingly be other options to the dollar,” he said.

Zoellick went on to emphasize how choices in the United States on inflation, fiscal policy and financial system reform would help to influence the dollar’s fate.

Quite true. The U.S. cannot simply devalue its way to competitiveness, nor can it appear to be inflating away its debts without risking a run on the currency. The Chinese and others would sell dollars or fail to buy up new debt if they felt the U.S. was behaving both cynically and irresponsibly.

China has good reasons not to force a crisis and devalue its holdings of dollars, but not immutable ones. The two nations are like two men trying to swim to shore while dragging a heavy box of gold, the difference being that the U.S. is tethered to the box while China is only holding on. If China decides the water is too rough it can let go, sacrifice its dollar holdings and swim for it. The United States is not so lucky.

“Exorbitant privilege” is a term coined by an understandably embittered French Finance Minister Valery Giscard d’Estaing to describe the fact that under the old Bretton Woods currency system the United States, unlike everyone else, could simply print dollars to cover current account deficits.

Bretton Woods is gone, but the arrangements which replaced it also tended to underwrite U.S. overconsumption, as purchases of U.S. dollars as reserves by other nations kept funding rates lower despite household or government profligacy.

“The United States is incredibly fortunate that the dollar enjoys this special status,” Zoellick said. “When I work with countries struggling to pay for budgets or finance trade deficits, I reflect on how Americans do not spend a moment considering the unique advantages of being able to issue bonds and print money freely.”

My best guess is that Americans will spend quite a few moments in coming years considering that unique advantage, and that while they will miss it, they should also be sorry they ever enjoyed the right to borrow freely and seemingly without consequence.

THERE’S NO “G20″ IN “TEAM”

Of course the U.S. current account deficit has contracted massively, standing at about 3 percent of gross domestic product in the first quarter as compared to 6.5 percent of GDP in 2006. That’s the result of plunging global trade and steep falls in investment in the United States. And while the personal savings rate has jumped in the United States, which after all it had to since credit was no longer easy, the government has stepped up massively as a borrower, overwhelming households’ efforts to save.

Barclays Capital calculates that the United States now needs to attract 46 percent of the world’s net savings, i.e. the sum of all current account surpluses, as opposed to 54 percent before the crisis broke.

That 46 percent figure is an improvement, but it too is ultimately unsustainable. It’s also arguably starving lots of other places of investment that could ultimately produce higher returns.

The newly empowered G20 group of nations has meanwhile resolved to rebalance the global economy, using peer pressure to force the irresponsible to shape up and the overly tight to start spending at home.

The world’s central bankers and politicians just received an object lesson in what a good idea it is to have a bunch of reserves piled up against a bad day. Even putting China aside, responsible leaders in places like India will have a very tough time trusting in an international body to protect their own best interests. And because that body doesn’t have any real power to compel, it will be ignored. That means that there is a good risk, G20 or not, that everyone is trying to simultaneously keep their currencies low and exports high.

The only body seemingly exempt from market discipline, the United States, is not going to be in a position to resume eating up everybody’s exports. This is a recipe for very slow growth and for rising international economic tension. That doesn’t make the changes proposed at the G20 a bad idea, but they are not sufficient and threaten to be a resolve-softening time waster.

So not so much as rebalancing but a re-basing of growth expectations. Look for continuing dollar weakness alongside that, with the real drama being not the decline but the rate of decline.

–At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–