FM: Would it have been better to stick with the original TARP program, which would have simply bought up the toxic debt of banks and force them to take a loss on them?
MS: In hindsight, yes. The sooner we would have been in cleaning the toxic things that are there, [the better]. We continue to underestimate what is still there. We declared victory too early yet the undercurrent was still there.
To me the Fed made a mistake when earlier this year it declared that they are not going to raise rates until 2014. Right now it seems that they were right, but two months ago when we had a couple of good numbers even Fed members and Bernanke tried to shy away from those kinds of predictions. What we do at the moment is a response to every economic number that comes out; we left the long-term stewardship in terms of policy. We still have a lot of structural imbalances. We don’t have much growth, the liquidity didn’t provide what it was supposed to, and we are in a situation where every development in Europe or in the U.S. has been amplified by political uncertainty, by regulation that keeps putting market participants in some kind of limbo because they don’t know what their tax environment is going to be. When it comes to the U.S. the new health care law created a huge [cost ] to small businesses, which are the major engine of job creation. What you did with all those new regulations and laws is put the real economic engines on hold and as a result we have been suffering from [low growth], which has been amplified because we are [still] in a major deleveraging process.
FM: BlackRock’s Peter Fisher blamed some of Europe’s problems on moving to austerity too soon. Is that a risk here?
MS: That is a great point. The solution always is in a balanced approach. What Europe underappreciated is by going to a huge austerity plan without having political stability, they will have political instability that can derail the whole process. So yes, they moved too strong in Europe because they underappreciated the political [environment]. They did have to move, however. As you know, in Europe you have different countries with different agendas. When you try to find a common ground, you find something that is [not good] for everyone. Take the UK as an example. The UK went to an austerity plan when there was a lot of political stability to do this. They still are in the midst of this but it will probably put them in better shape, once the cycle turns, than many other countries far behind in putting their fiscal house in order.
FM: What is the risk of keeping central bank policy accommodative for so long? What is the appropriate exit strategy?
MS: You have just asked the $64 million question: What is the exit strategy? When you keep interest rates low for so long, you make the market conditioned and addicted to that liquidity. When that liquidity starts to dry up, any kind of marginal positions that were dependent on those low rates will have to be unwound and I don’t think anyone knows, including the Fed, what the unwinding will do to those. Once the markets sense that a change in the interest rate cycle is imminent, they may run ahead of the Fed and may force the Fed to act earlier than it would otherwise. The exit strategy is to do it gradually and not to increase the doses of liquidity, because the more you increase it or commit to it, the more it creates imbalances and dislocation that will come back to haunt you.
FM: What we are talking about, particularly in fixed income and forex, is pretty heavy handed government action in markets. Is there a larger risk in how active central banks and government have been in affecting markets?
MS: I do think so. Governments, primarily in fixed income and currencies, have been more interventionist in their approach. In the past, monetary policy affected the front end of the curve and markets were affecting the long end, when that failed to do for the Fed and other central banks the goal of what they were trying to achieve, then they started to [affect] the long end by those QEs. As a result the yield curve currently is representing something artificial and not necessarily what a free market involvement would do. Once you start to [remove] some of that government involvement, the markets will have to adjust to that new reality and it can be significant.
In currencies, no one wanted a strong currency in a world where the global economic pie is shrinking. [Some] countries, like China, like the Swiss and Brazil recently, intervened. The U.S. didn’t intervene but currencies being a relative value concept reflect policies and demand on exports of different countries. So the fact that the Fed has been very accommodative accounted earlier for weakness in the dollar and only recently the dollar found new strength, more due to the problems in Europe than strengths of the U.S. economy. At the end of the day governments will find it very difficult, especially if it doesn’t achieve the economic growth that they are hoping for, to artificially keep intervening in the market, especially when they do it without a longer term plan or comprehensive coordinated policies globally.