"Fixing the banking system should always have been the No. 1 priority of the U.S. government," exclaims Harvard economic historian Niall Ferguson, the author of The Ascent of Money: A Financial History of the World. While recent rhetoric suggests the Obama administration is finally waking up to the importance of pursuing such changes, Ferguson sees little evidence that governments, here or abroad, have done enough to alter the status quo.

"The banks have become even bigger and their leverage has barely dropped," observes Ferguson, "and with the economy having seemingly moved away from the brink of meltdown, the urgency for change has been slipping away." Worse, he believes the focus on the symptoms of the financial crisis, rather than the root causes, is leaving the world even more vulnerable than it was a year ago.

The financial crisis was certainly not of President Obama's making, says Ferguson. But he feels that the president lacks a grip on congressional Democrats and thinks every one of Obama's policy initiatives has been wildly distorted in the legislative process.

"If Obama leaves solving the federal debt, budget deficit and banking reform to Congress, you're going to get a dog's breakfast of ideas and special interest measures," Ferguson surmises. "You won't get what we need, which is a clear root and branch reform. To that end, it will take Abraham Lincoln-like presidential skills."

Perhaps what has surprised Ferguson most over the first year of Obama's presidency is that in spite of having assembled some of the brightest economic minds in Larry Summers, Tim Geithner and Christina Romer, there remains an almost laissez-faire attitude toward the "too big to fail" problem. "I find this puzzling because I'm quite sure these people are intelligent enough to know there is something amiss with the system. It seems they are very reluctant, for reasons that aren't entirely clear, to tackle these problems."

He does see the recent proposals conceived by Paul Volcker as somewhat on point. But Ferguson doesn't believe focusing on just the size of banks or their proprietary trading-the targets of Volcker's plan-will address the root causes of the crisis.
He would like to see reforms focus on actual risk-on what the banks can actually lose in given scenarios-not just on the characteristics associated with these risks.

Ferguson would rather see a new international standard for bank leverage and the serious consideration of Boston University professor Larry Kotlikoff's proposal for "limited purpose banking." The proposal would limit the liability of all financial companies by turning them into mutual fund companies that have 100% capital requirements. They would not be permitted to borrow to invest, and therefore would never face a failure due to a bank run.

Ferguson has no problem with hitting the banks with special windfall taxes now that they have recovered their profitability following their bailouts. The government, he thinks, has a right to make back a part of what it has lost due to the crisis, which goes well beyond TARP money. But he sees the current banking proposals as more of an attempt to "punish the big banks for daring to make money and pay big bonuses so soon after they were bailed out." The reforms, aren't addressing the root causes of the crisis, such as the concentration of risk and the failure of the banks to anticipate the worst-case scenarios. Instead, populism is driving much of the dialogue.

Not all is bleak, according to Ferguson. Central bankers did save the system by decisively improving liquidity, easing credit and opening the discount windows to key institutions that previously would not have had access to cheap money. "We sort of avoided Great Depression 2.0," he observes, "but I wouldn't say we are out of danger. We've only addressed the symptoms of the financial crisis, such as bank failures and credit contraction."

What Still Worries
To Ferguson, the structural causes of the crisis that remain in place include excessive bank leverage, bond markets contaminated with AAA-rated toxic assets, the reckless insurance of financial risk, excessive economic incentives to increase home ownership, the huge credit line that China extends to the Unites States and, finally, China's currency policies.

China particularly worries Ferguson because he sees the United States addicted to an economic relationship that has significantly contributed to our fiscal imbalances. And he believes a weakening dollar would only marginally correct these problems.

"Contrary to popular sentiment," he notes, "the continuing decline of the dollar will not sway China's currency policies. Its vast U.S. Treasury assets represent only about 5% of [China's] total wealth. So any loss on its dollar reserves through subsequent revaluation of its currency would be completely overshadowed by the gain in the value of China's renminbi-based assets."

The key macro problem is that China's currency peg to the dollar makes its exports the cheapest in the world, helping it to generate annualized growth of 10%. The Chinese government will continue accumulating U.S. Treasurys (which we need to sell) to sustain that peg for some time to come. "But for the rest of the world's exporters, it's a very painful state of affairs," says Ferguson, "and that's why there is a need to seriously alter the present relationship."

He also worries that if commercial real estate defaults continue to rise and prices continue to fall, a new financial crisis could ensue. A protracted slump in this market could bring down the banks that are "too small to save"-the regional players that offer credit to small companies, without which we can't expect much recovery in 2010, says Ferguson.

With a good chunk of dodgy commercial real estate debt in the U.S. due over the next six to 12 months, he thinks up to 1,000 banks could fail over the next year. And this could in turn lead to a public financial crisis, given governments' already disfigured budgets.

"Here and abroad, if governments have essentially said that we will bail out our big financial institutions, then the former will start to lose financial credibility," concludes Ferguson. "Dubai is now, Greece is next, Spain is not far behind. Iceland showed the way. People are now asking questions about the U.K. This could very well be a key part of the financial story that evolves in 2010."

But the experience of subprime may provide a spot of comfort. "The market, which had been living in Cloud Cuckoo Land about where residential real estate prices could go, will not be caught off guard with the next round of real estate defaults," says Ferguson.

Perhaps his largest worry is our galactic debt. Ferguson sees it as a financial albatross that will weigh heavily on the United States' future if it isn't dealt with immediately.

"I'm enough of a supply-sider to believe radical U.S. tax reform will encourage growth and help the government cut into the debt," says Ferguson. He believes we need a system that's more efficient, less cumbersome and less distortionary, one that shifts the burden of taxation away from income and profits and more toward consumption. He proposes a flat-rate income tax of around 25%, significantly lower corporation taxes and a value-added tax of 7.5% to 10%. "These changes can speed fiscal recovery, but I fear we are adopting precisely the wrong measures to achieve that end," he says.

Meanwhile, he thinks that unemployment figures in the U.S. and Europe are stabilizing, though he doesn't suspect they will be improving significantly anytime soon. "I don't think we'll have another panic again like we saw at the end of 2008 and the beginning of 2009, when companies were significantly laying off," he says. "I think in that sense, the worst is behind us. But if stagnation is the name of the game in 2010, then it isn't going to bring much good news on the jobs front on either side of the Atlantic."

Do all these concerns make us vulnerable to another major market sell-off? Maybe, says Ferguson. If one makes an analogy to the Depression years, he believes we are in late 1931, having avoided that summer's banking crisis. But he wouldn't be surprised to see a downward move in equities as we get more stories about bad debt and more defaults and as sleepy consumer spending continues. So he's expecting both domestic growth and equity prices in 2010 to remain basically flat.

But he's more sanguine about conditions beyond our shores. While he thinks developed markets worldwide may grow around 2% this year, Ferguson is expecting emerging markets-led by China and India-to expand by 7% to 8%. And he believes this rate of growth will be sustainable as these markets reduce their dependence on exports to the U.S. and Europe and rely more on their own internal demand. "You can definitely see the evolution of a two-speed world," says Ferguson.

Investing
Ferguson is nervous about the prospects of bad economic news in the United States or from places like Dubai. "I wouldn't want to be holding Treasurys because of the fear of upward rate moves or [want to] have too much exposure to the S&P 500 because I don't see fundamentals driving greater upside," says Ferguson. In fact, he thinks it's possible that a lot of negative news could drive markets significantly lower.

He does, however, like Australia and Canada. He recommends indirect exposure to China through those of her major trading partners that are doing well. He believes Brazil will continue to offer good news as it continues to become a major economy. And he's getting more excited about India, which has many of the advantages the Chinese don't have.

"India doesn't have the most streamlined legal system in the world," he observes, "but the rule of law prevails, and there are private property rights." As India's infrastructure continues to improve, I think the country offers a lot of upside over the next few years. Plus, India has much more domestic demand, he says, and relies less on exports than China. Furthermore, it's an easier market for foreigners to get into.

Broadly, he says, he "can't overemphasize the need for restraint right now. I would be underweight both equities and debt, and up my cash position to 50% of my portfolio, denominated across multiple currencies, including the Canadian and Australian dollars."

Given the roller coaster ride the world has been over the past two years, it would be no surprise if we may indeed be witnessing not just the ascent of money but the ascent of caution.