There is nothing involved in federal regulation per se which makes it superior to market regulation.
-Alan Greenspan

Nothing captures the blind allegiance to laissez-faire economics and the dubious claims that the markets are always efficient than the above quote from the former Fed chairman. The credit crisis, combined with the near certain increase in Democratic power after next month’s election, will produce an increase in regulation and oversight of the financial markets and the economy. But what sort of re-regulation and oversight can we expect?

When it comes to regulation and oversight, there are two questions that stand above the rest:
 

• How effective will the effort be?
• How far will government go?

There are great risks tied to these two questions, and one to the other:
 

• Will the efforts produce a more efficient economic and financial America?
• Will the increased regulatory role go too far and, therefore, crimp American innovativeness?

The regulatory pendulum has swung away from laissez-faire and a blind faith in efficient markets and toward a new regime. Hopefully, it will not swing so far the other way that the actions will create more problems than they solve.

Investment Strategy Implications

One likely consequence of a new regulatory climate will be capital flows away from and out of the US to other parts of the global economy. Such capital flows are destined to occur anyway as US economic growth and profitability declines due to the forces of deleveraging and its impact on the US economy. This past Tuesday’s report on Consumer Credit (-$7.5 billion) is one of the first US consumer related signs that the credit crisis has begun to hit Main Street.

A sustained retrenchment of US consumer spending habits should result in a higher savings rate and a long overdue repair of the consumer balance sheet. This trend will be exacerbated by the reality that the wealth effect (real estate and financial assets) can no longer be counted on to satisfy future financial needs, most notably the retirement of millions of Baby Boomers – a fact made all the more true as Social Security benefits will not fill the lifestyle gap.

Higher savings and lower spending by the US consumer has worldwide ramifications. Domestic economic growth will slow with the slack being picked up by an emerging middle class in developing economies. These two factors will almost certainly drive investment capital out of the US and toward higher growth regions, an act made all the more imperative as capital seeks countries that have a less onerous regulatory climate.

The credit crisis will take a bit more time to resolve itself. But resolve itself it will. It is, therefore, prudent for investors to begin looking past the valley before us and to the new economic landscape that will be. And one central dynamic of the new economic landscape will be a changed regulatory and oversight environment. Let’s hope lessons have been learned and judgment and political courage does a better job than it has recently.