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Donald Marron — Signs of Inflation are Already Here

The markets face two pivotal events next week: the midterm Congressional elections and the two day Fed meeting.

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Will the GOP take both Houses in Congress? What will all of this mean for the future of financial regulation and the shape of Wall Street?

I recently had the opportunity to chat about these things with Donald Marron, former Chairman and Chief Executive Officer of Paine Webber Group and founder and Chairman of the private equity firm, Lightyear Capital.

DM: We have a much better sense of how the management of the companies that came through the crash were able to handle the it. We have much more information on companies, stresses and weaknesses. We now have a much better sense of valuation, and most important, we have more understanding on the value of the companies brands and products. Even after the crisis, you continue to see demand for financial services products. People still want credit cards, bank accounts and loans—although they are not getting as many as they should.

LL: This is classic capitalism—the strong survive, the weak don't. Strong companies evolve and expand their businesses to capture opportunity. You have expanded into the brokerage business. What kind of opportunities do you see in 2011?

DM: We see several areas of interest, one of them is general processing because of the continued growth rate in financial transactions. There's a big and growing demand for electronic trading and all the things that go along with that. So the processing in financial services looks like a good place to be.

The second thing which you point out is the securities business. Trading, investing, and most important, money management. You might simplify it and ask how do you manage money in a zero rate environment? And its much more demanding for both the managers and the investors.

A couple of years ago, "conservative" investing could be defined as keeping a good percentage of your investment in treasuries. Now if you're a pension plan or an endowment, you're keeping most of your money in treasuries, you are earning less than one percent and where as you're drawing down, probably five percent. You're actually losing money in that exchange. So you have a situation where there is a growing premium on the ability to manage money in this environment.

For example, you're now seeing a flow back into hedge funds. You have not seen yet a big increase in mutual fund sales but its coming and what you are also seeing is roughly three trillion in money market funds earning very, very little. In our view the money will migrate over time into other channels.

LL: One of the big uncertainties right now is financial reform. The new Congress elected in are going to be the ones to shape these rules. What kind of regulations are you anticipating?

DM: There are three kinds of regulations coming. One of them is regulated by the use of capital, Basel III. That second form of regulation is essentially dealing with products—what kind of businesses can you be in—the "Volcker Rule" being the most visible example of that.

The third kind of regulation is transparency—giving investors and regulators more insight into the structure of products and the type of products. But the devil is in the details. How these rules are written will determine if they do what they're suppose to do—which is to enhance confidence in the markets as well as provide guidelines for regulators Or, will they tangle us all up in government?

LL: Last week FDIC Chair Bair said the US capital requirements will be stricter than Basel III. Do you worry the US financial regulations will be tougher than the rest of the world and if so, will that put the U.S. financial industry at a competitive disadvantage?

DM: The Swiss government announced that their capital requirements will be higher than Basel III. Every country and every regulator is thinking through first what the impact of the crash has been on their own financial services structure and on the other side of it, their own competitive position in the world. So my feeling is you really don't know how its all going to work out yet.

LL: There is a fine line between regulation and over regulation. What would you like to see done?

DM: I believe we do need strong transparency. You can understand more clearly how products are created, how they are being marketed, and the balance sheet of banks. If you went back and looked at the stress tests of the U.S. banks, there was a lot of interesting information that came out.

The second thing is you clearly have to regain the confidence of the world in the financial services system. That issue is different for all the different parts of the world.

I think inevitably we'll have more regulation. I just hope the government doesn't increase capital requirements so much that is limits America's competitive position.

LL: Let's switch gears to the Fed. Everyone is looking at the two day meeting next week and if they will do QE2. Do you think additional quantative easing is needed?

DM: First of all, I assume the Fed knows more than any of us about what the dynamics are. So to try to second guess those decisions to me would not be appropriate. What we do know is the Fed is very much involved in impacting economies and the markets at the moment. Secondly, you basically have to watch the actions of the markets and the actions of the economy over the next six months. It sounds like to me, QE2 is coming in some form or another but the former other is the crucial thing. How are they going to stimulate? How is the Fed going to measure if its working? That we haven't heard yet. Also in the background of course- is the question if inflation could come back.

LL: Do you think the inflation fear is real?

DM: I do. There are already signs of prices rising in luxury goods and some other areas. Your biggest issue in the economy is unemployment and the other factor is housing. You have the most valuable commodity investment in America declining in price and no confidence in the part of buyers at the moment because housing prices could decline further.

LL: The midterm election is next week. What do you expect from the new Congress?

DM: I think what we have to see is what happens to the election of the more extreme candidates, or put it in another way, the most vocal candidates. Obviously, the Tea Party represents a significant part of that.

If those candidates get elected, at the very least, they are committing themselves to being highly vocal and very specific to the things they think are important. The result of that usually ends in a slow down of the process. And there is a feeling right now that a slow down in government could be a good thing.

LL: Sometimes gridlock is better.

DM: Some of the pundits think the Republicans will take at least one House and that will change things. That will slow things down and that will force hopefully the two parties will work together in ways they haven't done so far. And that would probably be constructive.

LL: Are you seeing any interesting trends right now?

DM: There are more feelings of being optimistic. When you go through declines, the audience is essentially looking for reasons of why things can get worse. You now have a lot of people looking for reasons of why things ought to get better. And those things will obviously be the actions of the government, unemployment, housing, the composition of the new Congress and taxes.

So it seems to me the responsibility of the government will be after the election to communicate as clear as it can, what its highest priorities are, and where are they going to go.

One thing that the Obama Administration made very clear was its priority on health care. And you can agree or disagree for both the process and the result. But at least you knew what was in their head.

Well right now, we need to know from the government where they stand on taxes, where they stand on the budget deficit and most important where they stand on creating the best opportunities to improve employment.

Obviously spending on infrastructure at least in my judgement would be high on my list. It would create highly visible jobs in a country where it is acknowledged where our infrastructure is not where it should be.

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A Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."