The Crash and Its International Consequences

Remarks to the Pacific Pension Institute Winter Roundtable

It’s good to be back at PPI, an organization that includes so many old friends, one whose formal launch I helped stimulate, and one that my wife, Margaret Carpenter (who sends her regards from afar) can take considerable credit for institutionalizing.

Since mention has been made of my pending appointment to a government position, I will reiterate what you already know, if you know me at all. I speak only for myself and do not represent anyone else, certainly not the Obama Administration, still less Projects International, the Middle East Policy Council, or any other private sector organization I have headed or on whose board or advisory council I have served, including PPI. Nothing whatsoever has changed. My views on absolutely everything remain tentative because I have an apparently disconcerting habit of revising them as I encounter new facts. I still have more questions than answers. And my remarks this evening are directed at launching the exploration we will carry out over the next two days, not at framing a government press release or claiming access to any information beyond what I read in the papers and on the internet.

We certainly live in challenging times, in which change is upon us, whether we like it or not. The world we knew is gone. We don’t quite understand the one we now live in.

The 20th Century ended a decade ago with the United States in a position of unchallenged global power, prestige, and leadership. Our old Soviet enemy had imploded and fragmented, leaving us without a military or ideological competitor. Democracy and the rule of law, our central values, were triumphantly advancing; no one any longer asserted an alternative political vision. Our capitalist system and the emphasis on free trade, fiscal discipline, and deregulation of financial and other markets that some called “the Washington Consensus” were seen around the world as the only reliable path to prosperity. We had a budget surplus. We saw ourselves as invulnerable and essentially omnipotent. With exuberant self confidence, we proclaimed ourselves “the indispensable nation.” No one laughed. No one contradicted us.

In 2009, that world seems unimaginably distant. The first years of the 21st Century have not been kind to us or to our place in world affairs. I have spoken elsewhere of the extent of our global political comedown and its causes. There is no need for me to review the sorry story of the collapse of our moral standing, prestige, and influence since the world last stood with us on 9/11.

Blessedly, the first decade of the new century is ending with the United States having once again demonstrated the remarkable capacity for peaceful political change that has been the hallmark of our republic. New leadership in Washington has inspired hope for the revival of American leadership abroad. But, no matter how brilliant his performance, President Obama will not be able to restore us politically and militarily to where we were as the century began. The damage to our alliances, to the global and regional orders, and to the deterrent value of our military has been too great. The threats we set out to cure through the use of force have mainly been aggravated by it. We do not know how the wars we began will end. Their end games matter greatly.

Since my topic tonight is the consequences of the crash for the world order and our evolving place in it, I will leave further discussion of political and military matters to the dialogue that will follow the filibuster. I am very mindful that you are investment professionals and I am not. I suspect I shouldn’t be talking about financial, fiscal, and monetary matters in your presence. Fortunately, the price of admission wasn’t to say anything profound or insightful or accurate. It was just to give a talk. Talk is, of course, cheap, because supply always exceeds demand. But sound advice is priceless. So I very much look forward to your comments and corrections and to listening to the presentations of others on related matters over the next few days.

I will try to be brief but believe that a short review of what preceded the current financial crisis and economic collapse may be helpful as a starting point.

This century began with our surprised rediscovery, as the dot-com bubble burst, that 8,000 years of economic history were not in fact irrelevant and that profits, not puffery, remain the only reliable foundation for enterprise value. This revelation belied the earlier conventional wisdom. Public trust in portfolio investment declined as shocked investors realized that what goes up can also come down and that faith-based investment only works in bubbles.

Then came 9/11. Anti-Muslim hysteria, greatly heightened visa barriers, humiliatingly intrusive inspections at our borders, seemingly capricious foreign assets seizures, and heightened controls on funds transfers began to inhibit foreign business and investment in our country. The Enron scandal followed immediately after 9/11. It brought down Enron and Arthur Anderson, of course. But, more than that, it greatly tarnished the reputation of American business and raised serious questions about corporate governance under modern capitalism. It also added the burdens of Sarbanes-Oxley to our unique practice of class action law suits as a serious disincentive to foreign investment here. The already damaged US investment climate was not improved by our xenophobic rebuff of CNOOC’s effort to acquire UNOCAL and Dubai Ports World’s attempt to buy out the British company that operated six ports here. For foreigners, the United States had become an unfriendly place. The same Arabs, Chinese, Indians and Russians whom London’s Heathrow airport continued to welcome complained of being treated with suspicion and discourtesy at US ports of entry. They became increasingly reluctant to come here.

One result of all this was the eclipse of New York by Hong Kong and London as the preferred markets in which to launch new companies financially through initial public offerings (IPOs). We helped catalyze a big increase in euro bond issuance and circulation. In recent years, London has had 26 percent of the world’s IPOs; New York, which once had 60 percent of them, accounted for only 6.5 percent. London has also been home to almost 50% of the world’s derivatives market (remember that?) and 70% of the global secondary bond market. By 2007, London accounted for 34 percent of global foreign exchange trading; New York, only 17 percent.

Meanwhile, the United States became a thoughtlessly thriftless, credit-addicted society with a dependence on excess consumption and a crumbling infrastructure. Tax cuts, a huge defense build-up, and two very expensive wars produced mounting trade, balance of payments and budget deficits. The world was flooded with greenbacks many saw as having uncertain value over time. In the absence of domestic savings, Americans came increasingly to depend on foreign lenders to fund our national debt. These trends led to a major shift of wealth and power to northeast Asia, Europe, and the Arab Gulf amidst rising concern about the dollar.

Real shortages of supply and rapidly rising demand underlay the rise in prices of energy and raw materials but hedging against the dollar through commodity purchases bid prices far higher than they otherwise would have risen. This created a huge windfall for commodity producers and a further massive shift in wealth to them.

Bubbles are beautiful but fragile things. The commodity bubble burst when the sub-prime mortgage crisis forced deleveraging by hedge funds and other commodity investors. The collapse of mortgage-backed securities and other derivatives put credit markets into cardiac arrest. The revelation that even those who had invented them did not understand, could not explain, and had no way to cover the tens of trillions of dollars of credit default swaps they had exchanged discredited financial institutions everywhere. The housing market collapsed amidst a rolling fusillade of foreclosures. What confidence remained in US financial markets has just been dealt a further heavy blow through the discovery that Mr. Madoff — living up to his name — had made off with $50 billion or so in an unprecedentedly immense Ponzi scheme that had escaped regulatory detection for forty years. The scams are beginning to look like they’re endemic. The latest to be outed is Stanford International Bank.

The response of governments to the ensuing global crash and slump has everywhere been the same. First, to try to save banks from the consequences of their own greed and folly, and then to spend a whole lot of money to stimulate job creation, or at least retard job destruction. Where financial institutions have approached insolvency — mainly here and in Europe — governments have made massive injections of equity. In our case, this investment has been entirely financed through new public debt, much of it bought by foreigners. Huge stimulus packages have been devised to sustain or increase employment. Ideally, these programs conform to three criteria: (1) They create immediate domestic employment opportunities; (2) They constitute investments in infrastructure or other long-term projects that contribute to national economic efficiency and competitiveness; (3) They do not entail much of an increment in continuing program obligations and hence do not impose large charges on future revenue.

The poster child for a stimulus package most closely meeting these criteria is China’s, which will apply an amount equivalent to 8 percent of this year’s GDP almost entirely to these purposes. We must hope that the congressionally crafted tax cut and stimulus package here does the job. I don’t want to comment on the extent to which it meets the criteria I have suggested. But someone I know said it reminded him of nothing so much as Mark Twain’s observation that “it could probably be shown by facts and figures that there is no distinctly native American criminal class except Congress.”

I know some of you have heard and others have read my remarks to other gatherings. I won’t bore you by replaying the list of challenges we face or the reasons we need to create new global financial institutions, but I do want to repeat a key point I made at Costa Mesa in November. “The fact is that we have kept huge amounts of debt off our books while running our government, paying for our wars, and financing our consumer society with credit rollovers — increasingly, rollovers from foreign lenders. The bailouts and stimulus packages we have recently conceived just repeat this practice. We have formulated no plans to pay for them. Instead, we intend to finance them with more borrowing. And we expect foreigners to continue to buy at least half the resulting growth in our ballooning national debt.” We still have no credit work-out plan to reassure them of our long-term solvency. The recent drop in T-bill prices and resulting rise in interest rates on long-term US debt, as well as other developments, suggest that foreign investors are beginning to price in the obvious risks that this signals.

All this is isn’t news. It is well understood by all of you here. While the crisis has yet to run its course, I think we can already see some elements of its likely consequences.

First, the discrediting of the American free market economic system and its institutions means that countries will no longer seek to emulate us. There is no obvious candidate yet to succeed the United States as a universal economic model. Many alternative systems are therefore likely to emerge. The Eurozone, with its big bureaucracies and interventionist economic architecture, seems likely to spread its pattern more widely. Others will seek to duplicate China’s peculiar combination of exuberant entrepreneurship and Communist capitalism. A few may follow the Russian pattern of harnessing oligarchs to national economic purposes through government-operated protection rackets. Perhaps, under the current shock treatment, Japan will overcome its political constipation and economic cramps and again come up with a model that inspires others to copy it. Still others may in time find merit in the model of socialized banking and subsidized capitalism the United States is now experimenting with.

The one thing that seems certain is that there will be many national experiments in economic organization. They can be expected to have little in common except varying degrees of state control of the heights of the economy, a lot more policy-directed and less risk-based lending, the blurring of the distinction between the state and private sectors, intrusive state regulation of the economy, greater economic nationalism, and reduced protections for private property rights.

What this may mean for rates of economic growth is unclear, but the greater politicization of economic decision-making that it implies points to increased risk for investors on many levels, including less predictable rates of return on investment, an enhanced probability of insider deals that disadvantage foreigners, and the occasional nationalization of foreign investments.

Second, all things being equal, low-leveraged economies — like China, Germany, and India — seem likely to come out much stronger than highly leveraged ones like our own. They have the money to spend on human and physical infrastructure to enhance their national competitiveness. But China, in particular, faces a requirement to boost consumer spending so that domestic demand can replace shriveled foreign markets for its products. To do that, it must create the social safety net and welfare system it has lacked. Without this, the only protection Chinese have from serious illness, unemployment, or insecurity in their old age is personal savings; they will continue to save rather than consume. If US consumption, at more than 70 percent of GDP, has been excessive, Chinese consumption, at 36 percent, remains grossly below what both it and the world need it to be.

As an adjunct to China’s stimulus package, its government has therefore instituted a national health insurance plan that extends coverage to all citizens. China also needs to plus up its pension plans. Its social security system is almost ready to go. In future, Chinese investment officers will be challenged, as you now are, to meet fiduciary requirements by squeezing performance from an unusually difficult market. You in this room are the best in the world at that. I am looking forward to your insights into the current investment climate and how to cope with it. I am sure that our foreign colleagues, especially those from China, are even more eager for your advice.

Many years ago, it was said, ‘only capitalism can save China.’ Now, it appears that only China can save capitalism.

Third, a lot of deglobalization in both the commercial and financial sectors seems likely to take place as different national and regional economic models emerge. China is still the “Middle Kingdom.” Globalization has recently made it the “middle factor” in a myriad of global supply chains. These supply chains are now sagging, along with the demand for imports they fed here, in Japan, and in Europe.

With the failure of efforts to liberalize trade at the global level through the Doha Round, regional economic integration has emerged as a substitute. The EU continues to achieve success in the economic integration of Europe. Latin America has been crafting economic groupings that deliberately exclude North Americans and others. Asian governments are accelerating their plans for regional economic integration. The key to success in the Asia-Pacific region will again be the development of a much larger consumer market in China, something that is entirely possible and that the Chinese government is committed to creating. There is no apparent alternative to this. Japan is maxed out on consumption and India remains relatively closed to imports. China seems destined for a much larger economic and financial leadership role in the Western Pacific.

Fourth, some sort of worldwide successor to the failing dollar-based system may emerge from the April G-20 summit in London, but at the moment the trends point to uncontrolled diversification away from the dollar amidst creeping regionalization of currency matters. It is becoming apparent that the US must print trillions of new dollars to buy those portions of our debt that foreigners will not and to fund the Fed’s liquidity programs. This is driving many away from the view that US government debt is a safe haven. They are searching for alternatives to T-bills. (This accounts, for example, for China’s decision to tap its dollar reserves to bankroll natural resource acquisitions by its companies. So far this month, such deals in the energy sector alone amount to $41 billion.) The dollar will certainly remain primus inter pares among the world’s currencies but it may not survive the global slump as the universal reserve currency of first resort.

The euro has already emerged as the dominant currency in Europe and adjacent areas and as a robust supplement to the dollar farther afield. The Gulf Cooperation Council, some of whose member states have already abandoned their dollar pegs, is set to create a common currency that could end up replacing the dollar as the unit of account for the energy trade. Without anyone much having noticed, China has worked out currency swap arrangements with Hong Kong, Macau, Taiwan, and key countries in Southeast Asia that enable them to bypass the dollar and to settle transactions in otherwise unconvertible Renminbi yuan. The Japanese yen is, of course, fully convertible, but Japan too is building swap arrangements with key countries in its region, like Indonesia. China, Japan, and south Korea have established a three-way swap mechanism.

Willy-nilly the dollar seems to be in the early stages of being dethroned as the unit of account for international transactions. At a minimum, its role in international trade and finance is evolving in ways that are not advantageous to anyone with an interest in dollar hegemony, which certainly includes me, as an American citizen, and, I suspect, almost everyone in this room. The implication, among other things, is the potential end of the dollar seigniorage created by the unique role of the dollar as the post-gold-standard universal medium of exchange. I am speaking here of the ability to print little green portraits of dead presidents and to pocket the difference between their printing cost and their face value. It also follows that the US ability to impose unilateral sanctions on countries like Iran, Sudan, and North Korea through restrictions on their dollar transactions is rapidly eroding. No doubt there are other implications that, as a non-economist, I do not understand. I await enlightenment.

Fifth, New York has unfortunately emerged as a global symbol of greed, folly, chicanery, and incompetence. The aversion to it as a financial center and to the highly leveraged investment approaches associated with it seems likely to last for a while. This and other factors will accelerate the development of other focal points for money management, some of them closer to the new concentrations of global wealth in China and the Arab Gulf.

The Arab world, which straddles Europe, Asia, and Africa and which contains the majority of the world’s hydrocarbon reserves, is becoming one of the world’s financial centers of gravity. Oil and gas prices are currently depressed due to sagging demand amidst ample supply, but demand seems very likely once again to exceed supply by the last half of 2010. This should be reflected in a rise in oil futures toward the fourth quarter of this year. The accelerating shift of global wealth to energy producers that the economic crisis has interrupted will then resume. This is why, when China Construction Bank recently set up branches overseas, it did so in Dubai and Doha as well as in London.

New York is going to have to try harder to retain a major role in global finance. New York — and the American hinterland it intermediates — will not prosper without serious efforts to increase competitiveness. Among the more obvious options are curbing anti-Muslim pronouncements, easing visa issuance, restrictions on class action suits, adopting more flexible and less burdensome accounting requirements, and reforming regulations. It will not be enough simply to restore confidence in US regulators’ capacity to intercept the Enrons and Madoffs in our midst before they can bring off their scams.

Leverage is now a bad word in many circles. As a corollary, Islamic banking, with its nominal avoidance of leverage, is likely to get a big boost. Already, London is emerging as a major center of such banking. Islamic banking is spreading throughout Asia. Is anyone in the US even thinking about Islamic finance and its potential?

Sixth, infrastructure is the asset class that will be the major beneficiary of stimulus packages. It presents the greatest potential for profitable investment over the next few years. With other asset classes showing poor results, global investors are likely to focus on infrastructure, for which demand remains relatively strong and which is large, tangible, stable, and relatively predictable in the long term. The US alone has a $2 trillion deficit in infrastructure investment.

All this means that construction companies and related industries, transportation, and telecommunications are likely to prosper. So are companies involved in environmental remediation, other aspects of the emerging green economy, and agriculture. By 2020 today’s 30 million refugees from climate change are likely to have become well over 150 million. By 2030, without massive new investment, nearly 4 billion people will live in areas of severe water stress. By that same year, energy demand will have risen 45 percent from current levels, with 87 percent of the increase occurring outside the industrial democracies.

Last but not least, nothing on the horizon will significantly weaken US military prowess in relation to other great powers, despite the certainty of a drop in US defense spending. But what’s happening in the global economy will obviously have differential effects on national wealth and power. As I have suggested, it will leave some countries invigorated and others weakened.

Hard times have their silver linings in terms of promoting efficiency, if sensible policies permit. The question is not whether the United States or another country can turn adversity to advantage but how we respond to the challenges we face. It is useful to speculate about what could happen as a result of the crisis in which we now find ourselves. Only by doing so can we hope to craft policies that avoid worst outcomes and improve the chances that better scenarios will emerge. The keys are first, how we and other countries adapt to the new economic circumstances and, second, what we do by way of a collective response to mounting environmental challenges.

There is a lot for Americans to learn from what others are doing to rebuild financial confidence, create jobs, boost competitiveness, and green economies. If there were ever a moment in our history when we must be alert to innovations and the successes and failures of friends abroad, this is it. One of the few positive consequences of our current difficulties is that they are pressing us to set aside complacency and abandon arrogance. We need to be both more alert and more humble. But, then, we have a lot more to be alert and humble about than we once did. President Obama and his cabinet have begun a serious effort to restore lapsed partnerships and cooperation with foreign nations. That is good. There is a lot of fossil friendship and admiration for the United States out there to tap into. It’s late, but not too late, to do so.

In my view, the crash and its consequences greatly increase the value of transnational gatherings like this. The opportunities PPI affords for exchanges of experience and views among investment officers from the public and private sectors of the many countries and institutions represented here are unique. I will be listening especially carefully over the next few days. I have never attended a PPI meeting at which I did not have what I thought I knew corrected, put in broader context, and recalibrated in terms of importance. I do not expect to be disappointed at this roundtable. I do not know about you but I, for one, need all the help I can get to understand what may be in store for us, what it may mean, and what might make one scenario or another more or less likely to occur.

I apologize for taking so much of your time on a pretty depressing topic. Even non-economists can be dismal, it seems, when they try to reason about economic trends.

I have been much honored by your attention this evening. I hope that what I have said will help to stimulate a lively dialogue over the next two days.

Thank you.

Ambassador Chas W. Freeman, Jr., USFS (Ret.)

La Jolla, California

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