The Future of Finance
We can already see the outline of the next crisis. The Federal Reserve is, just like in 2002 and 2003, preaching the need for low interest rates in order to recapitalise banks and encourage risk-taking. The deep dangerous flaws in Europe mean the ECB is also going to err on the side of keeping rate low and providing large liquidity. Our financial system, if Europe stabilises this time and avoids an immediate crisis, will be flush with cash.
Loose credit and money will promote good times and generate growth and more surplus savings in many emerging markets. But rather than intermediating their own savings internally through fragmented financial systems, we‘ll see a large flow of capital out of those countries, as the state entities and private entrepreneurs making money choose to hold their funds somewhere safe — that is, in major international banks that are implicitly backed by U.S. and European taxpayers.
These banks will in turn facilitate the flow of capital back into emerging markets — because they have the best perceived investment opportunities — as some combination of loans, private equity, financing provided to multinational firms expanding into these markets, and many other portfolio inflows.
So our banking system will soon become a major creditor and debtor to the growing emerging markets. We saw something similar, although on a smaller scale, in the 1970s with the so-called recycling of petrodollars. In that case, it was current-account surpluses from oil exporters that were parked in U.S. and European banks and then lent to Latin America and some East European countries with current account deficits.
The recycling of savings around the world in the 1970s ended badly, mostly because incautious lending practices and — its usual counterpart — excessive exuberance among borrowers created vulnerability to macroeconomic shocks.
This time around, the flows will be less through current- account global imbalances, partly because few emerging markets want to run deficits. But large current-account imbalances aren‘t required to generate huge capital flows around the world.
This is the scenario that we are now facing. For example, savers in Brazil and Russia will deposit funds in American and European banks, and these will then be lent to borrowers around the world (including in Brazil and Russia).
Of course, if this capital flow is well-managed, learning from the lessons of the past 30 years, we have little to fear. But a soft landing seems unlikely because the underlying incentives, for both lenders and borrowers, are structurally flawed.
Misreading the BoomOur largest financial institutions, in those nations where the sovereign is capable of and sure to back them, will initially be careful. But as the boom goes on, the competition between them will push toward more risk-taking. Part of the reason for this is that their compensation systems will remain inherently pro-cyclical and, as times get better, they will load up on risk. Equity holders will also demand that, since that raises short term returns on equity.
The leading borrowers in emerging markets will be quasi- sovereigns, either with government ownership or a close crony relationship to the state. When times are good, everyone is happy to believe that these borrowers are effectively backed by a deeppocketed sovereign, even if the formal connection is pretty loose. Then there are the bad times — think Dubai World today or Russia in 1998.
The boom will be pleasant while it lasts. It might go on for a number of years, in much the same way many people enjoyed the 1920s. But we have failed to heed the warnings made plain by the successive crises of the past 30 years and this failure was made clear during 2009.
The most worrisome part is that we are nearing the end of our fiscal and monetary ability to bail out the system. We are steadily becoming vulnerable to disaster on an epic scale.
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