Thursday, Feb. 04, 2010

The Chill in Davos

Could it be time to exhale? Cautious optimism about the state of the global economy pervaded conversation at the annual meeting of the World Economic Forum, the gathering of the financial and political élite in snowy Davos, Switzerland. On the eve of the conference, Britain announced it had officially (and finally) followed France, Germany, Japan and the U.S. out of recession with positive growth in the last three months of 2009. The same day, the International Monetary Fund raised its forecast for global expansion in 2010 to 3.9%.

But at the opening session, TIME's Board of Economists — a panel that has been notably bearish in the past two years — was not ready to say the global economy was out of the woods. Certainly, the worst of the financial crisis and global recession may be over, but they have left a painful and troubling legacy, and there are still large uncertainties about how the global economy will develop. Among them: whether emerging economies can truly shoulder the burden of recovery, how reform of financial-sector and banking regulation will take shape and the ramifications (both economic and political) of continued high unemployment, especially in the U.S.

The discussion kicked off with a sober view of top-line GDP figures. New York University economist Nouriel Roubini — the Cassandra of Washington Square, who warned long before September 2008 that there was a fundamental instability in the U.S. and global economies — cautioned that the U.S., Europe and Japan could see a fresh decline in growth in the second half of the year as the effect of government stimulus funds tapers off. Since many countries have pursued increased spending, worries about inflation could have an impact on recovery. Financial markets are already beginning to wonder how long nations like the U.S. can sustain huge fiscal deficits. "There is debate about the shape of this recovery," said Roubini. Those who are optimistic think the recovery will be swift and substantial, in a classic V shape. Roubini is in the camp of those who think it will be U-shaped.

Few in Davos dissented from that somber view. But David Rubenstein — co-founder and managing director of the Carlyle Group, a leading private-equity shop — pointed out that buyers were returning. "I'd say it's a pretty attractive time to invest," Rubenstein said, "because prices are relatively low. I think the risk of systemic failure in the United States' financial system or the global financial system is gone. And as a result I think investors are now willing to put capital to work again and to get reasonably attractive rates of return."

Many of those investors will be looking to opportunities in what used to be called the developing world. Yet the panel struck a note of caution there too. Consumers there are not yet ready to carry the load the American consumer did during other periods of global economic turmoil, such as after the Asian financial crisis of 1997. "My sense is that what we've had is a situation of excess demand being created by the industrial countries, and now the hot potato is being shifted to the emerging markets," said Raghuram Rajan of the University of Chicago. "Historically, they've never managed it well." If a country like India, where domestic demand is strong, is to continue to grow, it needs to meet huge challenges posed by inadequate infrastructure and a massive shift of population from rural to urban areas.

Dennis Nally, chairman of PricewaterhouseCoopers, reported the results of a recent survey of nearly 1,200 business leaders worldwide. Some 39% of companies planned to hire within the next year, yet 25% still planned to cut jobs. Cost management remained a global corporate imperative. "That tells you something about how the business community is looking at the next 12 months," said Nally. Without hiring, and the money it puts in consumers' pockets, the recovery in consumption-driven countries like the U.S. is going to get only so far.

That reality — of tens of millions of jobless Americans and Europeans — is shaping up to be a game changer. Ordinary hardworking Joes (and Josefs) watched as one company after another got bailed out by governments while they got little, if any, help with their own economic struggles. "I've had lots of conversations with very, very senior bankers in the last couple of years who said, 'Look, we didn't suffer enough pain. We did wrong, but we didn't get punished,'" said Arif Naqvi, CEO of the investment firm Abraaj Capital, based in the United Arab Emirates.

That's a sentiment large sectors of the developed world understand very well, which is why politicians across the rich world are finding an appeal in populism and why bankers need to understand where it comes from. Those in the banking community who opposed the proposed reforms of the Obama Administration, megainvestor George Soros told a lunch later that day, were "tone-deaf."

Anger and resentment, however, are rarely sensible drivers of policy — especially in an area as complex as financial-market reform and regulation. Taking back fat-cat banker bonuses plays well on Main Street, but it's not a particularly meaningful structural change if what you're going for is preventing the next near collapse of the financial system. Bringing transparency to the shadow banking system is more difficult to wedge into a sound bite — Heizo Takenaka of Keio University in Japan said the need to regulate the shadow banking system was one of the key lessons of his time as a policymaker — but it would be a wiser goal.

Or consider the movement now afoot, thanks to the so-called Volcker rule, to impose size limits on banks as well as prohibit deposit-taking banks from trading on their own accounts. At first blush, that seems like a simple and sensible policy solution, said Rajan. The problem: a quick look at history shows that the sheer size of banks isn't necessarily the culprit. In the 1930s — a time when thousands of small, local banks were going under across the U.S. — the problem was not "too big to fail" but "too many to fail." The right policy solution almost certainly exists deep in the weeds. Yet the more policy is driven by politicians trying to appeal to the (rightfully) outraged crowd, the less room there's likely to be for nuance. "In the democratic process, the support of the general public is very much needed," said Takenaka. "The education of the general public is indispensable."

And here's one of the more difficult lessons to teach: how to coordinate an international response for regulatory change. "In the long run," said Soros, "you can't have global markets without global regulation." That doesn't mean getting there is easy. International cooperation can quickly fall afoul of national politicians anxious to preserve — or at least appear to preserve — sovereignty. And as we have been reminded in the wake of crisis, institutions like the G-20 find it difficult to make even the simplest proposals stick. "At the World Economic Forum," said Rubenstein, "you should always say, 'Yes, multilateralism is possible, and we should come together.' But getting national solutions is difficult enough."

Those difficulties suffused the mood in Davos. It's a certain type of person who comes to this spectacular valley — surrounded by steep mountains, bitterly cold at night. And even those hardy souls this year kept a lucky rabbit's foot in their pocket. "I think most people who find their way to Davos are just naturally optimistic," said Naqvi. "But we've been through such a massive shock in the global system that we can't expect to recover from it overnight."