Wednesday, Jan. 20, 2010

Seeing Light Through the Gloom in Davos

In late January, the Graubünden, Switzerland's most easterly canton, is not where you go to see signs of spring. In its high valleys, along whose paths armies trudged from the lowlands of Italy to the German heartland during the Thirty Years' War, snow lies thick on the ground. Off the main roads, hamlets sit silent under the weight of it, reminders that until the 20th century, this part of Europe — so obviously prosperous now — was a rural backwater, its people as much as its livestock spending the long winter in a sort of quiet hibernation.

But as the global business and political élite prepare for their annual trek to this winter wonderland — making the journey from Zurich to Davos by train, car or, if they are still very rich, helicopter — they will think they can detect some signs of life in the ground beneath their feet. Not yet gentians and edelweiss — those are months away. But scrabble under the snow, and you'd find some of those famous green shoots.

They weren't there a year ago. At the World Economic Forum's annual meeting in 2009, the mood was dire. As growth contracted, credit froze and trade evaporated, attendees at Davos fretted over rising protectionism and the loss of confidence in the world's economic and political leadership, lamented the hardship brought upon the poor and unemployed and warned of the unthinkable consequences if the global community failed to take drastic action. Russian Prime Minister Vladimir Putin said the world economy was in "the first truly global economic crisis," one that was "continuing to develop at an unprecedented pace." A rare expression of optimism came from Chinese Premier Wen Jiabao, who predicted that his nation would reach 8% growth in 2009 despite plunging exports and millions of job losses — though he admitted that reaching that target would be tough.

Leaders collecting in Davos for this year's meeting can breathe more easily. The prospects for the world economy have brightened. Trade is recovering, banks are repairing themselves, and consumers are returning to shopping malls. Dominique Strauss-Kahn, managing director of the International Monetary Fund (IMF), said recently that "the recovery goes faster than expected." Wen now appears prophetic, as China is expected to meet or even exceed, his bold prediction of a year ago. The recessions in the world's biggest economies, including the U.S., Japan and Germany, have ended. Even some of the worst-hit are showing signs of life. Taiwan's chip-fabrication labs and LCD factories are humming again after the island's economy experienced record quarterly GDP contractions at the height of the crisis.

Of course, the perfect storm that struck the world economy in 2008 is not yet over. Many of the conversations in Davos this year will concentrate not on the elements of recovery but on the risks that lie ahead. But it would be surprising if the delegates did not also concern themselves with two other matters linked to but distinct from the recession: a change in the intellectual climate in which the global economy operates, and the geopolitical consequences of the crisis and recession.

Walking a Tightrope
In strictly economic terms, it's not hard to display a snapshot of where things stand now. After declining an estimated 2.2% in 2009, the global economy is projected to expand 2.7% in 2010, according to the World Bank. But recovery is fragile. Excess capacity continues to dampen expectations of growth, and the unemployment crisis in the Western world — especially in the U.S. — is likely to get worse before it gets better. The debt overhang from the boom years of the mid-2000s is still there. A recent study by the McKinsey Global Institute analyzed previous periods of deleveraging and found that they often take six to seven years to play out. Charles Roxburgh, the London-based director of the institute, says that in the current crisis, "the process is only just starting or is about to start," which means the world is potentially facing "a several-year period where the deleveraging process will act as a drag on GDP growth." "The worst of the downturn may well be over," Roxburgh adds, "but the impact of this crisis is not over yet."

That's why many economists harbor serious concerns about the strength of the recovery. Stephen Roach, chairman of Morgan Stanley Asia, has maintained that the deleveraging of the U.S. consumer will continue to weigh on global growth. He figures that the bursting of the housing bubble, combined with the recession's shock to employment, will reduce trend growth in real consumption in the U.S. to 1.5% to 2% over the next three to five years, compared with 4% in the precrisis decade. As a result of such headwinds, Roach forecasts, the global economy will experience "the weakest recovery of the modern era," as he wrote in a recent report, with trend growth of world GDP at about 2.5% on average over the next three years. Such an anemic recovery, Roach argues, is close to the "stall speed" for the world economy, making it more susceptible to a double-dip recession — which even Strauss-Kahn of the IMF does not rule out.

The uncertainty about the rebound is complicating the single most pressing issue facing policymakers today: when and how to exit from the stimulus measures governments employed during the downturn. Getting this wrong could be disastrous. Pulling back too soon, before the private sector has regained its muscle, could lead economies to tumble back into recession. Waiting too long risks fueling inflation or asset-price bubbles that could burst down the line. Making matters more complex are the divergent ways in which economies are emerging from the recession. China, worried about inflation and a property bubble, has already begun scaling back its easy-money policies, while Japan, where the main concern is deflation, may require even easier money. Australia has hiked its benchmark interest rate three times, while the U.S. is mulling a second stimulus package.

Whatever the underlying conditions of the world economy, the stimulus will have to end at some point. When that's done, attention will surely turn to the rapidly deteriorating position of public finances, as governments struggle to fund bank bailouts and stimulus programs even as the recession eats into tax revenues. From Greece to the U.S., from Britain to Spain, economies face years of fiscal deficits, the unwinding of which will just add to the sense that the recovery from the Great Recession will be long and slow. We are not over this yet.

Paradigm Shift
A purely economic analysis of the nature of the crisis and the recovery from it is, however, only part of the story. Just as important for the future is a change in the context in which the global economy is discussed.

It is now more than 20 years since Tom Wolfe coined the phrase masters of the universe for the Wall Street wizards he celebrated and satirized in his novel The Bonfire of the Vanities and Michael Lewis detailed the workings of the Street (to those for whom they had been a mystery) in his nonfiction book Liar's Poker. For all that time, the global economy has been shaped by a set of coherent behaviors and beliefs about the virtues of financial capitalism — among them the ideas that markets efficiently price risk; that innovation in financial markets benefits the broader economy and indeed makes it more stable rather than more prone to crisis; that light-touch regulation of such markets is best; and, not least, that those economies that pursue such policies will prosper more than those that do not. Along the way, the financial-services industry became the defining sector of modern capitalism, appropriating an extraordinary proportion of available high-powered human capital — and making many of those who worked in the industry not just rich beyond the dreams of avarice but the heroes of the age.

This worldview has been challenged by the financial crisis and the Great Recession. In the past few years, a series of academic papers and books — one of the most rightfully praised being The Myth of the Rational Market, by TIME contributor Justin Fox — have punctured the intellectual basis on which the explosion of the financial-services industry's innovations rested. But more than that, in recent months, policymakers have cast doubt on the central justification for financial capitalism: the belief that it assists those who work in what used to be called the "real" economy, not just those lucky enough to work for investment banks.

The trend began with a remarkable roundtable interview that the British magazine Prospect conducted last August with Adair Turner, the chairman of Britain's Financial Services Authority. Turner noted that the financial crisis of 2008 amounted to "a fairly complete train wreck of a predominant theory of economics and finance" — the idea that, as he put it, "more markets are always better." Beyond that, Turner went on to challenge the very idea that 20 years of innovation in finance — securitization, derivatives and the alphabet soup of securities that turned out to either be riskier than thought or have no liquid markets — had done the world much good. "The fact that the financial-services sector can grow to be larger than is socially optimal," said Turner, "is a key insight." And if you missed the point, he continued with the observation that some financial innovation amounted to nothing more than "socially useless activity." Where Turner led, Paul Volcker, the revered chairman of the Fed from 1979 to 1987, was quick to follow. "I wish somebody would give me some shred of evidence linking financial innovation with a benefit to the economy," he stated at a Wall Street Journal conference in November, going on to say that his favorite such innovation of the past 25 years was not a CDO or a junk bond but the humble ATM.

In nations around the world — especially in the U.S. and Europe — this intellectual assault on financial capitalism is already bearing fruit. Regulators and legislatures are grappling with ways of recasting regulatory regimes so the financial system continues to provide those flows of capital without which innovation is impossible — what has been called the "utility" aspect of a financial system — while controlling the overleveraged risk taking that can bring a whole economy crashing down. As current Fed Chairman Ben Bernanke told TIME in December, "We do need to have an effective, comprehensive financial regulatory system that will essentially allow us to tame the beast so that it provides the benefits, the growth and development, without creating these kinds of crisis."

A New Landscape
Good luck with that, Mr. Chairman. Given the lobbying resources Wall Street can deploy in Washington — and the difficulty of getting any comprehensive reform of anything through an increasingly dysfunctional American political system — the prospect that a shift in the intellectual climate will lead to meaningful regulatory change is far from assured. We have, after all, been here before. In 1997-98, the time of the Asian financial crisis, Russia's default and the collapse of Long-Term Capital Management, the quintessential highly leveraged, efficient-market-hypothesis hedge fund, there was a similar intellectual backlash against market fundamentalism. It delayed a new wave of risky innovation in financial markets, by, oh, at least a few weeks.

Yet there is a crucial difference between the late 1990s and the present. In the earlier financial crisis, the source of the world's economic problem was widely thought to lie in the developing economies: in Southeast Asian nations whose supposed economic growth had masked a "crony capitalism"; in a Russia that could no longer pay its debts. The U.S., at the height of the long Clinton-era boom, was (as — remember? — the French used to say at the time) the world's hyperpower. It was U.S. action — the willingness of Americans to act as consumers of last resort — that would, and indeed did, pull the world away from the risk of global meltdown.

That is not remotely how things look now. First, the origins of the financial crisis lie in the U.S.; it was Americans who dreamed up the mathematical models that supposedly proved the efficient-market hypothesis and who preached to the world the virtues of light-touch regulation of financial markets. Second, the American consumer, desperately rebuilding domestic balance sheets after gorging on debt for a generation, is tapped out, in no shape to carry the burden of global economic recovery. And third, it is not developing Asia that stands as the exemplar of economic policymaking gone wrong, as it did in 1997; on the contrary, it is developing Asia — China and India especially — that is leading the world into recovery.

That is why the Great Recession is more than an economic phenomenon with its roots in an interesting moment in intellectual history. It is a geopolitical event of profound significance. Not just the U.S. economy and storied U.S. financial institutions have been humbled; so has an American way of thinking about the world. And that will have — has already had — consequences. "In the short term," said Lee Kuan Yew, Minister Mentor of Singapore, last November, "I'm certain that what's happened will accelerate the shift of economic weight from the Atlantic to the Pacific."

The U.S., it bears reminding ourselves, is by far the world's largest, most open and most innovative economy. Any list of the companies most likely to shape society in the next generation would be dominated by American ones. Western Europe remains the most populous region of peace and widely shared prosperity in the world. Asia's continued success is not assured. India faces enormous problems over the next generation: relieving dire poverty, improving a barely functioning education system, building a modern infrastructure. China's astonishing growth in the past year has been fueled by a central government that has forced banks to lend money to enterprises like a drunken sailor. Morgan Stanley's Roach figures that 95% of China's GDP growth in the first three quarters of 2009 was from fixed investments, a sign that China's economy is still led by investment, not consumption. It is only when the Chinese consumer starts spending more and the U.S. one starts saving more (the latter, it should be noted, is already happening) that the imbalances in the global economy will start to even themselves out.

Yet a shift in world economic and political power since the crisis took hold in 2008 is already apparent. It can be seen in the way the G-20, including representatives of the developing economies, has supplanted the G-8 as the primary forum for discussion of global economic issues; and in the new confidence developing nations bring to debates on everything from climate change to global economic policy. The world really has changed since the last time Davos devotees made their way up the mountain. You would not expect it in Switzerland, but those green shoots under the snow of the Graubünden might just turn out to be bamboo.