Farewell, my country

The ructions in Europe have deeply shaken confidence in the financial markets. Not just the common type of confidence that is affected by a traditional bear market but confidence in being able to understand what is going on. A bear market is just part of the usual cycles that markets go through; they are as predictable as they are depressing. But the fear here is that something deeper and more damaging is occurring.

Fundamental assumptions are being revisited. For example, the chief executive of fund manager Centuria Capital, John McBain, says asset allocation needs to be rethought to take account of the volatility.

He says conventional “time in the market” wisdom, which holds that taking a long-term position will smooth short-term losses, should be viewed with “fresh scepticism” by many investors. (For more on the new wave of asset allocation, see )

The speed of the crisis is disturbing investors. Mark Burgess, chief investment officer for Threadneedle Investors, describes the rate at which the crisis has moved from Greece to Italy, and potentially onto France, as “quite breath-taking and unlike anything I have witnessed in my investment career”.

In truth, the recent events are neither especially new nor surprising. It is just that until the global financial crisis in 2008, currency and banking crises tended to occur in weaker and more peripheral economies. Now, they are happening in the world’s biggest economies or regions and are affecting the world’s biggest savings pools.

What is the cause of such volatility and uncertainty? The financial deregulation that has been prosecuted as an article of faith for about three decades has resulted in massive cross-border capital flows, well over $US3 trillion a day, according to the Bank for International Settlements. This “meta money”, mostly derivatives that are subject to eye-watering levels of debt, was used to cut a swathe through much of the developing world from the mid-1990s through to the middle of this decade: Russia, the Asian financial crisis of 1998 and many countries in South America.

The problems caused by the collapse of hedge fund Long Term Capital Management (LTCM) in 1998 have been forgotten. Former US Federal Reserve governor Alan Greenspan famously had to force the big investment banks to bail out the global system in the case of LTCM. But no lessons were learnt and now there are hundreds of highly leveraged LTCMs.

Often the national governments of the developing economies were “at fault” for their own poor management, just as Greece and Italy are “at fault” for the euro crisis. But the vehicle for their undoing has been massive capital flows. And to date, those financial activities have largely escaped blame.

The Asian countries that were ravaged by the financial markets in 1997 have learnt their lesson. They hold massive foreign currency reserves and are heavy savers – which has been one of the causes behind the current imbalances.

Meanwhile, Europe and the US considered themselves too strong to be vulnerable to these massive financial markets. Now they are learning otherwise. As the economist Kenneth Courtis comments, this is the “big one”, the moment when we find out if governments can deal with the global capital markets.

What is likely to occur? One possibility, floated by Courtis, is that the US Federal Reserve will help Europe, in effect moving towards global government to match global capital markets. China may also see it as in its interest to help Europe. A small tax on financial transactions, usually described as a Tobin Tax, may be imposed to take away much of the capital markets’ weaponry. It is being contemplated in Europe and Britain but not the US.

In the late 1990s, the consultancy McKinsey presciently noted that the rate of financial crises was increasing and predicted that this would continue until about 2020. But the speed has two sides: crises may happen more frequently but recovery also occurs faster. There are unlikely to be decades of 1930s-style Depression because events now move much more quickly.

What we are witnessing is a shift from what Philip Bobbitt, author of The Shield of Achilles, calls the “nation state” to the “market state”. The use of markets to catalyse economic growth requires us to live with markets, especially financial markets, being the centre of power. It will be a new world.

BRW

Comments (0)