Monday, October 8, 2007

The Globalization of Finance and the New Ugly Americans

The United States won two global wars in the 20th Century. The first was World War II, a struggle against fascism. The economic might of the nation produced 100,000 military aircraft, more than 50,000 tanks, over 100 aircraft carriers, 2,750 cargo vessels called Liberty ships, and enough other resources to support 16 million personnel in uniform. While valor and constancy in the face of hardship are essential military qualities, a steady supply of ammunition and rations, combined with friendly skies above, greatly enhance the prospects of victory.

The second global war of the 20th Century was the struggle against Communism. Although this war involved localized fighting in Korea, Southeast Asia, Afghanistan and southern Africa, along with a bunch of cloak and dagger stuff in Latin America, it consisted primarily of an arms race between the Soviet Union and the United States. At the end of the day, it’s hard to say who might have prevailed in a military confrontation. America dominated the skies, but Soviet submarines were a serious threat. There is no doubt, however, that America’s enormous wealth and technological lead made continuation of the arms race infeasible for the Soviets. The U.S. economy won the Cold War.

After the Iron Curtain fell in 1990, the values of the victorious economy spread rapidly throughout the world. The Soviet command and control economy was largely privatized. The Communists calling the shots in Beijing, with characteristic Chinese pragmatism, became capitalist in all but name, and more convincingly so than the Soviets. Socialist regimes throughout the Third World abandoned attempts to centralize their economies and solicited capital from Western companies and banks.

Stock exchanges sprang up everywhere. Financial markets were globalized. Many foreign nations established independent financial regulators modeled after the U.S. bank and securities regulators. American notions of investment and risk management received acceptance. Just as Roman gods came to be worshiped where Carthaginian armies once held sway, freewheeling American-style finance gained ascendancy.

American financiers were quick to promote their products worldwide. It became possible to buy U.S. stocks and bonds around the globe 24 hours a day. The U.S. Treasury securities that fund the enormous federal deficit were sold heavily overseas. And the U.S. housing market also came to be funded from overseas, as mortgage-backed securities were peddled as ways to safely secure a higher return than U.S. Treasury securities.

Unfortunately, not all of the American financial products worked out well. Mortgage-related losses have caused banks in Germany and the U.K. to effectively go under. Hedge funds in several foreign nations have folded. Many foreign banks have recorded hundreds of millions or even billions of dollars of losses. As we have discussed before (see, mortgage-related investments were created with the sophomoric notion that prices in the real estate market would keep rising, while scant attention was paid to the excessive risk levels that the investments contained. How could the brilliant minds on Wall Street, educated at the finest universities and working for the haughtiest of investment banks, have created such a mess? Did they really believe that the exceptionally favorable conditions of the post-Communism era would last forever?

Any salesperson knows that it can be easier to sell a product to a less knowledgeable customer than one that knows the lay of the land. Could it be that CDOs and other now toxic financial instruments were easy sells overseas when the mantras of asset diversification and risk spreading resonated under the peeling bells celebrating capitalism’s victory? Was the evident superiority of the free enterprise system used too glibly to promote belief in the infallibility of American financial products? Did any of the American bankers selling these products overseas consider the potential for long-term damage to relationships when their customers realized that the American prince was a toad? Or did the pursuit of the biggest annual bonus render all of these considerations immaterial?

A nation’s products, when sold overseas, fairly or unfairly reflect on the nation. Defects in Chinese food products and toys cast China in a poor light, even though the nation as a whole was not responsible for their manufacture. One could reasonably say that the Chinese government should have regulated these products more carefully, and it now may be taking steps toward doing so.

Similarly, defective American financial products, fairly or unfairly, reflect badly on the United States. Foreigners may quietly be saying that Americans were short-sighted and too quick to make light of risk, while looking for a fast buck at the expense of investors from other nations. They might think that U.S. regulators should have been more vigilant in overseeing the highly overpaid financial engineers who created these disasters. Perhaps U.S. regulators are taking steps to do so, although evidence to this effect remains scant.

With the dollar sinking, foreigners have plenty of incentive to shift capital away from American financial products. The stock markets of other nations have grown in the process of post-Cold War globalization, and there are ample investment opportunities denominated in currencies other than dollars for Middle Eastern oil potentates, Asian central banks, Swiss dentists, Japanese housewives, and other holders of excess capital. And don’t be surprised if American hedge funds sneak a peak across the oceans. After all, they won’t be earning that 2% and 20% for long if they don’t generate profits. While the most sophisticated of investors, regardless of nationality, will understand that investments must be evaluated on their own merits, many of the investors injured by the mortgage mess aren't so worldly.

Things in the world of money and finance are often done quietly, behind closed doors. Because the United States remains the world’s financial superpower, foreign criticism of its monetary policies and investment products may remain muted, if for no reason than to keep the financial markets calm. But there would need to be little more than a raised eyebrow from a government official, or a frown from a senior corporate officer, to make money managers worldwide turn away from dollar-denominated investments.

Economic models go in and out of fashion. The more heavily regulated economies of nations like Japan, Korea and, to some degree, Germany, operate better when markets are volatile and economic well-being is unpredictable. In these nations, government regulation, along with cultural restraints, prevent the intrusion of high levels of risk, even though they suppress the potential for the outsized profitability that fuels innovation and investment. Less regulated and more free-wheeling environments, such as America and the financial markets of London, do better when markets are less volatile and times are flush. Under such circumstances, risk-reward ratios swing in favor of taking chances, and lack of restraint and regulation pays dividends. Whither the world economic cycle? Ask three economists, and you’ll get four answers. But the sale of shoddy American financial products will look thoughtless and arrogant to foreigners booking losses, at the same time that those losses and the market volatility they have caused will push the world economy away from the conditions favoring the victors of the 20th Century.

Automotive News: the vehicle for a family of 19.

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