In Monopoly, the most expensive properties are the dark blue and green ones. If you manage to buy them, then you can leverage them up by building houses and hotels, collecting huge returns. If a parallel can be drawn, that was the banking system in 2005–2007. But it is no longer the case.
Instead, the new banking sector that is evolving is more like the two utilities on the Monopoly board: the water and electrical works. They are cheap to buy and you may still collect a reasonable return, though it is nothing compared with what went before.
Indeed, in the coming years, the banking system will be a shadow of its former self. With regulation more expansive in form and reach, it will be de-risked, de-leveraged and subject to greater burden-sharing. The forces of consolidation and shrinkage will spread beyond banks to affect nonbank financial institutions, as well as the investment management industry.
This situation is a reflection of a broader process being driven by lagged economic, political and institutional reactions to last year’s financial trauma. Indeed, we are experiencing important structural shifts that have long-term consequences – think of a secular transformation of the global economy caused by the fact that notable parts of the system that existed before the crisis broke out can be characterized as having reached a “dead end.”
Democratic societies [will] no longer accept a banking system that privatizes massive gain and socializes massive losses, and rightly soThe global economy, and the United States in particular, was unable to continue on its path due to debt exhaustion and poorly capitalized activities. Yet, it is also incapable of embarking smoothly on a different path, with de-leveraging leading to considerable collateral damage. While none of this is particularly surprising, what is astonishing compared to what I expected when I wrote When Markets Collide is the speed of the transformation. It is as if our journey to a new destination has been placed on fast forward.
The financial market turmoil that started in the summer of 2007 as a problem in the subprime segment of the US mortgage market has morphed into a series of disruptions that have shaken the foundation of our global financial system. These have contaminated housing, finance, the consumer and are now threatening the potency and credibility of the economic-policy-making apparatus and the stability of government debt.
As far as I can see, there are no first-best-policy responses that are readily available and easy to implement. Instead, the economy will continue to struggle, navigating both the adverse implications of last year’s financial crisis and the unintended consequences of the experimental policy responses that governments had to undertake. Given the inevitable socio-political dimensions, this will play out well beyond the realm of the economy, policymaking and markets.
SO, WHAT IS AHEAD?
At PIMCO we talk about a bumpy ride to the “new normal.” What will this be like? For the next three to five years, we expect subdued growth in the context of a shift away from the G-3 and toward the systemically important emerging economies, led by China and India.
It is a world of relatively high unemployment and where the heavy hand of government will be felt in several important sectors. It is also a world in which central banks and treasuries will find it difficult to undo smoothly some of their emergency steps. This has particular consequences in certain countries such as the United Kingdom and United States, where short-term policy imperatives conflict with more medium-term ones. Moreover, the balance of risk will tilt over time in the direction of higher sovereign risk and growing inflationary expectations.
Significantly, the core ofthe global system will be less cohesive and, with the Anglo-Saxon model in retreat, finance will no longer play as pre-eminent a role in post-industrial economies. Indeed, one of the lagged political reactions will be a situation where democratic societies no longer accept a banking system that privatizes massive gain and socializes massive losses – and rightly so.
Financial rehabilitation will happen in the US in the context of low growth and a view toward an eventual inflationary bias. One interesting question concerns the massive amount of fiscal and monetary stimulus adopted by US authorities. Will this erode confidence in the public goods provided by that country to the rest of the world?
One of the starkest images to emerge after the crash of Lehman Brothers is of Mohamed El-Erian calling his wife and telling her to go to an ATM and withdraw cash. When she asked why, he replied, “Because I don’t know if the banks will open tomorrow.” El-Erian, one of the world’s most respected financial and economic analysts, tells the story to illustrate his point that, as he explains it, “this is not a crisis in the system, but of the system.” How this arose, and where he believes it is going in the years to come, is outlined in the award-winning book
(McGraw-Hill, May 2008). When Markets Collide: Investment Strategies for the Age of Global Economic Change
That is, will the dollar remain the world’s reserve currency and will the tradition of deep and predictable financial markets to intermediate the world’s excess savings continue on as before? An erosion of both of these confidence factors would adversely affect inflation dynamics in the new normal.
In its weakened state, the United States can ill afford a reduction in the privileges that come with the provision of the public goods that support the dollar’s reserve-currency status. This issue goes beyond the inflation dynamics. If it is not careful, the United States could lose some control over its economic and financial destiny.
The United Kingdom will also be stuck in a low-growth world, but with greater vulnerability to domestic and/or external financial instability. In the European Union, growth will be hampered by a historical inflation phobia and concerns for the integrity of the European Union itself. Meanwhile, Japan will continue to face growth headwinds as it is too encumbered by fiscal and demographic issues.
Emerging economies will remain the global growth drivers in the years ahead, but we expect them to divide clearly into two distinct groups. Those with weak initial conditions will return to the old emerging market paradigm that alternates between austerity and financial instability. Those with strong initial conditions will maintain their development, but not at the torrid pace of recent years.
The bottom line is that the world has changed in a manner that is unlikely to be reversed fully over the next few years. Put another way, markets are recovering from a shock that goes way, way beyond a cyclical flesh wound. It is not just about the major realignment of the financial system and the extent to which governments have intervened to offset market failures. And it goes beyond the massive increase in government deficits and government debt in virtually every systemically important country in the world.
What makes this transformation an event that we will talk to our grandchildren about is that every level of the global society is facing great challenges in the years ahead: individuals, with those who are least prepared for the extreme change perhaps being US homeowners; companies; national governments and the multilateral system itself.
However, this does not mean that investment opportunities will be limited in the future. Instead, to go back to the Monopoly analogy, it is just that in the new reality, the best investment strategy may not always be striving to buy the prized dark blue and green properties.