This morning’s guest post is from PIMCO Managing Director Paul McCulley.
I got to spend some time with Paul at David Kotok’s Shadow Fed meeting earlier this month in Maine, and found him to be an engaging fellow. His commentary this morning is quite interesting, and hits upon some favorite themes of ours: Was it Bear Stearns that was rescued — or JPMorgan? (who really cared about Bear anyway?) Can the world truly decouple from the US, the biggest global economy? (No). Can we overstate the significance of Real Estate to the economy and broader financial system? (No).
“Has the world grown smaller?”
– Around the World in Eighty Days, Jules Verne, 1873
Not much has changed, yet everything has changed since Andrew Stuart, befuddled by Phileas Fogg’s outrageous proclamation, asked one of the most ignorantly pertinent questions of his time. The decades of the mid-nineteenth century witnessed major advances in transportation technology, including the completion of coast-to-coast railroads in the United States and India, and the opening of the Suez Canal across Egypt. In the 130-odd years since, the world continued to shrink in temporal terms, with air and space travel taking the place of steamers and rail. NASA has designed airplanes to circumnavigate the world in just two hours, and commercial jets can now make the 80-day trip circa Jules Verne in less than 24 hours. While not much has changed in terms of our rate of progress against time, neither Stuart, nor Fogg, (nor the ECB for that matter) could have predicted the effects of a far more important advance underway, where everything has changed.
Information technology, more specifically the development of parallel processing, “gigabit-terabit-petabit” bandwidth and networking logic, is changing the way we conduct our lives today. While jet-setting executives (or policymakers) of this decade can be present in more places in less time than any predecessor, corporate information, corporate processes and corporate controls can now be shared around the world in real time via information superhighways. These advances in information technology are catalyzing the globalization of business and finance in ways far more important to global central banks than something as basic as physical transportation. These advances are driving the age of financial networking, and what has been described by some as leading to the vastly narrowing ecologies of finance.
In particular, information technology advances are dramatically increasing the number of “connections” we are capable of achieving and maintaining in our everyday lives. These connections allow us to specialize and super-specialize not only our manufacturing processes, but increasingly also our service-based processes, predominantly so in financial services. The mobility of capital combined with the mobility of information across countless interconnected nodes, hindered occasionally by politics and the transparency tolerance of various governments, gives the largest holders of capital something of a “God-complex” in today’s global economy. Small banks expand to become mega-banks, regional banks consolidate to become universal banks, and foreign central banks “self-insure” to become sovereign wealth funds. Wealth and capital supercede the common CEO, the everyday purchasing manager, and humble central bankers of today in velocity, mobility and connectivity. Global central bankers in particular need to catch up quickly.
Bear Stearns: Too Connected to Fail
On Monday, March 17, 2008, global financial markets opened to news of a Federal Reserve-enabled rescue of Bear Stearns by JPMorgan Chase. We learned, in the days that followed, of a weekend marathon meeting conducted by Federal Reserve officials to find a buyer for Bear Stearns. Urgency was warranted such that the hyper-connected global financial system might escape the effects of a medium-sized U.S. investment bank filing for bankruptcy and risking reverberations to thousands, nay, millions, of counterparties that were connected to it. Speculation grew of which institutions could be next, and more importantly, of which institutions comprised the Federal Reserve’s “too connected to fail” list. In reality, there was no such list at the ready; however, we can think of several universal banks and investment banks that, by virtue of the network age, play a significantly connected role in global finance such that bankruptcy of one or more would multiply the effects on financial markets globally in a cross-defaulting negative feedback loop.
Bear Stearns fell specifically due to a broadening “run” on its liquidity spurred by increasing skepticism about the value of assets on Bear Stearns’ balance sheet. The Federal Reserve responded with a suite of policy actions that was aimed at shoring up liquidity to the remaining commercial banks and investment banks, but the run on liquidity at Bear Stearns was only a symptom of the real problem incubating beneath it. Unfortunately, the liquidity provisions of the Federal Reserve only succeeded in delaying the process, not in curing it.
Real estate values across the U.S., residential and commercial, continued to deflate post-Bear Stearns. The same went for property prices in the U.K., Spain, Germany, Japan, Italy and Australia. Valuations and the increasing dearth of credit availability were equally to blame for this disease, with the prior a bigger factor in more developed economies, and the latter a bigger factor in more emerging economies. The real rub for policymakers around the world is that no legitimate firebreak was created and held between the cause of the epidemic and its multiplier. The global financial system is “too connected to decouple.” The economics of the oft-cited “hard decoupling” thesis are falling victim to the network effects of the hyper-connected global financial system, and nobody seems to be able to do much about it.
Global Aggregate Demand: Too Connected to Decouple?
Global financial markets and policymakers initially interpreted the
events preceding the rescue of Bear Stearns as a U.S.-centric problem.
The U.S. dollar dropped below 0.63 versus the euro on the day following
the rescue, and the U.S. equity market’s share of global equity market
capitalization touched a lowly 25.5% the same day. The rest of the
world appeared to be in good health, with over-heating growth and
rising inflation the chief concerns of non-U.S. central banks and most
market participants. Network effects and the rising risk of negative
feedback loops notwithstanding, major non-U.S. central banks turned
their attention away from the U.S. asset deflation problem and looked
increasingly to the emerging economies as a source of continued demand
growth, higher commodity prices and rising inflation risks. Most major
non-U.S. central banks actually followed the Bear Stearns rescue by
raising interest rates in an effort to combat the rising risks of
relative price changes in commodity markets and building cost-push
inflation risks. They did not fully understand the deepening
relationships between real estate asset deflation, financial sector
balance sheets, liquidity provisions, and commodity price changes.
There was a misdiagnosis of global hyper-connectivity en masse.
The crux of the disease incubating underneath Bear Stearns is not
the availability of credit or the lack of liquidity. It is the value of
globally-held financial assets, and their credit elasticity to the
broader real estate markets. The lack of early and targeted policy
measures to curb the accelerating deflation in real estate markets
transmitted itself via the hyper-connected global financial system to
all corners of the world. There is growing uncertainty as to the
fundamental trough value of real estate assets, which leads to falling
prices of financial assets connected to real estate, which leads to
further write-downs on the tangible book value of commercial banks and
investment banks around the world. Slowly, what was misdiagnosed
earlier as a U.S.-centric liquidity problem is showing itself to be an
epidemic-like global systemic financial capitalization problem. And,
the credit freeze is suddenly turned on everywhere.
Financial sector incentives and central bank incentives appear to be
increasingly misaligned today. While the Federal Reserve and select
other central banks encouraged the financial sector to use liquidity
provisions and raise capital to make new loans, the cost of capital to
these very same banks and investment banks is becoming increasingly
disconnected from the risk-free rates of capital globally. Financial
sector management teams are relying on central banks to ease the cost
of capital and force-feed the necessary medicine, while central banks
are relying on management teams to self-serve the medicine no matter
how bitter it is. Neither is willing or able to force the other’s hand.
The window to raise “cheap” capital is quickly closing and the endgame
as a result is becoming harder to predict.
The economic result of misaligned incentives and a fundamental asset
valuation problem is the slow-moving spread of tightening credit
conditions across the world. Industrial economies that were previously
seen as healthy and far removed from the U.S. real estate problems are
suddenly showing symptoms of domestic credit contractions and their own
resulting asset and demand disinflations. The negative feedback loop
from a hyper-connected global financial system is surfacing and
downside risks from second-round effects on global aggregate demand are
At the time of this writing, 60–70% of global aggregate demand is
growing below its trend growth rate, hurting global corporate
profitability outside the financial system and encouraging a round of
largely avoidable global cost-cutting and layoffs.
Global Supply Chain: Evolution?
As the global economy prospered
from 2003 to 2007, corporate profitability sky-rocketed due to the
positive feedback loop from a rapidly expanding global financial
system. Aided by low interest rates at the onset, but fueled
fundamentally by archaic leverage rules, pro-cyclical capital rationing
models, significant credit rating innovations, and pure greed in most
real estate markets, global growth surged with increasing shares of
corporate profits to GDP in most countries. This self-fulfilling
dynamic rapidly accelerated the pace of industrialization in emerging
economies, as developed country consumer savings rates dropped to new
lows amidst rapidly inflating asset prices, and demands on global
production capacity increased significantly in a very short period of
time. The result was a deepening linkage between the hyper-connected
global financial system and the increasingly connected global supply
chain from developed country consumers to emerging country producers.
In the pre-BRICs1 era, one could observe the vast majority of the
U.S. supply chain from consumer to producer using the ISM index, its
various domestic components, and select manufacturing data from Europe
and Japan. However, in today’s increasingly connected global supply
chain, these traditional relationships have broken down and are no
longer an effective signal of the depth of the business cycle. They
have been replaced, importantly, by a more geographically diverse map
of consumers and producers, where the same intra-U.S. measures
of the business cycle can be observed across borders and temporally
downstream from the traditional U.S. business cycle. There has surely
been a degree of decoupling, however, to date this decoupling is mostly
temporal in nature because the distribution of wealth across borders is
not yet broad enough to drive a truly diverse global demand function.
Global Central Banks: Disconnected
Global central banks need to better recognize the new world order of
a hyper-connected global financial system and the inescapability of the
coming global profits down-cycle from asset deflation and tightening
credit conditions. Commodity prices, the scourge of central banks all
summer, are showing early but dependable signs of correcting amidst
recognition that global demand growth is indeed slowing to the tune of
tightening credit conditions and a rapidly deteriorating global
profits’ cycle. And it is important for the growing group of affected
central banks not to mistake lower commodity prices for easier
financial conditions. Asset prices are deflating or disinflating all
over the world, and simultaneously driving a deep second-round wedge
into the global demand function via tighter credit conditions. This
dynamic is real and only addressable via coordinated policy actions
from central banks around the world. Central banks need to reconnect
with the global financial system quickly and successfully.
At PIMCO, we are focused on three moving targets in cyclical time.
(1) Calculating the fundamental trough price of real estate markets in
major economies worldwide based on cash-flow yields and
market-equivalent cap rates. (2) Translating the trough price of real
estate into an assessment of financial system losses and the related
need to raise capital before regrowing credit. And (3) observing
closely the second-round negative feedback loops from the continued
tug-of-war between policymakers and the global financial system to the
real economy and back to real estate trough values. Not an easy set of
targets, but a critical set for any investor who wishes to emerge
relatively unscathed from the good old-fashioned Minsky moment in which
we are living.
It is important that central banks and others make their own
assessments of these growing downside risks to global aggregate demand,
and try to force a firebreak between the loss-generating
hyper-connected global financial system and a thus-far vibrant but
rapidly weakening global supply chain. In doing so, it will become
clear that there is an immediate need to address the market costs of
capital, either via lowering the global cost of risk-free capital
further, or via the provision of a coordinated, new balance
sheet. Time is becoming the most essential factor in this delicate
balancing act, as negative feedback loops are in full flow and the
asset deflation disease is spreading to narrow the ecologies of global
Great stuff, thanks Paul!
The Narrowing Ecologies of Global Growth
Paul McCulley and Saumil Parikh
PIMCO, August 20, 2008