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
When things go wrong in any complex interconnected system, the most difficult task is to see what is the root cause of the problem.
The implication in this article is that the root cause is the falling real estate market, although I am not positive, since the article is quite vague about the cause.
I believe the root cause is that salaries of most workers have lagged behind inflation for so long a time period that excessive debt was the only way to keep purchasing power from drying up.
If that is true, then deflation is the only cure. The great depression solved this problem with deflation.
Good article, but I have a quibble.
The world is not getting smaller, it is getting bigger. Globalisation means that we are more interconnected with more people in more parts of the world. In the past, a slump in US houseprices would be bad for the US. This would have knock-on effects for exporters around the world. Now, it has immediate effects on the solvency of not only US banks, but banks around the world. Just look at the possibilities for getting a piece of software work done – in the past you would look around for a local company and if there wasn’t one, you might go national. Now you look at software companies all round the world. Your choice has hugely expanded. This is not a smaller world, it’s a much, much bigger one. A last example. Fifteen years ago, what would your list of holiday destinations have looked like? Would it have included Antartica, Vietnam, China, Russia? There are far more destinations available to you at far lower cost. What you consider as local is a much bigger area. What you consider as accessible is the rest of the world.
Saying the world is smaller is simply implying that more is accessible (as if it were local), via technology, capital flows, lower barriers to entry, etc. It is not to be taken literally. Think of it as a metaphor.
Can someone please explain why, in Chart 1, Japan is shown as RHS when all the others are LHS? Especially since LHS and RHS here are going in opposite directions.
And why are some of the country lines shortened (especially for UK)?
There’s something not quite right about that chart. Missing data and the Japan line is upside down (is this because otherwise it would go against the narrative?).
Am I missing something?
Fred S. But the implications of the metaphor are wrong. The world is getting bigger – small events have bigger outcomes, the process of choosing a supplier is longer and more complicated because there is more choice, a small problem in US real estate is plunging the world into its biggest financial crisis since the Great Depression. If the world was really getting smaller, this wouldn’t be happening. Risk would be spread evenly. The models would have worked. The problem is the world has been modelled as small and simple, in reality it is big and complex. That is why I object to the metaphor.
The corollary question would be « have the financial actors and moreover the banks grown too big?»
Will the next consolidation yet to be taking place be creating more powerful potential future systemic risk by producing more outsized banks unmanageable in spite of all goodwill?
Overall the planet earth is still very large it is only the concentration,density and uniformity in some of its spots which may be disturbing.
Very intelligent analysis…root cause has to be moral hazard, fostered by central banks low interest rate, low regulation policies IMO.
What is the answer? I again propose an Economic Crisis Dream Team (ECDT – as someone helped me name my pet idea) to work through the solutions…Volcker, Shiller, Stiglitz, Roubini, Bogle and Barry to host and moderate. Since it ain’t exactly happening at rapid speed, here’s my answer. In a global economy, a more global-centric monetary policy and regulation is necessary. You can’t change everything overnight, so an evolution plan should be developed. An idealistic ULTIMATE goal, years away, would be one global currency and global regulatory body with representation from countries like an economic Congress.
The titles “narrowing ecologies” and “world grown smaller” led me for one moment to think that the article dealt with the real key issue facing economic thinking, but it completely overlooks it.
The real “ecological” constraint on the global economy is of physical nature, arising from the fact that we live on a finite planet where fossil fuels – on which most critical economic activities have become dependent – are non-renewable and exist in finite quantities, implying that their global extraction rate will inevitably peak (most likely around 2010 for oil) and relentlessly decline thereafter.
Thus, current US (and global) monetary policy would have been OK when the world was far from the physical limits to growth (or in other words, when the world oil production was on the way up to Hubbert’s Peak), and lack of aggregate demand was the factor that prevented economic output (and employment) from growing at their potential sustainable levels. This is no coincidence as Prof. Bernanke’s mindset seems to have been shaped by the study of the Great Depression.
But now that the world economy is bumping against the physical “limits to growth” – most notably, but not exclusively, in oil production – that kind of monetary policy is not just ineffective to increase production (as monetary stimulus cannot reverse the decline of oil fields, it only raises the price of the critical limiting resource) but downright dangerous, in that by stimulating demand generically it promotes misallocation of depleting critical resources and drives society away from the only safe path forward (“safe” meaning minimizing the likelihood of catastrophic societal collapse), which is to reserve fossil fuels for essential uses and start a massive program for implementing renewable energy sources (not corn ethanol!).
Sure enough, whether there is misallocation of resources or not is in the eye of the beholder. If someone in the Titanic had known future events several days in advance, he would have probably built a raft out of the furniture in his room. An unaware passenger would have viewed that course of action as a gross misallocation of resources (until sink day, i.e.).
For a couple of other voices making similar arguments:
The hunt for the guilty continue. Endless discussion from the financial elite about how and why it should be corrected and why it can be returned to the good old days, but somehow they can’t find the right levers
get everybody on the same page and the financial problems continue to roll down hill taking the players with them. So be it.
One of BR’s longest posts. Just ran across this through the FT blogs and supports the idea that everyone is in the same boat. Appears that some of the EU banks are feeding at the ECB teats:
Bank borrowing from ECB is out of control
“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.”
That the focus is on curbing asset deflation rather than dealing with asset inflation is fundamental. When house prices took a moon-shot, few (anyone?) in the financial elite complained.
“There is growing uncertainty as to the fundamental trough value of real estate assets”
That’s hysterical to me. There’s no confusion that house prices are matched to a population’s income and a market’s rents. Just because everyone ignored that for the first part of the decade didn’t make it go away.
“it will become clear that there is an immediate need to address the market costs of capital”
That works if you happen to have or need a lot of money. It does put you on the opposite side of the trade from lots of people who can’t pay more than a certain percentage of their income for where they live. Their immediate need is for lower house prices. It may be that their policy response will be to spend the mortgage money on food and gas when push comes to shove.
What RealThink said – I agree there is an oil connection to the current global conundrum. Since the article takes an historical sweep it’s important to point out that a lot has changed in the world vis-a-vis the old dollar-oil-Europe pricing mechanisms that existed as recently as 15 years ago: Russia is now the expanded EU’s primary supplier (25% oil, half or more natural gas) and China is in the picture as never before (China wasn’t even a net importer during Desert Storm).
This link is an outlier,
can anyone clarify?
Beijing-based ICBC , which has 380,000 staff, is benefiting from huge demand for loans and other banking services from its 2.7-million commercial clients and 170-million retail customers. Lending, investment banking and wealth management all saw significant increases as the Chinese economy continued to outpace much of the rest of the world.
The country’s overall growth cooled slightly in the first half of 2008, after four and a half years of double-digit increases. But China is still expected to produce growth of around 9% to 10%, a rate that would be the envy of many other nations. Fixed asset investment continues to rise, driven by a number of multi-billion dollar infrastructure projects. Bank loans to real estate developers and house buyers are on the up too, soaring 22.5% in the first six months of 2008.
I’ve not seen it mentioned here, but Britain today revised their Q2 GDP figure down from +0.2% growth down to 0.0% growth.
my mistake, this is a better quote:
The rise of ICBC — which went public in 2006 with a US$19-billion IPO that was the world’s biggest at the time — is matched by China’s other leading banks. Already this week China Citic Bank Corp and China Merchants Bank have each said their half-year profits rose by more than 100%. China Construction Bank, the nation’s second largest bank by assets, is expected to announce profits have leapt 70% when it publishes half-year results Friday.
Fascinating subplot here, between a larger world and a smaller one. The interconnectedness of communication networks and the velocity of data make it smaller. The resulting increase in information makes is larger and we’re all trying to figure out how to make sense of it and put it into an actionable framework of knowledge.
That the whole world is now our stage is the paradigm — there are no new frontiers of untapped resource to grow into in our traditional understanding of growth. The moral hazard comes from applying an outdated paradigm to a set of circumstances to which the paradigm does not apply.
Upgrading our measurement of the global interconnectedness is essential though I think a global financial regime is overly idealistic, unworkable and unnecessary. What is necessary is to shift our thinking from innovation in an unconstrained world to innovation in a world of resource scarcity where the real constraint will not be energy but water.
Unfortunately, paradigm shifts result in economic pain and dislocation as much because the strange attractor organizing the chaos is not clearly defined. In the same way 40 acres and a mule harked back to a pastoral idealism, the suburban house for all attached to the interstate plays to the passing era of unconstrained innovation. The new paradigm will have a new dream. It’s just not clear yet what that dream will be.
Hopefully we can get through the shift intact!
I’ve been telling everybody for awhile that turning the world into an economic monoculture was not a good idea.
BTW, I vote for “larger” world because to me I’m looking for a description that implies that you have many more inputs into your life – the thing about all the software companies to pick from, for just one example.
Nobody would argue that if you moved from some midwestern suburb to NYC that you would not be in a “larger” world, even if your commute drops from 30 miles each way to 3.
And my standard dig at Washington Consenses economists: The thing about the example of more software companies to choose from – it doesn’t lower, probably raises your risk of picking a really bad one. And makes it much harder to discover that fact, disentangle yourself, and transfer the work elsewhere in this larger, busier world. Somehow the elites never seem to quite get that.
a few months ago, PIMCO disclosed that it had gone on an incredible Fannie and Freddie paper buying spree over the previous few months!
That’s right, into the eye of the hurricane PIMCO went out and intentionally bought debt they knew was distressed, issued by a company that might fail.
This was not done “blind”. It was done by a couple of very intelligent men who have been investing in the debt markets for a very long time and are experts.
So what’s all this really about?
Simple – its about twisting the arm of the government and robbing the taxpayer.
Not because they were bamboozled, not because an unexpected calamity struck these firms, not because of an error.
No, this was a calculated act from the top down – buy a boatload of this debt at distressed prices after the threat has been identified by THEM, then WHINE at the United States Treasury and demand a bailout “or the end of the world will happen while Paulson sits and watches Rome burn.”
In truth if Paulson doesn’t do what PIMCO wants PIMCO will be the one who burns and PIMCO directly bought into a known distress situation!
See, this is where we’ve come to. We are now beyond “moral hazard” and “too big to fail”; we’ve now transmorphed the entire financial system into a mechanism to literally rob the people as institutions intentionally place themselves in harms way and then demand that the government cover a bet they knew was bad when they placed it.
It is one thing to argue that someone is “too big to fail” and that they pose “systemic risk.” We’ve heard that countless times over the last year, and it seems to be the justification for every bailout and proposal that is put on the table – and has been since LTCM collapsed.
But now we’ve seen institutions take it one step further, and intentionally purchase securities issued by firms that they allege are “too big to fail” yet in dire trouble, then scream for the government to come in and bail them out!
Do you understand what’s going on here?
Fannie and Freddie have been running one gigantic hedge fund for the last couple of years. They bought about $500 billion worth of trash ALT-A paper in the 2005-2007 time frame between them, with a goodly amount of “Option ARM” and “Interest Only” loans included. In addition they took in over a hundred billion dollars more from Countrywide and Indymac, most of which was done using “automated approvals” and are in fact stated income loans, although they’re called prime paper.
Institutions like PIMCO, The Chinese and Japanese Central Banks, and others all knew this. This is NOT a surprise to any of them.
They all invested knowing full well that these firms were running with leverage ratios far in excess of anything that could be reasonably called safe. In addition they knew these purchases of garbage mortgages had nothing to do with “sustainable housing” or any such claptrap. Fannie and Freddie were “levering up” and “chasing yield” just like the rest of these market participants and the buyers of their paper knew it.
But the award for “truly outrageous” is reserved for those firms like PIMCO that have bought increasing amounts of this debt since the beginning of the year, knowing full well that it is impaired and that the firms behind it are at risk of failure, purchasing it on the back of being able to FORCE the government to do that which the black print on the front cover of EVERY prospectus says won’t happen.
What you propose sounds like an evangelicals best case scenario. You should run for office, you could probably get a lot of votes with that kind of talk!
Karl Denninger’s comment rings a bell. How many non_US banks are dumping their bad paper on their US subsidiaries for the same reason? I’m being told that HSBC is in good shape, but HSBC USA has a D+ rating.
I concur with Karl D.
PIMCO has been spewing the same self-serving clap-trap for months now. Gross was far too early buying GSE paper and PIMCO has been screaming for help from the Fed and the U.S. Government ever since.
Why does McCulley’s post ignore the probability of $140 a barrel oil as the main driver of the weakness that “mysteriously” sprang up in the world economy after the Bear rescue? Simple. Any policy response to oil prices by the government would do NOTHING to help PIMCO’s positions.
I agree with Philippe.
What is required is a global central bank overseeing all aspects of an increasingly interconnected world financial and economic system. As long as individual countries are allowed to determine monetary and fiscal policy based solely on their parochial interests the world will continue to experience financial crises.
For many years, Soros has been eluding to the need for a centralized regulatory framework to oversee the global financial system in order to prevent financial crisis such as the credit collapse we are currently experiencing. Unfortunately, it appears the world will have to learn the hard way before it finally realizes that the old nation state paradigm is simply no longer viable.
Then, as Denninger correctly observes, organizations like PIMCO will no longer be able to profit from outrageous moral hazard plays on the taxpayer’s dime.
Great piece by Paul McCulley –
One correction to his comments that I would register is that it is my impression that, contrary to first impression, “negative” feedback loops are those that are self limiting and self correcting
while “positive” feedback loops are self reinforcing and perpetuating.
Global warming is a case in point of a positive feedback loop wherein – as ice-caps melt, the polar seas absorb more sunlight and lead to further warming, while as permafrost layers melt, they release stored methane – a considerably worse greenhouse gas, etc…