*The dramatic decline in communication costs, as fiber optics spanned the globe, and falling
transport costs everywhere have been additional important spurs to cross-border trade.
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rare until the mid-1990s. It was only then that the globalization of capital
markets began to develop, lowering the cost of financing and thereby augmenting
the world stock of real capital, a key driver of productivity growth.
Many savers, previously inclined, or constrained, to invest within their own
sovereign borders, began reaching abroad to engage a broader choice of
newly available investment opportunities. Given a wider variety of funding
sources from which to choose, the average cost of capital to enterprises declined.
The yield on the U.S. Treasury ten-year note, long the worldwide
benchmark for interest rates, has been on a declining trend since 1981. It
shrank by half by the time the Berlin Wall fell and by half again to its low
in mid-2003.
The resulting advance of global financial markets has markedly improved
the efficiency with which the world's savings are invested, a vital indirect
contributor to world productivity growth.* As I saw it, from 1995 forward,
the largely unregulated global markets, with some notable exceptions, appeared
to be moving smoothly from one state of equilibrium to another.
Adam Smith's invisible hand was at work on a global scale. But what does
that invisible hand do? Why do we experience extended periods of stable or
rising employment and output and only gradually changing exchange rates,
prices, wages, and interest rates? Are we fools to trust such stability when we
see it in the markets? Or, as a newly anointed finance minister once asked,
"How can we control the inherent chaos of unregulated international trade
and finance without significant governmental intervention?" Given the trillions
of dollars of daily cross-border transactions, few of which are publicly
recorded, indeed how can anyone be sure that an unregulated global system
will work? Yet it does, day in and day out. Systemic breakdowns occur, of
course, but they are surprisingly rare. Confidence that the global economy
works the way it is supposed to work requires insight into the role of balancing
forces. (Those forces regrettably seem more evident to economists than
to the lawyers and politicians who do the regulating.)
Today's global "chaos," to use the misapprehension of my finance min
*Even today, a significant fraction of world savings is wasted in the sense that it is financing
largely unproductive capital investment, especially in the public sector.
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ister friend, is without historical precedent. Not even in the "golden days"
of more or less total international laissez-faire prior to the First World War
did global finance play so large a role. As I've noted, the volume of international
trade has been rising far more rapidly than real world GDP since the
end of World War II. The expansion reflects the opening up of international
markets as well as major gains in communication capabilities that inspired
the Economist a few years ago to proclaim "the death of distance." In order
to facilitate the financing, insuring, and timeliness of all that trade, the volume
of cross-border transactions in financial instruments has had to
rise even faster than the trade itself. Wholly new forms of finance had to be
invented or developed—credit derivatives, asset-backed securities, oil futures,
and the like all make the world's trading system function far more
efficiently.
In many respects, the apparent stability of our global trade and financial
system is a reaffirmation of the simple, time-tested principle promulgated
by Adam Smith in 1776: Individuals trading freely with one another
following their own self-interest leads to a growing, stable economy. The
textbook model of market perfection works if its fundamental premises are
observed: People must be free to act in their self-interest, unencumbered
by external shocks or economic policy. The inevitable mistakes and euphorias
of participants in the global marketplace and the inefficiencies spawned
by those missteps produce economic imbalances, large and small. Yet even
in crisis, economies seem inevitably to right themselves (though the process
sometimes takes considerable time).
Crisis, at least for a while, destabilizes the relationships that characterize
normal, functioning markets. It creates opportunities to reap abnormally
high profits in the buying or selling of some goods, services, and assets.
The scramble by market participants to seize those opportunities presses
prices, exchange rates, and interest rates back to market-appropriate levels
and thereby eliminates both the abnormal profit margins and the inefficiencies
that create them. In other words, markets, fully free to reflect the value
preferences of the world's consumers, will tend to equalize risk-adjusted
rates of profit across the globe. Profits above such levels are evidence that
consumers' preferences are being shortchanged. Too low a risk-adjusted rate
of return is often evidence of a waste of productive resources, such as plant
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and equipment. Only when abrupt shifts in human exuberance or fears
overwhelm the market-adjustment process do most imbalances become
visible to all. But by then, they are all too visible.
The rapid pace of globalization of trade is being more than matched by
an expanding degree of globalization of finance. An effective global financial
system is one that guides the world's saving toward funding those capital
investments that will produce most efficiently the goods and services
that consumers most value. The United States, as foreigners are quick to
point out, saves too little. Our national saving rate—a scant 13.7 percent of
GDP in 2006—made the United States, by far, the developed country that
saved the least. Even including the foreign saving that is invested in our domestic
economy, overall investment in the United States, at 20.0 percent of
GDP, was the third lowest among the G7 large industrial countries. But because
we deploy our meager savings very efficiently and waste little, we
have developed a capital stock that has produced the highest rate of productivity
growth among the G7 nations over most of the past decade.
Implicit in the price of every good and service is a payment for financial
services associated with the production, distribution, and marketing of
the good or service. That payment has risen materially as a share of price
and is the source of the rapidly increasing incomes of people with financial
skills. The value of these services shows up most prominently in the United
States, where, as I noted previously, the share of GDP flowing to financial
institutions, including insurance, has risen dramatically in recent decades.*
Information systems that supply unprecedented detail on the state of
financial markets support the ability of financial institutions to rapidly
identify abnormal or niche profit opportunities—that is, those whose risk-
adjusted rates of return are above normal. Abnormal returns in an essentially
unregulated market generally reflect inefficiencies in the flow of the
*Much, but by no means all, of the increased U.S. value-added accruing from financial services
ends up in New York City, the home of the New York Stock Exchange and many of the world's
major financial institutions. But it also is spread across the entire United States, where a fifth of
world GDP originates and must be financed. London, of course, is a growing rival to New York
as an international financial center (by most measures it exceeds New York in cross-border finance),
but almost all of Britain's financial activity originates in London. The financial needs of
the rest of Britain are, in comparison with those of the United States, relatively small.
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world's saving into capital investment. Heavy purchases of those niche assets
restore their pricing to "normal." Although certainly not the objective
of profit-seeking market participants, the resulting price adjustments, to
paraphrase Adam Smith, benefit the world's consumers.
High financial profits have attracted a significant array of skilled people
and institutions. Most prominent is the reinvigoration of the hedge fund
industry. What I remember as a sleepy fringe of finance half a century ago
has morphed into a vibrant trillion-dollar industry dominated by U.S. firms.
Hedge funds and private equity funds appear to represent the finance of
the future. But not just yet. The exceptionally high values the market (that
is, consumers, indirectly) placed on financial services after the mid-1990s
induced many junior partners of investment banking firms to create hedge
fund boutiques. As a consequence, the hedge fund market became temporarily
surfeited in 2006. Funds were forced into liquidation as too many
new entrants tried to harvest the niche profits they saw their predecessors
pick with outstanding success. But what was picked is no longer there; the
easy money is mostly gone, and many of those eager would-be hedge fund
tycoons saw their large new net worths fall sharply. Few on the outside
have shed tears over their plight.
Even so, hedge fund investment strategies continue to be instrumental
in eliminating abnormal market spreads and presumably much market inefficiency.
Indeed, hedge funds have become critical players in world capital
markets. They are said to account for a significant share of the volume
on the New York Stock Exchange, and more generally supply much of the
liquidity in otherwise stagnant markets. They are essentially free of government
regulation, and I hope they will remain so. Imposing a blanket of
costly regulation will succeed only in stifling the enthusiasm for seeking
niche profits. Hedge funds would disappear or end up as undistinguished,
nondescript investment vehicles, and the world's economies would be the
worse for it.
The marketplace itself regulates hedge funds today through what's
known as counterparty surveillance. In other words, constraints are imposed
on hedge funds by their high-income investors and the banks and other institutions
that lend them money. Protective of their own shareholders, these
lenders have incentives to monitor hedge fund investment strategies very
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closely. As first a bank director (at JPMorgan), and then a bank regulator for
eighteen years, I was acutely aware of how much better situated and staffed
banks were to understand what other banks and hedge funds were doing as
compared with the "by-the-book" regulation done by government financial
regulatory agencies. As good as some bank examiners are in promoting
sound banking practice, they have little chance of uncovering most fraud
or embezzlement without the aid of a whistle-blower.
A major failure of private counterparty surveillance was the near-
collapse of Long Term Capital Management, the 1998 financial train wreck
described in chapter 9. LTCM's founders, who included two Nobel Prize
winners, were held in such awe that they could, and did, refuse to offer collateral
to their lenders—a fatal concession on the lenders' part. Before long,
LTCM ran out of opportunities to earn niche profits, as imitators followed
the firm's lead and glutted the market. Instead of returning all (not just
some) capital to shareholders and declaring their mission complete, LTCM's
principals turned into gamblers, making large bets that had little to do with
their original business plan. In 1998, LTCM lost its shirt.
The episode shook the market. But it's indicative of the development
of this sector, and of the financial system generally, that when another notable
U.S. hedge fund, Amaranth, collapsed in 2006 with a loss of more
than $6 billion, the world's financial system registered scarcely a tremor.
A recent financial innovation of major importance has been the credit
default swap. The CDS, as it is called, is a derivative that transfers the credit
risk, usually of a debt instrument, to a third party, at a price. Being able to
profit from the loan transaction but transfer credit risk is a boon to banks
and other financial intermediaries, which, in order to make an adequate
rate of return on equity, have to heavily leverage their balance sheets by accepting
deposit obligations and/or incurring debt. Most of the time, such
institutions lend money and prosper. But in periods of adversity, they typically
run into bad-debt problems, which in the past had forced them to
sharply curtail lending. This in turn undermined economic activity more
generally.
A market vehicle for transferring risk away from these highly leveraged
loan originators can be critical for economic stability, especially in a global
environment. In response to this need, the CDS was invented and took the
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market by storm. The Bank for International Settlements tabulated a worldwide
notional value of more than $20 trillion equivalent in credit default
swaps in mid-2006, up from $6 trillion at the end of 2004. The buffering
power of these instruments was vividly demonstrated between 1998 and
2001, when CDSs were used to spread the risk of $1 trillion in loans to
rapidly expanding telecommunications networks. Though a large proportion
of these ventures defaulted in the tech bust, not a single major lending
institution ran into trouble as a consequence. The losses were ultimately
borne by highly capitalized institutions—insurers, pension funds, and the
like—that had been the major suppliers of the credit default protection.
They were well able to absorb the hit. Thus there was no repetition of the
cascading defaults of an earlier era.
