THE AGE OF TURBULENCE As China continues its trek toward Western consumerism, its savings rate will fall. And though oil prices are more likely than not to go higher, any increase in OPEC's savings rates is likely to be far less than has occurred since 2001. Implicit in such a scenario is a consequent removal of an excess of saving intentions over investment intentions and, therefore, the lifting of that important factor that has helped suppress real interest rates since early this decade. Moreover, having largely bestowed its benefits, globalization will slow its pace. The recent frenetic pace of world economic growth will decline. The World Bank estimates that annual global GDP growth at mar- ket exchange rates will slow to 3 percent over the next quarter century. Global GDP grew at a 3.7 percent annual rate between 2003 and 2006. The dispersion of current account balances, a function of the pace of the globalized division of labor and specialization, should also slow. The U.S. current account is thus likely to shrink, though aggregate world imbal- ances may not. Other countries could eventually replace the United States as the major absorber of cross-border saving flows. With real interest rates and expected inflation likely to rise on average over the next quarter century, so would nominal long-term rates. The order of magnitude of interest rate change is difficult to pin down because of the uncertainties that a quarter century can bring. But for illustrative purposes, if real rates on ten-year U.S. Treasury notes were to rise by 1 percentage point from today's 2.5 percent (owing to a fall in global saving intentions) and if fiat-money inflation expectations added the 4.5 percentage points it has implied in the past, that would create a nominal yield for the ten-year note of 8 percent. Again, this excludes whatever premium is required to fund the obligations to baby-boomer retirees. But we can take this level as illustrative: sometime before 2030 the world is likely to be trading ten-year U.S. treasuries at a rate of at least 8 percent. This level is only a baseline—an oil crisis, a major terrorist attack, or an impasse in the U.S. Congress over future budget problems could send long-term rates significantly higher for brief periods. There are other threats to the long-term financial stability of the United States and the rest of the world besides a rise in riskless interest rates. A hall- mark of the past two decades has been a persistent fall in risk premiums. It is difficult to discern whether investors believe underlying risks have dimin- 484 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks TH E DE LPH IC FUTU RE ished and hence they do not require the yield premiums over riskless trea- suries that were prevalent in the past, or whether it is a need for additional interest income that is pushing them to reach for higher-yielding debt in- struments. Spreads over U.S. treasuries of CCC-rated corporate bonds (so- called junk bonds) in mid-2007 were mind-bogglingly low. For example, this spread declined from 23 percentage points amid a plethora of junk bond defaults at the end of the recession in October 2002 to little more than 4 percentage points in June 2007, despite a large rise in issuance of CCC bonds. Spreads of emerging-market bond yields over those of U.S. treasuries have declined from 10 percentage points in 2002 to less than IVz percent- age points in June 2007. This compression of risk premiums is global. I am uncertain whether in periods of euphoria people reach for an amount of risk that is at the outer limits of human tolerance, irrespective of the institu- tional environment in which they live. The prevailing financial infrastruc- ture perhaps merely leverages this risk tolerance. For decades prior to the Civil War, banks had to hold capital well in excess of 40 percent to secure their notes and deposits. By 1900, national banks' capital cover was down to 20 percent of assets, to 12 percent by 1925, and below 10 percent in recent years. But owing to financial flexibility and far greater sources of liquidity, the fundamental risk borne by the individual banks, and presumably inves- tors generally, may not have changed much over that time period. It may not matter. As I noted in my farewell remarks to the Federal Re- serve Bank of Kansas City's Jackson Hole Symposium in August 2005, "History has not dealt kindly with the aftermath of protracted periods of low risk premiums." At a minimum, as riskless interest rates rise and risk premiums are purged of the unsustainable optimism they now embody, prices of income- earning assets will surely grow far more slowly than during the past six years. As a consequence of the decline in long-term nominal and real inter- est rates since 1981, asset prices worldwide have risen faster than nominal world GDP in every year, with the exceptions of 1987 and 2001-2 (the years of the dot-com bubble collapse). This surge in the value of stocks, real estate deeds, and other claims on income-earning assets—that is, direct and indirect claims on assets, whether physical or intellectual—is what I desig- 485 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks THE AGE OF TURBULENCE nate an increase in liquidity. These paper claims represent purchasing power that can quite readily be used to buy a car, say, or a company. The market value of stock and the liabilities of nonfinancial corpora- tions and governments is the source of investments and hence the creation of liabilities by banks and other financial institutions. This process of finan- cial intermediation is a major cause of the overwhelming sense of liquidity that has suffused financial markets for a quarter century. If interest rates start to rise and asset prices broadly fall, "excess" liquidity will dry up, possi- bly fairly quickly. Remember, the market value of an income-earning secu- rity is its expected future income leavened by a discount factor that changes according to euphoria and fear as well as more rational assessments of the future. It is those judgments that determine the value of stock and other in- come-earning assets. It is those judgments that determine how much wealth a society has. Large manufacturing plants, office towers, even homes, have value only to the extent that market participants value their future use. If the world were to come to an end in an hour, all symbols of wealth would be judged worthless. Something far short of doomsday—say, a dollop more of uncertainty added to the mix of our future outcomes—and market par- ticipants will lower their bids and will value real assets less. Nothing has to be happening outside our heads. Value is what people perceive it to be. Hence liquidity can come or go with the appearance of a new idea or fear. A related concern in financial markets is the large and continuing accu- mulation of U.S. Treasury securities by foreign central banks, mainly in Asia. Market participants fear an impact on dollar interest and exchange rates if and when those central banks stop purchasing U.S. securities or, worse, try to sell off large blocks of holdings. The accumulations are largely the result of endeavors mainly by China and Japan to suppress their exchange rates to foster exports and economic growth. Between the end of 2001 and March 2007, China and Japan combined accumulated $1.5 trillion of for- eign exchange, of which four-fifths appears to be in dollar claims—that is, holdings of U.S. Treasury and agency securities and other short-term claims, including Eurodollars.* *China has embarked on an announced program to diversify part of its huge foreign-exchange reserves (1.2 trillion in dollars and the dollar equivalent of nondollar assets). 486 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks TH E DE LPH IC FUTU RE Should the rate of accumulation slow or turn to liquidation, there will surely be some downward pressure on the U.S. dollar exchange rate and up- ward pressure on U.S. long-term interest rates. But the foreign-exchange markets for the major currencies have become so liquid that the currency transactions required to implement large international transfers of U.S. dollar deposits can be accomplished with only modest disturbance to markets. For interest rates, the extent of a rise is likely to be less than many analysts fear, certainly less than a percentage point and conceivably much less. Liquidation of U.S. Treasury securities by central banks (or any other market participant) does not change the total amount outstanding of U.S. Treasury debt. Nor does the outstanding amount of securities or other assets that the central banks purchase with the proceeds of their sales. Such transactions are swaps, which affect the spread between two securities but need not affect the over- all level of interest rates. It is similar to an exchange of currencies.* The impact on interest rate spreads of a swap involving a large block of U.S. treasuries by a central bank (or anyone else) depends on the size of the portfolios of the world's other investors, and, importantly, the proportions of those investments that are close substitutes of treasuries with respect to maturity, the currency of denomination, liquidity, and credit risk. Holders of close substitutes such as AAA corporate bonds and mortgage-backed se- curities can be induced to swap for treasuries without undue disturbance to markets. The international financial market has become so large and liquid* that sales of tens of billions of U.S. treasuries, perhaps hundreds of billions, can be transacted without crisis-causing shocks to markets. We have had much evidence of the market's capability to absorb major transfers of U.S. trea- suries in recent years. For example, Japanese monetary authorities, after having accumulated nearly $40 billion a month of foreign exchange, pre- *Such swaps are quite different from the liquidation of equities whose values are falling be- cause the discounted expectations of future earnings are falling. In that case, the overall value of equities declines. There is no offset. It is not a swap. t Aggregate holdings of foreign exchange by central banks and world private-sector portfolios of foreign cross-border liquid assets approached $50 trillion in early 2007, according to the BIS and IMF. Domestic nonfinancial corporate liabilities are also available as substitutes for U.S. treasuries, probably at modest price concessions. Such liabilities net of foreign holdings of the United States and Japan alone amounted to $33 trillion at the end of 2006. 487 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks THE AGE OF TURBULENCE dominantly in U.S. treasuries, between the summer of 2003 and early 2004, abruptly ended that practice in March 2004. Yet it is difficult to find signifi- cant traces of that abrupt change in either the prices of the U.S. Treasury ten-year note or the dollar-yen exchange rate. Earlier, Japanese authorities purchased $20 billion of U.S. treasuries in one day, with little result. While it is conceivable that as part of a financial crisis brewing for other reasons, major liquidations in holdings of U.S. treasuries by foreign central banks could cause havoc, I see even that as a stretch. But that is not the end of financial fears. Along with the dramatic rise in liquidity since the early 1980s has come the development of technolo- gies that have enabled financial markets to revolutionize the spreading of risk, as we have seen. Three or four decades ago, markets could deal only with plain vanilla stocks and bonds. Financial derivatives were simple and few. But with the advent of the ability to do around-the-clock business real-time in today's linked worldwide markets, derivatives, collateralized debt obligations, and other complex products have arisen that can distrib- ute risk across financial products, geography, and time. Although the New York Stock Exchange has become a lesser presence in world finance, its trading volume has risen from several million shares a day in the 1950s to nearly two billion shares a day in recent years. Yet, with the exceptions of financial spasms such as the stock market crash in October 1987 and the crippling crises of 1997-98, markets seem to adjust smoothly from one hour to the next, one day to the next, as if guided by an "international invis- ible hand," if I may paraphrase Adam Smith. What is happening is that mil- lions of traders worldwide are seeking to buy undervalued assets and sell those that appear overpriced. It is a process that continually improves the efficiency of directing scarce savings to their most productive investment. This process, far from its characterization by populist critics as blind specu- lation, is a major contributor to a nation's growth in productivity and its standard of living. Nonetheless, the never-ending jockeying for advantage among traders is continuously rebalancing supply and demand at a pace that is too fast for human comprehension. The trades, of necessity, are thus becoming increasingly computerized, and traditional "outcry" trading on the floors of stock and commodity exchanges is rapidly being replaced by computer algorithms. As information costs drop, the nature of the U.S. 488 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks TH E DE LPH IC FUTU RE economy will change. With investment banks, hedge funds, and private eq- uity funds all seeking niche or above risk-adjusted rates of return, the dis- tinctions between these institutions will gradually blur. So will the defining line between nonfinancial businesses and commercial banks, as the distinc- tion between what constitutes finance and commerce largely disappears. Markets have become too huge, complex, and fast-moving to be subject to twentieth-century supervision and regulation. No wonder this globalized financial behemoth stretches beyond the full comprehension of even the most sophisticated market participants. Financial regulators are required to oversee a system far more complex than what existed when the regulations still governing financial markets were originally written. Today, oversight of these transactions is essentially by means of individual-market-participant counterparty surveillance. Each lender, to protect its shareholders, keeps a tab on its customers' investment positions. Regulators can still pretend to provide oversight, but their capabilities are much diminished and declining. For over eighteen years, my Board colleagues and I presided over much of this process at the Fed. Only belatedly did I, and I suspect many of my col- leagues, come to realize that the power to regulate administratively was fad- ing. We increasingly judged that we would have to rely on counterparty surveillance to do the heavy lifting. Since markets have become too complex for effective human intervention, the most promising anticrisis policies are those that maintain maximum market flexibility—freedom of action for key market participants such as hedge funds, private equity funds, and invest- ment banks. The elimination of financial market inefficiencies enables liquid free markets to address imbalances. The purpose of hedge funds and others is to make money, but their actions extirpate inefficiencies and imbalances, and thereby reduce the waste of scarce savings. These institutions thereby contribute to higher levels of productivity and overall standards of living. Many critics find this reliance on the invisible hand to be unsettling. As a precaution and backup, they wonder, should not the world's senior finan- cial officers, such as the finance ministers and central bankers of major na- tions, seek to regulate this huge new global presence? Even if global regulation can't do much good, at least, it is argued, it cannot do any harm. But in fact it can. Regulation, by its nature, inhibits freedom of market ac- tion, and that freedom to act expeditiously is what rebalances markets. 489 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks THE AGE OF TURBULENCE Undermine this freedom and the whole market-balancing process is put at risk. We never, of course, know all the many millions of transactions that occur every day. Neither does a U.S. Air Force B-2 pilot know, or need to know, the millions of automatic split-second computer-based adjustments that keep his aircraft in the air. In today's world, I fail to see how adding more government regulation can help. Collecting data on hedge fund balance sheets, for example, would be futile, since the data would probably be obsolete before the ink dried. Should we set up a global reporting system of the positions of hedge and private equity funds to see if there are any dangerous concentrations that could indicate potential financial implosions? I have been dealing with fi- nancial market reports for almost six decades. I would not be able to judge from such reports whether concentrations of positions reflected markets in the process of doing what they are supposed to do—remove imbalances from the system—or whether some dangerous trading was emerging. I would truly be surprised if anyone could. To be sure, the "invisible hand" presupposes that market participants act in their self-interest, and there are occasions when they do take demon- strably stupid risks. For example, I was shaken by the recent revelation that dealers in credit default swaps were being dangerously lax in keeping de- tailed records of the legal commitments that stemmed from their over-the- counter transactions. In the event of a significant price change, disputes over contract language could produce a real but unnecessary crisis.* This episode was a problem not of market price risk but of operational risk— that is, the risks associated with a breakdown in the infrastructure that en- ables markets to function. Superimposed on the longer-term forces I've discussed, it is important to remember, is the business cycle. It is not dead, even though it has been muted for the past two decades. There is little doubt that the emergence of just-in-time inventory programs and increasing service output has mark- edly diminished the amplitude of fluctuations in GDP. But human nature does not change. History is replete with waves of self-reinforcing enthusi- *Fortunately, with the assistance of the Federal Reserve Bank of New York, this particular problem is on its way to being solved. 490 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks TH E DE LPH IC FUTU RE asm and despair, innate human characteristics not subject to a learning curve. Those waves are mirrored in the business cycle. Taken together, the financial problems confronting the next quarter century do not make a pretty picture. Yet we have lived through far worse. None of them will permanently undermine our institutions, or even likely topple the U.S. economy from its place of world leadership. Indeed there are currently a number of feared financial imbalances that are likely to be resolved with far less impact on U.S. economic activity than is generally supposed. I indicated in chapter 18 that the unwinding of our current ac- count deficit is not likely to have a major impact on economic activity or employment. The fear that a liquidation of much of China's and Japan's huge foreign-exchange reserves will drive U.S. interest rates sharply higher and dollar exchange rates lower is also exaggerated. There is little we can do to avoid the easing of global disinflationary forces. I view that as a return to fiat-money normalcy not a new aberration. What is more, we have it within our power to sharply mitigate some of the more dire features of the scenario I have outlined above. First, the president and Congress must not interfere with the Federal Open Market Commit- tee's efforts to contain the inevitable inflationary pressures that will even- tually emerge (the members will need no encouragement). Monetary policy can simulate the gold standard's stable prices. Episodes of higher interest rates will be required. But the Volcker Fed demonstrated that it can be done. Second, the president and Congress must make certain that the eco- nomic and financial flexibility that enabled the U.S. economy to absorb the shock of 9/11 is not impaired. Markets should remain free to function without the administrative constraints—particularly those on wages, prices, and interest rates—that have disabled them in the past. This is especially important in a world of massive movements of funds, huge trading vol- umes, and markets rendered inevitably opaque by their increasing com- plexity. Economic and financial shocks will occur: human nature, with its fears and its foibles, remains a wild card. The resulting shocks will, as al- ways, be difficult to anticipate, so the ability to absorb them is a paramount requirement for stability of output and employment. Hands-on supervision and regulation—the twentieth-century financial model—is being swamped by the volume and complexity of twenty-first- 491 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks THE AGE OF TURBULENCE century finance. Only in areas of operational risk and business and consumer fraud do the principles of twentieth-century regulation remain intact. Much regulation will continue to be aimed at ensuring that rapid-fire ; risk-laden dealings are financed by wealthy professional investors, not by the general public. Efforts to monitor and influence market behavior that is proceeding at Mach speeds will fail. Public-sector surveillance is no longer up to the task. The armies of examiners that would be needed to maintain surveil- lance on today's global transactions would by their actions undermine the financial flexibility so essential to our future. We have no sensible choice other than to let markets work. Market failure is the rare exception, and its consequences can be assuaged by a flexible economic and financial system. H owever we get to 2030, the U.S. economy should end up much larger, absent unexpectedly long crises—three-fourths larger in real terms than that in which we operate today. What's more, its output will be far more conceptual in nature. The long-standing trend away from value pro- duced by manual labor and natural resources and toward the intangible value-added we associate with the digital economy can be expected to con- tinue. Today it takes a lot less physical material to produce a unit of output than it did in generations past. Indeed, the physical amount of materials and fuels either consumed in the production of output or embodied in the output has increased very modestly over the past half century. The output of our economy is not quite literally lighter, but it is close. Thin fiber-optic cable, for instance, has replaced huge tonnages of cop- per wire. New architectural, engineering, and materials technologies have enabled the construction of buildings enclosing the same space with far less physical material than was required fifty or one hundred years ago. Mobile phones have not only downsized but also morphed into multipurpose com- munication devices. The movement over the decades toward production of services that require little physical input has also been a major contributor to the marked rise in the ratio of constant dollars of GDP to tons of input. If you compare the dollar value of the gross domestic product—that is, the market value of all goods and services produced—of 2006 with the GDP of 1946, after adjusting for inflation, the GDP of the country over 492 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks TH E DE LPH IC FUTU RE which George W. Bush presides is seven times larger than Harry Truman's. The weight of the inputs of materials required to produce the 2006 output, however, is only modestly greater than was required to produce the 1946 output. This means that almost all of the real-value-added increases in our output reflect the embodiment of ideas. The dramatic shift during the past half century toward the less tangible and more conceptual—the amount of weight the economy has lost, as it were—stems from several causes. The challenge of accumulating physical goods in an ever more crowded geographical environment has clearly re- sulted in pressures to economize on size and space. Similarly, the prospect of increasing costs of discovering, developing, and processing ever-larger quantities of physical resources in less amenable terrain has raised marginal costs and shifted producers toward downsized alternatives. Moreover, as the technological frontier has moved forward and pressed for information processing to speed up, the laws of physics have required microchips to be- come ever more compact. The new downsized economy operates differently from its predeces- sors. In the typical case of a manufactured good, the incremental cost of in- creasing output by one unit ultimately rises as production expands. In the realm of conceptual output, however, production is often characterized by constant, and often negligible, marginal cost. Though the setup cost of creat- ing an online medical dictionary, for instance, may be huge, the cost of re- production and distribution may be near zero if the means of distribution is the Internet. The emergence of an electronic platform for the transmission of ideas at negligible marginal cost is doubtless an important factor explain- ing the most recent increased conceptualization of the GDP. The demand for conceptual products is clearly impeded to a much lesser degree by rising marginal cost and, hence, price, than is the demand for physical products. The high cost of developing software and the negligible production and, if online, distribution costs tend to suggest a natural monopoly—a good or service that is supplied most efficiently by one firm. A stock exchange is an obvious example. It is most efficient to have all the trading of a stock concentrated in one market. Bid-asked spreads narrow and transaction costs decline. In the 1930s, Alcoa was the sole U.S. producer of raw alumi- num. It kept its monopoly by passing on, in ever-lower prices, almost all its 493 This file was collected by ccebook.cn form the internet, the author keeps the copyright. More ebooks visit: http://www.ccebook.cn ccebook-orginal english ebooks [...]... rule of law more generally leading to increasing levels of material well-being is extraordinarily persuasive Formal statistical proof is inhibited by the difficulty of measuring quantitatively subtle changes in the rule of law But the qualitative evidence is hard to deny The widespread dismantling of much of the apparatus of state control and its replacement with market-based institutions appears invariably... full-blown market globalization The control of governments over the daily lives of their citizens has dramatically waned as market capitalism has expanded Gradually, without fanfare, the voluntary promptings of individuals in the marketplace have displaced many of the powers of the state.* Much regulation promulgating limits to commercial transactions has quietly been dismantled in favor of capitalism's market... economy of the United States, remains the financial capital of the world London's restoration of its nineteenth-century dominance of international markets began in 1986 with the "Big Bang" that significantly deregulated British finance, and there has been no turning back Inventive technologies have dramatically improved the effectiveness with which global savings have been employed to finance global investment... democracy the largest in the world its economy despite important reforms since 1990, remains heavily bureaucratic Its economic growth rate in recent years is among the highest in the world, but that is off a very low base Indeed, India's per capita GDP four decades ago was equal to that of China, but is now less than half of China's and still losing ground It is conceivable that India can undergo as radical... for the rest of the world, the United Kingdom has had a remarkable renaissance since Margaret Thatcher's decisive freeing up of market competition in Britain starting in the 1980s The success was dramatic, and to its credit, "New Labour" under the leadership of Tony Blair and Gordon Brown embraced the new freedoms, tempering their party's historical Fabian socialist ethos with a fresh emphasis on opportunity... however, we have chosen to strike a different balance in recognition of the chaos that could follow from having to trace back all the insights implicit in one's current undertaking and pay a royalty to the originator of each one Rather than adopting that obviously unworkable approach, Americans have chosen instead to follow the lead of British common law and place time limits on intellectual property... RE The last decade of unprecedented economic growth in much of both the developed and the developing world is the ultimate proof of the dysfunction of a more than seventy-year-long economic experiment The Soviet bloc's stunning collapse led to or accelerated the abandonment of central planning throughout the world, with China and India in the vanguard The evidence of increasing property rights, and the. .. Agenda, to bring the continent's state of technology to world leadership But the program languished and has since been put on hold Without an increase in productivity growth, it is difficult to see how Europe can maintain the dominant role it has played in the world economy since the end of World War II But the emergence of new leaders in France, Germany, and Great Britain may be a signal that Europe... outdistanced those of Germany and France Britain's demographics are not so dire as those of the Continent, though its education of its children has many of the shortcomings of the American system If Britain continues its new openness (a highly reasonable expectation), it should do well in the world of 2030 Continental Europe's outlook will remain unclear until it concludes it cannot maintain a pay-as-you-go... Britain has welcomed foreign investment and takeovers of British corporate icons The current government recognized that aside from issues of national security and pride, the nationality of British corporate shareholders has little impact on the standard of living of the average citizen Today London is arguably the world' s leader in cross-border finance, though New York, by financing much of the vast . Europe can maintain the dominant role it has played in the world economy since the end of World War II. But the emergence of new leaders in France, Germany, and Great Britain may be a signal that. hav- ing to trace back all the insights implicit in one's current undertaking and pay a royalty to the originator of each one. Rather than adopting that obviously unworkable approach, Americans. fear. A related concern in financial markets is the large and continuing accu- mulation of U.S. Treasury securities by foreign central banks, mainly in Asia. Market participants fear an impact