David M. Smick
Today the world financial system is still near a dangerous tipping point of uncertainty and chaos. The mortgage crisis was only the beginning. Yet our politicians, from both political parties, fixate on the trivial. Our financial house is on fire, yet our leaders are squabbling over arranging the furniture in the front parlor. Instead, they desperately need to develop a “big think” doctrine that defines America’s economic and financial future in the world.
The title The World Is Curved is sure to draw comparisons with Tom Friedman’s book, The World Is Flat. Why did you select the title? Why is the world now curved? Was it ever flat?
Friedman brilliantly presents the first installment of the globalization story, concentrating on the revolutionizing (flattening) of the global supply chain. But there is a second installment – the financial side of the story where the world is not flat; The World Is Curved. You can’t see over the horizon. Sight lines are limited. As during the subprime mortgage crisis, we are forced to travel down an endless, dangerously twisting and turning road of volatility with steep valleys and risky mountainous climbs. We can’t see financial risk ahead. A small village in Arctic Norway can see its entire financial future destroyed because its financial managers invested heavily in a Citigroup product called a collateralized debt obligation.
How does The World Is Curved differ from other books about our current economic state?
The book demystifies the complicated and terrifying world of international finance. This is a practical, insider’s guide to the revolution in global financial markets. I offer numerous anecdotes about my behind-the-scenes experiences in the hedge fund world and in key meetings with prime ministers, finance ministers and central bankers, from Alan Greenspan to Ben Bernanke to the European Central Bank’s Jean-Claude Trichet. The book is both frightening yet hopeful.
Why did you feel that now was the time to write this book?
Globalization, the great paradox of our time, has been an impressive wealth-creating, poverty-reducing machine. In the last quarter century of globalized markets, the Dow jumped from 800 to well over 12,000. To match that success the next 25 years, the Dow would have to exceed 170,000. Yet the fruits of globalization are distributed unequally. Globalization itself produces huge pangs of anxiety for average working Americans. Oil and food prices have skyrocketed. There is no denying the globalized financial system both enables and threatens our national well-being. In this year’s election, candidates must confront this paradox.
How would you define the future of globalization?
It depends on how politicians and policymakers respond to the fallout from the Great Credit Crisis of 2007-2008. The subprime mortgage crisis exacerbated an ongoing collapse of confidence in the sophisticated financial instruments banks use to diversify and reduce risk. The Federal Reserve, in particular, was caught asleep at the switch. Ultimately, however, the greed-driven bankers and investment bankers deserve the most blame. They set up dubious, off balance sheet vehicles to hide risk. The lack of transparency created a global crisis of confidence that nearly tanked the world economy and now threatens the future of liberalized capital markets.
Are we still in trouble?
The world still faces a trillion dollar credit problem. When the credit crisis hit in August 2007, the world’s central banks flooded the global economy with liquidity to avoid immediate disaster. Luckily, today’s policymakers have learned from the mistakes made in the 1930s. The Federal Reserve also placed all U.S. financial institutions under the government “safety net.” Sounds reassuring, but the credit contraction is still likely to linger for years, and could become worse if policymakers aren’t careful. In the face of today’s powerful ocean of capital, there are limits to the effectiveness of government solutions.
Are the banks still at risk?
Consider the case of UBS, Switzerland’s largest bank with major links to the United States. Today, UBS’s total financial exposure is more than four times the size of Switzerland’s GDP. Translation: In a crisis, the government couldn’t bail out the bank even if it wanted to. The rest of the world faces a similar scary situation. True, central banks can forever print money to try to prop up the banks, but even then there are limits because of the potential outbreak of inflation.
So what happens when the next financial crisis hits?
The survival of the world financial system, including our ability to protect the savings and livelihoods of average families, depends on an elaborate game of confidence. Confidence comes from market participants believing policymakers know what they are doing in a system of relatively complete and open transparency. Whether we’re prepared for the next crisis depends on the job our policymakers do in restoring confidence.
Why was it so monumental that the Fed stepped in with the Bear Stearns situation?
Friends of mine at the Fed say there was no other choice. I have no reason to doubt them. A collapse of the Wall Street firm Bear Stearns, as the devastation rippled throughout the financial system, would have savaged the pocketbooks and pensions of every working American. Still, policy moves have unintended consequences. The Fed appears to have placed a government guarantee under the entire U.S. financial system, not just the banks. Sounds great, but some new, all encompassing regulatory structure is therefore needed to protect the public interest at a time of financial deleveraging. That means the profitability of the U.S. financial services industry will decline. The bad news is that the health of a nation’s financial industry is key to future levels of entrepreneurial initiative and overall prosperity.
You talk about the “incredible shrinking central banks.” What does the decline in power of the central banks mean for the future of the world economy?
People picture central banks as having magical powers to step in and save the day. Dream on. I have known most of the world’s central bankers in recent decades, including Paul Volcker, Alan Greenspan, and Ben Bernanke. All would admit the power of the central bank is rapidly diminishing. Worse, in the case of the U.S., interest rates have increasingly become a captive of global financial forces. To a certain extent, therefore, Americans are no longer in complete control of their own monetary policy. That is why central banks, led by the Fed, have become a kind of grand global theater. Because the world’s ocean of capital is so huge and powerful, the central bankers have had no choice but to become the lead actors. They use their dramatic skills to try to tease, persuade, charm and bluff the markets. And of course the Lawrence Olivier of this process was Alan Greenspan. It’s not quite like the Wizard of Oz with the little man behind the curtain pulling the levers, but the analysis is not completely off the mark. In the end, the incredible shrinking of central bank influence over financial markets is a primary reason The World Is Curved.
So what’s the future of the world financial system?