I’ve often pondered the pros and cons of the globalization effect of the Internet. The benefit of increased communication and accelerated commerce and the possibilities presented to those in less developed or less powerful economies, should, in my view be considered in the context of the attendant homogeneity of culture and the domino effect of economic or cultural missteps. There is questionable value in the rapid and global rise in Farmville afficianados, or Angry Bird meisters, and there is no doubt that as soon as the USA sneezes economically, the rest of the world catches a cold. On the other hand, the ability for WITNESS to publicize global human rights atrocities, or for democracy seekers in northern Africa to leverage Twitter to further their cause, or for a start-up business in Ireland to harness an investor group on LinkedIn to tap into a support network in Silicon Valley, are each examples of the positive impact of the global network effect. The future will undoubtedly be partly shaped by how we, who are in commerce, collectively manage the mix, maintain a balance, and the extent to which we can adopt a mindset that I would describe as altruistic capitalism. We can do good while we are doing well, and our kids depend on it.
I know this post is a little heavier than usual, and perhaps a little off the track more frequently visited in this blog, but I was prompted to visit this topic after reading an excellent article written by the son of one of my colleagues. Colin Reed (bio below) just recently graduated college, and this summer starts his journey in the commercial world. In this article, not only does he visit a topic of importance, but he also writes well and cogently, showing insights lacking in many far beyond his years. With his permission, I republish the article in full here.
– o – o – o –
If the jabs and gut-shots of the 2008 global financial crisis were not enough to convince markets of the dangers of globalization, then the 2016 financial crisis will be the knock-out punch. In 2021, global markets will be just recovering from a world-wide depression – a downturn that originated from both the popping of a debt super-bubble, and the rapid deflation of asset prices in the BRIC countries. Had it not been for the ever-evolving “global grid” (McKinsey), each of these events might have been relatively contained. Instead, however, globalization of financial markets will be the path by which local recessions end up having an impact on all corners of the globe.
Post the 2016 financial crisis, the world will begin to realize that while globalization is good for business, it is inherently bad for financial markets. Realizing their mistake, governments and market participants will work to move the pendulum back to center – putting check-points in the new global grid, and in some sense hand-cuffing the invisible hand. In the 2021 world, three things will characterize financial markets: the rise of the market state (McKinsey), a higher price for debt, and the lack of a dominant currency. Taken together, these three developments will aide in deglobalizing financial markets in order to add conservancy where it is desperately needed.
Despite the objections of laissez-faire capitalists world-wide, the rise of the state capitalism, or the “market state” as McKinsey calls it, will become the new normal after the 2016 financial crisis. According the Ian Bremmer, “the  global recession [only] accelerated the trend of state involvement in markets as governments around the world spend billions to stimulate growth;” the same will be true in 2016. The problem with laissez-faire capitalism is that it requires there to be both winners and losers. All is well when the loser is a corporation, but when the loser is a state, group of people, or social class, modern society is not ready to deal with that kind of justice. Given that politicians are most often elected by the masses of losers rather than the few elite winners, governments around the world will continue to interfere with financial markets in order to ensure that the losers don’t suffer the fate they actually deserve.
Not only will state capitalism take hold because of political mechanics, but also because it may very well be the dominant political system. In today’s world, we can see that the fastest growing countries – China, Brazil, Singapore, Russia, and South Korea – are all using the state capitalism model. Embracing the G0 mantra (Bremmer), these countries are using capital controls and strict regulation to steer their economies toward success. Compared with what are considered mostly capitalist countries – the US, UK, Germany, Ireland, and Japan – these countries not only suffered less, but recovered remarkably faster. Does state capitalism “stem the rise of globalization, by hampering the flow of ideas, information, people, money, goods, and services within countries and across international borders” (Bremmer, State Capitalism and the Crisis)? Yes it does, but it also “safeguards their domestic political capital,” keeps “hot money” investors at bay, and reduces systematic risk by putting too-big-to-fail companies in the hands of the government. State capitalism will be the new normal, and it will safeguard the world economy from the devastating downturns that a purely capitalist economy with ultimately create.
The second reality that will characterize the 2021 economy is an unprecedented cost of debt due to the lack of an accepted risk-free rate. According to the Congressional Budget Office’s most optimistic projections, by 2021 the US national debt will have risen by $9.8 trillion. With the recent negative outlook issued by S&P, and the current stubbornness of Congress, it is almost a guarantee that the US will lose is AAA rating long before 2021 arrives. With US Treasury yields no longer serving as a proxy for the risk-free rate, the world will realize that perhaps there is no risk-free rate at all. Global finance will have to rethink how it issues debt, how it values companies, and how it assesses risk in the first place.
With this in mind, debt will become increasingly expensive as banks and investors figure out how to value risk appropriately. According to an Economist article, the 2008 financial crisis “is changing the way many financial firms think about risk” (The Gods Strike Back). Investors are starting to realize that their VaR calculations are unreliable; Black Swan events occur more often that they expect; and that risk as a whole has been undervalued for the past century. Once investors grasp this reality, risk premiums will rise across the globe.
The cost of debt will also rise as banks reach debt capacity. According to the Economist special report on debt, the average total-debt-to-GDP ratio in 2008 of the world’s top 10 economies was over 300% (Repent at Leisure). Over the next 10 years, this number will only grow as consumers continue to live beyond their means and governments, acting as state capitalists, continue to pour money into their local economies – at some point the credit will run out. In his paper “The Decent of Finance” Ferguson points out that Bank of America’s 2008 leverage ratio was almost 74:1. While this is one of the most extreme cases, it is no secret that the world’s biggest banks were, and for the most part still are, excessively leveraged. With banks already pushing the boundaries of Basel II capital requirements (not to mention Basel III and the likely emergence of a Basel IV), there is no way banks, or anyone for that matter, can extend the amount of credit needed to fuel the world’s ever-growing addiction to debt.
The third reality that will exist in 2021 is that of a world with no dominant currency; instead the world will revolve around three equally dominant currencies: the US dollar, the Euro, the Renminbi. As discussed earlier, the dollar will see its fall from power due to an increase in US sovereign debt and the subsequent downgrade by rating agencies. As investors begin to lose confidence in the safety of the dollar (especially if the Fed inflates the money supply to reduce the nominal value of the dollar) they will begin to sell dollar-denominated assets, pushing the dollar down.
Even if the US can manage its budget appropriately, China already had the means to unseat the dollar from power. According to Andy Xie, “if stagflation takes hold [or China becomes a net import economy], it will force China to accelerate reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.”
With a collapsing dollar and a rising Renminbi, all heads might turn to the Euro as a safe bet, but that will be far from the case. Despite Niall Ferguson’s bearish view of the Euro (The Euro Will Fail), the Euro will indeed exists in 2021 (spurred on by political mite), but not in the way it was envisioned. In 2021, having seen multiple sovereign defaults, the ECB will have made drastic changes to the eurozone. Realizing that a strictly monetary policy is unsustainable, the ECB will have created a fiscal authority that collects tax from each of the member countries, while some type of political committee then choses how that money is distributed. Still bickering over cultural divides, Europe will be akin to a haphazard Jenga tower on the verge of collapse, rather than the solid tower of economic stability it was envisioned to be.
With three currencies dominating the financial landscape, debt yields at historical highs, and state capitalism the dominant political mantra, many might think the world to be in a dire place. On the contrary, the world is exactly where it needs to be. For the entirety of the 20th century, the world economy experienced abnormal GDP growth rates by taking huge risks without a justified reward, and by gouging on debt whenever productivity ran low. The world was fooling itself, and it has the scares of depressions and recessions to show for it.
In 2021, the world will have shifted the pendulum back to center. Globalization can still exist, but only with a healthy amount of conservatism. There will be no such thing as a G7, G8, or G20, only a G0 (Bremmer). Countries will trade with, invest in, and hold capital from other countries, but when trouble arises it will be every state for itself. There will never be a global currency, just as there will never be a global language or a global government. The only thing that can be called truly “global” is risk itself. After a second global financial crisis the world will wake up from the knock-out punch, see globalization for the dangerous animal it is, and for the first time ever price risk the way it ought the be priced.
Colin Reed Bio: Colin recently graduated from the University of Virginia’s McIntire School of Commerce where he concentrated his studies in accounting and finance. In July he will begin his career as a Financial Analyst for Houlihan Lokey’s Financial Restructuring Group. Outside of academics, Colin has been actively involved in his fraternity, UVA’s club lacrosse team, and the local fire department. He can be contacted at firstname.lastname@example.org