CHAPTER1 ABERRATIONS. CONUNDRUMS, AND PUZZLES
In the Introduction, I noted that over the last few years, economic and financial issues have arisen that could not be explained using existing models, mindsets, or prior experiences. As a result, they came to be called "aberrations," "conun-drums," and "puzzles," and many in the marketplace dismissed them as being just "noise" and, as such, devoid of meaningful information. But these issues were, in fact, signals of underlying shifts or transformations that have proven to be of great consequence---in particular, as illustrated in the crisis that shook the foundation of the international financial system starring in the summer of 2007. These signals remain significant to investors now and will continue to be so in the future.
Perhaps the most famous reaction to the phenomena of anomalies and inconsistencies was contained in then Fed chairman Alan Greenspan's semiannual monetary report to the Senate. In the February 2005 report, he noted that "for the moment, the broadly unanticipated behavior of world bond markets remains a conundrum." I still remember the reaction on PIMCO's Trade floor when Greenspan used the word "conundrum," Many were struck by how the most-respected, well-read, and influential policy maker of the day did not have an explanation for something as basic as the shape of the U.S. interest rate curve (that is, the "yield curve").
Greenspan was far from alone. Later in 2005, The Economist ran a cover story about the puzzling global economy. A few months later, Larry Summers, the Harvard professor and former secretary of the U.S. Treasury, referred to "an irony of our time" when reflecting on the configuration of global payments imbalances. He was commenting on the large flow of capital from developing to industrial countries, or from the poor to the rich---a flow that runs completely counter not only to what is predicted in economic textbooks but also the logic of rich-poor relationships. Summers observed: "To my knowledge it was neither predictable nor predicted and the implications are large and have not yet fully been thought through," The finance minister of New Zealand was similarly perplexed when asked to comment about the actions of investors in his country. In a September 2006 interview with the Financial Times, he described these investors as "irrational," noting that their investment behavior was consistent with "someone [who] would have to be slightly strange."
For me, the biggest puzzle of all centered on the reaction of investors---particularly the ability and willingness of the financial system to overconsume and overproduce risky products in the context of such large systemic uncertainty. Like others, I was struck by how two phenomena that you would expect to be negatively correlated ended up being positively correlated for so long---namely, on the one hand, the significant fall in the premiums that investors were paid to assume risk and, on the other hand, the investors' desire to assume even more of this mispriced risk.
The dynamics behind this positive correction, which I will discuss in greater detail in Chapter 2, went something like this: Some investors were hesitant to accept the lower expected returns associated with the generalized decline in risk premiums. Accordingly, they tried hard to squeeze out additional returns. Leverage served as the best way to do so: By borrowing, they could put more money to work in their best investment idea; and this seemingly made sense as long as the expected return was higher than the cost of borrowing. In turn, the Leveraged positions pushed risk premiums even lower, encouraging another round of leverage.
That cycle is just one illustration of the amazing sense of calm and self-confidence that prevailed despite the abundance of things that could not be explained. Rather than stay on the sideline until proper explanations emerged, many investors rushed into ever riskier trades and even higher leverage. Wall Street responded by putting the production of ever-more-complex products into overdrive. Many of these products offered investors "embedded leverage," playing directly into the hands of those looking to magnify what would otherwise be for them, low expected returns. And while national and multilateral policy makers expressed a mix of concerns and bewilderment, no meaningful actions were taken to "take the punch bowl away."
A few months later, the world economy found itself in the grip of significant market turmoil. Unlike the majority of the global financial crises of the preceding 25 years, this one was triggered by events in the world's most sophisticated economy, the United States, It impacted segments closest to the monetary authorities---namely, the interactions among banks. The results were bizarre to say the least.
Consider the highly unusual intraday swing in interest rates of over 100 basis points that occurred in the U.S. Treasury bill market, that on at least one occasion, was associated with highly unusual erosions in liquidity and market flows. You would expect such a systemwide event to cause collateral damage or be contagious, perhaps even envisioning people lining up outside banks to pull their money out. Based on recent history, you might also expect the casualties to be in an emerging economy with a weak banking system and not in another industrial country with a sophisticated financial system.
There, was indeed a bank run, but it came from the United Kingdom. The event panicked the government into guaranteeing all bank deposits and triggered an amazing turnaround in the publicly stated policy of a highly respected central bank---the Bank of England. And there was collateral damage to an extent that in years past would have resulted in job losses on the part of ministers of finance and central hankers in emerging economies and in some cases, prime ministers and presidents. But this time, the high-profile casualties were the CEOs of some of the most influential banks in the world and other senior corporate officials.
The list of aberrations goes on. Interestingly, the numerous instances did not involve just one market, one country, or one set of actors. They pertained to several. Also notable was that the more usual tendency of inconsistencies occurring sequentially gave way to the emergence of inconsistencies occurring simultaneously.
It is therefore no suprise that, in the presence of so many anomalies, some conventional approaches to making investments have become less effective. Conventional strategies and business models are no longer adequately capturing the real dynamics that exist in the global economy; and the dominant industry players are being challenged by competitors who once seemed to be undertaken only lower-value-added activities and, as such, were not viewed as influential market participants. At the same time, policy measures and coordination mechanisms increasingly lack relevance and effectiveness.
In the following sections, I will discuss the nature of the aberrations, conundrums, and puzzles that have recently emerged. By focusing on topics that relate to market and policy issues, it will be clear that these inconsistencies contained important signals about underlying global transformations, In the process, I will shed light on the future evolution of the fundamentals that influence expected returns and risk---namely, global growth, trade, price formation, and financial flows.
Global Payments Imbalances and the Role of Developing Economics
Economics textbooks agree that the baseline expectation for the natural direction of capital flows across borders in the global economy is from developed countries to those countries still in the process of developing. The presumption is that because they are capital scarce, developing countries can offer a potentially higher expected return on a unit of invested funds than that offered by developed countries. The argument is based on the relative cheapness of labor in developing countries, as well as the relative lack of sophistication in their financial markets. Both factors serve to enhance the expected return on a unit of capital coming from developed economies.
This natural flow can be interrupted or even reversed by certain risk factors. For example, concerns about barriers to exit---such as capital controls or outright nationalization and confiscation---will discourage the flow of capital to developing countries. After all, why invest in a foreign country if you cannot repatriate the dividends, profits, and remaining capital as appropriate? For those reasons, the overall flow of capital can change directions---often so much so that there are outright large reversals in conjunction with episodes of capital flight as nationals of these countries also seek to protect or disguise their holdings.
As illustrated in Figure 1.1, the last few years have seen a sharp and sustained change in both the expected and historical trends. For example, at the end of the 1990s, the trend of developing countries' registering account deficits over time turned as these countries began to run up sizable surpluses---that is, they saved more than they invested. These surpluses have been large and persistent, resulting in a significant accumulation of international reserves. For example, as of 2007 China's reserve growth had been running at around 10 percent of its gross domestic product (GDP) for three straight years.
Another unusual aspect to these surpluses is that they have been accompanied by a pickup in economic growth and imports, not a decline. This is in stark contrast to past episodes when developing countries had to resort to highly