Twenty years ago, writing in his seminal work, ‘The Alchemy of Finance,’ George Soros, probably the world’s most famous (or to some, infamous) speculator, was at pains to point out that markets are not efficient
They cannot achieve equilibrium and overshoot continuously by over-supplying or under-providing any given good or service. This led to a ‘dynamic disequilibrium’ and always resulted in bubbles, booms, recessions and downturns.
Today, this is a mainstream view. Many now accept that markets are in a permanently quixotic quest for efficiency, so it’s fair to say that at any stage, the world economy is unbalanced. But that does not mean that it is unstable. In recent years, there has been an ominous change. Volatility has been growing, the wobbling, shown in America’s sub-prime liquidity crisis, has begun. In 2007, the world economy could lay claim to $167trn of financial assets.
Those assets are looking seriously overweight in high-risk trailer trash debt, Anglo-Saxon and Iberian Real Estate and above all, US dollars.
But the really big change in the near future will be who will have the most momentum, or ‘the big mo’ behind the next investment wave?
According to an October report by the McKinsey Global Institute, ‘The New Power Brokers of Global Capital Markets’ are increasingly going to be Asian central banks, oil investors (both of which you could categorise together loosely as sovereign wealth funds), private equity and hedge funds. Looking ahead, the projected infusion of capital from these intermediaries means that they are going to take over from mutual funds, pension funds and the banks as the chief arbiters of global capital.
And that’s no bad thing. They will collectively go some way to righting the imbalances of the world economy by seeking an honest return. And we will enter an even more liquid financial world.
Yet there is no escaping the imbalances, the overshoots, in the world economy. The question to ask though is exactly what is causing them?
The main culprits are fixed exchange rates, a liquidity explosion at the bottom, the state ownership of natural resources and above all, a lack of financial imagination. Authoritarian governments have a weakness for fixed exchange rates, believing that they have superior knowledge over the market of what the true value of their currency – and economy – should be.
In China’s case, this tends to favour large exports of manufactured goods, albeit at wafer-thin margins. This has for China created an enormous pool of foreign currency reserves, some $1.2trn. Yet the Chinese implicitly understand that money, even dollars, are not a store of value, merely a transferable token of debt. That’s why they are diversifying out of these dollars, setting aside $300bn for investment purposes – a figure that can only rise.
Meanwhile, the poorer parts of the global economy are woefully short of debt. As Hernando de Soto wrote in his award-winning book, ‘The Mystery of Capital,’ the world’s poorest lack basic property rights, which would enable them to secure debt financing, to raise capital to do anything.
The long-term answer has to be for developing world central banks and governments to return their surplus cash flows from central banks and state-owned natural resources in the form of vouchers or tax cuts to their people. This could engender the evolutionary flexibility and portfolio diversification that is the key to success in the 21st century economy as described by Eric Beinhocker in his excellent book, ‘The Origin of Wealth.’
No question, markets are going to become more and more efficient at allocating capital to maximise returns. That suggests dollars and euros, will lose out in the long-term value stakes to the Chinese Renminbi, physical commodities and emerging market equity. Like the cult exercise regime of Pilates, these wobbles can only make the world economy stronger. And be assured, without them, we’d be all the poorer.