Proventus: CEO's view
April 7, 2009
As 2008 ended, we looked back on what has been one of the most turbulent years in the financial history of mankind. That is a fact. What is less certain is where we go from here and what the long-term effects will be. Without any doubt the current crisis is the deepest since the Depression of the 1930s. Whereas credit in the US was 265 per cent of GDP in 1929, it reached 365 per cent in 2007. We may be experiencing what is only “the end of the beginning” – the real effects may be monumental.
Regular readers of our annual reports know that we have been observing major structural risks for a number of years. We have had many discussions on the unsustainable development of the Western economies; wage deflation and asset inflation making consumer buying power very unpredictable, the illusory benefits of outsourcing leading to Western companies losing key know-how in production, materials and technology, profit levels being 50 per cent higher in relation to GDP than normal and above all extreme profitability in the financial sector. It is difficult to be wrong – as we have been perceived to be for a number of years, but I am not sure it is much easier to be right…
Much of the discussion at present concerns what we can do and when we will see the turning point. Hopefully we can avoid the extreme economic hardship, nationalism, extremism and totalitarianism to which the events of the early 1930s led. This depends on our ability to avoid the mistakes that were made back then. It depends on our ability to shun protectionism and keep international markets open. It depends on how well we can restore the financial system to full functionality. It depends also on a fiscal response that is sufficiently large-scale, timely and well-directed – as well as our coming to the realisation that although these large fiscal interventions may help us solve our short-term problems, they will only exacerbate the structurally challenging situation by widening budget deficits. Then there are all the new potential mistakes that we can hopefully avoid. The question is not when we will see the turning point, but rather how the new structural context for the global economy will look. The jury is still out.
The mythology of crisis…
As always in times of great economic turmoil there is an abundance of analyses, theories and explanations. Parallel with this we also have to endure the creation of myths, oversimplifications and a certain universal vocabulary that sometimes hides the truth. If anything, the scale of the current challenges makes the mythology even more vivid.
“The financial crisis is spreading to the real economy”. Since this crisis first became visible through the sub-prime crisis and in due course the collapse of banks and financial institutions, there is an implied causality leading from the financial sector into the real economy. In my view, the causality is much more complex than that. The economies in the West have had severe structural problems for decades: the problems have been concealed through easy credit and overly liquid capital markets and the artificial demand that these create. An overextended financial economy has allowed us to pursue much more than we have produced. These structural problems first became visible in the failings of the financial markets, but they have been present for a long time. It is another matter that there are obviously severe long-term real effects from the present lack of financing and liquidity – it is probably the severest supply shock an economy can go through.
“This is the worst recession in decades”. The change in the real economy that we are facing is often labelled a recession – which in my book means a cyclical change in the ever-present cycle of boom and bust. But this is not a recession. What we are witnessing is a monumental structural shift – the unravelling of decades of financial overstretching and credit-financed overconsumption – especially in the USA. Notwithstanding all the bubbles in financial markets, the biggest bubble is the US consumption bubble. In 2005-2007 the US personal savings rate fell below 1 per cent (see footnote 1) and was thus lower than it had been since the 1930s, at a time when an ageing population and underfinanced pensions and social security in fact require savings to be higher than historical levels. The structural shift from consumption to savings that needs to take place in the USA will have enormous effects on the world economy (see below). The realisation of this new reality is already leading to major effects on the real economy (see footnote 2). Some claim that this will benefit the economy, since increased savings will lead to investment and spur growth in the economy. However, I fear that we are in a situation where Keynes's “Paradox of Thrift” applies; i.e. where individual savings reduce the overall level of savings in the economy and savings do not go towards investment because of both a lack of investment opportunities and general caution.
“The world economy is decoupling”. In the years leading up to the financial crisis, there was frequent mention of decoupling, the idea being that as the large developing economies (China, Russia, India, Brazil, South Africa, etc.) grew, dependence on the USA in the world economy would diminish and the global economy would therefore be better equipped to cope with a crisis. This is turning out to be completely false. With the USA representing over 25 per cent of the world economy and consumption being 72 per cent of US GDP, the US consumer in fact indirectly represents over 20 per cent of the world economy. This should be contrasted with the entire Chinese economy being 6 per cent of the world economy and the fact that 40 per cent of the Chinese economy constitutes exports largely driven by the growth in US consumption (see footnote 3). Add to this that the realignment of commodities and oil prices driven by the changing real economy has had a major impact on Russia and the Middle East. This crisis shows that as a consequence of globalisation the global economy is more interconnected than perhaps it has ever been. True, there is a different dynamic in China, driven by urbanisation and development, but this is still far from strong enough to have a major impact on the world economy.
“The crisis is spreading to Europe”. I realise that it is very convenient for European politicians to describe the crisis as a plague that originated in the sub-prime marshes of the American South and is now spreading over the world. The fact is however that even though the problems became visible and acute through the credit crisis, Europe has had severe structural problems for many years. Even if it is only a few European countries such as the UK and Spain that suffer from the kind of overleveraged household economy that we see in the USA, all of Western Europe is suffering from weak competitiveness and a dwindling industrial base. Where the crisis has really come in the form of contagion has been in the less developed economies that because of the flight to safety have seen their currencies collapse and interest rates explode. This is true for Eastern Europe as well as for example Latin America. A friend of mine in the Dominican Republic saw her mortgage rate rise from 12 per cent to 22 per cent in a month. In the last decades, globalisation has roughly divided the world into three groups; the Western world which has benefited greatly, the parts of the developing world that have also benefited greatly (such as China and other emerging industrial powers in Asia) and the part of the developing world which has been too far behind to benefit. Cruelly, all three groups are now suffering from the reversal of this development, even the countries that have never had the benefits.
“The crisis is reducing wealth and income inequalities”. The issue of income and wealth inequality is widely debated. When looking at a broad sample of countries in the world, a simplified conclusion is that in the period 1980-2000, although the inequality between countries has decreased (driven by the emergence of a middle class in China and India), inequality has increased within countries (in some cases this increasing inequality is characterised by increasing incomes on all levels but higher growth for the well-to-do; in other cases it is characterised by falling incomes among the poor). Looking at the developed economies in the West, a large part of the explanation for these increasing differentials is the extreme growth in income among the very top income brackets, largely thanks to capital gains. We now hear voices predicting that this will change with the crisis. However, the prediction is based on the loss of income and wealth for the top earners being the “canary in the coal mine”. Whereas stock prices, bonuses, house prices and executive compensation fall dramatically at an early stage in reaction to financial problems and in anticipation of future problems in the real economy, in the next few years we will see these problems taking the form of higher unemployment and falling incomes for a large number of individuals at the other end of the income distribution. We still do not know how this will affect income distribution over time, but the people who will suffer most are likely to be the low income earners – especially in Western countries, where certain industries (notably the car industry) are experiencing technology shifts and changes in competitiveness that may be permanent.
“Our way out of this crisis depends on our ability to sustain consumption growth”. It is true that consumption makes the world go round. As I have tried to show above, US consumption in particular has been the driving force behind the strong growth in the world economy in the last couple of decades. But we also know that a lot of this growth has come from unsustainable levels of leverage. While salary levels have not kept up with the development of the economy, asset inflation has made us all feel better off. As the structural changes we are now witnessing adjust the balance between spending and savings, we will witness structurally lower consumption levels. Also, these economic changes coexist with ideological changes which make us question our consumption-centred lifestyle. Furthermore, changing perspectives on resource usage, environmental protection and social responsibility will make us question our established attitudes to consumption and our lifestyle. Sustaining consumption growth therefore does not seem realistic or even desirable. We will have to revise our lifestyle and at least in certain parts of the world also accept a different level of economic activity. We can no longer rely on the US consumer to be the motor powering the global economy.
The new political economy; backlash against the open society…
The economic crisis coexists with and impacts politics on national and global levels. As mentioned above, one of the political imperatives to avoid slipping into the closed and nationalistic world of the inter-war period is to protect free international trade. The explosion in international trade in the last decades (world merchandise exports have more than doubled each decade between 1977 and 2007) has led to massive changes in both the developed world and the developing world. The beneficiaries so far (to simplify slightly) have been mainly the emerging middle class of countries like China and India and corporations benefiting from the reduction in production costs. When we look at the citizens of the West, the picture is more complex; while as consumers we may have benefited from lower prices, we may have suffered as employees and citizens as the competitiveness of our industry is under pressure and employment opportunities and salaries shrink. This is reflected in the attitudes toward globalisation. Over 40 per cent of both Europeans and Americans are negative to globalisation and 50 per cent want to keep or strengthen trade barriers (see footnote 4). Also, we see a new political climate where income differences have reached a point beyond the politically acceptable. According to a recent FT/Harris poll, 76-87 per cent of people in European countries, 78 per cent in the USA and 80 per cent in China are of the opinion that income differences are too large (see footnote 5).
These protectionist tendencies are worrying. Unless we devise a new model of globalisation that is good for the many, we will fail to keep the open international system alive. Paradoxically, while globalisation has increased the need for social protection, it has decreased the ability of governments to provide it (because of tax competition, etc). The advantages of globalisation are greater than the drawbacks, but we need to reinvest part of the profits from trade in systems for welfare and social protection for the many. If not, we can expect to see populist moves towards protectionism in many democratic countries. We risk a giant backlash against globalisation, against free trade and as a consequence also, against the market economy and open society. We know that the changing political climate in the aftermath of the Great Depression in the 1930s was one of the driving forces behind nationalism, fascism and eventually, war.
Another assumption that has gained ground over time is that there is a conflict between social protection and free trade. All measures of social protection such as strong unions, minimum wages, welfare systems, etc. have traditionally been seen as having protectionist effects. Perhaps we need to revise this assumption and realise that adequate social protection is conducive to risk-taking and may thus be a necessary prerequisite to positive attitudes towards trade and globalisation. There is no trade-off between protection and openness, they are complements. Social protection is an anti-protectionist measure.
Politically, the risk of a backlash against the open market economy on a national level is paralleled at geopolitical level by the declining legitimacy of the Western liberal model. One of the driving factors of this has of course been the foreign policy and unilateralist approach of the Bush administration. In parallel, the lack of unity and coherence in European foreign policy has meant that there has been no strong advocate or custodian of the liberal model. And now the financial crisis has dealt another devastating blow to the Western model and the so-called “Washington Consensus”.
This legitimacy crisis of the West is leading to major geopolitical shifts. Both the soft power and the economic power of the West are decreasing and at the same time the soft power and economic power of alternative models of modernisation, e.g. China, are increasing (see footnote 6). The increasingly conspicuous and provocative balance of power in multilateral institutions has also led to the rapidly decreasing legitimacy of the UN as well as the Bretton Woods institutions (the widely-quoted fact that Belgium has equal weight to India in the IMF says it all…). As a symptom of these geopolitical shifts, China has gained influence in the UN and is now on the winning side in 74 per cent of human rights-related votes. At the same time, European power is dwindling and as a consequence the UN with increasing frequency lacks teeth where human rights are being violated (see footnote 7).
Hopefully, the new US administration can help restore the legitimacy of the liberal model and also take the lead in finding solutions to some of the global problems that we face. However, Europe has a crucial role to play. Europe is a continent with great potential. We have a long history of established democracies securing norms and political traditions of individual freedom and popular sovereignty. We have a strong tradition of intellectual questioning and curiosity. Our long experience of the free-market economy has cultivated trust and compromise – both central to democratic government – as well as opening up our continent to free trade. Most Europeans live in prosperous societies with equitable welfare systems and far-reaching individual rights. Many people worldwide look to Europe as a model for what they want to become, and they expect European leadership in fields such as human rights, democracy, culture and sustainable development.
Yet, for the first time in many generations, today’s young European parents are not convinced that their children will be better off than they are. Europe is increasingly characterised by fear, polarisation and lack of vision for its future socio-economic wellbeing and geopolitical role. Worries about immigration, welfare and national security are being populistically exploited, rather than addressed. At the same time Europe’s dwindling competitiveness shows the vulnerability of regions losing their industrial base. We need a clearer vision on European competitiveness and on what will create the new industries, jobs and welfare for Europeans as well as a new, united and coherent vision for Europe’s role in the world.
Europe could take the lead in some of the processes that we need in addressing these global economic and political challenges, for example, in reforming multilateral institutions to make them credible, fair and legitimate. We often blame the smaller states in the EU for blocking development, but when it comes to the reform of the multilateral system, what will probably suffocate all such efforts is the refusal of the three largest states to accept that they need to cede their own representation in exchange for stronger European representation. If we do not manage to reform multilateral institutions in the next couple of years, we may lose the opportunity for ever as new regional networks and institutions emerge to replace them.
Short-termism in the long run…
One of Europe’s foremost challenges is the continuous erosion of the old industrial base. Especially in these times of rapid structural shifts, European competitiveness is woefully challenged. This is, as mentioned above, one of the forces driving scepticism about globalisation. But the issue should not be whether globalisation is good or bad, but rather: how do we choose to take advantage of the opportunities offered by technical advances and global markets for the creation of widespread prosperity?
The opportunities hitherto offered have been used for an intensive redistribution of production resources between the East and the West with short-term profitability and returns as lodestars, and with revolutionary changes as a consequence. In the West, the weakened competitiveness of industry has led to factory closures and increased polarisation. In the general eagerness to achieve cost advantages, production has in many cases been relocated without sufficient focus on the retention of key knowledge.
Our self-assured behaviour while sitting in offices in London, Paris or Stockholm devoting our time to strategic development, brand building and communication, while production is being moved to the lowest-cost location, is also in many cases short-sighted. In ten or fifteen years time, by which time production will have been remotely located for a long time, who will have the greatest knowledge of production technology, new materials and processes and from where is it most likely that innovations will come?
In a historical comparison, the capital market over the last decades has been extreme – with low interest rates, reduced risk premiums and enormous liquidity. This gave us a capital market that was principally driven by the supply of capital, not the demand. Almost all capital being managed by institutions circulates in the secondary market in pursuit of rapid returns – capital characterised by short-term valuation, the striving towards high liquidity and remoteness from industrial processes. Monthly benchmarking against profit and liquidity targets and the incentive system for money managers contributed to the short-termism of the institutions. Ironically, the same companies that were very recently targets of shareholder activists pushing for extraordinary cash distribution to shareholders are now seeking state guarantees.
How do we create a capital market that can replace the old industrial base with a new strong base; a capital market that has a sufficiently long perspective to invest in the necessary strategic research and product development initiatives; a capital market which is good not only at exploiting old innovations, but also at creating new ones? When looking at the current state of the Western economies, we must place our hope in technology. For many years now, the management of Western companies has been increasingly focused on efficiency and financial engineering – in short, on maximisation of the return on old innovations. We must turn our focus to developing new innovations and investing in the technologies that have the potential of creating a new industry in the West – such as renewable energy.
We need a capital market in which a greater proportion of the capital has a longer-term perspective and takes greater industrial responsibility. The great paradox in this is that a large proportion of the funds in the market is pension capital that in reality carries commitments that are often over twenty, thirty or forty years. Nevertheless, this capital is often characterised by the same incentive models and liquidity preferences as for the short-term capital; a yearly and quarterly perspective. The capital market has been characterised by mainstreaming rather than diversity – this is also visible in the current liquidity drought. Even with the restrictions present in current regulations on pension funds, the degree of freedom should be sufficient for a course of action that is different to the present one, so that the managers of our pension capital could utilise the opportunity to adopt a long-term perspective.
I am thirty eight as I write this, and my pension savings will have to mature for at least another thirty years. I would very much prefer to see a proportion of my pension capital being invested in structures that contribute to the building of a sustainable and competitive industry in Europe and thereby to long-term prosperity and a more humanistic social climate: building an industry that utilises the opportunities for a global division of labour, but which does so in a sustainable and responsible way; long-term capital that has the time and means to mature and that can afford to fail at times. This could of course be at the expense of short-term returns. But if you, like myself, do not believe that present developments are sustainable, it is even likely that we will achieve better long-term returns in this way.
I am not moralising. This is not a question of altruism, but rather of crass economic reality. It is not that we who are active in the capital market should give up opportunities for business and returns but rather conversely that in order to ensure these for the long-term we need to shift focus from a perspective of between three and twenty-four months to a perspective of between three and twenty-four years. Our pension money is an excellent departure point to lead this change of perspective.
Talking ‘bout my generation
Politics is making a major comeback in the economy and this is warranted. There seems to be a constant cycle between common purpose and private interest – after decades where private interest has taken centre stage, we are now seeing a major comeback of common purpose. This is an acute need in order to deal with challenges to the common good such as social polarisation and issues of environmental preservation and resilience. However, considering the economic challenges, there is a high risk of populism. Politicians being under pressure to “do something” may not be cool-headed enough to wait for a clearer analysis but may instead resort to short-sighted and populist measures and window dressing. It would be very damaging if the solutions to this huge shift were characterised by the same short-termism that brought us here in the first place.
We are in a time of severe structural crisis. Many of the things we value and take for granted are threatened – our environment, our democracy, our welfare and our prosperity. Economic historians have studied the rise and fall of family businesses. It is a generally accepted truth that the first generation builds, the second manages and maximises and the third sees decline as the advances of previous generations are taken for granted. Analogically, my generation is the third generation of modern liberal democracy. We have grown up in democratic systems, but we have never had to fight to protect their fundamental values. We have grown up with functioning welfare systems, but we have not had to strike the compromises and endure the revolutions needed to form them. We have grown up in prosperity, but it has largely been a prosperity built on past successes.
This moment offers both the threat of destructive conservatism and, at the same time, an opportunity for radical change. Fear may lead us to regress into the false safety of what was before, that which is most familiar and close to us; or it may lead us to take the opportunity that turbulence offers to fundamentally rethink our models and systems and embrace difference and alternative thinking. This is the time to revise our ideals and start anew – to build a new society.
1. The Economist, December 4, 2008.
2. For example, USA Today (October 2, 2008) reports that US car sales in September 2008 were the lowest since 1993 and the Financial Times (December 2, 2008) reported that US personal consumption expenditures are on track for rare back-to-back quarterly declines in the second half of 2008, at roughly a 3.5 per cent average annual rate. Since 1950, there have been only four instances when real consumer demand fell for two consecutive quarters.
3. According to The World Bank and The Economist, November 12, 2008.
4. According to a poll by The German Marshall Fund, cited in Financial Times, October 15, 2008.
5. Financial Times, May 18, 2008.
6. For a more detailed discussion of this I would recommend Glasshouse Forum’s project “The return of the capitalist-authoritarian great powers”
7. For a fuller description of this development, see A Global Force for Human Rights? An Audit of European Power at the UN, published by the European Council on Foreign Relations, www.ecfr.eu.
Proventus' annual report, which will include this text, will be published in June 2009 at the latest.