The Post-recessionary Global Economy: In Search of the New NormalPublished: November 09, 2009 in Knowledge@Wharton
Following the tumble of the world economy over the past two years, governments rushed to prop up shaky financial institutions and major corporations with infusions of cash. In some cases, the Fed and the Treasury department arranged corporate marriages. Regulations, along with belts, were tightened. After Lehman Brothers was allowed to fail, a sobering picture emerged. The days of loose rules, easy credit and lax oversight, which had led to excesses on many fronts, had to end.
In the midst of it all, the world financial picture was already changing significantly. The U.S. was losing stature as the model of fiscal responsibility; the weakening dollar was losing luster as the standard reserve currency; and the growth of emerging markets was showing a strength that demanded greater attention.
As the global economy climbs slowly toward recovery, two pressing questions remain: How do we prevent things from getting out of control again, and what is the so-called new normal? "The financial crisis of 2008-09 has created unprecedented opportunities for companies that have tightened their operations, reaffirmed their resolve and readied themselves for an anticipated global rebound," notes Michael Useem, director of the Wharton School's Center for Leadership and Change Management. "With their already more vibrant economies, companies in Brazil, China, India, and Middle East that have strong leadership may be especially well positioned for taking advantage of the global recovery that we all hope will come soon."
For investors who had always counted on the robust performance of U.S. equities, the outlook has clouded. Treasury and bond markets offer greater safety although less growth potential. Meanwhile, international investment has been assuming a larger role.
According to Jeremy Siegel, professor of finance at Wharton,the future is clear. "I believe that most economic growth is going to be outside the U.S.," he says. "Global equities are now more than 50% of world equities, so it's an extremely important part of any investment strategy that you globally diversify and have a large fraction of your portfolio not from U.S.-headquartered firms."
What about the inherent risks of political instability and currency fluctuations abroad? Should one pick and choose by region? "You can't hold just one and try to pick the winners," Siegel advises. "You have to go all across: Europe, South America, Asia. And then you don't have to worry so much about political instability, because in one country there may be instability, but if you're diversified, it won't affect your portfolio significantly.
"The way we diversify today is where the corporation is headquartered: Obviously that's only one criterion, and you could take [as another criterion] where they're actually selling or producing.... When you buy an India fund, for instance, you are investing in companies that are headquartered in India, although they may be producing in China and selling in the United States," Siegel adds. He recommends building a global portfolio, not so much in bonds, but with a large fraction -- say 40% to 50% -- of foreign-headquartered companies.
Regardless of where economies are stronger, what assurance do investors have that markets operate with any rationality? Some have blamed the recession on the efficient market hypothesis (EMH), which theorizes that all available information is automatically priced into the market. "I would say there are market failures, and that's the problem," argues Franklin Allen, a finance professor at Wharton and co-director of the Wharton Financial Institutions Center, who has pointed out the EMH's inadequacy. "The structure of the markets is such that [they] aren't efficient. It's not that people are behaving irrationally, although that may happen."
Allen has attributed some of the market failures to mispricing, particularly of esoteric bundled loan products -- collateralized debt obligations, for example -- whose true nature was often misunderstood even by those selling them. "It would be better if we could somehow make these markets more liquid. More transparency [in the marketplace], things like that, would be helpful," Allen suggests. In this way, more buyers would be willing to enter the market. Along with transparency, Allen says, we need "some standardization of the securitization process, making it easier to check what you're trading."
In answer to the question of what more should be done to fix the broken financial system, Allen responds, "We need to change banking regulations and the way that banks are treated if they go bankrupt and have to turn to the government....I think we need to have a financial stability mandate for the Federal Reserve. And we need to reform the International Monetary System." Allen adds that the new world financial order will not affect the position of the Middle Eastern countries very much. "There is a possibility that Saudi Arabia could lose its Board Seat at the IMF but I think that will probably not happen," he notes.
Mauro Guillén, Wharton professor of international management and sociology and director of the Lauder Institute at Penn, points out that other countries have withstood the financial crisis better than the U.S. "There are different ways of organizing a financial system and how it relates to the real economy," he says, citing particularly Canada, "which has a very solid financial system, less complex than the American system, and Canada's banks have withstood the crisis really well."
The reason is, "They have one single regulator for the whole banking system, which is absent in the U.S." Guillén thinks this is a very important lesson -- "that it does pay to simplify the system in such a way that we have one agency which is responsible for the banks." He also cites the Spanish system, which in 2001 started to "force banks to make more provisions toward bad loans when the business cycle is booming," rather than waiting until the loans become non-performing. This smoothes out the provisioning over the entire business cycle.
Guillén thinks one of the most provocative suggestions that came from a course he and Allen taught in the spring of 2009 was "the idea that maybe the U.S. should have a state-owned bank, which would be small when things were going well, but could take on bad assets from the private sector when times are bad. That way, you are prepared to do something about it."
Guillén adds that the new financial order that may emerge from the crisis will probably eliminate the huge imbalances in the global economy in terms of current account deficits. "The Middle East is a region that 'exports' capital because it earns a lot from exporting energy," he says. "This is unsustainable. Over time, Middle Eastern economies need to develop their internal markets so that more people import goods and services from other regions and there is more of a balance. "
As financial institutions inevitably reached crisis mode, the management ranks were in upheaval. Many CEOs resigned or retired early, exhausted by the struggle to shore up their firms or pushed out by angry shareholders and disenchanted boards.
In such a volatile economy, deft management decisions, as well as steady hands on deck, are vital to corporate survival, let alone recovery. If management's failure to read the signs of impending catastrophe is a contributing factor, what can management do to avoid the same future?
Useem believes the crisis offers several object lessons. "First, by surviving a crisis, you're better prepared to face the next one; second, failure is a better teacher than success; and third, overconfidence can blind you to potential pitfalls, like assuming too much risk."
Although some people seem to be born leaders, Useem asserts that good leadership skills can be learned. "We want people to think strategically," he says, "like the chess player who can see 20 moves ahead. We want people, even in mid-level positions, to think more broadly, [asking themselves,] 'If we do what we're doing now, could this put the company at risk?'"
This requires developing extra sight, what Useem calls "peripheral vision," after a book of that title by Wharton marketing professor George S. Day. It's "an ability to look sideways and see weak signals that are coming in that are important, as opposed to just noise, the kinds of things we see and quite properly ignore."
Training is crucial. Too often, Useem notes, "We simply say, if you're good as an engineer, you can run an engineering team; if you're good at banking, you can run a banking division. And, for me anyway, it's very important that those in financial services redouble their efforts to build training on how to lead, how to make good decisions, and how to manage risk."
As financial systems and corporations become increasingly complex, one CEO cannot be expected to know it all. Building a team with specialists who can share their knowledge will be important as well. "Having a lot of smart people with a good ability to make judgments to add to your own skill set -- if you don't understand how to do an acquisition and somebody else does, for example -- that actually makes you look smarter. You have the resources," Useem says. "And just like leadership, teamwork is not all that natural either. That's a trainable, teachable skill set," so that team members won't be scrambling over one another. "There's a Shakespeare phrase, 'All be ready if our mind be so,' [meaning] we're ready to face a battle, a crisis, a tough quarter, if we've already put in place our leadership created in the kind of teamwork we're going to need. You have to do that before you need it; it's almost a dictum out there."
This management division of labor may be the backbone of a strong corporation. But how does it play out in the wider economy, across companies, institutions and governments, all of which had a role in helping to pull us out of the most recent crises? To manage such large, complex challenges, you need resilience, according to Frederick Presley, president and co-founder of PathTree, a non-profit organization dedicated to providing educational tools and processes to teach people about the importance of whole-systems living.
Presley defines resilience as the ability "to anticipate change, to respond to change, in a very positive and proactive way, as opposed to what we tend to do now, which is a more linear approach. Instead of proactively transforming with change, we tend to react after it's already occurred.... Resilience is about being more open and receptive to what's going on, because you have a whole-systems view."
Attacking economic crises piecemeal after they have flared up is a mistake, he says. For example, as Allen notes, "The government's plan [to absorb the banks' mispriced assets and soured loans], was to step in and buy [them], but they never have managed to get that off the ground. It's very difficult to know how they should deal with that problem."
The approach Presley promotes is to see problems as part of a natural cycle. Natural systems "have what's called 'natural adapted to clime,' that whole idea of conception, birth, life, death [as the] natural state. In all natural systems there's that flow where you have this kind of growth, this time of conservation, and this release and rethink that happens.... And it's not just natural systems; all systems go through that."
Where the present institutions and governments err is in trying to hold conditions in stasis. "We ... try to manage that point of growth and conservation and hold it for as long as we can. And I think that's what we saw with the economy. During that whole period we were dropping interest rates and trying to hold onto that gold ring, not allowing that natural release and rethink to occur."
Overall, Presley sees the economic crisis as just one global shock, interconnected among many others, including environmental degradation, climate change and population shifts. "We have to embrace the complexity and not try to downplay it or try to manage away from it," he says. Solutions must to be found urgently, but he is hopeful they can be if organizations on the level of the G-20 or the United Nations can cooperate and embrace whole-systems thinking.
Presley is participating in The Festival of Thinkers, sponsored by the Higher Colleges of Technology, United Arab Emirates, November 1-4, which draws together people from many fields of expertise to discuss complex issues. "That's really the core of what we promote at a very base level. Getting different views from a different topic or a different condition and understanding them deeply and mutually coming to some kind of conclusion about where we are."
On a global level, Allen is less sure that nations will be able to come together on a plan for the global economy. The G-20 Summits aside, he says, "My guess is we won't do very much, because there's no consensus on what should be done, so I think we'll be back in a 19th-century world where these crises occur, on average, every decade or so, or maybe quicker than that."
Guillén believes it will take a while for the world economy to unwind from the crisis. The high level of unemployment and the banks' undigested toxic assets will be drags on the economy for some time to come. "It's likely the economy will start to grow again in the next few months," he says, "but I don't think it will be strong enough to reduce unemployment and go back to the previous situation." It may take a year or two before the economy will be going reasonably well; for the larger banks, the recovery may take even longer.