By Sebastian Mallaby (THE WASHINGTON POST, 06/08/07):
A decade ago, financial globalization seemed terrifying. Crises swept from East Asia to Russia and Brazil; the implosion of a globe-spanning hedge fund, Long-Term Capital Management, forced the Fed to orchestrate a bailout. But this decade may be remembered for the opposite lesson.
If the world comes through the current market turmoil relatively unscathed, it will be thanks to the globalization of finance. The demon will have turned into a hero.
Since 2001, pessimists have predicted that the United States would drown in financial self-indulgence. The Bush administration inherited a federal budget that virtuously saved money every year; it cut taxes recklessly and spent like a drunken sailor. But the nation has escaped the dire consequences that were supposed to follow from this profligacy. The administration’s appetite for borrowing did not push interest rates up because foreigners demonstrated a bottomless capacity to lend. This capacity has proved more durable and stable than almost anyone predicted.
Then came a second gloomy prophecy. Bankers, private-equity moguls and hedge funds were loading up on debt, outdoing even the Bush administration in recklessness. Sooner or later the party would end, and the hangover would be horrible. Well, this proposition is about to be tested. The predicted end of easy money has arrived, and the riskiest kinds of loans have essentially been frozen. But just as the Bush administration has so far escaped punishment for its budget irresponsibility, the bulk of the financial system may escape relatively lightly.
The reason, again, lies in lending from foreigners. The world is awash in savings, and markets are increasingly adept at moving money to the places where it’s needed. Whereas a decade ago Russia and East Asia exported financial turmoil, now they export capital; collectively, they and a few other countries are in the habit of lending the United States around $16 billion a week, so the disappearance of a few billion from the balance sheets of imploding American lenders may not be enough to faze them. And whereas a decade ago Long-Term Capital gave hedge funds a bad name, today hedge funds seem to play a different role. They are vacuuming up savings, including savings from abroad, and applying them to the planks in the financial system that need shoring up, dampening market instability.
This, admittedly, is not the standard view of hedge funds. In the recent market turmoil, a handful of hedge funds have blown up; they continue to be seen more as a destabilizer than a stabilizer. Two of the hedge funds were managed by Bear Stearns, the Wall Street bank whose uncertain future triggered the stock market decline on Friday and whose co-president resigned yesterday. It remains possible, albeit not likely, that a really major hedge-fund bust will require a Long-Term Capital-style bailout. Still, consider the case for optimism.
Optimism starts with the story of Sowood Capital, which lost $1.5 billion recently, or roughly half of its investors’ money. The pessimistic line on hedge funds is that this sort of body blow can trigger a crisis: Once a fund loses a large chunk of its capital, lenders demand their money back; this forces the fund to dump assets fast, driving down the markets and triggering meltdowns in other hedge funds. But in Sowood’s case, something else occurred. Another hedge fund heard of its troubles and smelled a bargain. It bought Sowood’s assets wholesale. No panic necessary.
This was not an isolated incident. Citadel, the Chicago-based hedge fund that snapped up Sowood, also bought what was left of Amaranth, a hedge fund that blew up spectacularly last year. A whole subindustry of “distressed debt” investors has sprung up; in the first six months of this year alone, investors poured $23.7 billion into these vehicles, enough to stabilize 15 Sowoods. A lot of this money is hunting for opportunities in the mortgage mess. Citadel just bought a large stake in Beazer Homes, stabilizing its stock price, at least for the moment.
And so, far from causing financial fires, hedge funds often act as firefighters. They plunge into infernos because they understand financial risks better than others and are less likely to get burned by them.
Armed with abundant capital, much of it from foreigners, they make it less likely that markets will plunge irrationally low. They have not repealed all bubbles for all time, but in some ways they can stabilize the system.
Before the crises of the 1990s, many economists believed that financial globalization was a good thing. After the crises, the consensus turned; economists reported little to no correlation between openness to global capital and economic growth — not least because their data now included open countries that had experienced growth-destroying crises.
But, depending on how the next few weeks turn out, the consensus may swing back again. Maybe historians will determine that, in the first phase of financial globalization, governments and financiers didn’t know how to manage the attendant risks. Maybe they will record that, finally, in this decade, they grew better at it.