[This review was published in the Summer 2009 issue of The Journal of Social, Political and Economic Studies, pp. 260-267.]

Book Review

 

The World is Curved: Hidden Dangers to the Global Economy

David M. Smick

Portfolio, 2008 

 

            Imagine you walk into a saloon in Texas and are told it has just acquired a “Super-Colossal Electric Bull” for the customers to ride.  You are told that the ride is more exhilarating than electric bull riders have so far ever experienced.  But there is a caution: on average, one in every three riders is sent flying through the ceiling.  Ambulances stand by outside to take them to the hospital or the morgue.

            You might feel that anyone with sense will refuse to ride.  But the saloon has hired an expert in electric bull riding who insists that “you haven’t lived unless you’ve ridden the bull.  The risk is just something you’ll have to accept.”

            Most likely, you will consider the expert a modern-day Mephistopheles, a devil seeking to seduce you to your doom.  Unlike Faust, you will reject the seduction.

            Opening the pages of The World is Curved is like walking into the saloon.  The expert in this case is David M. Smick, one of global finance’s top monetary advisors.  He has for twenty years edited The International Economy, a magazine he founded that is “geared to the global central bank and finance ministry community.”  Smick runs a “global macroeconomic advisory firm” and tells of giving advice to U.S. presidential administrations of both parties.  Just as Thomas Friedman’s striking description of global business in The World is Flat reflects first-person contact with national and corporate leaders around the world, Smick’s experience includes meetings over several years with top global finance ministers.

            It isn’t an electric riding bull that Smick praises as so exhilarating; it is the great swirling pool of global finance, which brings the world the benefits of entrepreneurial dynamism.  “We will not have lived,” he in effect says, if we don’t continue to reap the spectacular rewards of that dynamism.  But along with his enthusiastic endorsement comes a spine-tingling warning: that at any given moment the unforeseeable vicissitudes of global finance threaten to launch the world over a precipice into a catastrophic international economic collapse.  In effect, ambulances stand by to take us all to the hospital or morgue.

            He has much to tell about global finance.  As economic globalization has become magnified during the past quarter-century, a “raging ocean of capital” amounting to “hundreds of trillions of dollars” has served as the monetary lubricant, and “appears to know no limits.”  Much of it is based on “leverage” (“borrowing for investment”), which gives rise to “the leveraged global financial risk-taker.”

            Smick describes how “financial markets have been internationalized through an intricate web of financial engineering called securitization.”  The financial tools found within this “modernized, multilayered financial system” include, among others, “private equity funds, private debt placements, hedge funds, high-yield bonds, venture capital funds, turnaround funds, and private mezzanine investing.”  At the time Smick was writing, there were already 9,000 hedge funds, with their operators earning “enormous fees.”  (Because Smick rightly assumes that not all of his readers are fully conversant with these financial vehicles, he explains “securitization,” “hedge funds,” “private equity investors,” and the like, adding an additional dimension to an already very informative book.)

            Computers make instantaneous transfers of money and securities possible in a “world loaded with cash.”  A striking example comes when he tells of the Japanese housewives.  Since in Japan husbands devote most of their waking hours to work, it is left to their wives to handle the family finances.  Japan is the world’s largest repository of savings, and this means the housewives are in control of a vast pool of cash to invest.  Computer literate, they increasingly use the Internet to invest directly, often across national boundaries.  This introduces a highly unpredictable element, since tens of billions of dollars can swing from one place to another at “the click of a mouse” (actually quite a large number of mice), depending upon the extent to which the housewives are susceptible to mass psychology.  “Shifts of savings across borders [are] making the old financial models obsolete.”

            As with our fanciful expert in electric bull riding, Smick praises the new mechanism as something the world can ill-afford to do without.  The benefits of “this phenomenal success” are inestimable: “this quarter-century represents the most successful period of mass poverty reduction in the history of mankind.”  “Securitization” is “the system that allocates capital so successfully for the industrial world.”  This facilitates “the high-risk-taking entrepreneurs [who] are the magic ingredient.”  A United States that has declined in most other economic efforts deserves much of (what Smick considers to be) the credit, since he says “financial services remains one of the industries in which the United States globally is competitively superior.”  Global finance has become so central to the U.S. economy, indeed, that there is no way to “opt out of the system… without experiencing brutally negative consequences.”  If the world in general reacts to the “Great Credit Crisis of 2007-2008” by rejecting globalization policies, it “will be risking nothing less than the financial health of the global economy.”  So we are told that not only is riding the bull wonderfully desirable; not riding it is out of the question.

            But, of course, the analogy to the bull-riding in Texas doesn’t stop here.  The expert has yet to tell us how extremely dangerous the riding is (in itself, and not just for those who try to opt out).  What Smick has to say about the dangers provides the context for the book’s subtitle: “Hidden dangers to the global economy.”  It is no overstatement to say that the risks he describes are so many and so palpable that any objective observer, such as the visitor to the saloon, would be justified in considering them intolerable.  It is amazing that, in light of what he tells us, Smick holds fast to his professionally-engrained bias in favor of more of the same.  Here are some of his admonitions:

          It is well to start with his general observations, which include: “…increased number of unknowns”... unbelievably fragile.  It is a house of cards”… “The global system is becoming more vulnerable with each passing month.” This explains why Smick titles his book The World is Curved [as distinct from being flat, as Friedman described it].  Being curved, “we can’t see over the horizon.”  Such warnings have been made for several years; in his 1997 book One World, Ready or Not: The Manic Logic of Global Capitalism, William Greider said that “our wondrous machine, withal its great power and creativity, appears to be running out of control toward some sort of abyss.”

          “The industrialized world has surrendered control of its financial system to a tiny group of five thousand or so technical market specialists spread through investment banks, hedge funds, and other financial institutions.”   

        “What do we know about the accuracy of the accounting ledgers of even our largest, most trusted financial institutions or of the sophisticated financial instruments these firms deploy?”

         “The bankers who engage in lending are no longer tied to the risk of the borrower… The lender no longer has incentive to avoid dangerous risk… [The loans are] sold as investment to the unknowing global financial community.”         “The size of the financial markets, relative to governments, has become so monstrously huge… [that] the governments themselves cannot by edict restore order… The global economy is becoming increasingly beyond the positive control of governments.”  Smick gives examples: Private equity firms may well leave the country if the United States tries to raise its now-favorable tax rate on them, just as there was a “huge shift out of New York” after accounting and management reforms were put in place following the Enron debacle.  And it was “disastrous” for France in 1981 when that country tried to keep capital from leaving.

        “…the declining power of central banks… There are limits to monetary stimulus in contrast to the seemingly endless ability of the global financial markets to create leverage and risk.”

        “…the global financial system… is vulnerable to a psychological herd effect that could wreak havoc with the industrialized world economies.”  We have seen Smick’s reference to the Japanese housewives, but the herd effect can be much larger than even that suggests, with “hundreds of trillions of dollars” subject to rapid transfer. 

        Catastrophe can come from within the currency markets.  “…a dollar free fall… could send the U.S. economy into complete collapse.”  “If the financial market perception developed that [an] economy was about to weaken, the traders across the board would dump [the currency], sending it into a free fall.”  There is “a highly leveraged, globalized ocean of skeptical currency traders.”  Greider wrote in 1997: “National governments watch helplessly as global finance raises their domestic interest rates or devalues their currencies.”

        China is a huge unpredictable force with the power to help or sink the world economy… When the Chinese bubble bursts (and bubbles always do…), China could instantly become a deflationary threat to the world… China could have no other choice but to dump [its] stockpiles of commodities and finished goods onto world markets.”

        Further, “because of China’s daunting challenge, the world is a house of cards in a way no one in the world yet fully comprehends.”

        The Japanese, Chinese and others have purchased so large a volume of U.S. Treasury bonds that the United States is extremely vulnerable in case they decide to pull out.  At least a temporary check on this is that if they bail out precipitously, they will themselves suffer a major financial loss on their holdings.  Further, China has predicated its social and political stability on production for export to the United States, and at least until “its bubble bursts” it is motivated to keep that going.        

·           Global investors “have placed large amounts of capital into high-yielding developing-world bond investments.”  This has been based on expectations that have “reflected an incredibly rosy picture that [has] had little in common with reality.”

             The “sovereign wealth funds” established by “China, Russia, Saudi Arabia, and other nondemocratic regimes” are now so large that not even the International Monetary Fund comes close to matching their amount of capital.  In a global financial crisis, the United States and Europe may need to seek their help as “our only hope.”

         What Smick calls “the Great Credit Crisis of 2007-2008” is just one (very important) case in point.  Oddly, it was precipitated by a relatively small cancer that was metastasized by the financial architecture’s having been manipulated in a way that resulted in a global loss of confidence.  The toxic subprime mortgages amounted "to, at worst, $200 billion in exposure in a global market worth hundreds of trillions.” 

          Smick says the global financial system could easily have handled the housing bubble of $200 billion, were it not for something deeper: the “dubious dual system that banks and investment companies used to hide their exposure.”  The banks set up “structured investment vehicles” (SIVs) “not under their ownership or control” and whose holdings wouldn’t show up on the banks’ balance sheets.  They thereby “created their own private market,” and made enormous profits selling securities to those off-balance-sheet agencies.  The costs were passed on to investors around the world: after the toxic waste was mixed with other loans in “securitized” form, the securities were “divided… into many smaller portions, and sold… to financial institutions throughout Europe and Asia.” 

          When the real estate bubble burst, “the world’s credit markets seized up… The issue was not the size of the subprime mess… [but] where the toxic waste was located… Ultimately, the issue was information, or the lack of it.”  “The panic unfolded precisely because suddenly nobody could say which financial institutions held the subprime toxic waste… Securitization [had] resulted in a lack of transparency.”

          Smick captures the spirit of it when he speaks of the “sheer greed” of “bankers and investment bankers” that was “most responsible for the crisis.”

          Beyond that greed and manipulation, there is the intriguing question of why the eventual purchasers of the securities were so lacking in “due diligence” in buying securities they didn’t understand.  The answer lies in the absence of diligent and astute regulation and with the credit rating agencies upon which the world financial community relied so implicitly.  Smick speaks of “the mother of all regulatory failures,” since the bank regulators and global credit rating agencies assured the financial world that the SIV securities were ultra-safe, having foolishly persuaded themselves that real estate prices will always go up, never down.  “The only measure of risk and value came from the credit rating agencies, which measured risk merely on sophisticated mathematical models.”  [Smick often describes something, such as securities or the mathematical models, as “sophisticated” even though by his own account they were at bottom quite stupid.  It is a sign that technical complexity often trumps wisdom.]

          One of the features of our analogy to bull-riding was that ambulances were standing by to minister to the casualties.  Such ready assistance isn’t evident for global financial catastrophe.  It is chilling when Smick informs us that “the world today lacks a financial doctrine, or even much in the way of a set of informal understandings, for establishing order in a financial crisis.”  Central banks can try to flood the world with liquidity to counteract the drying-up of lending and investment, but this is blocked by “the global market’s lack of confidence.”  There is even a term for this blockage: it is called “a liquidity trap.”  In the United States, “the Fed itself is still trying to figure out its role in crisis management.”

          We have seen with what fervor Smick praises the benefits of global finance.  Now that we know of the horrific dangers (“world economic collapse”) that he says inhere in it,  we see how dubious his notion is that the world should press on with ever more of it.  The worst villains in his scenario are those who find it intolerable.  What really rankles him is any mention of “protectionism and clumsy financial market regulatory tinkering.”  A “populist discontent” is “boiling,” with “an emerging era of class warfare.”  This, above all, is to be avoided.   

          A reader approaches the end of the book with some anticipation that an expert of Smick’s experience will have specific recommendations to make about how the world can step back from the precipice.  That expectation is dashed, however, as the pages run out.  His prescriptions are broad generalities:

          “The United States should work quickly to bring about an international effort to correct global imbalances and negotiate a more uniform global financial structure with greater transparency.”   This leaves open the question of how the imbalances are to be corrected without deviating substantially from the “open borders” free trade ideology that has led the United States to flood its market with imports and several other nations to become export-dependent.  It is precisely that ideology that most informs Smick’s thinking.

          “There must be new mechanisms for increased transparency… Off-the-balance-sheet independent vehicles must be banned” and the world must “find ways to improve the performance of the international credit rating agencies.”  There must be “surgically precise global reforms that avoid threatening the larger financial system as a wealth-generating force.”  He doesn’t advise as to the content of these new mechanisms and surgically precise reforms.  It should be noted, though, that they do not, in any event,  address the potential catastrophe inherent in “hundreds of trillions of dollars” being susceptible to herd psychology and to panic whenever there is any tweaking of confidence.  Nor do they speak to the inability of governments and of central banks to handle such an enormity.

          As he praises the benefits of globalization, Smick gives no attention to the deindustrialization of the United States that has come from opening the economy to a gigantic pool of low-cost foreign labor.  Nor does he find it embarrassing that the United States has thrown itself so exclusively into the very “global finance” that puts the peoples of the world in danger from all the threats he describes.  And he seems to assume that his praise of “the global risk-taking entrepreneur” is sufficient without any mention of the scientific and technical revolution that has come with the computer age.  This omission is noteworthy because there is reason to suppose that the benefits he ascribes to global finance might well be due at least in large part to that scientific revolution, and would continue even if financial markets were made much more local and controllable.

          Smick does make an important contribution, however, even though he gives it  only brief attention.  He mentions the growing polarity of incomes and of wealth in the United States and elsewhere.  He sees that “the middle class has not fully enjoyed the benefits of the global wealth machine,” and notes that “where the wage-earning sector… is shrinking, middle-class wages alone may never be enough to keep families from financially backsliding.”  Quite separately from Smick’s analysis, we know that in the advanced economies work is becoming ever-less compensated, first because of competition from low-cost foreign labor and ultimately from the rapidly-advancing automation that introduces non-labor-intensive technology.  It is capital, not labor, that will receive the lion’s share of remuneration in the future.  Smick sees this when he says that “mere wage earners, relative to those with a global stock portfolio, can’t participate in this wealth creation.”  This leads him to endorse an idea that is coming to be taken more and more seriously: the need to make everyone an owner of capital.  He calls for “bringing more people into the economy as capital owners….”  He supports a proposal to “have the federal government give every child at birth an ‘American Birthright Account’… to be invested in the financial markets for use later in life.”  Although the proposal is hardly adequate to the magnitude of the advancing displacement of wage-earners, it is at least a start toward a more comprehensive system of ownership sharing.

          In all, The World is Curved is well worth reading—not because it is wise, but because of the nightmare scenario it describes so well.  (There is the possibility, although it seems remote, that the book is not to be taken at face value.  One can imagine a global financial expert’s wanting to alert the world to the immense dangers, while at the same  time toeing the globalist ideological line sufficiently to avoid alienating the international leaders with whom he has long been closely associated.  If that were true here, it would explain the incongruities—the lack of wisdom—in the book.  The reasons for thinking this possibility remote are that in the main people do genuinely embrace the ideologies they express, and that years of working in a given professional milieu generally do create a strong predisposition in its favor.)                                                                                                                                                                                                                                                                                                      Dwight D. Murphey