12th July 2012
While a number of economists would consider themselves political, few politicians can accurately describe themselves as economists. Nevertheless it is the latter camp that is being increasingly looked to in order to find a way out of the quagmire faced by western economies.
Much of the brave new post-financial crisis world has so far proven almost indistinguishable from its immediate predecessor. In some important aspects, however, the landscape has been profoundly altered.
As investors have faced a rolling progression of crises – from subprime mortgages, to excessive debt and existential threats to the euro – they have understandably sought to preserve their wealth by ploughing money into areas they perceived as safe. This favoured assets such as US Treasuries, which appeared to offer a steady level of income and were backed by the US government.
Yet with America's political system paralysed by partisan divisions there are signs that faith in Treasuries is being shaken. According to Gillian Tett writing in the Financial Times, the investment bank Merrill Lynch has sent out a memo advising clients to position their portfolios for a "fundamental geopolitical shift".
In essence, the memo advocates a redefinition of which assets can be considered "safe". It suggests that with western geopolitical dominance in decline investors looking to preserve their wealth should consider reducing their Treasury holdings and allocating more to corporate bonds and emerging markets government debt.
This may not seem a radical step given that economic growth in emerging market has significantly outpaced developed countries over recent decades. Indeed IMF figures show the developed world's share of global output fell from 64% in 1992 to 52% by 2010 and is predicted to fall below 50% over the next few years.
Nevertheless the focus on geopolitical risk does betray a broader shift in thinking. Before 2007 the dominant theory in economic circles advocated a light-touch approach whereby financial markets could be left to police themselves, while the role of regulators was to manage the fallout when things went awry.
This became known as the Greenspan Doctrine, named after Alan Greenspan who served as Federal Reserve Chairman from 1987 to 2006.
Following the onset of the financial crisis, however, a number of public figures suggested that this laissez-faire approach to regulation had allowed banks to indulge in excessive speculation. In a speech given at the International Research Conference in February 2010, Dr. Duvvuri Subbarao, Governor of the Reserve Bank of India, claimed that the crisis had "dented the credibility of the Greenspan orthodoxy ".
Given the pivotal role that central banks have played in supporting financial markets in the past few years through ultra-low interest rates and repeated bouts of quantitative easing (QE) the Greenspan model already appears to be defunct. In fact Greenspan himself conceded as much at the Economic Club of New York in 2009:
"It is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk management techniques and risk-product design were too much for even the most sophisticated market players to handle properly and prudently. Accordingly, I see no alternative to a set of heightened federal regulatory rules for banks and other financial institutions."
Although the doctrine specifically applied to central banks, it also helped keep governments at an arms-length from markets. What the Merrill Lynch memo makes clear is that geopolitical considerations now sit at the centre of investment decisions and that the lack of political leadership on both sides of the Atlantic is seen as the central risk to investors.
As Tett explains:
"Inside the US, politicians still cite the American dream; but no one today quips that US leaders could form a "committee to save the world", or even the eurozone. And in Europe, politics is being driven not by any positive vision, but a terror of collapse. Fear, not mission, is the order of the day. Rarely has politics seemed so crucial for investors, and yet so impotent."
So does this focus on geopolitics offer investors any practical solutions?
To assume, as Tett seems to, that a shift away from Treasuries should concern the US government is a little bit of a stretch. Currently the two largest buyers of American government debt are China – which holds around £770 billion worth – and the Federal Reserve.
Through QE the Fed is explicitly acting to support the Treasury market and keep yields low, while China is locked into additional purchases in order to maintain control over its currency. These alone should provide sufficient confidence that a sudden drop in demand for the asset class is unlikely.
That said, the growing importance of developing markets and the difficulties facing the West should encourage investors to look at spreading their money outside of traditional favourites. Maybe, then, Merrill Lynch have offered a timely reminder but no cause to panic.
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