I spend a lot of my time thinking about "low-probability disasters." That's a polite term for those unexpected, unwelcome events that take a stock market or a currency down 40%, 50%, or even more in a relatively short time. Low probability disasters -- like the 1997 Asian financial crisis or the tech bust -- can wipe out years of gains in a flash. They're the monster in the woods that every once in a while turns out to be real.
Right now, there's a low probability disaster -- a global financial crisis -- lurking out there somewhere in the wilds of the world financial system. There are too many stresses and strains in the financial markets, too many massive imbalances.
The U.S. is absorbing almost a trillion dollars a year in other people's money. China is running a trade surplus in excess of $100 billion per year, and funds are sloshing around the globe almost too fast to be counted.
WHERE TO TURN?. What's more, there's no global central bank standing guard. The Federal Reserve is still very powerful, but it doesn't have the heft or the reach to cushion the effect of a global financial crisis. And the European Central Bank and the Bank of Japan are still too inward looking.
The eventual result is clear: a collapse in currency values, plunging stocks markets, and a flight to safety. My big problem is, I can't figure out which country or region is most likely to bear the brunt of the low-probability disaster, and which will turn out to be the safe haven. I don't know which currencies and stock markets are going to hit the skids, and which ones are going to sail through comparatively untouched. More precisely, I wonder if the U.S. will be a safe haven, as it was in 1997, or will Wall Street be the epicenter of the crisis?
For investors, of course, this is the $64,000 question (or if you prefer, the 512,000 yuan question). A financial crisis that hit the U.S. hard would send the dollar sliding, make imports more expensive, push up inflation, force the Fed to raise interest rates, and generally wreak havoc in the U.S. stock market. A financial crisis that hit Europe or Asia would have the opposite effect. The U.S. would become even more attractive to risk-averse foreign investors and money would flood into the country, driving down interest rates even further than they are today.
STILL STRONG. Which scenario is more likely? Many economists believe the low-probability disaster is more likely to hit the U.S., because of its big trade deficit and the low savings rate. Smaller countries with similar characteristics, such as Iceland and New Zealand, have already come under pressure.
A country with a big trade deficit needs a constant flow of money from overseas to finance its imports. If foreign investors start losing confidence in that country, financing the deficit becomes harder, the currency drops, interest rates rise, and the country drops into a downward spiral.
However, there are powerful arguments for the alternative scenario. It's hard to deny that the U.S. has the strongest, deepest financial system in the world, and the strongest, most dynamic economy. American financial institutions are well-capitalized and regulated, and American companies are still the world leaders in many industries. In a knowledge-based global economy, that's a reality the trade deficit numbers don't capture (see BW Online, 2/13/06, "Why the Economy Is a Lot Stronger than You Think").
Besides, the other possible safe havens have big problems of their own. Western Europe is still stuck in a long slump, with sky-high unemployment and political unrest in France and Germany, massive budget deficits, and slow productivity growth. Japan hasn't yet shown that its financial system has fully recovered after 15 years of slow growth.
ANYBODY'S GUESS. And China -- China still has a communist government managing one of the great capitalist growth booms of all time. That's worked just fine so far, but it's a recipe for political disaster should the Chinese economy ever slow down.
Which scenario do I think is most likely? I'm still leaning toward the U.S. as safe haven, though I'm not as sure as I was a year or 18 months ago. Back then, I was convinced that the next financial crisis was going to happen in China (see BW Online, 10/25/04, "China's Coming Financial Crisis").
Now, with that country having more than $800 billion in foreign-currency reserves, a financial crisis there looks less likely, at least for now. My odds on Europe as epicenter, though, have gone up, especially after the latest events in France. But even though I believe a crisis is coming, this is one case where the best thing to do is admit, with a shrug, that I'm simply not sure where.