The World Was Never Flat

March 01, 2012  

By Patrick Wolff

In today’s world, one of the few points on which everyone seems to agree is that the pace of globalization will only accelerate. Economies around the globe will become ever more interconnected, and poorer countries will continue to catch up to the West. An optimistic interpretation suggests a richer world where everyone gets along better, while pessimists see a more dangerous world where rising powers pose risks to peace and stability. Either way, the relative decline of the U.S. is presupposed.

Investors would do well to consider the contrary view that globalization is more likely to slow down or even reverse. Indeed, the rapid pace of globalization during the past decade looks like a bubble now poised to burst. If true, economies may become less integrated, and emerging economies may see slower growth than anticipated. Seen in this light, America looks like an attractive place to invest.

Consider first the prospect for economic integration, à la the European Economic and Monetary Union. Ten years ago the euro replaced such venerable currencies as the German mark, the French franc and the Italian lira. For a while this seemed to be the height of globalization.

In hindsight, the economic boom ushered in by the euro was primarily driven by unbalanced trade and capital flows: Germany’s exports were subsidized by a comparatively weak euro, while the resulting current account deficits in the importing nations with too-strong currencies caused debt-fueled bubbles. It is now evident that the EMU was a case of false globalization, because leaders were not forthright about the costs and commitments involved in creating a common currency. German citizens never understood the costs of financing their exports by making bad loans to the likes of Greece; Greek citizens never understood the risks of accepting a currency that was stronger than the underlying fundamentals of their economy.

Europeans as a whole were never told that a common currency might require integrating their fiscal and monetary policies — essentially surrendering their national economic sovereignty. Just as the true test of a marriage comes after the honeymoon, the true test of globalization comes after the boom. As the bust deepens, the prospect of divorce looms large for Europe.

The European Union is not the only place where a boom gave birth to this false globalization. The rise of emerging markets and the so-called BRIC nations (Brazil, Russia, India and China) has largely been the story of China’s extraordinary economic growth and its associated appetite for commodities. China’s boom has been powered by its supernormal investment in fixed assets such as housing, railroads and airports. According to official statistics, fixed-asset investment is roughly half of the level of China’s GDP and an even greater share of the growth of its GDP. These numbers are historically unprecedented and more than twice the amount for the world on average.

For China to keep growing its economy at the same rate, one of two things must happen: Either it must keep increasing the buildings, roads and railroads it builds by the same amount each year, or at whatever point it stops, all those assets must produce a very good return on investment. Investors generally assume that all this investment has been made intelligently, but why should we believe it, given China’s lack of transparency and notorious corruption? The typical response is that the destiny of poorer countries is to catch up to the West, yet this belief reveals the triumph of hope over experience: Economic history over the past century and a half teaches that convergence is the exception, not the rule.

Things may seem tough for America today, but the U.S. has prospered throughout its history in the face of many adversities. What about dysfunctional politics? It’s true that Will Rogers once said, "I don’t make jokes. I just watch the government and report the facts." (Or maybe that was S&P . . .) But he said it almost 100 years ago! Not only has the U.S. always prospered before, it can do so on its own if necessary. The economy is largely self-sufficient, as gross trade is only a little more than 20 percent of total GDP and a good deal lower than most other large, developed countries. Yes, the rising tide of globalization lifts all boats, but the U.S. will stay afloat either way.

Meanwhile, the U.S. economy is slowly recovering, and it continues to attract both people and capital. U.S. equities and the dollar, after being two of the worst investments of the past decade, are now cheap. And that may be the best argument of all in their favor.

Patrick Wolff is the founder and managing member of Grandmaster Capital Management, a long-short equity hedge fund firm based in San Francisco.

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