Now What?

As large parts of the world set up shop as a giant, low-cost, export engine, the low saving U.S. consumer became almost addicted to consumption. As we kept consuming, many of the world economies began stockpiling record amounts of excess savings. This reliance on exports, in lieu of developing consumer-based economies, created enormous global savings imbalances. In China alone, excess savings in the form of central bank reserves quickly approached $2 trillion. The problem was that there were too few investment opportunities for so much capital. A lot of this excess saving was recycled back into the U.S. financial system, usually in the form of fixed income purchases, with U.S. Treasury securities a favorite target.

This dangerous ocean of capital, which again reduced global wage demands, allowed American policymakers to think they had defied the financial laws of gravity. That was the period when Alan Greenspan was called “the Maestro” and attempted to tame the business cycle. At one point, the Federal Reserve launched a series of hikes in short-term interest rates. Long-term rates not only failed to rise but dropped. That’s not supposed to happen. In the process, financial risk became severely underpriced as long-term interest rates dropped to unrealistic lows. Wall Street thought it had discovered riskless risk.

Because the global economy was out of balance, Americans went on a credit binge. U.S. household debt soared from 75 percent of annual disposable income in 1990 to 130 percent just before the crisis. At the height of this period, gluttonous Americans were spending far more than a dollar for every dollar they earned as they propped up the global economy.

During the administration of George W. Bush, the U.S. economy would have grown at an annual rate of less than 1 percent without a steady stream of private equity loans, according to economist Niall Ferguson. And why were private equity loans so attractive? Because this dangerous global ocean of capital in our interlinked world financial system had unrealistically reduced long-term interest rates to unheard of low levels. This was an unsustainable situation. Asset prices, including the price of housing, shot through the roof with little response from the regulators, including the Federal Reserve. At the same time, U.S. monetary policy remained extraordinarily accommodative. With the regulators asleep at the switch, here was a giant bubble certain to burst. Why? Because sooner or later financial bubbles always burst.

THE “SALAD” EXPLANATION OF THE CREDIT CRISIS

Perhaps the greatest mystery of this Great Credit Crisis is how some mortgage defaults in a relatively small subprime market (initially of only $200-$300 billion) could topple a world financial system worth several hundred trillion dollars. How could some collapsing mortgages bring about the worst financial crisis since the 1930s? It doesn’t make sense.

The answer is the credit crisis reflected something larger and more fundamental than a mere problem of mortgage defaults. The crisis erupted to such magnitude in large part because global markets declared a buyers’ strike against our less than transparent financial architecture–the sophisticated paper assets including securitization financial institutions use to measure risk and deploy capital. The housing crisis was a mere trigger for a collapse in trust of paper, followed by a deleveraging of the entire bloated-with-credit global financial system.

In the Wall Street Journal, J.P. Morgan Chase CEO Jamie Dimon recently wrote an op-ed in which he chastised the thrifts and other non-money center bank financial institutions for overly aggressive mortgage lending practices. The chairman has gall because his article conveniently overlooked the main culprit for the crisis–the big Wall Street banks and investment banks themselves.

Here’s how events unfolded. In 1998, Wall Street was deluged with this dangerous ocean of excess savings. So the bankers, to increase their fee and bonus income, received permission to deploy a new business model involving securitization. In the past, I as a banker would lend you the money for a mortgage based on my assessment of your character and financial base. If you were a business, I would bring together other banker friends and we would offer you a syndicated loan, but again based on our comfort with your reputation and the strength of your firm’s balance sheet. In both cases, as a banker I had skin in the game. We knew each other. But that wouldn’t be the case for long. The new model for handling risk and distributing capital–the securitization model–no longer required the big banks to have much skin in the game.

For many people, the concept of a securitized asset or a mortgage-backed security is a mystery. So let me offer this analogy: As a banker, what if I took the thousands of mortgage loans I had issued and piled them onto a table, slicing and dicing them up into small pieces like a gigantic beautiful tossed salad.

Then, for a nice big fee, what if I sold individual salad bowls of these bits of diversified assets all over the world. I’ll call the salad bowls mortgage-backed securities. Each salad bowl would carry a report card issued by a credit-rating agency such as Moody’s or Standard and Poor’s. But of course there is no way logistically to investigate the content of each individual salad, so the final rating will be determined based merely on an educated guess–on mathematical modeling.

For a while, the system worked spectacularly; securitization became particularly useful in the financing of expansion in the developing world. And even today we have to figure out reforms that both preserve this process but also make it transparent. But back then, it worked out particularly good for the banks–in fact, too good. In the five months prior to the outbreak of the credit crisis, for example, some Wall Street banks, because of the huge fees earned through this process of securitization, were achieving a return on equity in excess of 30 percent. During that particular period, some of the world’s savviest investors, including George Soros and Warren Buffett, were achieving rates of return of only half that amount. Nobody, including the regulators, ever asked how the bankers could overnight have become such brilliant investors.

Then something happened to fundamentally change the financial world. In the fall of 2007, some global investors noticed that every once in a while, one of the salad bowls contained a lettuce leaf under which was a speck of toxic waste in the form of a defaulting subprime loan. There weren’t many of these contaminated pieces, but if you ate that salad’s speck, you’d be dead. The only problem: No one knew which bowls of salad contained the toxic waste. That’s called a problem of transparency. In financial markets, when transparency is compromised bad things happen. Markets become highly volatile.

Suddenly, the global investment community was no longer ordering salad. Investors had suddenly declared a global buyers strike against the sophisticated paper instruments of securitization that formed one of the main windpipes of the financial system. The unpurchased salad began piling up. Our financial system began wheezing for lack of financial oxygen. Then the patient turned red, then blue, and then all hell broke loose. And although the central banks’ actions since then have unclogged the patient’s windpipe some, things have yet to return to normal. And one reason is despite government’s quick efforts at reform, including the bank stress tests, the suspicion is that the industrialized world banks still have balance sheets with murky balances, including off-balance-sheet liabilities that reflect overly optimistic valuations.

So at the heart of the of the Great Credit Crisis was not the fact that some financial institutions made mortgage loans to poor people who defaulted on those loans at a rate three times higher than normal. Such political banking shouldn’t have happened. But if it was all just about mortgages, the global financial market would have experienced merely a bumpy six or eight weeks of turbulence. Instead, the credit crisis involved something far more fundamental–the collapse of global investor confidence in our financial architecture itself. The fact is we have surrendered control of our financial system to 5,000 specialists who are the only people who can understand the nature of these sophisticated financial paper instruments, particularly during a crisis. Global investors concluded our complex financial system, including our system of shadow banking, no longer accurately measured risk.

This lack of transparency was exacerbated by the realization that the financial system had implemented unheard of amounts of leverage to maximize the fee accumulation from the issuance of its dubious financial paper. To make matters worse, this dubious paper was insured by mountains of even more dubious financial paper, those notorious credit default swaps, where again the only measure of risk and value was sophisticated guesses that proved in the end not to be that educated.

Our large financial institutions borrowed massively from the global ocean of capital to magnify their positions in the markets–to magnify their fee income from selling mortgage-backed salads. The failed U.S. investment firm Bear Stearns engaged in dangerous leverage–34 to 1. Freddie Mac and Fannie Mae, the U.S. financial institutions which enjoyed an implicit government guarantee, used lethal leverage of 75 to 1. But the grand prize goes to the German bank Hypo Real Estate, which employed the leverage of lunacy–112 to 1.

HOW THE BANKS SKIRTED THE REGULATIONS

There is a common belief that the financial crisis was the result of a complete lack of regulation–but that’s only partly true and oversimplifies the situation. It is true things like the derivatives market were unregulated entities. And I think the Obama Administration’s proposal for regulatory clearing house facilities, while not perfect, represents a realistic step in the right direction. The futures markets have deployed the clearing house concept for more than a decade–and to great success.

But the sad thing is that the global financial system had rules which, if followed, would have protected against a lot of the reckless risk. The BIS capital adequacy standards stipulate that banks, if they take on additional risk (such as the issuance of mountains of mortgage-backed securities), must also set aside additional emergency rainy day capital. But for the banks, setting aside more capital would have hurt earnings. So for more than a decade they deployed a scheme to circumvent risk. Out of sheer greed, the banks and investment banks nearly tanked the world economy.

To maneuver around the BIS requirements, the banks and the investment banks set up a kind of dual market. Almost every large financial institution set up independent, off-balance-sheet financial vehicles in a legal attempt to obscure risk. The outside world, including the bank regulators and credit rating agencies, thought the banks’ balance sheets looked reasonably healthy. What the world couldn’t see were the obscure, independent vehicles separate from the parent institution.

But why would a bank set up a separate vehicle not under its own ownership or control? The answer is that the banks created their own private market–a kind of automatic, legal, dumping ground for asset-backed securities with enormous fee income. But then things got complicated. The independent vehicles, using the just purchased mortgage-backed securities as collateral, issued commercial paper to the rest of the global financial market. When the global housing bubble burst in 2007, global markets suddenly became distrustful of the commercial paper issued by the independent vehicles. The commercial paper market collapsed. Now the world had a reason to hate America.

The banks had made a foolish bet. If the paper went bad, they hoped, they could cut and run. Unfortunately for the banks, global traders tied the parent and independent vehicles together by reputation. When the crisis hit, Citigroup’s stock went down almost as fast as the stock of its independent vehicles.

Now the Obama Administration has come out with its financial regulatory plan, which is already being attacked by the left as too timid and by the right as downright onerous. But there is a third opinion–the view of the agnostic. Having worked daily with financial traders for nearly a quarter century, I’m not sure any government regulator is capable of going toe-to-toe with the Wall Street wizards and their lawyers who begin figuring legal ways around the regulations at times even before the regulations are promulgated.

I recently asked a Goldman Sachs executive: “If you found a brilliant regulator, you’d hire her, right?” His response: “In a minute.” Today a senior regulator at the SEC earns between $160,000 to $190,000 a year. Executive secretaries at Goldman earn $200,000 per year. Typically even relatively junior executives can earn in the millions. It is not an equal talent match.

Washington is looking for a quick regulatory fix–a magic pill to make the financial headache go away–but the heart of today’s regulatory problem may relate more to the crumbling of the fundamental ethical underpinnings of our society. The financial crisis may say a lot about what we have become as a people.

Don’t get me wrong. I still favor our Anglo-Saxon version of capitalism which tolerates the drive for individual self interest and shareholder value precisely because, in the end, this system historically has delivered. During the 1990s under Bill Clinton this system created 20 million net new jobs. During the same period, the German financial system of universal banking, for example, supposedly a system more concerned with serving the collective good, produced a dozen net new jobs.

But make no mistake, our Anglo Saxon approach to markets is prone to abuse. It is the necessary evil we can live neither with nor without–no matter how clever Tim Geithner thinks he is in reforming the system of making and selling salad. For our regulators, this is an unfair fight which is why the public-private model of oversight may be our best recourse. The bankers along with the regulators need to watch each other because they all have skin in the game.

A WORLD TOO EXPORT DEPENDENT

Since the outbreak of the crisis, the global economy has experienced a brutal financial deleveraging not seen since the 1930s. The value of virtually every asset in the world has been reappraised downward, led by housing in the United States. The situation has been like an unstoppable force of nature, a swift downward tidal move–and it may not be over. From August 2007 until last September, we experienced a mere financial crisis. Then with the collapse of Lehman Bros. came a full-blown global panic. Nobody trusted anybody or any institution, forcing our policymakers to pull out all the stops, with almost certain unintended consequences in the future.

The U.S. budget deficit has quadrupled and the Fed has doubled the liabilities on its balance sheet. Next year federal spending will reach 28 percent of GDP. Spending has exceeded 25 percent of GDP only four other times in American history–the Civil War, the Revolutionary War, and World Wars I and II. U.S. policymakers have had no choice but to enter uncharted waters in their efforts to thaw the credit markets and revive the economy.

It is never wise to bet against the ingenuity of Americans, but the past 12 months have been a humbling experience for the economics profession. For decades, the common assumption has been that a second economic depression was impossible because today’s policymakers won’t make the mistakes of the past. This is the Milton Friedman thesis–that if policymakers in the 1930s had carefully observed the monetary aggregates and had not run a restrictive monetary policy, things might have turned out differently. And it is also the Keynesian thesis–that had Congress not blundered in 1936 and tightened fiscal policy, a lot of pain could have been avoided.

Today we are running unprecedented fiscal and monetary policies and the results to date have been disappointing. From August 2008 to June 2009, the Consumer Price Index (CPI) dropped from 5.3 percent to negative 1 percent–a 6.3 percentage point drop. During the same period in 1929-30, the CPI dropped from zero to negative 1.8 percent, a drop of only 1.8 percent. In other words, today’s deflationary trend so far is ahead of the pace of the early 1930s.

From July 2008 to June 2009, unemployment jumped from 5.8 to 9.5 percent, a rise of 3.7 percentage points. During the comparable period from 1929-30, the unemployment rate jumped from 2.3 to 5 percent, a rise of only 2.7 percentage points. The bottom line is that our fundamental theories about how different policies might have affected the outcome of the Great Depression are today facing a test of their credibility. Meanwhile, our current, extraordinarily aggressive fiscal and monetary policies are sure to have serious unintended consequences which I’ll get to in a minute.

But let me propose a new thesis about the broader aspects of the financial crisis, including the potential unintended consequences of a global economic and financial system out of balance. For the last 18 months, we have fixated on the financial crisis and collapse in global demand brought about by the devastation collectively of household wealth, with American households alone losing between $12-14 trillion in wealth.

What we have missed is that the very model under which the world has operated the last two decades–the emerging market export model–appears to be crash landing. We in America are fixated on our financial woes, yet this export model crack up threatens to dangerously heighten geopolitical risk. That means the world could become a lot more dangerous in coming years. It turns out that at the same time that overleveraged U.S. consumer had become the world’s gluttonous consumer of last resort, large parts of the world became dangerously export dependent.

Recently, Treasury Secretary Tim Geithner was at Beijing University to assure the Chinese that despite declining U.S. financial credibility, their dollar investments were safe. The audience broke into laughter. The Chinese should be wary of such hubris. While America’s public finances are troubling, to say the least, Beijing and the rest of the world should examine the future for economies, including China’s, that have become overwhelmingly dependent on exports. Their future looks as problematic as the future of the debt-ridden United States.

As ugly as the credit markets have been, trade has been worse. Since World War II, global trade has grown twice as fast as gross domestic product. But things have shifted with the downturn. For starters, the exports of the world’s three biggest exporters — Germany, Japan and China — are 35 percent lower than they were a year ago. With American imports down by roughly the same amount, two-way trade has contracted by $1.5 trillion. There are real questions as to whether this development is more than a temporary pullback and will evolve into a quiet shift toward a new era of deglobalization.

Those in that snickering Chinese audience should consider that, on paper, the United States looks relatively immune to this trade collapse. American exports are 11 percent of GDP, according to the World Bank. Compare this to the exports-to-GDP ratios, for example, of China (42 percent), South Korea (46 percent), Germany (47 percent) and Thailand (73 percent).

Policymakers from these economies need to ask themselves: What happens if the U.S. consumer–the world’s consumer of last resort — pulls back permanently, as seems distinctly possible? Recent surveys by the Harris Marketing Group and American Express show that Americans earning over $100,000 are responsible for 50 percent of retail sales and 70 percent of retrial profits. These individuals say they are finding pleasure in pulling back. They now want to be more like their neighbors. To a point, this pullback makes sense. We need more saving, but only to a point. A U.S. savings rate of 8 or 9 percent could make recovery any time soon extraordinarily difficult.

True, the export-dependent countries are scrambling to stimulate domestic consumption. This will be tough, though, given their aging demographics almost across the board (as people age, they save more and consume less). In China, with no social security system nor much in the way of a safety net of governmental services, families save significant amounts of their income. They’d save more except that the government and state-run corporations are even bigger savers, a situation which has left families with relatively low incomes.

In Germany, policymakers have gone out of their way to limit consumption and reduce wage gains as a means of dramatically improving the economy’s global competitiveness. Yet with global demand for German capital goods waning, Germany is in trouble with serious industrial overcapacity even as consumption remains modest. The Germans’ secret hope? That the U.S. consumer locomotive starts moving again at full speed.

Indeed, Europe’s dirty little secret is that its banks are deeply exposed to loans made to emerging market trade financing, particularly to Eastern Europe. This is an exposure larger than the U.S. banks’ exposure to subprime-related loans. But the Europeans won’t fully acknowledge this exposure for one reason: They are betting on a U.S. recovery to come to the rescue.

The Chinese secretly have the same hope. Beijing boasts of its big stimulus package. Yet the government’s efforts to stimulate domestic consumption appear to be not much more than a large subsidized lending operation, a stimulus that, while producing a spike in growth now, is unlikely to be sustainable. Government lending, often noncollateralized lending, has reached a level equal to 50 percent of GDP.

Remember the big $4 trillion stimulus around last year? A lot of that stimulus was supposed to derive from spending by regional and local governments that so far hasn’t materialized. Moreover, transforming China into a consumer economy to compensate for lost exports will take years. Meanwhile, the theory that China’s stimulus will rejuvenate the rest of Asia seems to be crash landing too. Last month, Japan’s exports to China dropped by 30 percent, which was an accelerated decline from the previous month. China’s exports to Asia declined by 36 percent, again an accelerated decline from the previous month.

The Chinese leadership talks of having already emerged from the global recession, yet China’s recent aggressive trade conflicts and provocative strategic positioning toward India indicate just the opposite. Trade is 42 percent of China’s GDP. Global trade has collapsed. If this collapse in world trade is not a problem for China, I don’t know what is. It is not surprising that geopolitical risk is soaring and China is hardly helping the situation, a fact that is underappreciated by global equity markets.

China has contributed to a global commodities bubble with its massive commodities purchases and stockpiling since late last year. These purchases were intended as the ultimate inflation hedge as China waited for the U.S. consumer to come back. Here’s the problem. Once China puts a halt to its panic-stricken lending practices, and that halt or slowdown is coming soon, today’s commodity bubble will burst. The resulting deflationary after effects will prove to be a real headache to the world’s central bankers. And the disillusioning fact is that China will continue to remain a mystery because of the severe censorship of economic data that began in June.

But the important point here is after the outbreak of the financial crisis, the world proclaimed that the “Washington consensus is dead.” The “Washington consensus” was the policy of the past two decades urging the excess saving/export-dependent economies to bolster their domestic sectors. The major governments of the G20 concluded that the financial markets, not global imbalances, were alone the cause of the crisis. And since then, these governments have spent more than $30 trillion (roughly 100 percent of the GDP of the United States, Europe, the United Kingdom, and Japan combined) attempting to reestablish the pre-crisis level of prices for financial assets before the global collapse in trade, consumption, and industrial production set in.

Yet what have been the results of this new policy? From January to May 2009, the U.S. trade deficit halved. Personal savings jumped from nothing to nearly $800 billion. A year from now the U.S. trade deficit will likely have vanished.

Let me put this in perspective. The world has spent more than $30 trillion to return capital and trade flows to their pre-crisis levels. Yet trade and industrial production have collapsed by rates worse than during the first years of the Great Depression. And, comparatively speaking, this collapse has been less aggressive for the United States than for our trading partners.

The G20 is committed to protecting an economic order that no longer exists. This is why analyst Criton Zoakos calls these nations “zombie governments.” Today’s policy paralysis will soon become tomorrow’s political paralysis. Incumbent governments in Britain and Japan already are experiencing the lowest approval ratings in history. Global political paralysis may be just around the corner.

COMING TREND TOWARD DEGLOBALIZATION

Notice that we are already seeing a stealth-like shift toward deglobalization, which is not good for the world economy but is absolutely devastating for many emerging market economies. World governments should listen carefully to President Obama, a leader with an uncanny ability to make activist, even radical, proposals sound benign. At the recent Group of 20 Summit in London, for instance, Obama said the United States cannot be the world’s consumer. On the surface, this sounds like a statement about the temporary condition of the business cycle.

Actually, Obama was talking about something far more significant — not outright Smoot-Hawley-style protectionism but the potential for a coming policy of small tax, spending and regulatory changes that will encourage this quiet trend toward deglobalization. Like it or not, this shift reflects a growing Washington mind-set that globalization has gone too far. Witness the ‘Buy American’ provisions on Capitol Hill and China’s own new ‘Buy China’ policy. Obama is playing not only to his union supporters but also to a segment of the U.S. corporate community whose enthusiasm for the global supply chain and “just-in-time” inventory management is waning. The Europeans are following the same route. Indeed, in responding to the financial crisis, the European governments themselves found surprising difficulty arriving at a unified response and largely preferred go-it-alone approaches.

And the coming rise in shipping costs has the potential to turbocharge this deglobalization process. The U.N. agreement last October on sulfur-burning levels for ships (not to mention California’s own restrictions on ship emissions) could send shipping costs skyrocketing. A decade from now, it may be profitable to send by sea only items with relatively high value to weight, such as laptops. The net result could well be that a lot of low-wage jobs that moved to China, India and other emerging markets will move back to the West. This is already happening in the furniture industry.

But here’s the punch line: A capital-dependent America can’t easily decouple from the world. Nor can we separate ourselves from geopolitical risk. For now America needs the world’s capital as much as the world needs American consumers — an economic situation tantamount to a policy of mutually assured destruction. True, the global system needs rebalancing. But until that happens, the Chinese should stop snickering at our Treasury Secretary and weigh the fact that in this interconnected world of finance and trade, there are no escape routes of independence. That’s why the world’s prominent economies need to think seriously about a joint effort to achieve a permanent worldwide recovery despite serious headwinds.

GLOBALIZATION PARADOX

In the end, globalization is the great paradox of our time. On the one hand, it produced unprecedented wealth creation and helped bring a billion people out of poverty. On the other hand, it distributed that wealth unequally, creating huge, troubling disparities in income. At the same time it sent us on a terrifying rollercoaster ride of financial terror that now could bankrupt us as our policymakers experiment with various remedies that are certain to have far reaching unintended consequences.

My worry is also that our policymakers will attempt to achieve economic and financial stability as an end goal, but that stability itself in may not be enough to satisfy the American people. Talk about heightened expectations. The median age American was born in 1966. All he or she has known are economies with unusually low levels of joblessness with high levels of GDP growth. Now they are about to face potentially a world of diminished economic performance. Along the way, our policymakers will face some serious questions: Can we effectively roll back globalization? Or can we have “smart” globalization? And what level of financial risk from now on is considered reckless–or is dangerously inadequate? And who decides in today’s economic system of enormous complexity how much leverage is adequate? What wizard is smart enough to make the call? Last year I asked a friend, Bill Seidman, the former F.D.I.C. chairman who sadly has since passed away, who could decide this question of leverage? Seidman’s answer was to be successful, that person would need almost supernatural powers–“a person with divine inspiration,” he quipped. “Know anyone qualified for the job?”

Nothing about the coming world will be easy. The big Wall Street banks deserve to be fitted with straitjackets. But having the banks become like water or electric utilities, while it is what they deserve, may limit the distribution of risk capital to business startups and small businesses which Barack Obama says are responsible for 70 percent of all net new jobs. The American financial system has been unique because of its ability to deliver financing to new startup ventures, the entrepreneurial risk-taking sector. Most of these risk-takers fail, but a few go on to become googles. Compare that to the European system with less tolerance of new innovative risk and thus less employment opportunities. But then can we ever trust Wall Street again?

TROUBLING UNINTENDED CONSEQUENCES

The question is where things go from here. The good news is that the world is not lacking in capital. Today there is plenty of capital–a lot of it still on the sidelines. This includes trillions in money market funds alone. Global stock markets have rebounded some, creating more than $10 trillion in corporate equity value. Corporate debt yields have fallen. This stock surge is encouraging as long as we remember the stock market in the 1930s rose by more than 20 percent on five separate occasions.

The bad news is consumer spending, 70 percent of our economy, could continue in the doldrums for a long time. U.S. households are still shell-shocked having lost collectively $12 trillion in household wealth. People are spending just on what is essential. Neiman Marcus is down 30 percent; Walmart is up 3 percent. Sounds fine, unless you work for one of the suppliers to Neiman Marcus.

The most troubling issue is interest rates. Since Christmas, U.S. long-term interest rates have nearly doubled. Rising rates make it difficult for housing prices to find a bottom. Rates have recently come down as the Federal Reserve has taken the unusual step of purchasing Treasury bonds. To many bond traders, this has been an early Christmas present, a huge wealth transfer from U.S. taxpayers to bond market short sellers. But this is a potentially explosive issue politically, so the Fed’s purchases are not likely to continue permanently.

Washington is struggling to find an answer to why rates have risen from last year’s lows. The Administration says while we are still in recession, the depression scenario of last December is now off the table. Thus the market is simply adjusting rates to this new reality. The Chinese and others finger America’s extraordinary budget deficits, some of which President Obama inherited. The Chinese fear the Federal Reserve will monetize Obama’s quadrupled budget deficits eventually producing higher inflation. Either way, trying to have an economic recovery with rising long-term interest rates is like trying to sprint through an Olympic-sized swimming pool. It is a slow going, disappointing race.

The truth is the deficit has been an unreliable economic predictor. The reason stems from this ocean of capital I’ve been talking about. For example, interest rates (10-year Treasury bond yields) never dropped below 5.25 percent the entire eight years of the Clinton Administration which produced budget surpluses. Yet at one point during the deficit-ridden George W. Bush Administration, long-term interest declined to nearly 3 percent–and at a time of relatively robust growth.

Here’s another oddity. When inflationary expectations rise, long-term interest rates are supposed to rise. In mid 2007, inflationary expectations were around 3.2 percent. A year later, still at a time of significant budget deficits, expectations had jumped to 5.2 percent, the highest level in 25 years. Yet long-term interest rates dropped.

Running large budget deficits for long is a crazy way to operate an economy. It means sacrificing control to outside interests. But it is important as we work our way out of this deficit stranglehold, to understand the nature of this globalized financial system.

Even the world’s best minds sometimes have trouble figuring out this system. A few years ago, Warren Buffett, concerned about America’s budget deficits, bet big on a dollar freefall, arguing that foreign investors would flee the dollar in droves. Buffett called this trade a “slam dunk” and lost a reported billion dollars on the bet. Then the dollar completely reversed course which frankly is what happens to the reserve currency of an international system. There are continual periods of volatility.

Why have even the experts at times been off the mark about the effect of deficits? A good guess is they underestimated America’s ability to import capital and to innovate. Buffett was correct that foreigners were concerned about America’s deficits. Turned out they cared even more about the attractiveness of U.S. asset markets relative to asset markets elsewhere.

Yet just because the United States dodged the deficit bullet in the past is no guarantee for the future, particularly if there are concerns about the attractiveness of the United States as a target of investment. It will be interesting to see whether the Obama health care reforms produce the expected budgetary savings. I hope so. But as for keeping the U.S. economy an attractive magnet for global capital, Washington’s recent heavy-handed effort to trample the rights of automobile company bond investors sent a troubling message worldwide.

After the Second World War, America grew out from under a massive deficit. But that was after four years of pent up demand followed by unprecedented optimism. By contrast, consumers today are in a gloomy period of deleveraging.

That leaves investment as the primary growth engine if we have any hope of both dealing with deficits and reviving our economy. The president wants government investment in new green technologies as the “game changer” for the 21st century. All well and good. We wouldn’t have the Internet had there not been Pentagon investment. But my concern is with timing. It could take two, three or even four years to sort out the winners and losers in government investment efforts. That’s a similar situation to what happened when, after the financial liberalization of the late 1970s, a lot of venture capital appeared in the 1980s. It took years to sort out the winners from the losers before the general investment community stepped in.

That is why Barack Obama will have no choice but to try to stimulate private investment and innovation which are likely to have a far broader and more immediate impact. Without an explosion in innovation, Washington in trying to confront the deficit could be in a situation not unlike rearranging the chairs on the deck on the Titanic. But innovation entails risk-taking. And my great fear is that we are moving from a period of reckless financial risk-taking to a situation even more dangerous–no financial risk-taking as all our efforts focus on stability as a short-sighted end game. Economic depressions ironically often produce aggressive bouts of innovation. The Obama Administration needs to encourage this process by pivoting some strategically to help reignite the investment-led engines of our economy.

If you listen to policymakers, they’re always talking about liquidity. “We’re providing liquidity,” Ben Bernanke assures us even as the banks refuse to lend and companies refuse to borrow. But when all is said and done, economies are influenced by more than numbers, by more than the size of central bank liquidity injections or the size of a stimulus. They are ruled by psychology. That’s why, at the end of the day, the definition of liquidity comes down to one word–CONFIDENCE. Liquidity is confidence. And if our leaders can restore confidence, the financial system will begin operating efficiently and eventually we’ll rise out of today’s quagmire.

David M. Smick, is Chairman & CEO of Johnson Smick International and the author, most recently, of the book The World Is Curved: Hidden Dangers to the Global Economy. Portions if this article reflect remarks presented by the author June 30, 2009 at the Aspen Institute’s “Ideas Festival.”