The Wall Street Crisis Will Help ... Wall Street?

Michael Pettis knows more about financial crises than most people living; his book on the subject, The Volatility Machine, should have been required reading for anyone on Wall Street who thought that the rules of history had been suspended - he traced the mechanics of every previous major financial crisis, back in 2001, and was spot on in the basic dynamics that are again manifest today, and will certainly reappear in another crisis in a generation or two.

Now based in China and a close observer of China's emerging financial system, Pettis has a counterintuitive take on one of the likely results of the crisis that sounds right to me. Rather than heralding the end of New York and London, he holds that this crisis like others will actually reinforce these two cities' dominance in world financial markets:

The debate about the “paradigm shift” seems mainly to be between those who say that the current crisis marks the relative decline of Wall Street as the center of world finance and those who argue that it will maintain its relative position.

But I think the effect of the crisis will actually increase the relative position of New York and London as world financial centers. Why? I say this largely because previous global financial crises were just as brutal as the current one, or even more so (1825, 1837, 1873, and 1929 were all more brutal), and yet during the subsequent years the then-global-financial-centers became more, not less, central.

Why this happened is not hard to figure out, I think. During the liquidity booms, the great advantage of the primary financial centers – the fact that they are much more liquid than other markets – is usually sharply eroded by the huge increases in liquidity, trading volumes, and financial transactions across the world, and with them, the decline in the value of liquidity. In fact it was always during the long boom periods that secondary financial centers were able to grow in importance – just as Sao Paolo, Frankfurt, Delhi, Shanghai, Singapore, Dubai and even Hong Kong have all grown dramatically in the past 10 years.

After the booms, however, the sudden reduction in underlying liquidity and the greater value investors and issuers placed on liquid markets typically causes most of the secondary financial centers to die out as trading and issuance migrate to the deeper markets of the primary financial centers. This is simply a form of the old traders saw – “liquidity draws liquidity.” If liquidity truly dries up around the world and trading and issuance volumes collapse, the value for investors and users of capital of accessing New York or London will be greater, not smaller.

Cold comfort for those weathering the storms on Wall Street and in the City now, yes. But a useful reminder that the fundamental strengths that made these two cities the financial capitals of the world haven't evaporated overnight, and that they will remain central to the global financial system as it puts itself back together, whenever that happens.