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5 THE INTEREST RATE CONUNDRUM,
Part 2
How
currency devaluation destroys
wealth <
/STRONG>
By
Henry C K Liu
network of
hedging blurs the all-important dividing line
between debtor and creditor, and allows an economy
to borrow from itself, not just against its
future, but against its current and less
sophisticated debt, not for productive investment
to generate real wealth, but for financial
manipulation to achieve virtual profit.
The use of debt as collateral for more
sophisticated debt has
characteristics of a bubble.
The broad unbundling of risk to maximize
transactional surplus (profit) ultimately leads to
the socialization of risk (transferring unit risk
into systemic risk), while the privatization of
the resultant profit remains a sacred
prerequisite. This maldistribution of virtual
wealth exacerbates both the risk and the effect of
a bubble by making a bubble inside a bubble.
The Bank of International Settlement's
Lamfalussy Report defines systemic risk as "the
risk that the illiquidity or failure of one
institution, and its resulting inability to meet
its obligations when due, will lead to the
illiquidity or failure of other institutions". The
prospect of systemic risk becomes commonplace when
lenders are also borrowers who depend on the
return of the funds they lent to pay for the sums
they borrowed.
Risk of illiquidity, not
any drop in demand for goods or loans, is the
improvised explosive device (IED) of financial
terrorism that puts in harm's way unsuspecting
investors running a relay race on the
debt-securitization treadmill.
Whether or
when a bubble will burst depends on the central
bank's ability to extend the bubble's elasticity,
which is not unlimited, albeit flexible through
inventive redefinitions of theoretical
relationships and the cause-effect paradigm. To
support the market, a central bank needs
increasingly to intervene, which in turn destroys
the market.
As is already apparent, the US
Federal Reserve is increasingly reduced to an
irrelevant role of rationalizing the virtual
finance economy rather than directing it. It has
adopted the role of a cleanup crew rather than the
guardian of public financial health.
Ironically, a cure for a debt bubble can
come from a bloodletting through asset
hyperinflation, euphemistically called "unlocking
value". In that scenario, the traditional strategy
of holding cash gives no protection, because real
currency value can fall faster than nominal
asset-price depreciation. Such hyperinflation has
brought down many governments and socioeconomic
systems in history.
In a financial bubble,
the real economy may not be growing, but the
monetary value of financial assets rises, and is
defined as growth, not inflation. Thus we have
robust "recoveries" that continue to lose jobs,
with the value of money protected by high
unemployment and stagnant income from wages. Or we
can have a recovery with low unemployment with
rising nominal income that is accompanied by a
decline in real aggregate income, with wages
falling behind inflation.
In the finance
sector, wealth is created by escalating systemic
risk-taking, known as the "Greenspan put".
Inflation and deflation have become two sides of
the same coin that alternate as monetary concerns
in a matter of months, through a highly
manipulated global foreign-exchange market that
tends to destabilize real economies via a
multitude of conduits such as wealth effects,
balance-sheet effects, and recurring alternates of
credit excesses and crunches and liquidity booms
and busts.
Central banks seldom adjust
their monetary policies to arrest asset bubbles
and related imbalances and instabilities. The days
of the central banker being the spoiler who takes
away the punch bowl when the party gets going are
long gone. Central bankers now bring stronger
drinks when the party slows.
While central
banks still cling to the mandatory task of
fighting inflation, they never try to reverse
inflation by allowing deflation. Thus any battle
lost against insipid inflation is a battle lost
forever, with no prospect of ever regaining lost
ground. Therefore among market participants, bulls
enjoy the advantage of having the wind of
inflation behind them even in a continuous bear
market.
Inflation targeting becomes
labor targeting In the United States, the
Fed has served notice that it is prepared to move
toward inflation targeting to prevent deflation,
as suggested by then board member Ben Bernanke,
now Fed chairman.
Prices of assets can
only go up but are never allowed to fall, even to
adjust previous irrational exuberance. Trapped by
their own doctrinaire fixation, central banks will
continue to provide excess liquidity to support
asset-price bubbles, and to mask the
destructiveness of burst bubbles by unleashing new
bubbles with more liquidity, euphemistically known
as recoveries.
At the same time, central
banks will vehemently fight inflation as measured
by rising wages. Thus central banking operates
with a severe institutional bias against labor.
In fact, market volatility, another term
for shot-term instability, in the financial sector
of the economy has become a major source of profit
for financial institutions. Long-term investors
are endangered species in the financial world;
most market participants have become leveraged
traders for short-term profit, even pension funds
and university endowment funds. The only factor of
production that maintains any semblance of
stability is wages.
The recurring
financial crises around the world shared similar
characteristics. Each crisis was largely
unanticipated by market analysts and central-bank
economists, with the forward markets providing no
indication of the impending upheaval.
Going into each crisis, complacent traders
took on highly leveraged long positions in
currencies, bonds, or spread products that soon
came under heavy speculative counterattack. In
each case, traders adopted trading models
constructed from historical paradigms to guide
their trading strategies. When a decisive majority
of traders followed similar trading strategies,
the market would overshoot from technical
pressure, and conventional wisdom became
disconnected with reality. But once a crisis hit
and conventional wisdom was discredited by facts,
traders rushed to liquidate their highly leveraged
positions en masse, hoping for a timely exit
before the crowd.
In each instance, the
rush to unwind highly leveraged positions
accentuated the magnitude of the currency or
fixed-income crises.
Exchange rates and
purchasing power parity Theoretically,
exchange rates adjust to achieve purchasing power
parity (PPP) between two currencies. PPP is
achieved when a unit of domestic currency can
purchase the same quantity of goods in another
economy when converted to foreign currency at the
prevailing exchange rate, to conform to the law of
one price.
If PPP holds, then identical
baskets of goods should sell for the same price in
each economy after exchange-rate conversion. If
they do not, then opportunities for "risk-free
profits" will exist through arbitrage in
foreign-exchange markets that translates into
massive flows of funds across national borders.
Eventually, price arbitrage will set a market
exchange rate, or the prices of goods in the two
economies will change so that PPP between the two
currencies is re-established. With deregulated
global capital markets, prices of assets also
adjust toward convergence of PPP between two
currencies to cause market crashes.
In
adjusting, the market tends to overshoot up or
down like the swing of a pendulum until
equilibrium sets in. But if the overshoot is
boosted each time by speculative forces, then the
swings of the pendulum will never reach
equilibrium.
The dollar-exchange-rate
overshoots of 1985 and 1995, similar to the 1994
global bear market in bonds, proved to be
transitory events. But while the dollar-crisis
episodes represented dramatic overshoots at major
turning points in the dollar's long-term trend of
decline, the 1994 global bond market selloff in
hindsight seemed to be simply an interruption of a
long-term rally in global bonds, although
substantial losses were incurred during the
selloff. This was because the Fed used a bigger
bubble to cushion the collapsing bond bubble,
keeping interest rates low, causing nominal bond
prices to rise, while in fact the real value of
bonds might have declined.
The lessons
of 1994 It is instructive to analyze the
situation in 1994 because the data and dynamics
are by now indisputable.
Going into 1994,
many highly leveraged fund managers had taken on
huge long-duration positions in several key
markets after riding the 1993 global bull market
in bonds created by historically low interest
rates, and thought that additional hefty returns
could be achieved in 1994 by maintaining those
highly leveraged long positions. But they
evidently ignored the fact that leading indicators
of global economic activity were already turning
up strongly from the long period of monetary ease
accompanied by currency devaluation, making those
long positions extremely vulnerable if there
should be a shift in monetary policy toward
tightness, meaning rising interest rates.
The US Federal Reserve's rate hike from
its low of 1% that began on June 30, 1994, that
eventually reached the current 5.25% on June 29,
2006, was the catalyst for traders to unwind their
highly leveraged long positions, triggering a
major selloff in bond markets around the globe.
Global bond yields rose by 200-300 basis points,
or 2-3 percentage points, on average over the
first three quarters of 1994, causing a collapse
in bond prices. By the fourth quarter of 1994,
bond yields managed to stabilize and then begin to
fall steadily in 1995, causing a bond-price
rebound. By late 1995, bond yields had returned to
their pre-crisis levels.
This pattern of
collapse followed by stabilization and then
recovery through stealth inflation was not too
dissimilar to the pattern of the dollar's collapse
in early 1995. In both crises, the collapse stage
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