Page 3 of
4 Cold turkey for financial
addiction By James Cumes
trade. Its essence is that money is
borrowed in a market where borrowing costs are low
and invested in markets where returns are high.
This has meant borrowing, for example, in Japan or
Switzerland and investing in, for example,
Australia or New Zealand - or, for that matter,
Iceland or the United States.
The carry
trade has apparent advantages. It is part of the
financial regalia that enables the
high-consumption economies to keep right on
consuming; but that coddling of debt-based consumption
also
has its price, particularly by creating huge trade
and payments deficits and by stimulating the
export not of products of domestic industry but of
the industry itself.
The US dollar, for
example, loses value vis-a-vis "producer"
currencies and commodities, its role as a reserve
currency is undermined, and volatility - on which
speculation thrives - replaces the stability
derived from, for example, gold or the system
based on the dollar, which in turn was related to
gold, contemplated under Bretton Woods. Stability
is replaced by an anarchy that encourages movement
away from production and fixed-capital investment
into asset-price speculation and "ownership"
investment.
Another part of the price is
that the tap might be turned off at any moment,
and perhaps quite sharply, if the carry trade
reverses - and, sooner or later, reverse is what
it certainly will do. If the Japanese yen
appreciates or threatens to appreciate
sufficiently or if interest rates in Japan move up
significantly, a robust carry trade will rapidly
become a robust unloading exercise.
The
outcome can then be that asset-price booms are
sharply collapsed and, down the line a little,
consumers too are required to adapt themselves to
more Spartan living. The export-driven economies,
which are based on high consumer-export markets,
will also be hurt. So the markets will carry the
impact of speculative volatility from one point to
another.
As part of this, we might just
take a quick look at the way in which the housing
market in Australia has appeared to evolve. Recent
years brought a frenetic boom to Australian
residential property, especially in Sydney and, to
a lesser but significant degree, in Perth. The
boom then showed signs of slowing, again
especially in Sydney.
That tendency to
slow still applies to the Sydney market, although
prices even there have recently seemed to be
moving up again. However, what seems to be
especially worthy of note at this point is that
prices in the capitals of most of the other
Australian states seem to be heading or to have
already gone into frenetic mode. This is despite
affordability for houses and apartments having
declined dramatically for the average buyer. So it
would seem that much, at least, of the persistent
boom in housing is due to speculation rather than
to demand from the consuming public.
That
suggests that funds have been flowing into the
housing market, presumably in a quest for capital
gains through asset-price inflation. Where have
these funds come from? Frankly, I do not know from
any reliable data available to me; but a
reasonable hypothesis may be that some of it is
foreign money, possibly from the carry trade,
seeking to find profitable outlets for the money
borrowed cheaply in - most likely - Japan.
The housing that is being bought in
Australia, except possibly some in Sydney, would
seem to be different from the largely alpha-luxury
property that, for example, is being bought in
London by foreign money seeking speculative
outlets for investable funds; but something the
same kind of speculative stimuli may be producing
much the same kind of ultimately unsustainable
property boom in Australia.
In either the
Australian or the London case, a collapse of the
housing market - along probably with a collapse of
other asset markets - is inevitable. It is a
question only of when rather than if.
That
"when" might now be rather close. It could get
under way as early as the next couple of months.
October and November have seemed to be dangerous
for events of this kind in the past. The US
stock-exchange crashes of 1929 and 1987 are
examples. The current nervousness on Wall Street
and stock markets around the world may quickly
flow on to asset markets everywhere.
Central banks now recognize the dangers of
a meltdown in credit markets and seem ready to do
whatever they can to prevent it. They have already
made available to banks at least half a trillion
dollar-equivalent loans to give them extra
liquidity. The US Federal Reserve has cut the
discount rate. They have kept the more general
interest rate, or "bank rate", on hold, and some
might be about to reduce it.
But the
feature that is perhaps of most significance and
that carries the most startling risks is their
willingness, already demonstrated by the Fed, to
accept "securitized" paper, even relatively
high-risk collateralized mortgage paper, as
security for their loans to the banks. That
process would seem to mean that that paper would
become, in some measure, a substitute for Treasury
bills or similar securities of other central banks
that have been used in traditional open-market
operations in the past.
Already the
limited acceptance of this paper is a token of its
extraordinary evolution toward respectability. The
junk bonds or creations of what I once called the
"adventurers, marauders and buccaneers" have now
been endorsed by central banks as seeming to
belong in the same ball-park of acceptability as
gilts or Treasuries.
This may be, on the
one hand, the only real way to deal effectively
with the disruption to credit that this paper has
caused and threatens further to cause on a vastly
greater scale. Only in this way, perhaps, can the
vast burden of intrinsically speculative debt be
"neutralized". On the other hand, if the practice
is indulged in any sufficient way for it to be
effective in its "neutralizing" function, it will
destroy the US dollar and perhaps other currencies
and put the entire global financial system as we
have known it at grave risk.
To make
"liquidity" available to the banking system is not
to be certain that the banking system will use it
in a way to keep the credit markets adequately
open to normal commercial business. At the same
time, if the central bank proves willing to accept
any amount of this securitized paper, then it
would mean the injection of mountains of paper
currency into the financial system, presumably
starting with the United States but possibly or
probably extending to other major financial
markets and ultimately polluting the entire global
system.
If the "notional value" of
derivatives is something of the order of $600
trillion, we do not have to postulate that the
central banks will absorb and "neutralize" all of
this paper. Even if they were to absorb only 10%
of the notional value, this would amount to about
$60 trillion - more than the GNP of the entire
world economy.
The figures are so
staggering in themselves that the mind boggles;
but perhaps the even more important thing is that
we - and the central banks - cannot know the true
extent of the problem that confronts them. Will
they have to accept "only" 10% of this paper or
will 1% turn out to be enough? If only 1%, what
impact would acceptance of paper to that amount -
$6 trillion - have in unfreezing the credit
markets?
Would it also mean that central
banks would have embarked on a course of
hyperinflation that would make the US dollar and
possibly several other major currencies worthless?
There would then have to be an issue of new
currencies as there was after the hyperinflation
in Germany in the 1920s. There would also have to
be a fundamental renegotiation of the ways in
which the global financial system would operate.
All of that would take time. While it was
going on, national economies and the global
economy could be brought near to standstill.
Economies might have to resort to some form of
barter as the only way in which trade could
continue securely to take place. Unemployment
would become socially devastating. Many
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