By Neville Bennett US real interest rates are negative. In effect, the Fed is giving away money. Every financial institution in the world of any magnitude is borrowing US$ and investing it for positive yields or opportunities elsewhere. This massive carry trade is feeding arbitrage and asset-buying sprees and bubbles in everything from gold, the shares, Hong Kong penthouses, and even fine wine. The APEC leaders rightly warned about the dangers of the carry trade, but did not discuss the remedy"”raising US interest rates. Obviously the US administration is prioritizing domestic recovery, but my argument is that this is creating bubbles. The Americans are aware that bubbles are forming, but some of their spokespeople are making the incredible argument that there are good and bad bubbles and the present ones are OK. There are times when one wonders if the inmates are in charge of the asylum! Lax monetary policy is creating the next crisis.
APEC To be sure APEC paid lip service to sustainable growth, and it supported polices "to help prevent credit and asset price cycles from becoming forces of destabilisation". But this was only one of many desirable targets: poverty reductions, SMEs, mobility of workers, and enhanced womens' access to education were mentioned before climate change, curbing protectionism, supporting multilateral trade and accelerated regional integration. It refrained from emphasizing global imbalances, but it is an oxymoron that imbalances are an impediment to sustainable economic growth. The stimulation of the US economy is widening internal imbalances by increasing its deficits and Asia's surpluses. These imbalances are not addressed because, as Geithner said at G20, "they cannot be addressed by the United States alone". The US will not control its deficit and China will not reduce its surplus. Meanwhile the carry trade is flourishing. Carry Trade Some analysts believe that the unwinding of the yen carry trade deepened the Wall Street crash last year. The Wall Street crash ignited a rush for security, and this was reinforced by US investors selling off foreign assets to meet liquidity needs. Once the US dollar appreciated violently there was a mad rush for the exits as investors unwound their yen trades and released an avalanche of fire sales. A sudden change in exchange rates could precipitate a massive crisis arising out of the US$ carry trade. Speaking at APEC, Donald Tsang, CE of Hong Kong, said that the dollar carry trade "scared him" because Japan's zero interest rate policy had created asset bubbles around the world. He foresees "gyrations in financial markets and asset bubbles". Tsang is conscious of this because of record land prices and a 28% rise in house prices this year. As the Hong Kong dollar is pegged to the US$, it is forced into low interest rates which are driving the property bubble. The carry trade is thriving because the Federal Reserve has promised to keep rates "exceptionally low" for "an extended period". This certainty means that hedge funds would be deranged if they did not borrow US currency and invest it in higher yielding assets such as Australian securities. The trade is even more profitable because the US dollar is depreciating so it is easy to repay the original principal. Traders would be mad not to gear up. Similarly the cost of speculation in commodities is low but the rewards outstanding. Also attending APEC, Robert Zoellick, president of the World Bank, urged central banks to think about depressing bubbles. He explained that Asian bankers were reluctant to raise interest rates as this would attract too much capital and strengthen their currencies. He recommended administrative action to restrict credit as well as raising rates. As I write, The Bank of Japan has condemned US zero interest rate policy for inflating assets and threatening global economic recovery; "emerging economies" particularly "might overheat and experience financial turmoil". Moreover, China's top banking regulator complained that US policy presented "new, real, and insurmountable risks to the recovery". Speculative inflows are causing great concern. I suspect they are affecting the New Zealand housing market which appears to be rising despite poor affordability. More significantly, speculative capital is causing concern in many emerging markets whose currency is rising. China is feeling the pressure. Taiwan, Russia, Brazil, Thailand and Chile are planning to slow this capital inflow. These capital flows underlay the surge in profitability of banks and investment banks around the world, including the big Australian banks. They are booking huge profits while often enjoying government guarantees. The burgeoning trade once again threatens over-commitment. Bubbles The essence of bubbles is that asset prices greatly exceed intrinsic value. Investors assume the market will rise much higher than fundamentals would suggest. Professor Fred Mishkin, a former Fed Governor, has asked if the current rapidly forming bubbles mean that the Fed should exit from its zero-interest rate policy. Mishkin answers "No" because not all bubbles are dangerous, especially the present category which he calls "the pure irrational exuberance bubble". He believes the Fed should uphold its policy of exceptionally low interest rates for an extended period. Mishkin concedes that the alternative, "credit boom bubbles", are dangerous. Both types form in exuberance and lead to asset price increases. The latter become malignant when further lending against these assets increases demand and creates a positive feedback loop. The loop involves increased leverage, an easing of credit standards, and then more leverage. When the bubble bursts; loans go sour, deleveraging occurs and prices decline. Loan losses weaken financial balance sheets and diminish credit. Deleveraging depresses business and household spending. In the 1987 stock market crash and the late 1990's tech wreck, Mishkin says, there was not a credit boom, and the crashes did not cause deterioration in bank balance sheets. Mild recessions followed. Mishkin thinks present bubbles are not credit bubbles "Credit markets are still tight", so low interest rates should remain. This is an extraordinarily ignorant view. Credit might be tight for business, but it is available in finance and especially for speculation in the markets. The big brokers and banks maintain a safe margin (deposit) on highly leveraged loans. Arbitrage is the most profitable business around at present because of the low cost dollar. An increase in US interest rates is essential to restore some fundamentals. I would like to invite interest.co bloggers to discuss evidence that cheap US interest rates are spilling into NZ. Obviously there is a currency effect, but are foreigners buying NZ assets? * Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared. neville@bennetteconomics.com www.bennetteconomics.com
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