The Next Bubble?

OK I am officially done with this. We are scarcely beyond the crisis, indeed from my perspective we are still firmly mired within it, than we are faced with a torrent of hand wringing about our ‘over accommodating’ monetary policy. Not just here but worldwide.

How many times do we need to talk about this?

Too many, obviously.

There is a new catch phrase in town we all need to get used to: the ‘carry trade’. This apparently is something so dire that we need to raise interest rates right now even though everything we know tells us otherwise. Deficit hawks all over the globe are now talking ‘carry trade’ at every opportunity.

What’s that?

The phrase carry trade describes the flow of capital around the world based upon borrowing short term in low interest rate currencies – notably the dollar – and investing in higher return and usually longer term assets elsewhere. In the old days this flow would be called ‘hot money’. Nowadays we call it ‘the carry trade’.

The source of the flow is all that liquidity we pumped into defunct economies like the US. Trillions of dollars are now sitting about the place with nowhere to go: the US is determinedly avoiding investing in its own businesses and infrastructure, so the cash needs a home. Naturally it tends to flow to where the returns are highest. At the moment that’s the Asian market place where local economies have regained a goodly growth rate and therefore look, for now, like a good bet.

But since the amount of cash available is way in excess of the opportunities to invest in sensible stuff like factories it is finding its way into silly stuff like Hong Kong apartments and commodity stockpiles.

Can we all say bubble?

Since we have all just been burned by the stupidity of the banking system and its complete inability to discern the difference between good and bad investments, it is only natural that conservatively minded folks around the world are now building up to a panic over the possibility of a new bubble. The flow of cash into flat-out speculative and downright silly investments is well under way. No doubt the geniuses on Wall Street are currently figuring out how to securitize and sell it all to unsuspecting investors. That’s what financial geniuses do. Anything to make a quick buck and hit this week’s quota.

The drumbeat of reaction is building and the financial media is almost hysterical over the potential damage this all could do if and when interest rates in the US start to rise.

Here’s the problem: in the carry trade nothing is invested for long. Yes the assets may look long term, but they are being held speculatively for the short term – until something better pops up. Once US rates rise the arbitrage gets squeezed and the speculators run for cover. All that hot money flees home and the asset prices that depended on it, indeed the asset prices that were inflated by it, collapse. This sparks a banking crisis. And we all know how that goes.

So the world’s central banks are riddled with fear that if rates stay too low for too long this new round of bubbles will implode soon.

Hence calls for the US to raise its rates even though unemployment is way too high.

Let them eat cake. Just protect those banks.

Here’s what these finance ministers seem to be missing: if that hot money does move and create big holes in stupid bank balance sheets [is calling a bank stupid an oxymoron these days?], who cares? It is not necessarily a macro economic or fiscal policy event. It is a financial regulatory policy event. It would call for a bail out of the banking system. Again. It would not call for the ending of expansionary fiscal policy.

At its root the ‘carry trade’ panic is a reaction to fiscal deficit spending by people who ideologically oppose such spending anyway. They see ghostly bubbles everywhere they look simply because of their visceral dislike of government deficits. Naturally these are the same folks who argued we should not do anything about the US real estate bubble that caused all this commotion in the first place, but, hey, who wants to be consistent when there’s a good ideological panic to stir up?

I agree that we need to get back to something at least resembling fiscal rectitude in the long term. The US has been reckless ever since Reagan and the Republicans abandoned conservatism in favor of illusion. Since then the US has failed to make choices. Instead it has acted as if the world owed it a high standard of living and that, by golly, it didn’t have to actually … you know … work for it. This was the illusion. The idea was that deficits didn’t matter. The US, we were told, was so vibrant and wonderful, that foreigners would simply trip over themselves to invest here come what may. That’s because w are so special. We defy gravity too if you close you eyes and imagine hard enough. It’s the American Dream. Or something.

But the carry trade is some dark force undermining all this. It is the flood of cheap dollars we have had to print to avoid depression that now is going to boomerang and spike us.

So, we are told, we have to raise rates and stifle the carry trade arbitrage opportunity. It is our duty. Even if it means plunging into a decade long depression.

Frankly nothing could be more stupid.

If it weren’t coming from the mouths of bankers and finance ministers I would fear for their intelligence. As it is I regret it is simply an innate elitism. The kind that pervades finance folks who seem to see everything in terms of interest rates, currencies, and arbitrage. Apparently the little people have to be sacrificed once more in order to save the bankers from their own folly.

I think not.

If the banks want to throw their capital down the drain by financing the carry trade, go ahead. The same goes for the hedge funds and the private equity investors. Clearly they are all too lazy to think through the consequences of their actions even though every finance media outlet is now full of breathless analyses of impending doom. Maybe they don’t read.

In any case nothing could be more damaging than raising interest rates at the moment. Our economy could not stand the shock.

Plus: there is a very sound case to be made that we all could do with a healthy dose of inflation. Japan has just announced that it has fallen back into deflation. This is despite the massive run up in the Japanese deficit, which makes ours pale by comparison.

The lesson is all very clear: if we want to avoid a decade of horrible economic conditions and endemic unemployment we have to persist in inflating the economy. That means government spending to fill the gap left by the fear crazed and irrational private sector. And it means pumping inflation up to the 3% to 4% range – above the current Fed target of 2%. That extra inflation will have the effect of reducing debt burdens and allowing deleveraging to take place without Hoover like pain. It will allow home prices to restore equity levels and thus restore consumer confidence. It will relieve the burden on GDP of the government debt being piled up and make paying that debt down much more palatable.

But none of this will happen.

The deficit hawks have the upper hand.

We should all study the life and times of Hoover. We could well be re-living those days shortly.