30/10/2009: A golden paradox in the making

“As good as gold,” we say to indicate certainty and worth. Gold is safe, according to common wisdom, so rising gold prices are a sign of rising worries. Stock markets, too, are barometers of sentiment, rising or falling with the outlook for the economy.

But lately both shares and the gold price have been on a roll. Gold recently set a new record against the US dollar at around USD 1,050 an ounce. And the Dow just broke the symbolic 10,000 mark, a move that many commentators see as a sign that the financial crisis is over.

Something is wrong with this picture. How can both gold and equities rally at the same time? Is the market schizophrenic, with investors hedging their stock positions by purchasing gold? Or is this yet another skirmish between stock market bulls and gold bears?

Actually, we see a better explanation for this double surge. To connect the dots of causality and correlation, we see one factor common to both rallies: the deeply sagging US dollar. Why is the dollar behind both surges? In short, because carry trades are back.

Carry trading is an investment strategy that calls for borrowing in a low-yielding currency to buy assets in a high-yielding currency. Carry-traders get a quick win from the yield differences, since the higher yield of the purchased assets exceeds the cost of the debt in the low-yielder. When carry trades are in fashion, the exchange rate between the two currencies generates a second gain: High-yielding currencies, being in demand, appreciate against the abundant low-yielders.

The favorite carry trade of the past decade used the Japanese yen for funding and the Australian dollar for investments. Between 2003 and 2007, this trade enjoyed an average annual interest rate differential of 5% and the Aussie appreciated 10% per year versus the yen. Easy money, while it worked. Then, in the course of 2008, the Australian dollar lost 45% against the yen, more than erasing all the gains of the three previous years and putting an end to the strategy of carry-trading, or so it seemed.

But a funny thing happened in 2009: carry trades returned to fashion. The Aussie resumed its starring role as investment currency and the yen reprised its ugly duckling turn as funding currency. But this time the yen has a rival: the once-mighty US dollar. Currently, money-market interest rates paid on the US dollar and the yen are about the same. So the new carry-trade mantra is: borrow cheap greenbacks; buy Aussie assets.

Let’s be very clear on this: it is not the recent dizzying increase in US government debt that explains the dollar’s current weakness, nor is it the astonishing output of the Fed’s printing presses. Carry trades are the cancer eating at the US dollar’s value today.

Now we can connect the dots between the equity and gold rallies: it is precisely the greenback’s weakness that is driving up the price of gold. For a euro or a Swiss franc investor, gold has barely moved this year; for a dollar investor, gold has performed rather well.

We see the makings of an exquisite, truly golden, paradox in the surges of equities and gold: If, for whatever reason, stock markets were to fall by 10%, we might not see gold appreciate in US dollar terms, as would normally be expected; but rather gold’s price would tumble as the unwinding of carry trades would strengthen the greenback.

The financial crisis may be over but one of its notable aftereffects, the high correlation of usually uncorrelated assets like gold and equities, definitively is not. And we expect to see more such paradoxes in the near future.

29/10/2009: Pick your poison: deflation, imbalances or inflation

With its public deficits climbing dizzyingly into the trillions of dollars and a government debt-to-GDP ratio ominously approaching the 100% level, the US is in a fiscal tailspin. But despite all the red ink, its debt is still finding buyers, allowing US interest rates to remain very low, at least for now.

Who is buying America’s debt? This is a vitally important question because where the US is headed, the world will follow, and much will depend on who proves to be the “buyer of last resort.” There are only four possibilities here: US households, foreigners, the Fed, and financial intermediaries. Let’s look at the implications for each.

If US households buy their government’s debt, they are, in effect, saving more. While this is virtuous behavior and would help to ease global imbalances, it would also stifle consumption, which would cripple the US business cycle and, by extension, global growth. In fact, if only US households were buying US government debt, America would slip into a Japanese-style deflationary spiral, as subdued domestic private demand hobbled growth and fueled an explosive debt-to-GDP ratio, which in Japan is now set to pass the mindboggling 200% level.

If foreigners buy US government debt, they merely reinforce the abysmal imbalances between the US and the rest of the world. Indeed, they would hinder a much-needed dollar depreciation as they stockpile more US dollar reserves. How high is up? China’s reserves just passed the two trillion US dollar mark. Another mindboggling sum. These massive reserves create a global liquidity (money) overhang that could easily feed into the next financial bubble, whatever form it might take, and the next financial crisis.

If the Fed continues to do “whatever it takes” to avoid a Japanese-style slump, as Chairman Bernanke has vowed, and it buys up a mountain of US Treasuries, thus keeping interest rates low, let’s be frank here: it is just running its printing presses, with the ugly consequence of rising inflation.

And if financial intermediaries jump into the breach? Then we merely have a somewhat more sophisticated version of plain-vanilla Fed monetization of debt, where banks score a nice, riskless profit by borrowing short at the Fed (a US government entity) at near 0%, and lending long to the Treasury (another US government entity) at around 3.5%. Moreover, as long as the difference between long interest rates on government bonds and short rates on the Fed’s liquidity lending remains this high, there is no incentive for financial intermediaries to lend to businesses and individuals. So this scenario could even lead to stagflation.

In sum, there is no painless cure for our debt problem. Each remedy has unpleasant side-effects. The not-merely-inconvenient truth of the matter is that the bill for “fixing” last year’s financial crisis is about land on the table with a very loud thud.

22/10/2009: Dollar, dollar, dollar...

Travel broadens the mind, they say. In my case, a recent tour of Germany, France, Belgium and the UK, attending client events and one-on-ones, has given me a valuable new insight that I would like to share with you now: Whatever the dollar does, we won’t like it.

Talking with clients, many questions that come up have a rather local perspective, understandably. But one of the most consistent concerns among clients everywhere I’ve visited lately is the weakness of the US dollar.

The dollar’s fate has also started to concern European decision-makers. In a flight of rhetorical gymnastics at which he is becoming increasingly adept, Jean-Claude Trichet, the European Central Bank President, stated, “I trust that it is extremely important that the US authorities […] will pursue policies that are taking into account the fact that the strong dollar is in the interest of the United States of America.”

After recovering from the whiplash induced by this gem of central-banker-speak, we note that it positions not one but two big elephants in the room. The first is that, without US dollar weakness, the global imbalances that led us, over decades, to where we are today will likely not diminish. The world simply cannot satisfy its growth ambitions by endlessly exporting to the US. Obviously, China comes to mind here as it is unwilling to let its currency appreciate against the dollar; but at least the Chinese authorities have boosted domestic consumption demand quite a bit, which can hardly be said of many European countries.

The second awkward truth is, in our view, the real cause of US dollar weakness today. Here, we must be careful not to mix the long term with short term. While it is true that the lax fiscal and monetary policies the US is currently practicing will likely keep the dollar on a depreciation trend, policies are not eroding the greenback today. Rather, it is the dollar’s role as the preferred funding currency for carry-trades – the investment strategy that calls for taking on debt in a low-yielding currency and buying assets in a high-yielding one – that is the immediate cause of the greenback’s weakness. The Fed’s commitment to prolonging low interest rates has made the US dollar even more attractive than the Japanese yen in carry trades now.

One lesson from the financial crisis is that carry trade activity is closely correlated with equity markets. If equities rally, carry trades also pick up; and if they correct, carry trades sputter. This leads me to recall another useful insight: be careful what you wish for; it might just come true. In this case, a stronger dollar could ultimately mean that stock markets are losing steam, a development that few would welcome.

16/10/2009: Money and inflation: putting the cart before the horse

“Inflation is always and everywhere ultimately a monetary phenomenon.” Often wrongly attributed to the late Milton Friedman, this comment reflects the conventional view of inflation as a continuous increase in overall prices. It presumes that what economists call the money supply must first grow before prices can move higher. In short, it argues that inflation is merely the symptom and money growth is its cause.

But this view ignores a sturdy pillar of Aristotelian logic – and common sense: a need (more money to pay higher prices) is not a cause. As a matter of historical fact, money growth does not automatically lead to inflation. Just look at the years between 1997 and 2007, when money grew at an astounding pace worldwide. Central banks’ reserves increased fivefold, and that only accounts for “visible” money. Last year, US Treasury Secretary Timothy Geithner estimated that the same amount of money held in “official” coffers could be found in the “shadow” liquidity of hedge funds, structured investment vehicles and other off-balance-sheet instruments.

Let’s recall that in 1998 these instruments were in their infancy. Thus, if Geithner’s estimate is correct, global money increased at least tenfold in a decade. But inflation was subdued during this period. In fact, its polar opposite, deflation, constituted enough of a threat for central banks to open the floodgates of liquidity creation on several occasions.

So, with all that money around, how come inflation was held at bay? There were several factors at work, but two prominent ones were the productivity surge from the information technology revolution – sometimes called “digital deflation” – and the rise of emerging markets as low-cost producers, well-known today as “globalization.”

Indeed, if it weren’t for the enormous money increase, these two factors would have assured deflation, but not the ugly, demand-driven deflation of the Great Depression and Japan’s Lost Decade. Rather, we would have seen a supply-driven version, something that has often occurred throughout history, most recently in the nineteenth century, whenever new technologies made things a lot cheaper.

Are digital deflation and globalization still at work today? According to the latest measurements, productivity gains are slowing now as the IT revolution matures. The promising technologies of the future (nano- and biotechnology, and energy sources like cold fusion, etc.) have not yet left the laboratory and achieved commercial scale. And globalization is no longer as deflationary as it once was. Emerging markets are shifting from low-cost labor suppliers to consumption competitors. They are no longer just lowering global prices through cheap production; now they are also raising prices through increased demand. This shift is already visible on commodity markets.

Moreover, after rescuing the global financial system and their local economies from the economic abyss, governments are set to play a much larger and more central role in economic affairs. Their active involvement raises the risk of a new era of protectionism. Meanwhile, tighter regulation of financial markets appears inevitable. Both of these developments could easily obstruct international capital flows.

So, while money growth alone surely would not lead to serious inflation today, other “horses” stand ready to pull prices higher in the future.

08/10/2009: The unemployment story and the stereotypes

In January 2003, just before the Iraq war began, US Secretary of Defense Donald Rumsfeld scolded what he called “Old Europe” as congenitally uncompetitive and old-fashioned while praising the region’s more dynamic countries that embraced the challenges of globalization (and war).

Donald Rumsfeld’s “Old Europe” was a coded epithet for France and Germany, while he saw England as a progressive role model. Economic proof of his worldview could be seen in the unemployment statistics at the time. For years, the jobless rates of France, Germany and Italy seemed frozen above 10%, twice as high as in the UK and the US. Meanwhile, between 1994 and 2007, Spain cut its unemployment rate from roughly 20% to less than 8% and “Celtic Tiger” Ireland from 16% to just above 4%.

Today, in the wake of the financial crisis, those trends have reversed dramatically. The UK’s jobless rate now hovers at around 8%, up from 5% in early 2008. And the US had to absorb a rather shocking September labor market report that put unemployment at 9.8%, its highest reading since the early 1980s and almost the double that of two years ago. Even more spectacular, Ireland’s unemployment rate currently stands at 12.5% while Spain’s is 18.9%. In both countries, these are levels last seen before their (credit-fueled) “growth miracles” began. Meanwhile, Old Europe’s labor markets have withstood the crisis far better, with unemployment rates rising only slightly, if at all.

Are these developments strong enough arguments to dismiss once and for all the Anglo-Saxon model capitalism as the one true path for economic development? We doubt it. The real test will come when economic momentum really picks up again. Then we will see whether the unemployment rates in the US, the UK, Spain and Ireland will fall as fast as they have risen, thus proving the case for their “flexible” labor markets. Meanwhile, without knowing the outcome of this challenge, the resilience we have seen in the major Eurozone labor markets lately is one reason why Europe remains our favorite region among the developed equity markets.

02/10/2009: Our Japanese future and the future of Japan

For outsiders, Japan is a land of mystery, formidable but opaque. Our perceptions are often little more than clichés that we try to apply, in vain, to an uncooperative reality.

In the 1980s, with its economy thundering on all cylinders, Japan was regarded with awe as the benchmark for management and productivity. Remember the wonder of just-in-time production, the much-revered circles of excellence? Back then, the Land of the Rising Sun basked in the economic glory of its crown jewels, the six Keiretsu. These vast, interlocking networks of companies – each with a big bank at the center of the web – controlled virtually all the strands of Japanese industry, guided by the omnipresent but impenetrable MITI.

Japan’s muscular business model was also feared. After all, they bought the Empire State Building and half of Hollywood and would soon, according to the worriers, overtake the US as the dominant global economy. In fact, the story did turn into a Hollywood blockbuster, but as a disaster film leading a prolonged period of stagnation known as Japan’s Lost Decade.

Some economists believe that Japan has still not recovered twenty years on. They attribute the country’s malaise to an economic policy apparatus that failed to adapt to a changing reality and thus was unable to take effective countermeasures. Hero worship is so fickle: yesterday’s invincible model is today’s “obvious” loser.

Not only that; some pundits see Western economies succumbing to the same paralysis that froze Japan’s economic juggernaut in the 1990s. But, as usual, we think reality is a bit more complex.

Rightly embarrassed by failing to foresee the big tsunami – the financial crisis unleashed by the burst housing and credit bubbles – a kind of Cassandra Complex has emerged among economists. Disaster lurks behind every data point. This time, despite the fiscal and monetary tools employed to comb the crisis – soaring government debt and oceans of new money printed by central banks –the West will still descend into its own Lost Decade. Or so they say.

We think that storyline is built on some false presumptions. In the US, and to a lesser extent the UK, the equation that ends up with the West repeating Japan’s Lost Decade is missing a crucial element: Japan’s steeply aging demographic profile. This factor explains a large part of Japan’s economic anemia since 1990. Despite all the talk, the US and the UK have still relatively young and, more importantly, growing populations. In this regard, Italy and Germany, with their declining birth rates and populations, may be susceptible to Lost Decadism, but the West as a whole is not.

And Japan itself? Here, a new myth has recently emerged: With the first real change in government in more than fifty years, the way Japan conducts its economic policy will also change, so the story goes. Instead of an export-driven economy, we will see the dawn of a new age of domestic and especially private consumption. Indeed, the new Finance Minister, Hirohisa Fujii, and new the Bank of Japan Governor, Masaaki Shirakawa, at first seemed to advocate that storyline, expressing the view that a strong yen could help the Japanese economy.

While it’s too soon to judge how this particular story will develop, it faces at least one daunting hurdle to a happy ending: again, demographics. We have difficulties imagining Japan’s senior citizens going on extended shopping sprees, and hence we remain skeptical about the country for the time being. The future of Japan could well end up repeating its recent past.

01/10/2009: The Nobel Prize season

With October, the Nobel Prize season is again upon us. As usual, the selections for the more political categories, peace and, to a lesser extent literature, will no doubt inspire controversy. Over the past couple of years even the economics prize has seen its share of contention.

Interestingly, economics was not named in Alfred Nobel’s original testament in 1895. The Economics Nobel Prize was first awarded only in 1969, called the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel,” to celebrate the tercentenary of Sweden’s central bank.

That economics is less of a hard science than its practitioners would have us think is reflected in the only slightly scurrilous jest that the Nobel Prize in Economics is best awarded to two people who have completely opposite views. This was actually the case in 1974, when Gunnar Myrdal and Friedrich von Hayek shared the Prize. Gunnar Myrdal was a Social Democratic member of the Swedish Parliament and then Trade Minister, while Friedrich von Hayek was a leading advocate of free-market capitalism.

The Nobel Prize for Economics generated another controversy in 1998, after LTCM’s bankruptcy almost brought down the global financial system. Two of that hedge fund’s co-founders, Robert C. Merton and Myron Scholes, had been awarded the Prize in 1997 for precisely the theories that led LTCM to take on too much risk and finally go bust.

So who will get the Nobel Prize in Economics this year? Actually, it’s easier to say who will not. It probably will not go to a macroeconomist, as they are currently licking their wounds after the financial crisis and in desperate need of a new conceptual framework. Nor is the Prize likely to go to an advocate of the financial sciences. Their workhorse, the efficient market hypothesis, is also exhausted after the rapid sequence of speculative bubbles and busts of recent years.

Behavioral economics might be a good candidate. The Prize already went to this promising union of the economic sciences, psychology and neurology in 2002, and the financial crisis has made it clear that more knowledge in this area is certainly needed.

Another contender could be environmental economics, which has not yet been honored by the Nobel Committee. True, the issue of climate change was acknowledged in 2007, when the Peace Prize was shared by the UN Intergovernmental Panel on Climate Change and Al Gore. But if the Nobel Committee were to recognize achievements in environmental economics with a Prize, it would not only be raising awareness of an urgent issue. It would also be making the sound point, in my view, that any solutions must ultimately involve economics, which is, after all, the study of choices and how they are influenced by incentives and scarcities.