This is certainly a possibility. For example, if Bill (the borrower) forgets his lunch money on Monday, he might ask his coworker Sally (the saver), “Can you lend me $10 and I’ll pay you back $11 tomorrow?”  If Sally agrees, then it is clear that her $1 in interest on the personal loan was paid out of Bill’s reduced income for that month. In other words, if Bill’s take-home pay that month were $5,000, then he would actually only have $4,999 to work with, because of his $1 expenditure in “buying a loan” from Sally. At the same time, if Sally’s normal paycheck were also $5,000, then this particular month she would actually have $5,001 to work with, after earning $1 in providing “lending services” to Bill.

In the scenario above, what basically happened is that Bill financed his consumption with an “advance” made by Sally. On the Monday morning is question, when Bill left his wallet at home, Sally had to have in her pocket enough spare cash to lend $10 to Bill. Perhaps this made her rearrange her planned spending that day, or perhaps it simply meant that Sally carried less cash in her own purse than she originally had desired. In any event, Sally provided a definite service to Bill. Given his mistake, both parties benefited. In a sense Bill’s total monthly consumption was lower, but he preferred having $1 less in order to obtain his usual $10 lunch on the particular Monday. There is nothing irrational or “uneconomical” about Bill’s decision to pay $1 for Sally’s loan.

Making loans so that borrowers can finance their present consumption (at the expense of future consumption) is certainly part of what happens in a market economy on a grand scheme; it constitutes a large portion of the credit card industry. However, you should not conclude that all savings and investments are of this nature. When we consider the lifetime savings plan (outlined in a previous section), there doesn’t need to be one or more borrowers who grow deeper in debt as the decades roll on. In fact, it is possible that every single person in a market economy provides for a comfortable retirement through saving and investment during his or her working career.

[This is a point worth pondering more. It is essential and its misunderstanding is the root cause of much of a lot of misery. To read more explanations about basic economics, make sure to read Robert Murphy’s book Lessons for the Young Economist — Ed.]

How is this possible? For every Sally who saves and earns ever-growing streams of interest income, doesn’t there have to be a Bill somewhere who borrows and pays ever-growing streams of income? Yes and no. The key is that the loans or investments can be made in productive enterprise, rather than simply being lent to an individual who increases his consumption in the present. Is the savings are channeled into expanding production (rather than merely financing consumption), then “total output” grows over time, in principle allowing every member of society to enjoy larger incomes.

In Lesson 12 we will go over the mechanics of credit card and debt more carefully, but for now we just need to understand that the big picture of what would happen if everyone in society suddenly decided to save a large fraction of his or her income. In order to save more, each person would cut back on consumption. That means people would spend less on fancy restaurant, sports cars, electronic gadgets, and designer clothes. At the same time, people would increase the amount of money they lent and invested in businesses, either directly (through buying corporate stock or bonds) or indirectly (by depositing the money with banks which then advanced loans to businesses).

These large swings in how people spent their incomes — diverting it away from consumption and toward investments — would ultimately steer workers and other resources out of the industries catering to immediate consumption, and toward industries catering to long-range production. For, example, high-end retail and jewelry stores would see their sales plummet, and they would lay off workers and cut back on their inventory. Fancy restaurant too would lay off workers and close down some of their locations.

The laid-off workers would look for jobs in other industries, and this extra compensation would push down wage rates in those sectors. At the lower wage rates, businesses in these other industries would be willing to hire displaced workers. Other resources besides laid-off workers would be redirected to new uses, as well. For example, the owners of now-vacant buildings (which used to house clothing stores and other retailers) would lower their asking price for rents, making it easier for other businesses to expand their operations by filling the buildings.

If we ignore the real-world disruptions that would occur during the transition, even a large and sudden increase in the savings rate wouldn’t affect “total spending.” It’s true that consumption spending would (initially) be much lower, but investment spending by businesses would be correspondingly higher. The total number of jobs (eventually) would also be the same, because the laid-off waiters and mall employees would now be working in factories producing drill presses and backhoe loaders.

The essential insight is that a sudden increase in savings allows the economy’s output to shift away from consumption goods and into capital goods. Just as Robinson Crusoe was able to enhance the power of his bare hand through the wise use of saving and investment — even though he had nobody to “lend to” on the island — so too can the whole population enhance each other’s labor productivity by channeling more resources into the production of machinery and tools. There is no “cheating” going on here; everyone’s income can grow larger over the years when everyone is more physically productive because of the growing stockpile of capital goods.

Regards,
Robert P. Murphy
Whiskey & Gunpowder

February 14, 2011

How Savings and Investment Increase an Economy’s Output was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Doug: Sure. But as I said at the beginning of our conversation on Russia, the first thing to say is that any time you’re dealing with a large group of people, it’s almost always wrong to think of them as a group. Logically, the more specific your statement about a lot of people is, the more people within that group won’t fit the bill, and the more general – i.e. vague – your statement, the less useful it is.

I always do my best to treat each individual I meet as exactly that; the individual he or she is.

Thinking of people in terms of groups, Groupthink, is simply sloppy thinking, whether it’s “the proletariat” vs. “capitalists” or “African-Americans” vs… What? All Americans came from elsewhere. But we risk anger if we say “white people.” Groupthink is logically unsound, one error among many of the communists and socialists made.

L: I knew a white guy from South Africa, who immigrated to the U.S., who used to put “African-American” on all the forms. I sympathize with his desire to mess with stupid social expectations by putting square pegs in round holes.

Doug: Shaking people up can be a good thing; it can force them out of mental ruts, so they start dealing with you as they should, as an individual. But don’t expect them to ever thank you for it.

L: Heh. No. When I went to Rensselaer Polytechnic Institute, I put “other” for race on the forms. To me, “Hispanic” isn’t a race, it’s a culture (of which I am not a part, regardless of my genetic inheritance), and I always experience such attempts to group me by race to be more racist than the racism such information is supposedly gathered to fight. So, anyway, I usually put “human,” but I put “other” – and I kept getting letters inviting me to join the RPI Society of Black Engineers. Every time I got one, I was struck by how offensive it would be to so many people if there were a Society of White Engineers… But, back to your point, I didn’t think I’d make any friends marching up to their building to point this out to them. So I let it be.

Doug: Doubtless, a wise choice.

L: Groovy. But Doug, I’ve heard you say many times that you have more in common with polo-players you’ve met in Argentina, or cigar aficionados you’ve met in the Congo, than with the majority of the… er… European-Americans? Screw it. Let’s just say “white people.” Anyway, you have more in common with many visibly not-white people from around the world than with most of the white people down the street from your house in Colorado. An admirably color-blind statement. You said last week that you form your relationships based on what people’s values, ethics, spirituality, etc., are. But fess up, aren’t you more likely to find people who share your values among white North Americans who share the remnants of the culture of freedom America once had?

Doug: It might have been so a generation or two ago, but the libertarian values that made America great beat a steady retreat throughout the 20th century, and were largely out of fashion before the current young generation was born. And most of their teachers are actively hostile to these values. So, who knows – it might be less likely for a kid growing up in the U.S. to encounter these ideas and values than one growing up in China, where people value hard work, innovation, creative effort, etc.

L: I’m not sure the same is true of a child growing up in the Congo.

Doug: Maybe so, but that’d be because society there is so debased by corrupt government – not a function of race.

L: Okay, so you’re an equal opportunity investor, friend, and poker-player. You’ll sit down for a chat with anyone from anywhere, if the individual seems interesting to you. But if you happened to be walking alone at night in New York City, and took a wrong turn, ending up on a street with a group of large, young black men in what look like “gangsta” clothes, wouldn’t your adrenaline level rise? And might it not drop sharply again if suddenly a streetlight revealed that they were all carrying bibles? Is that prejudice?

Doug: No. Aside from the fact that the bibles might make me worry that they would chase me down the street, trying to save my lost soul, it’s not prejudice to assess your environment for potential threats – most of which will take the form of other human beings. People do get mugged in some places. That’s a fact, and being aware of that fact is not prejudice – it’s prudence. Prejudice would be deciding that those men were hostile before they made any hostile moves. Deciding to walk in a different direction even before a threat was made would not be prejudice, but a tactical decision based on the way our world is at present, not imagined knowledge about the individual men in question.

Prejudice. As always, we should work with a good definition before going on.

L: My Webster’s says that prejudice is 1) a preconceived judgment or opinion, 2) an adverse opinion or leaning formed without just grounds or before sufficient knowledge.

Doug: So, prejudice – pre-judgment – involves thinking you know things about people before they give you any evidence for those things being true. It’s not prejudice to consider a possibility, but it is prejudice to make assumptions and treat them as facts.

Let me put it this way, if I see a guy wearing an Arabic headdress, and I don’t start our conversation by offering him a glass of wine, that’s not prejudice. Or if I see a guy dressed like a Hassidic Jew, and I don’t offer him a ham sandwich, that’s not prejudice. They are displaying themselves in a way that gives evidence of their being members of certain groups about which some things are known. But if I told myself the Arabic guy was going to give me a hard time for me having a glass of wine, or that the Jewish guy was going to try to stick me with the bill for lunch, and was hostile with them in advance of them having done any such things, that would be prejudice.

L: Okay: assessing possibilities, based on visible cultural and other data, is not the same as judging people before you know them. Let’s move on from prejudice and get back to race. In our conversation on Russia, you said that Russia’s problems could go beyond culture to the impact of Soviet and even Tsarist policies on the gene pool. That may be completely true, but isn’t it a kind of Groupthink, and racist to boot?

Doug: I didn’t say that groups don’t exist. Of course they do, and there are many groups of people in the world with well-defined characteristics. It’s reasonable to conclude that a guy dressed like a Hassidic Jew is probably a Hassidic Jew, and it’s necessary to make such assumptions in day-to-day life. If we don’t, and we stop to test each individual assumption, we’ll never get anything done. But just because I acknowledge the group’s existence and, in this case, don’t offer the guy a ham sandwich, I still treat him like the individual he is, and if he asks for a ham sandwich, I’m fine with that. Groupthink is not a problem of acknowledging the existence of groups, including human groups; it’s treating individuals as though they were the group, or as though they necessarily hold all the traits that define the group.

And if it’s racist to acknowledge that human groups exist, including racial ones with genetic commonalities, then we are all racists, whether we admit it or not.

L: Webster’s says racism is the belief that race is the primary determinant of human traits and capacities and that racial differences produce an inherent superiority of a particular race.

Doug: So, again, it’s about Groupthink. It’s not racist to acknowledge that there’s a subset of the human race with darker skin and curly hair, but it is racist to think you know something about an individual because he looks that way. And what’s bothersome about racism isn’t acknowledging differences, but the belief that one’s own race is superior. Near as I can tell, there’s no superior race. So I just look for excellent individuals with whom I can enjoy spending time.

L: Right then. Investment implications?

Doug: Broadly speaking, the big conclusion is to short cultures that, on average, discourage individual achievement and have no work ethic. Even if such a society has not existed long enough to impact the gene pool, if it exists at all it has impacted the meme pool, and that’s bearish.

I’m not judging any individual Russians, but saying that I’m not optimistic about Russia. For the same reason, I’m bearish on the U.S. America was once the land of the free and the home of the brave, but it has degraded into the country of intellectual lap dogs and welfare recipients. There’s a large minority of Americans who have The Right Stuff and are still struggling to set things right, but that’s hard to do once you’ve been trussed, stuffed, and placed on the sacrificial altar to satisfy the hungry lust of needy voters.

L: So what cultures are you bullish on? This is not the same question we’ve taken up on your favorite places to live – I’m not asking about quality of life now, but about The Right Stuff to build a better future.

Doug: Well, I think China has a lot of short-term problems, but over the course of the 21st century, it’s a good bet that it will surge ahead to lead the field.

L: As you know, I’m partial to a number of former Soviet republics, but I need to go back and look at their demographic trends. What I do like about them is that they have living memory of real, naked socialism, and they know it doesn’t work. In places like Belarus, people want to get ahead, are willing to work hard, are very smart, and I have met many people with strong personal ethics. It’s hard for me not to be optimistic for them, even though they’ve got a horribly obstructive government.

Doug: You may be right, but I think most, if not all, of the Baltic states have the same demographic problem the rest of Europe does.

L: Population implosion. Who-da thunk it in the 20th century? At any rate, as far as the places and cultures you’re bullish on, the general idea is to watch for strengthening rule of law, stabilizing business environments, etc. and then invest in those markets? Or would prices be high by then, making it better to speculate now on the cultures that seem to have The Right Stuff, while prices are low?

Doug: Too early to say. That’s something we’ll be tracking in The Casey Report as we go.

L: Okay. But this seems like a good time to repeat your mantra of getting your ass…ets out of the U.S., or as much of them as you practically can, as soon as you can.

Doug: I’m afraid that’s the way the odds say to play it. We’re already seeing the tightening currency controls we talked about last year, and it’s going to get worse. Much worse.

L: Roger that. You know, I’ve always thought of America as a beautiful young woman, full of hope and promise and all the greatness in our species. I even considered the name for a daughter – it was that beautiful to me. But a real woman of flesh and blood would age, in time, and I never wanted to see America as an old woman, bent with age and the care of years. Unfortunately, I’m starting to see her that way anyway.

Doug: I know exactly what you mean. But, as gloomy as I may sound about America, I am extremely bullish on humanity, in and of itself.

L: That’s right. America herself may not rise again, but some of her children, and the best and the brightest from around the world may make a new beginning, just as those who fled the tyrannies of Europe hundreds of years ago did in America. Maybe we’ll do it on Mars. Hey, if I stake a few of the Martian canals, will you buy a lot in my development project?

Doug: Only if I can play Polo.

L: I’m not sure if the lower gravity would make it safer, or more dangerous…

Doug: One way to find out.

Regards,

Doug Casey and Louis James
Whiskey & Gunpowder

April 26, 2010

Race, Racism and Investing was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Introduction

Although I read and collect information and ideas every day, whenever the day comes each month when I actually have to start writing this report, the words of Gene Fowler (an extremely successful screenplay, sports, and humorous writer) come to mind: “Writing is easy. All you do is stare at a blank sheet of paper until drops of blood form on your forehead.”

On these occasions, I then usually turn to works of science, politics, history, or philosophy in the hope of calming down and finding some inspiration. Since so many investors look to investment advisers such as myself, whom they often call “gurus”, for guidance on the future of the markets, I think it is appropriate to remind my readers of these words of Lao Tzu (the sixth-century Chinese sage): “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”

I have mentioned this because I was recently invited by my friend Manish Chokhani, of Enam Financial Consultants in Mumbai (the most successful investment bank in India), to give a presentation. The founder of the company, Vallabh Bhanshali, introduced me by saying that his staff consider me to be a hero for having correctly predicted the bull market in Indian equities in 2002, and for having called in 2006 for the 30% May/June sell-off. I felt deeply embarrassed by this, as I know only too well that I have made just as many, or even more, poor and erroneous market calls as correct ones in the course of my life, and not only about economics and asset markets but also about people… Moreover, I know people who are far more knowledgeable about the financial markets than I am – people such as Henry Kaufman and Peter L. Bernstein – who focus on presenting well-researched facts in their excellent papers, publications, and presentations, and refrain from making predictions.

In fact, addressing large audiences makes me feel uncomfortable – not because of the size of the audience, but because, as a contrarian, it is not desirable for my views to be popular and because assets that I consider will perform well in the future seldom attract large crowds. Two friends of mine, Jon Thorn and John Shrimpton, who manage, respectively, the India Capital Fund and the Vietnamese Dragon Fund, used to have tiny audiences when they presented at investors’ conferences. But as their markets more than doubled in size, so did their audiences.

In 1981, I was invited to speak about bonds at a gold conference that had attracted over 500 participants. Just one person came to my presentation. (September 1981 saw the end of the bond bear market, which had begun in 1942.) A small audience can sometimes be distressing for a speaker, but at such times they would be wise to remember Victor Borge, a Danish pianist with a sharp mind and humorous bent, who fled to the United States in 1940 and made a name for himself with his brilliant blend of musicianship and humour. One evening, in Flint, Michigan, Borge performed to a sparse audience. The sight of so many empty seats might have discouraged the average performer, but the witty Borge looked out over the audience and exclaimed: “Flint must be an extremely wealthy town. I see that each of you bought two or three seats.” (Lateral thinking at its best!)

As an investor looking for guidance from newsletters, blogs, financial publications, and conferences, I would also be mindful of Ralph Waldo Emerson’s words: “Do not go where the path may lead; go instead where there is no path and leave a trail.” Unfortunately, in today’s high-liquidity driven global investment environment, I find it hard to identify an asset class “where there is no path”. There are far too many smart – and not so smart – treasure hunters who have bid up every imaginable investment class right around the world. It is only in the most unusual places that I can find true value (often, however, in assets that are difficult to invest in), as opposed to relative values, which certainly do exist. The problem for investors is that, as the German theologian Dietrich Bonhoeffer wrote, “If you board the wrong train, it is no use running along the corridor in the other direction.” (Bonhoeffer opposed Nazism and was executed in prison for his involvement in a plot to overthrow Hitler.)

I mention this because it will become increasingly important for investors not only to decide which asset class train they want to board, but also, and even more importantly, whether they want to board any of the asset trains. If we look at the economic and financial history of capitalism, we can see that over periods of five to ten years there were always some assets that performed well. But there were times, such as in the early 1930s and the 1970s, when very few assets appreciated. Gold and gold shares performed well in the early 1930s. And in the 1970s, precious metals, and energy and energy-related shares, appreciated dramatically. But what were the chances that, in 1929, an investor would have had all his assets in gold, or, in the 1970s, in energy and precious metals-related investments? Moreover, in both cases, these investments had to be liquidated at some point because, as is always the case, “over-staying” eventually leads to huge losses. And this is where I see the biggest problem in the current investment environment. At the beginning of a bull market in an asset class, there are very few participants. But by the tail end of the boom the vast majority of market participants have become convinced that the boom will last forever or that a greater fool will soon emerge and take them out at a higher price. (This is likely to be the thinking among private equity fund managers.) So, in every boom, the majority of investors eventually get caught when the investment bubble bursts, as was the case in 2000 with high-tech stocks and in 2006 with US homes.

In last month’s report, entitled “When Too Many Investors Think Alike, Nobody is Thinking”, I pointed out that a peculiar feature of the bull market in asset prices since 2002 has been that all asset prices around the world have appreciated in concert as a result of highly expansionary monetary policies, which has led to excessive credit growth and a credit bubble of historic proportions. Therefore, if my theory of slower credit growth in future holds, it is conceivable that, for a while at least, all asset markets (with the exception of bonds and cash) could come under pressure, albeit with different intensities.

In fact, asset markets would come under pressure even if credit growth continued at the present rate and didn’t accelerate. In this instance, investors would be better off not boarding any investment train at all and, instead, staying at the station loaded up with cash. (However, they would still have to decide what kind of cash to hold.)

An Attempt to Pierce Through the Investment Mist

I have mentioned in the past that the first signs of credit tightening would be visible in the performance of US brokerage stocks. Recent pronounced weakness not only of brokerage shares, but also of other financial stocks and, in particular, sub-prime lenders, would seem to confirm that the “irreparable cracks in the financial system”, about which we wrote in the January issue of this report, are now spreading. These cracks are now causing some “illiquidity”, not only in the household sector but elsewhere in the system as well. First, it is important to understand that mortgage debt has begun to grow at a slower pace largely because home prices are no longer appreciating. The growth in the mortgage market was about equal to nominal GDP growth between 1980 and 2000. But, in the 2000 to 2006 period, a massive breakout from the trend occurred and, combined with a decline in the saving rate, drove consumption and GDP growth. But, as home prices began to decline in 2006, and as problems in the subprime lending market became evident, lending standards were tightened to their highest level in 15 years. Declining home prices and tighter lending standards brought about a slowdown not only in mortgage debt growth but also in overall debt growth. Mortgage debt, which grew at an annual rate of 10.2% in the second quarter of 2006, declined to an annual growth rate of 8.6% in the third quarter and to 6.4% in the fourth quarter. It is likely that mortgage debt growth slowed down further in the first quarter of 2007, and will decline even more in the second quarter given the problems in the sub-prime lending industry and the tight lending standards.

In the meantime, household debt growth in the United States has declined from a peak of 11.9% in the third quarter of 2005 to 6.6% annual rate in the fourth quarter of 2006. According to David Rosenberg, the fourth-quarter 2006 annual credit growth was the slowest since the third quarter of 1998 and the sixth consecutive quarterly deceleration, “which hasn’t happened since 1956″ (emphasis added). Now, ceteris paribus, this significant slowdown in mortgage and household debt accumulation would have already brought about a significant slowdown, or even a decline, in US consumption. However, because of the stock market rally in the fourth quarter of 2006, equity wealth increased by 4.2%, or an annual rate of 18%.

Moreover, as David Rosenberg notes, “just as households are beginning to curb their appetite for debt, the once-dormant corporate sector stepped up its borrowing sharply in Q4 (M&A related perhaps?). Net debt raised by the nonfinancial corporate sector steamed ahead at a 10.9% annual rate in Q4, almost double the Q3 pace (of 5.9% annualized) and the strongest pickup in seven years. You have to go all the way back to the cashburn era of 2000 Q2 to see the last time that the corporate sector outdid the household sector in terms of debt buildup.” And as David Rosenberg correctly suspects, corporate borrowings have been rising along with M&A activity. But corporate borrowings are far smaller than household debt; therefore, while corporate debt growth has increased by around US$100 billion since the second quarter of 2006, household borrowing has grown since then by around US$300 billion. (Note also how, in the late 1990s, debt growth took off.)

Now, this deterioration in household debt growth hasn’t yet led to a consumer spending decline; but, very clearly, retail sales are now growing more slowly. Continuous consumption growth was therefore driven less by household debt growth in the fourth quarter of last year and the first quarter of this year, than by the continuation of an increase in household wealth and the selling of US equities by the household sector. But herein lies the problem. If declining home prices are now joined by equity prices that are either declining or no longer rising, it will only be a matter of time before consumer confidence declines and the consumer either slows down their spending further or stops spending altogether.

Slower consumption growth, as a result of tighter lending standards and flat or declining equity prices, should have the following consequences. The US trade and current account deficit will no longer expand at an accelerating rate. This should lead to a relative tightening of global liquidity, which would likely be unfavourable for asset prices but could temporarily strengthen the US dollar and even more so the Yen.

The full extent of the sub-prime lending problems isn’t known. However, since at least 12% of the mortgage market – whose total size is over US$1.2 trillion – is comprised of sub-prime loans, the fall-out could be considerably worse than expected. This certainly seems to be indicated by the recent poor performance of banking stocks and, as indicated above, brokerage shares. My friend Gerard Minack of Morgan Stanley recently published a figure showing how financial sector earnings have exploded in recent years. Figure 12 depicts earnings growth for the financial and nonfinancial sectors indexed to a common base (1990 = 100).

As can be seen, the financial sector’s earnings rose 14-fold since 1990 to an annualised US$251 billion, whereas the rest of corporate earnings experienced only a fourfold increase, to US$636 billion. I have mentioned in earlier reports that if we were to include in the financial sector’s earnings financial profits from speculating in all kinds of derivatives and financial products by industrial and multinational companies, the profit contribution from financial earnings to S&P 500 total earnings would be more like 45%. Also, the recent contribution to profit growth would amount to around 70%. Therefore, I suppose that if asset markets failed to appreciate further, financial earnings would begin to decline and likely pressure S&P 500 earnings. (Aside from the financial sector, the energy and material sectors have in recent years also boosted S&P earnings. Never before have energy and financials contributed so much to the S&P profit pool.)

In the past, poor performance of financial stocks has always been an unfavourable indicator for the entire stock market. In an economy that has become addicted to credit growth, this should be even more so! The other point to remember is that if corporate profits no longer expand, the ammunition used by the corporate sector to take over other companies and to buy back their own shares is likely to diminish. Last year, a record US$548 billion worth of shares were retired by corporations buying back their own shares and by acquisition-minded private equity funds. Any reduction of this activity in 2007, when simultaneously the increasingly “illiquid” household sector is likely to diminish its equity purchases further, is going to have an unfavourable impact on the stock market. I may add that, sooner or later, private equity funds will place the acquired companies back on the stock market and so increase the supply of equities through high IPO activity.

If the assumption is correct that global liquidity is tightening – at least relatively – as a result of a stagnating US trade and current account deficit, the asset markets that benefited the most from surplus liquidity should come under some pressure. I am thinking here in particular of the extended emerging stock markets, which in this scenario could be vulnerable to corrections of between 20% and 40%. In turn, a decline in these peripheral markets should have an impact on Japan and, in particular, on the Yen.

Regards,
Marc Faber, PhD

April 16, 2007

“Relax, the Over-all Market Probably Won’t Tank” was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The answer comes from the San Francisco Fed in an article entitled, “Interest Rates, Carry Trades, and Exchange Rate Movements”:

“What is the carry trade?

“In the most common version of this strategy, an investor borrows a given amount in a low-interest-rate currency (the ‘funding’ currency), converts the funds into a high-interest-rate currency (the ‘target’ currency), and lends the resulting amount in the target currency at the higher interest rate…

“According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. Consider two countries, one with a high interest rate, and the other with a low interest rate. According to another equilibrium condition of international financial markets called the ‘uncovered interest parity,’ the difference in interest rates between the two countries simply reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. When this depreciation occurs, investors who borrowed a given amount in the low-interest rate currency and then lent it in the high-interest rate currency will find that their return is worth less. The uncovered interest parity condition implies, indeed, that investors should expect to receive no profits, as they should expect the return from lending in the high-interest-rate currency to be worth ultimately as much as the cost of borrowing in the low-interest-rate currency.

“In practice, however, investors in international financial markets do seem able to make profits through such strategies…

“Empirical evidence shows that currencies that are at a forward premium and that, correspondingly, have a low interest rate, actually tend, on average, to depreciate, not appreciate, as the theory of interest parity conditions predicts…Similarly, currencies that are at a forward discount and that, correspondingly, have a high interest rate, tend, on average, to appreciate, not depreciate. This anomaly, then, implies that an investor who enters a carry trade is quite likely to make predictable profits from two sources: the interest rate differential between two currencies and the appreciation of the high-interest rate currency that was originally bought at a forward discount.”

Referring back to the COT numbers on the yen from Part I…they might seem huge. After all, $13,212,986,904 bet on shorting yen futures sure looks like a big number, but in all likelihood is peanuts in the grand scheme of things. Expressed as $13.2 billion, it seems much smaller. Please consider Brad Setser’s excellent article, “A Trillion Dollars Gets My Attention, Whether It Comes From the PBoC or the Yen Carry Trade”:

“Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets…

“I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets — and not just the obvious ones.

“Just how large the carry trade is, nobody really knows… But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

“After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5% a year, apply a bit of leverage and — hey, presto — produce returns of 20%, or more. Conversely, if an investment bank wants to create a collateralized debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books — funded by ultra-cheap yen. The yen has thus been tantamount to the ATM of the global credit world — spewing out (almost) free cash.

“There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.

“Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back…

“That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars — and got a bit of carry in the process. And the MoF did it on a truly enormous scale.

“A private investor might even want to start to take some profits…

“Bottom line: A ton of people — the Japanese government and Japanese ‘real money,’ as well as the leveraged community — are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.”

In September 2006, MarketThoughts.com had an interesting article called “The Yen Carry Trade Revisited”:

“The second great yen carry trade began in the summer of 1995 and it did not end until October 1998 — when the yen ended its decline by rising 15% in a week…

“As for the current yen carry trade, there is little evidence to believe that much of the borrowed yen went into commodity speculation — as the decline of commodity prices in the last four months has generally not led to a higher yen. More likely, the typical profile of the latest yen carry trade participant is as follows:

“1. A speculator who borrows or shorts yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., U.K., or countries in the euro zone. The days of using this money to invest in higher-yielding countries in ‘peripheral’ developed countries like Iceland and New Zealand has definitely ended — given the crash in both of these currencies earlier this year.

“2. A Japanese investor (e.g., a pension fund, a life insurer, or an individual investor) who converts his money from yen to U.S. dollars (or the euro or the pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged — which again puts further pressure on the yen.

“Quoting the IMF’s ‘Financial Stability Report’:

“‘The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors — particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1% of GDP’…

“Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006… [Mish Note: Speculators are hugely short yen futures again, as discussed above.]

“So the $64 trillion question is this: When will the yen carry trade end? On a purchasing power parity basis, the yen is undervalued against the U.S. dollar, but massively undervalued against the euro. That being said, things can always get more extreme before reversing — especially when it comes to the financial markets. Drawing a tentative uptrend line from the previous lows in the yen in early 1990, October 1998, and early 2002, one gets a target range of approximately US$0.78-0.82 (for every 100 yen) before we see the yen bottoming. But in all likelihood, it will need some kind of trigger. Just what is that trigger? I will discuss more about this as we approach the US$0.78-0.82 range and my preferred time frame (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play, starting Jan. 1, 2007. Historically, a goods and services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different — despite the prevalent optimism among the German government at this point.”

So now we have Japanese life insurers speculating in the carry trade. Isn’t that special? One possible answer to the “$64 trillion question” (When will the yen carry trade end?) is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the yen (as noted in Part I and repeated below) is a real one. Those following along carefully will note that is the opposite of what I suggested in Part I in reference to the COT data (i.e., an unwinding of the futures positions is dollar negative on balance).

Yen/U.S. Dollar (Monthly)

Fundamentals

• All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there
• Gold has never gone to zero, and barring a Star Trek-like replication device or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero, either
• In the meantime, the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and foreign direct investment. The much ballyhooed trade deficit is far down the list
• When it comes to the yen, the interest rate differential between Japan and the U.S. or Japan and Great Britain is substantial
• Japan is also sitting on a national debt of 150% of GDP. What that will do to interest payments if rates rise rapidly should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is yen negative
• Europe has demographic problems of its own. Europe also has a very rapid expansion of M3, but a much lower interest rate than the U.S’s. That is euro negative versus the U.S. dollar
• Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound, as expected rate hikes in the U.K. may not occur.

Everyone has a tendency to look at problems in the U.S. in isolation. As you can see, the issues are both many and complex. There are a lot more to currencies than the one-sided view often heard that “The U.S. dollar sucks.” This post is an attempt to look at things from as many angles as possible.

From a purely technical standpoint, I would have to suggest “Trust the trendline breaks on the charts.” From the standpoint that things almost always get crazier than anyone thinks, I am inclined to believe the yen is likely to sink further and then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade, one should be watching those charts carefully.

From a political standpoint, I am rather unimpressed with Paulson even as others seem to be going gaga just because he is “watching very, very carefully.” From the standpoint of the U.S. dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the Euro. Ultimately, however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing (in whatever direction you are doing it) seems like the best advice at this juncture given that the situation is potentially explosive in both directions.

Regards,
Mike Shedlock ~ “Mish”

February 13, 2007

Focus on Currencies, Part II was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.