Re: [A-List] A question to those among us who follow the financial markets

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

This is an exerpt from my article in progress:

Bubbles, Interest Rates and Liquidity

By

Henry C.K. Liu


The Japanese yen, which had been fixed at 350 yen to a US dollar from
1950 to 1970, began to rise after 1970, peaking at 201 in 1978. That did
not dampen the Japanese export boom due to US Cold War geopolitical
preference for subsidizing trade with Japan. After the US Federal
Reserve under Paul Volcker raised the Fed funds rate (FFR) to a
historical high of 19.93% on July 8, 1981 to fight a rising annual
inflation rate of over 15%, the exchange value of the dollar rose as a
result, causing an alarming rise in US trade deficit. This was a time of
geopolitical detente when trade deficits in favour of US allies began to
matter, being before the arrival of dollar hegemony through which the
trade deficit could be financed by a dollar capital account surplus
coming from foreign central banks. Despite US complaints, the yen fell
steady until 1985 to 238.5 to a dollar. The Plaza Accord of 1985 was a
coordinated effort by the US, Japan and Germany to force the Japanese
yen and the German mark to rise against the US dollar. The yen rose
against the dollar from 238.5 in 1985 to 158.5 in 1986 and kept heading
north to peak at 94 yen in 1995, despite the Louvre Accord of February
1987 to stop the dollar decline overshoot. Much profit was made by those
who speculated against the dollar by buying yen, which in turn
accelerated the dollar’s fall. Those who borrowed yen to take advantage
of low yen interest rate to invest in dollar assets lost their shirts as
the yen they borrowed took more dollars to repay, which was bad enough,
but the real pain came after the 1987 crash when the dollar assets they
bought lost more than one third of their peak market value.

After the Plaza Accord, the FFR followed a downward trend, falling to
below 6% until the Louvre Accord of February 1987, when the Fed began
raising the FFR to stop the dollar’s decline, reaching 7.59% on October
14. Five days later, on October 19, 1987, the Dow Jones Industrial
Average (DJIA) dropped 508 points, or 22.6 percent in one day on volume
of 608 million shares, six times pre-1985 normal volume (current normal
daily volume is over 1.4 billion shares, with top volume of 2.8 billion
shares on July 24, 2002), and ending at 36.7% lower from its closing
high of 2,787 less than two months earlier, on August 25. The immediate
trigger that burst the bubble was legislation passed by the House Ways
and Means Committee on October 15 eliminating the tax deductibility of
interest on debt used for corporate takeovers. As shown by these events,
interest rates obviously have a direct relationship to the forming and
bursting of financial bubbles.

In response to the 1987 crash, the US Federal Reserve under its newly
installed chairman, Alan Greenspan, with merely nine weeks in the
powerful office, immediately flooded the banking system with new
reserves, by having the Fed Open Market Committee (FOMC) buy massive
quantities of government securities from the market. He announced the
next day that the Fed would “serve as liquidity to support the economic
and financial system.” Greenspan created US$12 billion of new bank
reserves by buying up government securities. The $12 billion injection
of “high-power money” caused the FFR to fall by three-quarters of a
point in one day and halted the financial panic, though it did not cure
the financial problem, which caused the economy to plunge into a
recession that persisted for five subsequent years. High power money
injected into the banking system enables banks to create more bank money
through credit multiplying, by lending repeatedly the same funds minus
the amount of required bank reserves at each turn, since bank loans came
back as bank deposits. At 10% reserve requirement, $12 billion of new
high power money could generate in theory up to $120 billions of new
bank money in the form of recycled bank loans.

The 1987 crash reflected a stock market bubble burst that led to a
property bubble burst that in turn caused the Savings and Loan crisis.
The Financial Institutions Reform Recovery and Enforcement Act (FIRREA)
was enacted by the US Congress in August, 1989, to bail out the wayward
thrift industry in the S&L crisis by creating the Resolution Trust
Corporation (RTC) to take over failed savings banks and disposed of
their distressed assets. The Federal Reserve reacted to the S&L crisis
with further massive injection of liquidity into the commercial banking
system, lowering the FFR from its high of 9.86% reached on May 10, 1989
to below the 3% inflations rate, making the real rate near zero until
January 1994. Since there were few assets worth investing in a down
market, most of the new money went into bonds. This resulted in a bond
bubble by 1993, which then burst with a bang in 1994 when the Fed
finally started to raise short-term rates.

By 1994, Greenspan was already riding on the back of the debt tiger from
which he could not dismount without being devoured by it. The DJIA was
below 4,000 in 1994 and rose steadily to a bubble of near 12,000 by 2000
while Greenspan raised the FFR seven times from 3 percent to 6% between
February 4, 1994, and February 1, 1995, to try to curb "irrational
exuberance" in the stock market, and kept it above 5% until October 15,
1998. Greenspan made his famous "irrational exuberance" speech at the
American Enterprise Institute in Washington DC on December 5, 1996, when
the DJIA was at 6,437, more than twice of the pre-crash 1987 high. Yet
the market kept rising and on January 14, 2000, the DJIA peaked at a
hyper-irrational level of 11,723, and two months later, on March 16,
2000, the DJIA experienced its largest one-day point gain in history -
499.19 points - to close at 10,630.60. On April 14, 2000, 22 trading
days later, the DJIA plummeted 617.78 points, closing at 10,305.77 - its
steepest point decline in a single day historically so far. This
volatility came purely from speculative forces operating on a bubble.
The economy did not change in 22 trading days.

In the mid-1990s, excess liquidity fuelled a worldwide equity rally led
by the Asian emerging markets, where it fed an unprecedented bubble of
easy money in the form of undervalued currencies pegged to a falling US
dollar. When the Asian emerging markets crashed abruptly on July 2,
1997, ignited by the Thai central bank running out of foreign exchange
reserves to maintain it currency peg, followed by the Russian debt
crisis in 1998, all the major central banks of the world, led by the US
Federal Reserve as head of the snake, reacted yet again by pumping even
more liquidity into the global banking system. Initially, this flood of
money inflated another bond bubble, which popped viciously in 1999.
Then, more liquidity boosted equity prices further and provided the fuel
for the enormous tech stock bubble of 1999 and early 2000.

The first three years of the 21st century saw a world-wide equity market
crash followed by a recession plagued by overcapacity,
over-indebtedness, and excessive leverage. And the response of central
banks was always more liquidity through low interest rates, which helped
pump up the bond bubble in 2003 and supported artificial rallies in
housing prices, equities, corporate debt, commodity prices and
mushrooming emerging markets, particularly China. Fools are calling the
onset of a bigger bubble a US-led recovery.

When the DJIA started its slide downward after peaking at a historical
all time high of 11,723 on January 14, 2000, closing on January 2, 2001
at 10,646, the Fed lowered the FFR from 6.5 percent on January 3, 2001,
to the current rate of 1.00 percent set on June 25, 2003 after the DJIA
hit a low of 7,524 on March 11, 2003. Since then, the DJIA has climbed
steadily to peak at 10,737 on February 11, 2004 and closed at 10,225 by
April 30, 2004, 400 points below the level of twenty-eight months
earlier when the Fed began its rate cut saga on January 3, 2001. For
quite sometime now, the market has been treating good economic news,
such as falling unemployment, as bad news, on account that an economic
recovery will push the Fed to raise interest rate. After having kept
real short-term rate at zero for 14 months, the FMOC omitted the word
“patience” from its May 5 statement on future interest rate
deliberation, replacing it with the term “measured pace” to describe
needed interest rate rise. There is now wide expectation that the Fed
will need to raise interest rate soon and much talk of a repeat of a
1994 burst of the bond bubble is now circulating. The choice for the Fed
now is crisis soon or bigger crisis later.

Once the genie of excess liquidity is out of the bottle, it is almost
inevitable that a bigger genie will be let out of a bigger bottle to
keep the ongoing bubble from bursting, to avoid the nasty consequences
of a burst bubble for the financial system and the real economy. Central
banks, led by chief wizard Alan Greenspan of the US Federal Reserve,
despite their central role in helping to create financial bubbles,
nevertheless declare that bubbles cannot be anticipated and nothing can
be done to prevent them, but central bankers comfort markets by claiming
magical power to handle the destructive consequences of bubbles, through
a one-note monetary policy of rate cuts to inject fresh liquidity, to
save a bursting bubble by creating a bigger bubble. Greenspan asserted
in his Jackson Hole symposium speech on August 30, 2002 that it is
virtually impossible to diagnose a bubble with any certainty until it
bursts, and even if a bubble could be diagnosed, it is not the task of
central banks to target asset prices, but only to control inflation and
target growth. And even if central banks reacted to asset bubbles by
raising interest rates, the extent of the rate hikes needed to reverse
asset prices in times of exuberance might be so large that it would
destabilize the real economy worse than a bubble burst would. This view
is supported by the experience Greenspan had in his battle against
“irrational exuberance.” While declaring that central banks cannot
prevent bubbles, Greenspan has admitted more than once that he sees as
one of the roles of a central bank the support of the market value of
financial assets, however inflated.

It is arguably true that the distinction between a bubble and solid
fundamentals can only be perceived after the bubble bursts. So the
question of a bubble is a conceptual dilemma, like forgetting. One does
not realize something has been forgotten until after one again remembers
it. Still, some useful observations can be made about the market value
of US assets at this juncture. US financial assets are built on debt.
Debt is not intrinsically objectionable if it is adequately
collateralized by real assets, and the proceeds are invested to increase
national income to service the debt. But if debt is serviced mostly by
the wealth effect of asset appreciation, a bubble is in the making. The
so-called air-ball financing caused the telecom bubble of the 1990s.
Widely used in financing telecom expansion in the 1990s, air-ball
financing involved the use of unrealistically anticipated future
earnings as collateral for financing over-investments in hope of
generating those earnings. A housing bubble exists because houses are
being financed and refinanced by full-value mortgages collateralized
only by the continuing rise in home prices.

As economist Hyman Minsky observed, money is created whenever two
parties enter into a mutual credit/debt obligation. The size of the
invisible money pool created by financial derivatives is now many times
(no one knows how many) the amount of M3, a money supply category
accounting for the sum of all short-term liquid funds, excluding
Treasury bills, savings bonds, commercial papers, bankers acceptances
and non-bank Euro-dollar holdings of US residents. One firm alone, the
since-collapsed LTCM which lost big betting wrong on interest rates,
commanded open positions of US$1.2 trillion of notional value in
financial derivatives financed by100-fold leverage. That was the
equivalent of the entire daily transactional value of the world's
foreign exchange markets at the time. Granted, notional values are not
the amount at risk, but they are the underlying asset value that allows
the contracting parties to bet on the derivative implications of
fictional assets they neither own nor can safely afford. Derivatives fit
the definition of bubbles, being all air and no substance. Another hedge
fund (Tiger Management) suffered value evaporation (loss) of US$2
billion in 6 hours by a 10% appreciation of a single currency (yen)
against the US dollar. This invisible supply of virtual liquidity
outside the reach of central banks supports an artificial level of asset
market value very much detached from fundamentals, and the un-wounding
of their open private derivative contracts based on astronomical
notional values will inevitably cause drastic readjustments in asset
prices in the real markets.

The pervasive securitization of debt blurs the all important dividing
line between debtor and creditor, and allows an economy to borrow from
itself, not just against its future, but against its current and less
sophisticated debt, not for productive investment, but for financial
manipulation. The use of debt as collateral for more sophisticated debt
has characteristics of a bubble. The broad dis-aggregation of risk to
maximize transactional surplus (profit) ultimately leads to the
socialization of risk (transferring unit risk into systemic risk) while
the privatization of the resultant profit remains a sacred prerequisite.
The Bank of International Settlement “Lamfalussy Report" defines
systemic risk as "the risk that the illiquidity or failure of one
institution, and its resulting inability to meet its obligations when
due, will lead to the illiquidity or failure of other institutions.”

Under the accounting rules of capitalism, capital cannot exist until
ownership is specifically assigned and applied to increase labor
productivity. Thus socialization of capital is a self contradiction in
term and must stay off the balance sheets of the system. To own assets,
even government must act as if it is a corporation, i.e. a "legal
person." Public pension fund assets and other forms of collectively
owned assets must adopt the governing characteristics of “private”
capital in order to participate in the capitalist economic system. Such
assets enjoy no prerogative to invest at less than maximum profit for
the common good because the ultimate definition of the common good is
maximum profit, never-mind unintended consequences. Thus employee
pension funds will invests for highest return in shares of companies
which ship their members’ jobs overseas to low-wage economies. The
formula of socialization of risk in support of privatization of profit
leads to the hollowing of the center - a classic definition of a
systemic bubble. Yet the ownership of debt is largely socialized,
dispersed throughout the financial system, with encouragement of moral
hazard – the lack of fear for the private consequences of financial
adventurism.

Whether or when a bubble will burst depends on government's ability to
extend its elasticity, which is not unlimited, notwithstanding
Greenspan’s wizardry. To support the market, government needs
increasingly more power to intervene, which in turn destroys the market.
As is already apparent, the Federal Reserve is increasingly reduced to
an irrelevant role of explaining the virtual economy rather than
directing it. It has adopted the role of a cleanup crew rather than the
guardian of public financial health. With every passing quarter,
Greenspan sounds more like a deadwood lecturer in Econ 101 rather than
the powerful central banker of the world's biggest economy. Another
characteristic of a bubble is that no one inside can escape without
bursting it or for that matter has any incentive to. Except that the
laws of physics are generally not forgiving. Expanding bubbles will
burst by their very nature.

In a financial bubble, the real economy may not be growing, but the
monetary value of financial assets rises, and is defined as growth, not
inflation. Thus we have robust “recoveries” that continue to lose jobs
with the value of money protected by high unemployment and stagnant
income from wages. The US economy by the end of April 2004 was still 1.5
million jobs short of its employment picture in January 2001 when the
Bush administration took office. Some 8.2 million workers are still
unemployed, with 22% of whom being long-term unemployed, without work
for 27 weeks or more.

In the finance sector, wealth is created by escalating systemic
risk-taking, known now as the “Greenspan put.” Inflation and deflation
have become two sides of the same coin that alternate as monetary
concerns in a matter of months, through a highly-manipulated global
market of foreign exchange that destabilizes real economies via a
multitude of conduits such as wealth effects, balance sheet effects and
recurring alternates of credit excesses and crunches. A few months
earlier, China was blamed by Western economists for exporting deflation
through an undervalued currency. Now China is being blamed for exporting
inflation while the Chinese currency continues to be pegged to the
dollar at the same rate.

Yet China does not have an export economy; it has a re-export economy.
Most of the factors of production for Chinese exports are imported, raw
material, infrastructure investment, energy, capital equipment, design
and development, financial services, parts for assembly, intellectual
property, overseas distribution and sales, the exception being only
labor and raw land. China incurred a trade deficit of $8.4 billion in
the first quarter of 2004. If anything, China is importing inflation
which is now at a 3.2% annual rate and rising. China's foreign trade for
2004 is forecast to reach US$1 trillion, up 17 percent on a year-on-year
base, according to the Ministry of Commerce and the International Trade
Economic Cooperation Institution, which predict that the country's
export will reach US$505 billion, up 15 percent while import reaching
US$495 billion, up 20 percent. Foreign trade then constitutes more than
two thirds of China’s US$1.4 trillion GDP with import growing faster
than export. And import growth cannot be slowed as much of it is
required by export needs.

The recent global commodity market bubble was not caused by real
increased demand by the Chinese economy but by speculation fueled by low
interest rates and speculation on China’s future demand based on
projected Chinese export growth. Yet the inevitable rise in dollar
interest rates will burst the commodities bubble, affecting the exchange
value of the currencies of commodity exporting nations, such as
Australia. It will also torpedo US recovery and curb demand for Chinese
exports. The global economy, led by super-low short-term dollar interest
rate, has been propped up by carry trade, a technical term that describe
a speculative strategy of borrowing short-term in low-interest money
markets to invest for gain long-term in high-interest money markets, or
to speculate in high-inflation sectors such as commodities.

A steep fall in copper, gold and other metal prices in April 2004 may
suggest that the two-year boom in commodity markets may be coming to a
close. Copper and nickel each lost more than 5 percent of their value on
April 28, 2004, accelerating a drop that began in early April. Copper,
the most widely used industrial metal, traded at $2,657 a metric ton on
the London Metal Exchange, down from $3,100 in late March, having more
than doubled from early 2003 until the March 2004 peak. The price
collapse was described by traders as blowing off speculative “froth.”
Nickel, used for making stainless steel, has lost almost 40 percent of
its value since reaching a peak of close to $18,000 a metric ton in
early January 2004. The gold price was fixed in London at $386 an ounce
on April 28, down from a recent peak of $428.20 in January 2004. The
growing nervousness in the metal markets stems mainly from China's
announced moves to cool its fast-expanding economy, as well as a recent
rebound in the dollar, reflecting expectations of higher dollar interest
rates. The rebound of the dollar has roiled metal markets because most
prices are denominated in dollars and often move in the opposite
direction of the dollar.

Booming demand from China has been identified as a driving force behind
the spike in commodity prices since late 2002, with China either
overtaking or approaching the United States as the world's biggest
consumer of materials like aluminum, coal, copper, iron ore and steel.
But with fears growing of an inflationary bubble, the Chinese
authorities ordered banks in late April, 2004 to curb their rapid rise
in lending. The government has also tightened capital requirements for
investments in steel, aluminum, cement and real estate projects. The
State Council, China's cabinet, halted construction of a $1.3 billion
steel mill in Jiangsu province, as part of an effort to rebalance
economic growth. The fast expansion of China’s steel capacity has
outstripped its electricity capacity and raw material supply.

The commodity boom of the 18 months between the last quarter of 2002 and
the first quarter of 2004 had attracted the interest of hedge funds and
other speculative investors in what was normally among the least
glamorous segment of the financial markets. Analysts estimate that about
$5.2 billion was raised for exploration and mine development in 2003,
more than double the amount in 2002. Another $2.6 billion has been
raised so far in 2004. Easy and cheap money, undirected by policy and
unconstraint by regulations, seldom stimulate the economy in
constructive ways. Markets are singularly without foresight or vision.

Central banks seldom adjust their monetary policies to arrest asset
bubbles and related instabilities, which are not registered as inflation
in economic statistics. And inflation is the sole concern of central
banks. The days of the central banker being the spoiler who takes away
the punch bowl when the party gets going are long gone. Central bankers
now bring stronger drinks when the party slows. In the US, the Fed has
served notice that it is prepared to move toward inflation targeting to
prevent deflation, as suggested by board member Ben Bernanke. Trapped by
their own fixation on inflation, central banks will continue to provide
excess liquidity to support asset price bubbles, and to mask the
destructiveness of burst bubbles by unleashing new bubbles,
euphemistically known as monetarily-induced recoveries. In fact,
instability in the financial sector of the economy has become a major
source of profit for financial institutions. Long-term investors are
endangered species; most market participants have become leveraged
traders for short-term profit.




Sabri Oncu wrote:

> Henry, Anne, Michael Hudson and the rest,
>
> What is your assessment of what is going on in the
> capital markets lately?
>
> I don't have the time to follow the markets as closely
> as I used to in these days, so I am interested in
> cheating from you guys.
>
> Give me a hand please.
>
> Best,
>
> Sabri