Will governments ever learn?
Wise advice: “Today’s eager interventionists should take note. Far more than they realize, they are setting up one-way bets for traders.”
The reason: sooner or later, markets “revert to the mean”: markets ultimately adjust to their underlying economic value.
“Hedge funds know that South Korea’s won is being artificially held down by the government and is therefore more likely to rise than to depreciate, so they are hosing Seoul with capital and compounding the problem of hot inflows that Korea is desperate to alleviate.”
Both of these quotes come from “Currency Warriors Should Consider India” by Sebastian Mallaby in the Financial Times. (See http://www.ft.com/cms/s/0/0f26703c-f105-11df-bb17-00144feab49a.html#axzz15Rw49cE9)
In other words, international investors, like hedge funds, are pouncing on the opportunities governments set up for them.
The won situation is just the reverse side of the classic George Soros “bet” against the British Pound in 1992. The British government tried to keep the value of the pound above an agreed lower limit in agreement with the policies of the European Exchange Rate Mechanism. “Black Wednesday” refers to the events of September 16, 1992 when the value of the pound was allowed to drop toward its underlying economic value. Soros, who had been selling the pound short is reported to have made over one billion dollars on this effort of the government to intervene in the market. The government set up a “one-way bet” for traders.
But, this is happening all over. Karim Abdel-Motaal and Bart Turtelboom, portfolio managers at GLG Partners, write this morning: “…emerging markets are being flooded with freshly minted dollars. No matter how much sand is thrown in the wheel in the form of intervention, transaction taxes or capital controls, these capital inflows will get through.” (See http://www.ft.com/cms/s/0/81dd24ea-f0c9-11df-8cc5-00144feab49a.html#axzz15S17R06s)
Preparations to take advantage of these “one-way bets” are not limited to one part of the world. “Asia’s financial firms are on the prowl—for deals as well as for new investors. Even as they continue to strengthen their capital base through stock offerings, Asian banks, insurers and other financial firms are converting the floods of capital in the region into firepower for acquisitions.” (See http://professional.wsj.com/article/SB10001424052748703670004575616162768312620.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)
Financial capital is being built up around the world to take advantage of the incentives that exist within the current environment. And, governments are creating some of the most attractive incentives going!
With these huge amounts of capital available, governments can only maintain their interventions for a limited amount of time. Eventually, the markets win!
In trying to overcome the market, the “one-way bets” are created that make certain traders enormously wealthy, as in the case of George Soros. That is, these governments are underwriting Wall Street and not Main Street, just what they say they don’t want to do!
This seems to be what is happening to the debt markets in Europe. Earlier this year the European Union pulled together to avoid a collapse of the debt markets and save the Euro. It has become apparent that these efforts just provided a temporary escape from the underlying economic realities alive in Europe.
Europe, once again, seems to be approaching the edge of the abyss. Now, participants in the financial markets are calling for a debt re-structuring in many nations and not just a financial “safety net” to help support existing debt levels. Investors seem to be insisting that Ireland, Portugal, Spain, Greece, Italy, and even, possibly France, write down their debt and begin anew.
The earlier efforts did not produce the result desired. The earlier efforts did not achieve the path to the real underlying economic realities that exist.
Speaking of debt, let’s shift to the debt situation in the United States. I was taught that the Federal Reserve could only really control short-term interest rates because they had short-term maturities. The Fed could impact longer-term interest rates but only for a limited amount of time because these investments provided cash flows for a longer period of time than the Fed could dominate the markets. Thus, longer-term interest rates could be held below real economic values for the short-run, but the “bets” of the financial markets would come to dominate over time and the longer-term interest rates would either rise back to the levels market conditions warranted or could even rise above levels the market was once happy with because inflationary expectations would overcome and offset the efforts of the central bank to hold down long-term interest rates.
In other words, in attempting to artificially keep long-term interest rates low, the Fed will be creating a “one-way bet” that market participants can take advantage of and make lots and lots of money.
This is a “reversion to the mean” argument and is the basis for “Value Investing.” Over the longer run, markets adjust to economic realities. The risk associated with this conclusion is connected to the length of time it takes for the market adjustment to take place. This is the problem that Long Term Capital Management ran into. The “reversion to the mean” did not occur soon enough.
Eventually, the long-run is achieved and many investors make a lot of money!
Large amounts of cash have been accumulated to take advantage of these “one-way bets.” If it is observed that governments have set up “one-way bets” and will set up even more “one-way bets” in the future, capital will rush to take advantage of the free gift of the governments. The more the government’s attempt to maintain this intervention, the more money there is to make.
The underlying question concerns how much the government is willing to pay to maintain its intervention. In the Soros case described above, it has been revealed that the British government expended £3.3 billion in its attempt to keep the value of the pound above the lower limits. These are 1992 values and not 2010 values.
Who knows how much governments in Europe and the United States have spent in order to try and maintain their interventionists policies. The basic guess is in the trillions.
And how much have investors made taking advantage of these interventions? The Fed has kept its Federal Funds target close to zero for two years. This policy has put trillions of dollars into the hands of the already wealthy. So much for a more equal distribution of wealth in the world!
Governments never seem to learn.