Friday, January 14, 2011

The Bubbles Are Real

On Thursday, three-month forward contracts put the yield spread between Brazilian and United States rates at 8.75 percentage points. And, you have questions about the existence of the carry trade, the borrowing at excessively low interest rates in one country to invest at much higher rates in another country.

Well, these yield spreads are not quite as attractive as they once were because Brazil has placed a tax on foreign investment in sovereign bonds. This tax was initiated in 2009 and after two increases is now 6 percent. Several fund managers told the Financial Times outlet that “the appeal of the carry trade had diminished considerably as a result.” (

Two points on this: first, there is no doubt in my mind that the quantitative easing (QE2) on the part of the Federal Reserve System has created bubbles in other parts of the world: and second, countries around the world have reacted to these bubbles by selectively trying various policy tools to try and contain the capital flows into their financial markets confirming, to me, that the bubbles are real.

Yesterday, the Brazilian central bank introduced a new effort to slow down the rise in the Real “by offering to buy as much as $1 billion in the currency futures market. (“Brazil Central Bank Intervenes,”

But, governments all over the world are trying to clamp down on “hot money flows”. Gillian Tett writes about “New Ways to Control Hot Money Bubbles,” in the Financial Times this morning. (

South Korea, in particular, is “launching” experiments aimed at stemming rising currency prices or frothy stock markets or other cross-border flows of funds. The effort is to find ways to apply more activist and “macro-prudential” policies to banks or the banking system.

Even the International Monetary Fund, this week, recognized the legitimacy of and the need for

countries to control capital flows when other countries are following independent economic policies aimed at resolving domestic economic problems that have impacts on others.

The problem is “what constitutes a bubble?”

A bubble seems to be like pornography, it depends upon who is looking at it. Former Federal Reserve Board Chairman Alan Greenspan never saw a bubble, at least while it was taking place. Apparently, the current chairman Ben Bernanke can’t see one either.

Now, it seems, that there are other economic phenomenon that are maybe not so easy to identify. United States Treasury Secretary Tim Geithner has stated that it is hard to identify financial institutions that are “systemically important” in advance of a crisis. “It depends too much on the state of the world at the time. You won’t be able to make a judgment about what’s systemic and what’s not until you know the nature of the shock.” Well, so much for “too big to fail.” (

Still, there are flows of funds that seem very “bubble-like” Take a look at the following chart. Notice the flows of funds into emerging markets in 2009 and 2010. It was December 2008 that the Federal Reserve forced the effective Federal Funds rate into the range of 15 basis points to 25 basis points. Fund flows into emerging markets took off to new highs once this policy was in place. Who says the international flow of funds is restricted.

The next point, however, is the movement in the exchange rates in these emerging countries relative to the dollar. Note, the figures presented are the percent change over the past two years.

One definition of a bubble is when fund flows into a nation or a sector exceed the ability of real economic activity in that nation or sector to grow. In the case of funds flowing into these emerging nations it certainly appears as if the funds flowing into the countries exceed the ability these countries have to grow.

Raghuram Rajan and Luigi Zingales, in their book “Saving Capitalism from the Capitalists” argue that bubbles occur when you get people investing in markets that are not familiar with the markets, people who don’t really understand the fundamental characteristics of the new market they are investing in. As a consequence, people make money as prices continue to rise and this fact draws more and more people into the market place. In this respect, bubbles can possibly be observed by paying attention to who is being drawn into the market. This can be another piece of evidence in attempting to discern “bubbles.”

Thus, the carry trade has proven to be very attractive, has produced a lot of profitable positions, and has gained a lot of publicity in the popular press and in the investment community. One could argue that investments in the bonds and equities in emerging nations have drawn a lot of new investors over the past two years. More are coming into the markets every day.

One can also make a similar case for the flurry of activity in world commodity markets.

In fact, one could argue that in many of these situations policy makers are setting up attractive “one-way bets” for investors and these are drawing new money into these areas from investors not familiar with the markets. (

It seems to me that in present circumstances it is harder to argue that bubbles ARE NOT real than that they really exist.

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