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.” (http://www.ft.com/cms/s/0/ec755d4a-1f40-11e0-8c1c-00144feab49a.html#axzz1B0wmwdeP)

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,” http://professional.wsj.com/article/SB20001424052748703583404576079511405101244.html.)

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. (http://www.ft.com/cms/s/0/8bfc81e2-1f30-11e0-8c1c-00144feab49a.html#axzz1B0wmwdeP)

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.” (http://www.ft.com/cms/s/0/1122ed96-1f7e-11e0-87ca-00144feab49a.html#axzz1B0wmwdeP)



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. (http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders)

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

Bubble, Bubble, Everywhere!

The Federal Reserve just doesn’t seem to get it!

Monetary ease can cause bubbles and not just in the United States. Bubble Ben at the Fed still denies that the Federal Reserve had anything to do with the bubbles in asset prices in the early 2000s in housing and the stock market. Bubble Ben, in 2005, placed blame on the Chinese and other countries for the “Global Savings Glut” that helped to finance the budget deficits of the United States government thereby allowing the interest rates in the America and other countries to be excessively low, causing substantial concern about world inflation and international resource misallocation.

Bubble Ben continues to see price moderation as a problem, just as in 2006 and 2007 he saw inflation as a problem far beyond the period when inflation was a problem. When it comes to price movements and asset bubbles, Ben Bernanke is a lagging indicator!

What is happening in the real world, Ben?

We see the headlines, “Investors Pile into Commodities”, (http://professional.wsj.com/article/SB10001424052748703963704576005933072423242.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.) “Investors are holding their biggest positions on record in the commodities markets as prices surge…Hedge funds, pension funds and mutual funds dramatically ramped up their holdings in everything from oil and natural gas to silver, corn and wheat this year. In many cases, the number of contracts held for individual commodities now far exceeds the amount outstanding in mid-2008, the last time commodity markets were soaring to records and debate raged about whether excessive speculation was driving up prices.”

We read in the Financial Times, “Crude Oil Tipped to Bubble over $100 a Barrel,” (http://www.ft.com/cms/s/0/cfb5cd58-022f-11e0-aa40-00144feabdc0.html#). “For the first time in two years, oil bulls are starting to outnumber bears.” Have you noticed that the price of gas has jumped $0.30 or so over the past month or two. And, the price of gasoline at the pump is going to continue to rise.

And the same picture arises for worldwide commodity prices, “Material Difference,” (http://www.ft.com/cms/s/0/d1e31d98-023d-11e0-aa40-00144feabdc0.html#axzz17WmrNvT3). “World prices for cotton have risen by 73 percent since the start of June.” This is just one item; one can go to other commodities and see substantial increases. This is sure going to help the economic recovery?

“In other words, a generation that has grown up with food and clothing deflation must now get used to paying more for the shirts on their backs and the bread on their table. The options: less breakfast cereal in the carton and hair-raisingly static-inducing nylon shirts, or pummeled profit margins for the global food and clothing industry.” That is, world commodity inflation is causing cost pressures that must surface somewhere. And, this is going to help the recovery?

And, we are seeing China, Brazil, and India, among other countries, raising interest rates and restricting bank lending so as to combat increasing levels of inflation. Governments are very concerned.

Last week, the Federal Reserve released information about the financial and non-financial institutions that it assisted throughout the world during the recent financial crisis.

Commentators responded by referring to the Federal Reserve System as the “world’s central banker.”

The Federal Reserve System has become the “world’s inflator”!

International financial markets have become so interlinked and flows of funds have become so fluid that pumping up the world’s reserve currency can affect almost every corner of that world. If the Federal Reserve creates an environment in which investors can borrow at 25 to 50 basis points and lend elsewhere at much higher rates, money is going to flow from the United States into these other opportunities.

And, bubbles result...worldwide!

What the Federal Reserve fails to understand is that industry and finance in the United States is in need of a massive re-structuring. Efforts to pump funds into the U. S. economy in a short-run attempt to put people back to work is just resulting in the money going “off-shore”. These efforts are not helping people and businesses de-leverage and modernize; it is not helping them re-structure.

And, these efforts are not helping America compete in the 21st century when its educational system is just producing students that are average or just above average in science, math, and reading when compared with other children throughout the world.

Also, the Federal Reserve does not understand the role it has played in exacerbating the increasing gap in incomes between the highest earners and the rest of the income spectrum.

As a consequence, the Federal Reserve is just producing bubbles everywhere and it is hard to see how this is really going to help us.

Why Future Bubbles Can Be Expected

We have been told for at least two years now that the problems in the banking sector are liquidity problems. But, liquidity problems are of short-term nature and need to be resolved within a relatively short period of time. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

The policies that are used to combat a liquidity crisis are also of a short-term nature. These policies are based upon the need to supply the market with liquidity so that asset prices will stop dropping.

Given this interpretation, the Federal Reserve, under Chairman Bernanke’s leadership, has supplied liquidity…and more liquidity…and more liquidity to resolve the issue.

This is a sign that the model being used by Bubble Ben and the Fed is inappropriate for the particular situation that they face.

But, this was the policy prescription for the Federal Reserve in the early 2000s when interest rates were kept around one percent for about 18 months. And, what did we get…a pair of asset bubbles.

In terms of fiscal policy, the situation is similar. The “experts” in the Obama administration, led by Treasury Secretary Tim Geithner, have called for more spending…and more spending…and more spending.

In both cases, the reason given why the policy prescription is not working is that the particular stimulus package tried has not been large enough. The solution Ben and Tim have given is to make the policy package larger. More spending…and more liquidity!

This is a sign that something is wrong!

The model and the analysis being used are not appropriate. The model being used to develop economic policy must be changed.

In the financial markets, the problems that exist are solvency problems. Households are declaring bankruptcy in record numbers and foreclosures on homes continue to run at very high rates. Small businesses are also declaring bankruptcy and loan demand coming from small businesses is dropping as of the last Federal Reserve survey. Thousands of small banks are on the verge of insolvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

And, guess what? The monetary policy that the Federal Reserve is following has successfully resulted in the accumulation of massive amounts of cash in the hands of large banks and large corporations. I am just waiting for the acquisition binge to begin once the economy stabilizes a little more. So much for "Main Street"!

In the economy, the “consensus” economic model that has been used over the past fifty years is still contributing to the “more-of-the-same” policies that are being followed by the Federal Reserve and the Treasury Department.

Yet, over these past fifty years the application of this model has produced the following results: the United States has moved from an “under”-employment rate of around 8% of the working population to about 25% in the current environment; these policies have also resulted in the capacity utilization in industry moving from about 93% in the 1960s to about 75% at the present time, constantly eroding throughout the whole time period; and, the distribution of income in the United States over this fifty years has moved dramatically toward the end of the most wealthy.

The foreign exchange markets have signaled to the United States that something is wrong! Over the past fifty years, the value of the dollar has declined by more than 40% in foreign exchange markets. After a recovery in the latter part of the 1990s, the value of the dollar once again tanked until we hit the financial crisis of 2008 and there was a “stampede to quality.” Once this “stampede” was over and markets and economies stabilized, the value of the dollar declined once again. And, after Ben made his remarks in Jackson Hole concerning the forthcoming quantitative easing, the value of the dollar plunged 7% in a matter of weeks.

Paul Volker has written that the most important price in a country is the price of its currency in terms of other currencies. If the value of your currency declines, this is a sign of weakness…weakness in your economy and in your economic policies.

And, here we are. Thursday November 11, 2010, the President of the United States was lectured to by Hu Jintao, the Chinese President, over the United States currency. Other world leaders, from Germany, Great Britain, and Brazil, have also reprimanded the President over the United States currency situation. (http://seekingalpha.com/article/236430-release-from-the-g20-what-more-needs-to-be-said)

Furthermore, given the election results in the mid-term elections held last week, the American people seem to have a problem with United States economic policies.

The policy direction in Washington needs to be changed and changed soon.

However, I don’t expect a change to be made in the near future. President Obama seems to be adamant that this policy must be effectively enforced.

Therefore, like the early 2000s I expect bubbles to occur here and there.

The problem is, as we well know…that, sooner or later, bubbles burst!