Nouriel Roubini, professor at the Stern School of Business at New York University, who called the coming crash in 2006 and has been among the more prescient commentators on macro-economic trends, recently argued in the FT that we are already pumping up the next, highly leveraged, asset price bubble. Equity, oil, and commodity prices have risen sharply, far more than justified by economic reality, and stock, bond and currency prices in emerging markets have increased by even greater proportions. At the same time, the US dollar has fallen, and US bond yields remain broadly low and stable. The eventual and inevitable bursting of this bubble will lead to an even bigger price crash than we saw in 2008 and the inability of the main participants to repay the borrowing that supports this market activity will lead to wholesale institutional collapses.
Now whilst the easy money and near-zero interest rates of government and central bank policy have contributed to this asset price surge, the really dangerous aspect, Roubini believes, is a highly leveraged speculation against the US dollar, referred to as a carry trade. This bears translation into layman’s terms, since if Roubini’s fears are realised we’ll certainly hear more of it before long.
Basic markets theory tells us that there is no profit in switching from one currency to invest in another offering a higher nominal yield, and then at the end of the investment period converting everything back to the original currency, since the difference in interest received will be cancelled out by movements in the exchange rate. This is known as interest rate parity. It is a central pillar of the notion that international exchange markets are efficient.
But there are all sorts of reasons why markets – and currency markets are no exception – are not efficient. For example, significant sales of a currency will depress its price, especially if it is taken as a signal that those trading have better information than others. If enough people bet against the currency they can make a profit. This profit has two sources. On top of the increased yield they can obtain because interest rate parity doesn’t apply, much larger gains can arise on re-translating the principal sum into the now devalued currency. If a currency is subject to sustained depreciation, that makes it very attractive not only to trade one’s existing currency holdings like this, but to borrow the currency in order to trade even more. Borrowings in a falling currency will be worth less when they come to be repaid, and indeed the net cost of borrowing can end up significantly negative. Speculative borrowing will of course drive the currency price down and so ensure that – short term – the speculation is profitable. This borrow-and-switch strategy on the expectation that your borrowed currency will fall in value is the carry trade. Roubini believes we are already in the midst of a huge carry trade run against the US dollar.
This position is possible because of the policies pursued by the US Government and the Fed, with many other significant authorities following suit. Dollar interest rates are near-zero and are expected to be held there for some time. The Fed has bought huge quantities of corporate and government debt in order to reduce volatility and inject money into the economy. These factors and the slide in the value of the dollar have brought net dollar borrowing costs to the region of negative 10 to negative 20 percent. Traders have borrowed vast quantities of dollars and are pumping them into every high-yielding, risky asset they can find.
As Roubini writes, “The combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.”
Near-zero interest rates and quantitative easing are common to most major economies, but the dollar’s weakness is making the situation worse. Central banks in Asia and Latin America have seen unwarranted domestic currency appreciation which they either must ignore, so allowing the negative cost of dollar borrowing to become more negative, or try to control by lowering domestic interest rates, so encouraging asset price bubbles in their own economies. The conditions are in place for a perfectly correlated bubble across all global asset classes.
As all bubbles, this one has to burst. Why? First of all, the value of the dollar cannot fall to zero; it must stabilise somewhere. Secondly, the Fed can’t indefinitely keep a lid on volatility by buying debt in the market, as it presently is. Thirdly, an unexpected improvement in the US economy is likely to lead people to expect a tightening of monetary policy. And finally, an external event may lead to a sudden flight from risky assets to the apparent safety of US Treasuries.
And what will happen? Well, just as the bubble is highly correlated, the crash will be too – all asset classes will collapse together. If at the same time the dollar’s value rises sharply, which on previous form is to be expected, there will be a stampede to close out dollar borrowing that suddenly looks very exposed. That will in turn further depress asset prices and push up the dollar. The implosion will dwarf the crash of 2008, Roubini believes.
There is little sign that the policy makers at central banks and treasury departments understand the risks of what they are doing. They explicitly (as explained in the Bank of England’s Q2-2009 commentary) intend QE to raise asset prices and so through the wealth effect and lower borrowing costs stimulate domestic spending, thereby avoiding undershooting their inflation targets. But what if this process isn’t working? As the Bank of England admits, “Standard economic models are of limited use in these unusual circumstances, and the empirical evidence is extremely limited.” Nouriel Roubini believes that, in short, huge sums of public money are being leveraged into a horrendous speculative bubble rather than invested in the slower, tougher business of rebuilding a manufacturing and service economy.
What of the politicians? How are they preparing us for this outcome? Unsurprisingly, not at all.
If the scenario Roubini describes comes to pass financial institutions will inevitably fail, maybe a whole row of them. What will that do to the financial system? Will they be bailed out? How, and what with? There is neither the money nor the public will and a second crash would be a social and political catastrophe. But Roubini’s scenario should be taken seriously; it cannot be dismissed as an outlier. So what can we do?
First, central banks and treasury departments need to give much stronger signals that policy tightening could happen at any time, not just in an indefinite future. Speculation must become immediately less attractive.
Secondly, there should be urgent and public analysis and disclosure of the capital flows of commercial financial institutions. Today these are pretty opaque. Speculation requires insiders and manipulators. We must know who they are and what they are doing. It may then be possible to control some of the more egregious behaviour.
Thirdly, we must surely separate the utility functions of banks from everything else they do. We cannot again expose the financial infrastructure to the risk of institutional collapse and public blackmail. We know how to do this, we know it would be a good thing, and many important commentators are arguing for it or for more aggressive restructuring. For the authorities to sit on their hands now – with or without international coordination – would be cowardly and negligent. There is no time to lose.
And finally, we must demand a much clearer, deeper, more honest exposition from central banks and politicians of the risks and judgments that are in play. The public underwrites the economic system: it is entitled to decide in advance what the scale of its support should be.