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'When the World is Free …'

By James Cumes - posted Thursday, 8 March 2007


During World War II, we sang that there would be blue birds over the white cliffs of Dover along with all sorts of other splendid things, “tomorrow, when the world is free …”

However, especially in the last 20 or 30 years, we have discovered that freedom can often have strange outcomes, especially in such affairs as free markets, free trade and the free flow of globalised capital.

Of course, for even longer than that, there have been some strange features of freedom. When we look like having a record number of jobs and a record number of our people in them, then our central banks raise interest rates to make sure we put a stop to that. When wages rise after stagnating for years, our central banks race, sometimes almost in panic, to stop that too.

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We’re used to all that; but the more freedom we get and the longer we get it, the stranger some of its features become.

For example, we recently had a meeting of the Finance Ministers of the Group of Seven in Germany. These are - economically and financially speaking - just about the most important people you get, and usually they take their central bankers along with them.

At this recent meeting, they were faced with a situation of global imbalances of trade and payments - of credit and debt - that were unprecedented.

China’s currency reserves are approaching a trillion US dollars and have been increasing at an accelerating rate of around US$200 billion a year. Japan’s current payments surplus is not quite so high and increasing at a lesser rate but still both Japanese figures would be historically unprecedented if it were not for the even more extraordinary Chinese situation.

Financial analyst Gary Dorsch has written:

Since the BOJ (Bank of Japan) dropped its overnight loan rate to zero per cent in March 2001, the Euro has advanced from around 105 yen to as high as 158.70 yen today. Aided by the Euro's strength against the yen, Japanese exports to the European Union nearly doubled to 1.06-trillion yen in December [2006]. But on the flip side, European exports to Japan have waffled between stagnation and deterioration. Last year, Japan racked up an 18.6 trillion yen ($160 billion) current account surplus, while the Euro zone suffered a 16.8 billion Euro ($21.5billion) deficit. Yet the power of the “yen carry” trade was able to swim against the tide of these trade imbalances, by pushing the Euro 12 per cent higher against the yen last year.

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Characteristically, in the past, this situation would have meant a powerful surge in the value of both the renminbi and the yen; but, strangely, this did not happen and was not about to happen. True, the renminbi continued on its gentle course upwards in relation to the US dollar, a course on which the Chinese authorities set it a year or so ago. If there was any acceleration of this course, it was scarcely perceptible; and, as for the yen, not only did it not strengthen but it became noticeably weaker in terms of the United States dollar. That was at a time when the overall gap in the American balance of trade for 2006 was announced to be running close to $US800 billion a year.

However, as Alice might have said, things got curiouser and curiouser.

The Chinese authorities, who were, after all, nudging the value of the renminbi upwards, were put under pressure by the Finance Ministers of the Seven to nudge their currency upwards much more dramatically, while the Japanese, who were doing as close as it gets to nothing at all to revalue the yen, were left in peace.

Now there is some explanation for what appears to be such blatant discrimination. The Japanese economy, after the collapse of the real-estate and stock-market bubbles in the late 1980s and early 1990s, went through more than a decade of low or negative growth, deflation and chronic unemployment. Drastic financial measures including reduction of the BOJ interest rate to around zero for long periods were introduced to get the economy moving again - moving in terms of internal demand and investment, rather than in terms of the external balances, which remained robust.

Only in recent months have clear signs emerged of reviving real, including consumer growth. Interest rates have been lifted from zero in two steps of 0.25 per cent to 0.5 per cent - a rate which may still be zero or below as deflation in Japan has slowly been transforming into a gentle inflation.

Even so, the experience of the last 15 years advised caution in any too rapid a rise in interest rates, to reduce any risks that growth might be stalled. This transparent caution on the part of the BOJ meant that the weakness of the yen persisted and, if anything, became more pronounced. This was then further exacerbated by the announcement from the BOJ that any further rise in interest rates would be “gradual” - an assurance that was taken to mean that interest rates would remain stable or would rise perhaps only a further 0.25 per cent during 2007 and perhaps into 2008.

Now we come to the really interesting bit. Freedom has meant, in the last 20 years or so, freedom to move funds around the world at the drop of a hat - or the press of a button. That freedom to move has meant a dream come true for the masters of the ancient art of arbitrage. If you can move money around freely and often, you can create unprecedented “liquidity”, you can “create credit” on almost a global basis and, of course, if you are smart, you can make profits of dimensions and at a speed that could, in earlier times, have been the stuff only of the speculator’s wildest imaginings.

That situation has produced its own operators, its own “system” and its own language. The phenomenon is called the carry trade and, in an era when all financial magnitudes have reached astronomical levels, it has grown to a size that is undoubtedly significant and may have indeed reached a point at which it is crucial to maintaining the “stability” or at least helping to postpone the collapse of the entire global financial “system”.

The essence of the carry trade is that its operators borrow short-term in a low interest rate economy and lend, often long, in a high interest rate economy. That means that they borrow at something close to zero real or nominal interest rates in, let us say, Japan and they lend at 5 per cent or more in relatively high interest-rate environments in, let us say, the United States.

They might take up Treasury bonds or they might invest, in one form or another, in real-estate mortgages. The essence is that a significant margin should exist between the rate at which the money is borrowed and the rate at which it is lent.

There are two other important factors to be taken into account, although these are, characteristically, not considered with the immediacy of the margin between rates.

The first is the value of the currency in which the borrowing takes place and its relative stability vis-à-vis the currency in which the funds are lent. If there were to be a sudden and significant appreciation of the former, the anticipated profit could disappear - and could be replaced with a perhaps heavy loss.

The other major and fundamental risk is that the interest rate in the economy in which the funds are borrowed could go up - relatively or absolutely - to such an extent that the profit margin is reduced or eliminated. If funds have been borrowed short and lent long this could entail particularly acute difficulties since new funds could not be obtained - at least from the same source - to continue the longer-term lending.

So long as the carry trade was on the speculative margin of the financial system, it could not be ignored but did not need to attract any special focus of interest or concern. However, it has moved close to centre stage in recent years because of the persistence of the American trade and payments gap, usually at between $60 and $70 billion a month, and the need to cover this gap with an inflow of foreign capital.

The tendency has been for the gap to be less adequately covered recently and for the pressure on the value of the American dollar consequently to increase.

This is not a phenomenon that affects only, let us say, Japan on the borrowing side or, let us say, the United States on the lending side. Switzerland is a financial centre where borrowing costs may be low at, say, around 2 per cent and New Zealand is a country with a large trade deficit in which lending rates are relatively high.

The carry trade might therefore continue to flourish to the “benefit” - as it is seen at least in the short term - of both the country in which the trader borrows and the country in which he lends; and it might help to “stabilise” - again, at least in the short term - the world economy and the global financial “system”: whose breakdown, if it were to occur, would cause such loss and suffering to so many people, presumably on every continent and in every region.

So we come back to the curious discrimination, at the Group of Seven Finance Ministers’ Meeting, shown between China on the one hand and Japan on the other. It is Japan that has a large and, so far as we can gather, a dominant role in the carry trade; and it is that trade that must be protected even though it introduces the most extraordinary distortions in the global financial “system”.

What should be one of the world’s strongest currencies is weakened by yen being sold for, let us say, American, New Zealand or Australian dollars which are thereby kept at a level that they could not otherwise sustain.

Equally, there is a distorting impact on interest rates. If Fed Chairman Bernanke were to reduce the Fed rate, the inflow of funds to cover the huge monthly trade gap would possibly be reduced. The carry trade does not supply the whole of this inflow but it has been - increasingly - supplying a sufficient proportion for it to deserve and to have won the approval of the American Treasury, the Fed and other American financial institutions. It thus achieves a “respectability” that in other circumstances, might not be warranted.

Overriding all this is the distortion that the current global financial situation inflicts on liquidity, credit, interest rates and asset-price and consumer-price inflation. The purpose that central banks are supposed to serve in disciplining inflationary trends is almost completely lost.

Though they may raise interest rates, this has little or no impact on inflationary pressures - as it has characteristically been imagined to do - because liquidity has been vastly expanding and credit has been generously available on easy terms despite the local cost of consumer or investment money. Indeed the high local cost of funds only serves to make the profits of those who supply the credit and provide the liquidity higher than ever.

So the trade and payments deficits of New Zealand, for example, reach unprecedented levels as a percentage of GNP but the value of the NZ dollar is maintained or even enhanced and the deficit is easily financed through the inflow of funds borrowed in low-interest-rate economies.

Much the same phenomenon may mark other economies such as Australia and the United Kingdom. In these economies, the central bank may raise - and indeed it has raised - interest rates and so damp down the housing boom but then the higher interest rates attract those with money borrowed elsewhere. As a result, they may breathe new life into the housing and other asset markets so as to sustain or intensify the boom or slow down its decline.

All of these effects may be seen, with justification, to constitute a happy outcome, if the prospect were otherwise for a catastrophic economic and financial collapse in the short term. However, it is difficult to see that it does more than postpone such a catastrophic collapse in a slightly longer, medium or long term, unless decisive action is taken to remedy the fundamental disequilibria in national, regional and global economic and financial situations.

So far as we can gather, no such action is being taken or contemplated. Rather have the Group of Seven Finance Ministers’ meeting and subsequent events suggested that there has been collaboration in manipulating capital flows, interest-rate impacts and divergences, and other factors, so as to preserve the American and other economies from the catastrophic collapse that would otherwise be the outcome of their economic and financial policies.

That does not mean that there will not be a catastrophic collapse, only that it might be postponed to a date that cannot easily be predicted. On the basis that an economic depression has historically tended to be proportionate to the intensity of the preceding boom, the longer-running distortions and the ever more massive sums involved in global financial undertakings must reasonably be presumed to make the catastrophe, when it finally does arrive, even greater, more devastating and entailing more widespread suffering than ever.

Will such a collapse treat more or less equally all participants in the global economy? On this, it is impossible to be precise. There is perhaps some reason to conjecture that some countries such as China might have a greater awareness of the reality of what is happening; they might already have been taking some precautions and the nature of their government - this would seem to apply also to Russia - can more readily than some others be adapted to the situation of economic and financial crisis that seems now to be foreshadowed.

If so, this could mean that, unlike the Great Depression of the 1930s, the depression that confronts us now could affect countries unequally and that the shifts in economic, social, political and strategic power that have already occurred in the last three to four decades could be dramatically intensified and from the economic and financial collapse there could emerge a fundamentally new balance of global power - strategic as well as economic.

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America's Suicidal Statecraft is available most readily through Amazon, at $26.99 a copy.



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About the Author

James Cumes is a former Australian ambassador and author of America's Suicidal Statecraft: The Self-Destruction of a Superpower (2006).

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