'When the World is Free …'

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.