Sky Blue Monthly (Dec. 1999)
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Dec. 18, 1999
This is the very first online issue of Sky Blue Monthly. So, we are going to talk a lot about introduction and recent economic history. (Old issues of Sky Blue Monthly from Oct. 1997 to Nov. 1999 are not available online.)
First question, of course, is why we decide to choose Dec. 1999 as the month to launch Sky Blue Monthly. Well, as you will soon know, the uniqueness of our economic theory is all about far-from-equilibrium state. And as we observe, now, the global economy (particularly American economy) is so far away from the equilibrium point that we think the timing is perfect.
Before we discuss deeply into our main subject (world economy), we want to have a brief history on how we get here. Start from the late 1960's (wow, that is so far back!), we know there were Vietnam War and Great Society Program in the USA. Vietnam War was an ill-defined operation that did not have a reasonable timetable to reach a clear objective. So, it dragged on. Money was wasted in the war and it put financial pressure on the US. Great Society Program was another scheme that did not work. The reason? Simple. It showed us that throwing money at the problem usually did not solve the problem. As a result of these 2 factors, inflation rate rose. In those times, US Dollar (USD) was fixed on gold and other currencies were fixed on USD. Continuous inflation ruined this system. (Bretton Woods System) This was how we got our current floating exchange rate system. There were also supply shocks. (Energy shocks, caused by OPEC oil embargo (1973) and later the Islamic revolution in Iran (1979). ) Therefore, in the 1970's, the industrial world, particularly the UK and the US, was in stagflation. (Slow growth in output + High inflation rate) Another factor that was suppressing our economic growth was that the government in the industrial western world had grown too big. For example, in Great Britain, public spending accounted for 43% of the economy in 1979. Not only did they grow very big, they also meddled in our economy with red tapes.
In 1980 and 1981, Prime Minister Margaret Thatcher (UK) and President Reagan (US) began their revolutions. Thatcher followed her monetarist ideals while Reagan pushed forward his supply-side economics. In the USA, marginal tax rate was lowered, red tapes were cut, and the businesses were welcomed. This sent a shock wave across the globe. Investors and entrepreneurs were amazed. They could not believe that there was still a place on this planet where investment was appreciated. That created a "gold rush" to invest and set up business in the US. That rush would be very positive for USD, according to my Far-from-equilibrium Macro Economic Theory (FFEE). Indeed, as the capital flooded into America, USD rose briskly from 1981 to 1984. This part was very healthy. However, there was another reason for the USD to rise. That was because of the high interest rate in the US. President Reagan cut taxes and increased military spending simultaneously. His effort to cut public spending failed. The result was budget deficit. Since the budget deficit had to be financed within the limit of strict money supply targets, interest rates rose to unprecedented heights. (For economists only: Some economists cannot understand common everyday language. So, here we go. Increase in budget deficit shifted IS curve to the right. Decrease in money supply shifted LM curve to the left. Thus, the intersection of IS curve and LM curve was higher than it had been on the y-coordinate (interest rate). i.e. Interest rate was higher. ) As a result, USD strengthened and a strengthening currency combined with a positive interest rate differential made the capital inflow into USD and USA irresistible. This part, however, was unhealthy. (So called "hot money")
As USD rose, US manufacture products and exports became expensive in world market. Japanese imports to the US rose too. This created strong political pressure in the US. Eventually, the industrial nations got together and we had the Plaza Accord in Oct. 1985. Even without the Plaza Accord, USD would fall anyway because the "gold rush" was cooling down. However, US government went too far because of the pressure from the interest groups. "Talk dollar down" became everyday event. Those (foreign investors) who had invested in the US became nervous because of this currency risk. (Artificial currency risk) Then, we reached an interesting period in 1987. On Oct. 17, 1987, Secretary of State James Baker urged Germany to stimulate its economy. When Germany refused to cooperate, Baker made a weekend announcement that the US was prepared to "let the dollar slide. " An unknown devaluation of a currency was not something that any foreign investor wanted to live with. What did "slide" mean? 10%? 20%? On Monday, Oct. 19, 1987, foreign investors just wanted out. Investors who held dollar-denominated securities were going to sell until they knew what "slide" meant!
Anyway, after 1987 stock market crash, the underlying economy in the US was still healthy. (See discussion above) Another reason that we recovered so quickly was Bank of Japan's actions. Bank of Japan was given advice by the US to provide liquidity to the world to prevent a global depression. (We don't think a depression would occur even without Bank of Japan's actions.) Bank of Japan was glad to do this because it was a good opportunity for Japanese to "buy up" the world while it was cheap. Unfortunately for Japan, things did not turn out this way. A huge bubble was created during 1988-1989. In Jan. 1990, it burst. Japan only started to recover in 1999.
In 1991, Soviet Union dissolved. Cold War was won by default. Meanwhile, the US entered a mild recession. For those American commercial banks, they were in a worse situation because of the real estate fiasco. The Fed cut interest rates several times to help them out. (In the future, if we want to discuss the real meaning of the phrase "moral hazard", we shall use this as an example.) This was, in Sky Blue Monthly's opinion, the worst decision made in recent decades. Developing countries were abandoning those old socialistic economic policies. Markets were opened. State dinosaurs were privatized. We think these were the right things to do. However, some local commercial banks in these nations got too excited and too bullish. They loosened their lending standards. This problem would not have got out of hand if the Fed had not cut rates so many times. Then, there were plenty of opportunities to do the Carry Trade. The best example was found in South East Asia. We use Indonesia as an example because it was the most severe.
In early 90's, interest rates in the US were low because the Fed was cutting rates to "bail out" commercial banks from the real estate fiasco. In the meantime, in South East Asia, there was an economic boom caused by lax commercial bank lending. The situation was the most severe in Indonesia. See the "Dec. 30, 1997" issue of Wall Street Journal, we know what had happened in Indonesia. The article was at A1 and the title was "Speculators Didn't Sink Indonesian Currency; Local Borrowing Did". Local bankers in Indonesia in early 90's found out that the interest rates in Indonesia were much higher than those in America because (1) high demand for credit and money in the midst of an artificial boom; (2) high inflation due to the lax lending of the local banks. So these "bright" local bankers found an easy way to make money: be a middleman, borrow money from the US at low interest rates and re-lend the money in Indonesia at high interest rates and then take profit at the spread. (This was called "Dollar Carry Trade".) How popular was this activity? "'Borrowing US Dollars was part and parcel of life in Indonesia. It was like going to McDonald's, ' says Kenny Tjan, who runs Nomura Asset Management Co.'s Jakarta Growth Fund from Singapore. " That was free money, wasn't it? The only risk was the forex rates. Borrowing was done in USD and lending was done in Rupiah. Hence, the cost was USD while the profit was Rupiah. If USD rose against Rupiah, this "Dollar Carry" had to be unwound, which was exactly the case in the second half of 1997.
Yes, indeed, a Carry Trade has to be unwound sooner or later. Why did it occur in 1997? What triggered it? Go back to our economic theory, FFEE. FFEE predicts that the currency of a nation will rise if there is a capital inflow into that nation. The reason is simple. If everyone in this world suddenly decides that Salvador Dali's paintings are the most beautiful arts in the world, and everyone loves to own them, the price of Dali's paintings will go up for sure. If investors decide that the US is the best place to invest their money, USD will rise because of the increased demand. (For economists only: Shift the demand curve upward and hold the supply curve unchanged, then you get a higher intersection point on the y-coordinate, i.e. higher price.) Thus, as long as there was a capital inflow into Indonesia, nothing bad would happen, for the time being. Japanese capital and also Dollar Carry were the major capital inflow that supported Indonesia Rupiah. Since 1995, the world has changed. The US has replaced developing countries as the Mecca of capital inflow. Why? Look at S&P or NASDAQ! If you want to invest, where are you going to place your money? The answer is obvious. So, since 1995, these developing nations had been under increasingly severe problem of capital outflow. Even if the capital outflow had not occurred, these developing nations would have been in trouble. Their booming economies were built on foreign liquidity. A decrease in capital inflow was big enough problem. Think about it in this way: you need to throw wood into your fireplace to keep it burning and keep you warm, right? If you stop throwing wood, it will stop burning sooner or later. Capital inflow is simply like the wood, and the foreign liquidity driven economy is like the fire. While US stock market was rising rapidly, it was attracting more and more capital from the rest of the world. When the capital went to the USA instead of those developing nations, the fate of those developing nations, like Indonesia, was sealed.
Since 1995, there has been a "Yen Carry" trade. Japanese interest rates were (and still are) very low because of the recession there and Bank of Japan's (BoJ) attempt to "jump-start" the economy by cutting rates. Meanwhile, the US economy has been booming as a result of the liquidity that the Fed had injected into the system during early 90's (huge). Therefore, "bright" middlemen borrowed in Japan and then bought US T-Bond and made the difference. As the capital flowed into the US, USD rose against Japanese yen and made this carry trade even more profitable. Was this free money? Maybe not. There was only one risk. Borrowing was done in yen and lending was done in USD. Hence, the cost was yen while the profit was USD. If yen rises against USD, this "Yen Carry" has to be unwound.
Therefore, from what we have observed in the YEN/USD cross, the danger is clear and present. The Christmas holiday is coming. The volume will be thin during holidays because traders and investors are out of town on vacation with their love ones. This presents central bankers an opportunity to intervene the forex market. They (The Fed, Bank of Japan (BoJ), and European Central Bank (ECB) ) can use this opportunity to sell yen. If they don't and yen takes off (against USD in particular), US bond market and US stock market will most likely get hammered. Forex-induced corrections in stock and bond markets are usually huge.
Back to our original discussion, why has yen been going up since last summer? Our feeling (subjective) is that Japanese economy is recovering. A depressed economy usually recovered during the most hopeless hours. Stock indices usually are the best leading indicator of future economic situation. Nikkei Index and Nikkei OTC Index are soaring. Japanese capital is returning and foreign capital (particularly European capital) is rushing in. This is the reason why yen is surging upward. In late 1998 (last year), the US government wanted Japanese government to do something in order to revive her economy. Well, be careful what you wish for. If Japanese economy recovers, it will take the wood out of the fire. The soaring yen seems to indicate that the wish comes true.
What policy can the government take to "cure" this problem? No, nothing can cure the problem. Once the bubble has formed, it will either expand or burst. Therefore, the Fed has only 2 opposite choices: 1. Let yen take off and then the US T-Bond market will get smashed and US stock market bubble will burst right here. 2. Intervene the forex market with BoJ and ECB to suppress yen and increase money supply to jack up the stock market. (i.e. pump up the bubble to an even bigger size) From the Fed's past behavior, we expect the Fed to take the second option.
Jan. 2000 issue of Sky Blue Monthly will be available by Jan. 14, 2000.
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