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Monday February 9, 2009 - 18:16:35 GMT
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Risk Appetite Returning on Stimulus Hopes – Dollar Correction?

Key News
• Brazil has spent $61 billion on foreign exchange intervention since early October. (Reuters)

“We recently argued that the pick-up in money supply growth and the related nascent turnaround in our favorite excess liquidity measure should help to support asset markets, end the recession later this year and prevent lasting deflation (“A New Global Liquidity Cycle” The Global Monetary Analyst, January 14, 2009).  This view has met with much interest among our readers, but also with much disbelief. 

Many Think Credit Matters More

“A frequent response has been that a pick-up in economic activity and asset prices not only requires rising money supply but also accelerating credit growth. But credit growth is unlikely to accelerate as banks are deleveraging, and hence the economy and asset markets are unlikely to recover, or so the story goes. This sounds intuitive, and it is unsurprising that after the bursting of the mother-of-all-credit bubbles, everybody is focused on the importance of credit.

The Evidence Suggests Otherwise

“However, in our view, the story still gets the sequencing and the causality the wrong way round.  Banks, in their lending activities, have rarely ever been leaders in economic or market cycles, but are usually followers. Credit growth can be a powerful accelerator in economic expansions and usually kicks in strongly in later phases of the upswing, but it rarely leads markets or the real economy on the way up.  Put simply, the statement that there can be no recovery or pick-up in asset prices without a prior or coinciding pick-up in bank lending flies in the face of the available evidence.”

    By Joachim Fels & Manoj Pradham, Morgan Stanley

FX Trading – Risk Appetite Returning on Stimulus Hopes – Dollar Correction?
Seems traders are betting the US stimulus package/rescue plan will juice investor confidence.  The dollar is in corrective mode, having broken below its near-term trend line support levels. 

 (Chart unavailable in text format.)

Ebbs and flows between risk aversion and appetite were more common a few months ago.  Usually these were multi-day or multi-week events.  Lately ebbs of optimism and pessimisms seem be measured in hours not days.  It begs the question: How long might this one (dollar correction) last?  We’ll answer that next week. 

Reader Comment: Responding to our M x V = P x O equation and monetary velocity comments in last week’s Currency Currents:

It's Stanley Fischer, not Irving Fischer we should be heeding!!!

What a great article Jack the Pipper (our CC post at, and very eloquently put.

Apologies in advance for such a long and rambling post. Please be assured of my intentions, I read and enjoy a lot of your Blog postings and this is not a critique, argument or opinion on your Blog, just simply my?conscious stream of thought?. You are right in that monetary policy, does not seem to be succeeding in having what is usually a very subtle, but very powerful effect on steering economic growth (Output) in the right direction.

But the reason modern economics follows Milton Friedman and puts so much emphasis on the left hand side of the equation is that the effects of monetary policy can almost be instantaneous and can usually gets straight to the problem, all this without most of the adverse effects on the real economy that would or does occur from negative adjustments on the right hand side.

"The viable policy is to accept the fact that "V" (monetary velocity) shrinks dramatically at times like these--thus we have the big dip in "O" (output) and "P" (prices)"

M x V = P x O
M = Money Supply
V= Velocity
P = Price Level
O= Economic Output

"P" in this equation encapsulates wages and prices of all goods and services in the economy. Stanley Fischer of MIT along with John Taylor of Columbia (now at Stanford I think) showed that the adjustment of "P" can be incredibly slow, even under the theoretical notion of rational expectations. This means prices and wages stay way too high for far too long for the given level of "M" and "V" in the economy.

That only leaves reducing "O" to balance the equation. This is by far the most important part of the equation. Why? Because it is the physical measure of how we are doing as a country. So it’s ok if O declines maybe? How does it decline? By reducing employment; by businesses going bust; by values of assets declining; by individual, commercial and national wealth decreasing. Until eventually down to the level until ?O? has reduced far enough to make the equation balance; or in other words America has gone economically backwards in time far enough for the equation to be in equilibrium again! Be warned this can set off a viscious reinforcing circle, i.e. reducing "O" reduces  "V" and vice versa, both these variables can act as cause and effect at the same time. (All economics can be reduced to a single word: Expectations)

Even with this there is nothing guaranteed or inevitable about a recovery! At the turn of the century, Argentina was the number 1 economy in the world, its people were the richest and had everything going for them. Complacency got them nowhere. All the economic indicators signaled a steady forward march of inevitable economic growth and economic domination: generously endowed with natural resources; perfect climate and geography for its huge agriculture industry; a growing and successful industrial base; good infrastructure including modern cities, transport, ports, railways etc.; excellent trading position; and  a young educated, and motivated European population. Somehow they threw it away.

Getting back to the original problem and examining Milton Friedman’s famous monetary model of the economy. The US government could take the easy route and abdicate itself of its responsibilities to the country and sit back and let the fiscal economy (right hand side of equation) work itself out and adjust to match the monetary economy (LHS). This might bring the US economy back into equilibrium steady state growth i.e. the equation eventually balances out but at much reduced output.
[Worst case scenario it leads the US into a steady state decline and the US meets Russia and China on the way down, remote but possible].

Well who wants to wait that long to find out if doing nothing will make everything all right again? It is a lot of waiting; a lot of hoping; and absolutely no guarantees; and an unbelievable amount of real pain, real people will have to endure and survive somehow on their own, without help from their elected government. And what is the optimistic prognosis; maybe... if in 5 yrs time the US is back to where it was 5 yrs ago, and the economy is growing again “that's OK!”

This same debate occurred around the time of the last Depression. Those who thought (wrongly) they might lose out from an active government, argued vehemently against any intervention from the government. In the long run they said, everything would work itself out. They were attacking that other great giant of 20th century economics, John Maynard Keynes, who had created the famous fiscal model of the economy on which the “New Deal” was grounded on. He was the quintessential pragmatist and believed strongly that macroeconomic policy should be based on how it effects the welfare of the common man (or woman). It turned out though, he agreed with his critics completely, and he replied with the most famous quotation in economics.

“Yes,” he said, “but in the long run we are all dead.”

Great stuff!  Thank you “T”!


Jack Crooks
Black Swan Capital


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