Wednesday February 8, 2006 - 16:27:19 GMT
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Monetary and Fiscal Fallacies Feed Unsustainable Outcomes
I am of the view that a series of bubbles exist in financial markets, no better manifested than in Latam equities and currencies, just as an example. But this condition applies to a host of assets and currencies...gold, Asian currencies (including the yen), credit derivatives, copper, European equities and global bonds. And the cause for these bubbles? Multifaceted of course, but the main causality is simply too cheap credit chasing too few assets. The world is awash in liquidity...risk takers want it (it's cheap) and the banking system wants risk takers to use it, so they lend. Asset prices are juiced by readily available cheap capital, which at the end of the day reflects a low level for nominal and real interest rates...or in a more reduced form, low inflation expectations.
But what if the market is wrong about what any reasonable person should expect about inflation in the future? What if most financial actors operate on a self-fulfilling prophecy approach to investing and past mistakes get repeated until they don't, allowing risk aversion to become skewed (toward high) and financial asset pricing to reflect more group think than group know. Behavioral economics are working this out in mostly a microeconomic landscape, but in time it will be used to explain macroeconomic developments. I just hope not too late for mainstream thinking in finance to recognize that markets rarely offer stable equilibria as the tendency to see actors think and act the same way proves self-fulfilling and allows distorted visions of risk to emerge and malinvesting.
Here are some of the my pet market fallacies.
Monetary policy (read Greenspan) has allowed the US and global economy to reach its maximum growth potential without generating inflation. A little bit of this (Fed funds rate changes), a little bit of that (open mouth policy), and voila, the riddle of how to smooth the business cycle has been solved. Don't get me wrong. Monetary policy plays a significant part in shaping market expectations about inflation, economic performance and hence setting asset prices. What monetary policy does not really impact much directly, albeit indirectly, is real economic activity and the level of prices. Most economists and economic texts would have us believe that when a central bank raises rates for instance growth slows and firms have a harder time raising prices. But this is sheer fantasy. The Fed funds rate changes since June 2004 have done what? Not much when it comes to the supply and demand for goods and services. What official rate changes have truly impacted is asset prices. Getting the crowd think in motion and then watch it self-replicate until asset prices are unsustainable and they reverse, painfully at times. The reason there have been 14 straight rate increases from the Fed since June 2004 says more about catering to group think than have any sense at all about what level of Fed funds is consistent with say 3.5% GDP pace and 2% core rate of inflation.
The things that Fed monetary policy are supposed to impact - prices and demand for money and ultimately goods and services - are being influenced by things like foreign government currency policies that require massive accumulation of dollars to prevent a loss of competitiveness from occurring. But not the Fed. Did last week's swan song rate hike by Greenspan mean anything to the supply of and demand for money/credit/goods and services? I think mostly not and surely far less than what theory and market assumptions will tell you.
Is it any wonder that some of the great macro hedge fund managers around have done best when they could see shifts in group-think early and get in, spread the word of a shift and watch new group think emerge. The Fed saw this unfold in the mid-80's to late 90's and said why can't we try and do the same...shape group think and worry less about the real economy. It has been only more recently that central banks could pay less attention to prices of goods and services and more attention to the prices of assets. China, India and productivity. I am sorry but I do not think Greenspan deserves much credit for keeping wage and goods/services inflation in check. I think the call centers in India and the manufacturing center of Southeast China deserve the lion's share of credit for checking inflation. But over time wages and currencies (if allowed to float) will lead to higher wages in the offshore centers and less competitive exports. Probably this adjustment is years away, unless of course the currency component is addressed by markets and officials alike and Asian currencies are allowed to appreciate more significantly...speaking of which, it was reported today that Asian FX reserves ex-China have risen the most in January 2006 than any other month in over a year (up some $29bln).
So assuming the Fed can only influence asset prices only as long as asset markets believe the fallacy, then rate changes and open mouth policy together can be pretty effective in shaping market expectations and asset prices. And this gets reinforced with Asian and oil producing central banks amassing a huge stockpile of US securities where intervention-accumulated dollar reserves are stored. And another great irony - the "third world" financing "first world" growth. Countries that need huge infrastructure investment are more inclined to buy Fannie Mae and Freddie Mac debt than to fund domestic rail and road developments. I do not think this is sustainable.
The productivity story is also a key factor in generating low inflation and fat profit margins for firms. Technological innovations of the 70's through the 90's have been widely adopted and have yielded a major benefit to consumers...the web and PC's have had a far more profound impact on checking inflation than 14 Fed rate hikes. But eventually productivity growth slows and prices and wages adjust upward. Even the Fed backs this assumption.
The other main fallacy I find utterly annoying is the belief that US tax cuts played a key roll in driving GDP and investments. This is simply an assertion and academic work on the dividend tax cuts and investment/equity prices are far from establishing any causality. And the most irritating part of the tax cut charade is that the largest acceleration in government spending the modern world has ever seen has occurred in tandem with tax cuts. Why not then attribute most of the gain in G of C + I + G + X to spending...not tax cuts. Don't get me wrong tax cuts are good when paid for. But stop with the free lunch economics.
So why am I so negative on asset markets that are bubble like...unsustainable? Because you can only fool some of the market some of the time, but you can't fool all of the market all of the time. Fallacies are unsustainable. Monetary and fiscal policy fallacies are do for a comeuppance.
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