Page 2 of
5 THE INTEREST RATE CONUNDRUM,
Part 2
How currency devaluation
destroys wealth By Henry C K Liu
in
theory up to $120 billion of new bank money in the
form of recycled bank loans from new deposits from
borrowers.
The Brady Commission
investigation of the 1987 crash showed that on
October 19, 1987, portfolio insurance trades in
S&P 500 Index futures and New York Exchange
stocks that crashed the
market amounted to only $6
billion by a few large traders, out of a market
trading total of $42 billion. The Fed's liquidity
injection of $120 billion was three times the
market trading total and 20 times the trades
executed by portfolio insurance.
Yet
post-mortem analyses of the 1987 crash suggest
that though portfolio insurance strategies were
designed to be interest-rate-neutral, the
declining FFR was actually causing financial firms
that used these strategies to lose money from
exchange-rate effects. The belated awareness of
this effect caused many institutions that had not
understood the full dynamics of the strategies to
shut down their previously highly profitable bond
arbitrage units. This move later led to the
migratory birth of new, stand-alone hedge funds
such as Long Term Capital Management (LTCM), which
continued to apply similar highly leveraged
strategies for spectacular trading profit of more
than 70% returns on equity that eventual led it to
the edge of bankruptcy when Russia unexpectedly
defaulted on its dollar bonds in the summer of
1998. The Fed had to orchestrate a private-sector
creditor bailout of LTCM to limit systemic damage
to the financial markets. The net effect was to
extend the liquidity bubble further - it migrated
from distressed sector to healthy sector.
The 1987 crash reflected a stock-market
bubble burst the liquidity cure for which led to a
property bubble that, when it also burst, in turn
caused the savings-and-loan (S&L) crisis.
The Financial Institutions Reform Recovery
and Enforcement Act (FIRREA) was enacted by the US
Congress in August 1989 to bail out the wayward
thrift industry in the S&L crisis by creating
the Resolution Trust Corp (RTC) to take over
failed savings banks and disposed of their
distressed assets at fire-sale prices. The Federal
Reserve reacted to the S&L crisis with a
further massive injection of liquidity into the
commercial banking system, lowering the FFR from
its high of 9.86% reached on May 10, 1989, to 3%
on September 4, 1992, making the real rate near
zero until February 4, 1994.
It was too
late to help president George H W Bush in his bid
for a second term in the election of November
1992, but it gave the era of his successor, Bill
Clinton, a liquidity boom. Since there were few
assets worth investing in a down market plagued by
overcapacity, most of the new money went into
relatively low-yield bonds. This resulted in a
bond bubble by 1993, which then burst in 1994 when
the Fed finally started to raise the short-term
rate, which reached 6% on February 1, 1995.
By 1994, Greenspan was already riding on
the back of a debt tiger from which he could not
dismount without being devoured by it. The Dow
Jones Industrial Average (DJIA) was below 4,000 in
1994 and rose steadily to a bubble of near 12,000
by 2000, a 300% rise, while Greenspan raised the
FFR seven times from 3% to 6% between February 4,
1994, and February 1, 1995, a 100% rise, to try to
curb "irrational exuberance" in the stock market,
and kept it above 5% until October 15, 1998, after
contagion from the 1997 Asian financial crisis hit
Wall Street, when the Fed reversed course on
interest rates.
By the mid-1990s, excess
liquidity had fueled a worldwide equity rally that
found its way into the Asian emerging markets,
where it fed an unprecedented bubble of easy money
in the form of undervalued currencies pegged to a
falling US dollar. When the Asian emerging-market
bubble crashed abruptly on July 2, 1997, as the
Thai central bank suddenly ran out of
foreign-exchange reserves in a matter of days
trying to maintain its unsustainable currency peg,
followed by the Russian debt crisis in 1998, all
the major central banks of the world reacted yet
again by pumping even more liquidity into the
global banking system, exacerbating a new wave of
global decline in currency value.
During
this period, the US dollar never rose in real
value, although its exchange rate with Asian
currencies rose because those currencies were
falling in value faster than the dollar was.
Confusing money with
wealth Money itself is not wealth, only a
generally accepted measuring unit of wealth.
Liquidity, the flooding of the financial
system with money, does not necessarily add
wealth. Liquidity accelerates financial
transactions that can create or destroy wealth
depending on the terms of exchange.
In the
days of industrial capitalism, wealth was created
by the creation of productive hard assets, while
in finance capitalism, wealth is created only by
earnings. Whereas wealth is increased by more
production in industrial capitalism, earnings in
finance capitalism increase only money income,
which only adds wealth if the purchasing power of
money does not decline. When asset prices rise
without real expansion of the purchasing power of
earnings, money is simply devalued, while the
nominal value of assets increases as real wealth
remains stagnant or even declines.
Initially, this flood of money that began
in 1994 inflated another bond bubble, which popped
viciously in 1999. Then, more liquidity released
by the Fed boosted equity prices further and
provided the fuel for the enormous tech-stock
bubble of 1999 and early 2000.
The first
three years of the 21st century saw a worldwide
equity-market crash followed by a recession
plagued by global overcapacity, over-indebtedness,
and over-leveraging. And the response of central
banks was always more liquidity through low
interest rates in relation to return on capital,
which helped pump up the bond bubble in 2003 and
supported artificial rallies in housing prices,
equities, commodity prices, higher corporate debt
without changing debt/equity ratios, and
mushrooming emerging markets, particularly China.
Fools were calling it a US-led recovery.
A bubble within a bubble Once
the genie of excess liquidity is out of the
bottle, it is almost inevitable that a bigger
genie will have to be let out of a bigger bottle
to keep the ongoing bubble from bursting, to avoid
the nasty consequences of a burst bubble for the
financial system and the real economy.
Central banks around the world, led by the
US Federal Reserve, despite their pivotal role in
helping to create financial bubbles, nevertheless
declare that bubbles cannot be anticipated and
nothing can be done to prevent them. But central
bankers comfort markets by claiming magical power
to handle the destructive consequences of bubbles,
through a one-note monetary policy of short-term
rate cuts to inject fresh liquidity, to save a
bursting bubble by creating a bigger bubble. With
structured finance, bubbles can be created by
endogenous liquidity, and bubbles about to burst
are expected by be rescued by central-bank
intervention.
And even if central banks
react to asset bubbles by raising short-term
interest rates, the extent of the rate hikes
needed to reverse asset prices in times of
exuberance may be so large as to destabilize the
real economy worse than a bubble burst would. This
view is supported by the experience Greenspan had
in his battle against "irrational exuberance".
While declaring that central banks cannot
prevent bubbles, the Fed has admitted more than
once that it sees as one of the roles of a central
bank the support of the market value of financial
assets, however inflated. Instead of being the
guardian against moral hazard, the Fed has become
the promoter of moral hazard.
A market
anomaly is thus created in which equity prices
rise in response to what normally would be
considered bad news for the real economy, such as
falling home sales, because the market then
expects the Fed will lower short-term rates,
causing equity prices to rise, even though home
mortgage rates are tied to 10-year Treasuries
rates. Conversely, equity prices can fall in
response to what normally would be considered good
economic news such as rising home sales because
causes the Fed to raise short-term rates, which
really do not have any direct connection to home
finance. This is because the market knows that in
a bubble about to burst, good news of further
expansion is bad news.
US financial assets
have been built not only on debt, but on debt
recycled at high velocity. It is a form of
turbo-debt, in which one dollar of debt can act as
equity to finance more than $100 of credit through
sequential leveraged financing and leveraged
securitization. Borrowers in turn become lenders,
who themselves lend borrowed money. Massive
financial energy is released through chain
reaction of a tiny amount of equity.
Debt
is not intrinsically objectionable if it is
adequately collateralized by real assets, and the
proceeds are invested to increase real national
income above what is needed to service the debt.
But turbo-debt by definition is generated by
practically no equity. And if debt is serviced
mostly by the wealth effect of debt-propelled
asset appreciation, a bubble is in the making.
So-called air-ball financing enabled the
telecom bubble of the 1990s, when it was widely
used in financing telecommunications expansion in
the 1990s. Air-ball financing involves the use of
unrealistically anticipated future earnings as
collateral for financing overinvestments in hope
of generating those earnings.
A housing
bubble exists because houses are being financed
and refinanced by full-value mortgages
collateralized only by the anticipated continuing
rise in home prices. A liquidity boom generates
asset bubbles because liquidity is not wealth,
only an illusion of wealth. And the rise in asset
prices beyond the growth of gross domestic product
is really a decline in currency value. A market
rise of 40% against a GDP growth of 3% translates
into a currency depreciation of 37% in a year.
Blurred distinction between debt and
equity The pervasive securitization of debt
accompanied by a complex
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