Mr Zhu noted that investors are increasingly borrowing the cheap US dollar, and investing the borrowed funds in emerging markets, where interest rates are higher, and therefore generating a better return than saving in the dollars.
This phenomenon called carry trade in the US dollar is a “massive issue today,” said Mr Zhu.
“It’s bigger than the Japanese yen carry trade 12 years ago,” he said.
However, if the United States were to tighten its lax monetary policy, making borrowing more costly, funds could then flow out just as suddenly from emerging markets, back into the US market.
This could cause a collapse in emerging markets’ currencies, and spark a repeat of the 1997-1998 Asian financial crisis.
Things almost always get rather ugly when carry trades unwind, especially when national currencies are involved. There’s another one lurking in central and eastern Europe, and it could take many large European banks to the brink.
In this case it has been driven by hundreds of thousands of homeowners taking out mortgages in Euros, Swiss Francs, and even Yen because the interest rates were so low, and the exchange rates favorable. Hungary (where my wife has family) offers a good illustration of how these things work.
Because interest rates in nearby Vienna were low and the Forint rather strong (about 200 HUF=1 EUR) it seemed to make sense to get your mortgage from a Viennese bank. As people make their payments they convert Forint into Euros, shifting the exchange to 220 HUF because relative demand favors EUR. The mortgage becomes 10% more expensive to service, every month.
The Hungarian central bank increases interest rates in order to attract money into Hungary so as to strengthen the Forint. More people pile into the trade because Viennese interest rates are much lower. At that point the vicious cycle has begun.
More monthly payments converted to EUR. The exchange rate is now about 270, which is 35% higher payments on the mortgage. Ouch. But high interest rates were absolutely crushing the Hungarian domestic economy, leading to lay-offs and business failures. The central bank in Budapest recently [i]cut[/i] the key interest rate to 6%, while here in the States it’s 1/4% and in Britain 1/2%.
The HUF:EUR exchange rate is heading south, meaning that monthly payments are moving out of the range in which it’s even possible to make them. The defaults will follow. Then the bank failures. That’s what happens when these things unwind.
The amount of delinquent and badly underwater Polish, Czech, Slovakian, and Hungarian real estate debt held in Euros is mind-warping, and vastly exceeds the magnitude of the sub-prime problem in the US.
The worldwide ugliness of this unfolding depression is only in the early innings. “The prudent man sees danger ahead and prepares, but the simple-minded continue on unaware, and suffer the consequences.” Prov 22:3
#1 Bart Hall – thanks, useful analysis.
[blockquote]The worldwide ugliness of this unfolding depression is only in the early innings. “The prudent man sees danger ahead and prepares, but the simple-minded continue on unaware, and suffer the consequences.†Prov 22:3[/blockquote]
What would you recommed the prudent man should do in these circumstances?
Pay off debt as fast as you can.
First, understand the context. There are two sorts of economic adjustment: the standard, and somewhat uncomfortable, business cycle inventory adjustment recurring every five years or so; and the much less common (but vastly more painful) balance-sheet adjustment recurring every few generations. We are in the second, and every one of them has come to be called a Depression.
[b]Depressions are caused by over-indebtedness[/b], and every one of them has — at first — looked and felt like a lingering recession. It does not matter whether the debt is public or private, and it does not matter whether that debt is owed domestically or to foreigners. At a certain point the debt becomes so great an economy is no longer able to grow itself out of the problem.
There is quite simply too much debt, and too much of it is bad debt. One key thing the prudent (wo)man understands about depressions is that they continue until every bit of bad debt is wrung out of the economy by default, and much of the good debt has been repaid.
Government interventions are consequently at best ineffective, and more commonly have quite negative consequences because they delay the day of reckoning for over-indebted and failing companies — like GM — which eventually collapse anyway and cause vastly more damage than would have been the case had they been allowed to fail.
[b]Every debt is eventually repaid, either by the borrower or the [i]lender[/i][/b]. Dealing with debt (by either path) is profoundly deflationary, and deflation punishes those in debt. Deflation is characterized by over-abundant goods and services pursuing cash as companies and individuals scramble to re-pay debt and meet expenses.
Governments almost always attempt to re-flate the previous bubble, but deflation, once launched, is very hard to control … until all the bad debt is washed out. All of it. Attempts by central banks to “print” money depend upon the newly created funds being borrowed. When customers don’t wish to borrow, and bankers don’t wish to lend, you have a classic liquidity trap which completely hamstrings attempts to restore an inflationary environment.
Therefore, you should expect deflation for several years, except in certain core necessities, particularly food and energy.
Because governments and bureaucrats will not easily tolerate a reduction of their power, expect repeatedly increasing taxes, fees, rules, and regulations. Therefore, deploy legitimate avoidance techniques, such as converting a 401(k) or a standard IRA to a Roth IRA. You’re presently allowed to forward average conversion taxes for three years.
Governments in particular will have problems financing their debts at present interest rates. There is so much debt out there already people will demand greater returns because there’s little penalty for purchasing gold or sitting on cash. As interest rates rise, bondholders will be mangled, especially at any durations past about five years.
If you have long bonds of any sort … sell them yesterday. If you have any desire to sell your home, sell it yesterday, at whatever you can get. Demographics are working against home values for the next fifteen years. If you don’t plan to stay there for a long time, your house is a liability, not an asset.
Acquire the skills to do various things for yourself, because that isn’t taxable, and begin to learn who around you has a skill or products they’re willing to trade.
Develop and implement your personal disaster preparedness plan. America will not recover as easily from a major attack as we did a decade ago. You might be on your own with no power and no water for three weeks.
Expect rising levels of social unrest, especially in the more urban and inner suburban areas, so have a plan for leaving on short notice, a communication point for separated family, and all that standard preparedness stuff. Understand that there may also be dangerous times when seconds count, but the cops are many minutes (or hours) away from helping you.
Develop plans and the means for assisting those in genuine need. If you grow a garden, plant extra for the local homeless shelter or soup kitchen.
Remember, above all, that depressions include many new opportunities, both for profit and for ministry. Keep you eyes — and your heart — wide open. Be prepared for both danger and opportunity. You will encounter both.
#4 Bart Hall
Thank you – that is a very helpful summary. It reminds me of a book I read a long time ago, so long ago that I was in my late teens. I can’t remember the name, but it was predicated on a crisis based on the collapse of the US dollar due to it representing a considerable multiple of any asset base underlying it. Nevertheless the consequences were seen in very much the apocalyptic terms you envision: collapse of urban infrastructure; social unrest; lawlessness in inner cities and inner suburbs etc; perhaps even a return to a barter economy and the desirability of holding gold.
From a Christian perspective, your point about setting aside produce for others is a good one.
You say that such circumstances also represent an opportunity. What would opportunity look like in such circumstances?
Wow, Bart. Very interesting. But could you clarify this: Won’t all the deficit spending cause inflation (or hyperinflation) rather than deflation?
Yes, it will cause inflation. Eventually.
The first, deflationary, stage of a depression, however, is historically the most harsh and lasts from three to five years — which suggests a bottom somewhere between late 2011 and late 2013. If we’re lucky.
We could also quite well be facing something far more unusual. There is a much longer cycle of inflation and deflation that reverses trend every century or so. The initial deflation in these reversals lasts between three and seven years, during which prices drop by 25 to 55 percent. The most accessible work on this is David Fischer’s 1996 book [url=http://www.amazon.com/Great-Wave-Revolutions-Rhythm-History/dp/019512121X/ref=sr_1_1?ie=UTF8&s=books&qid=1264777406&sr=1-1]The Great Wave[/url], which looks at the last thousand years or so of price revolutions.
In my own amateur research into inflation/deflation cycles I have worked backward from Fischer to about the time of Abraham at Ur. What emerges is a series of seventeen waves running peak to peak 235 ± 50 years (n=17). The current long-term inflation began in 1897, and the 113 years since that time is right in the wheelhouse for a shift to several generations of deflation.
In the same fashion that the long inflationary rise was punctuated by several deflationary interludes, the deflationary side will have periodic inflationary episodes. If we are indeed embarked on a long wave reversal (and my sense is there’s a good chance we are) those inflationary corrections will not be particularly long or intense.
Consider the trillions of notional money shovelled into the financial economy. A generation ago that sort of monetary expansion would have led to inflation way into double digits. This time it has been overwhelmed by the forces of overhanging deflation, and least during the initial phase of this depression.
It is additionally worth noting that depressions also tend to include a false dawn of sorts after the crash: go back and read financial reporting from late 1930. Most commentators were convinced the recession was over.
Finally, I’m tremendously optimistic about these times and those to come. That is not to say they’ll be easy, but there are already multiple emerging opportunities to make an honest profit by providing affordable small luxuries — consumption of ice cream and the better cuts of beef [i]doubled[/i] in the 1930s, and what is now the largest orchid grower in America got its start selling those little luxuries to brighten the lives of people in Chicago.
We are also on the doorstep of bio-medical developments that will change lives at least as profoundly as the introduction of anti-biotics: eliminating cancers, growing new organs from scratch, nearly instant disease diagnosis by scanning metabolites, a solution to Alzheimer, re-growth of severed spinal chords, and others we can’t even imagine. Some experts in cellular aging believe that not only is the first person to reach 150 years of age already alive … (s)he is probably already over 50.
And that doesn’t even account for molecular technology, nano-tech, and profoundly increased computational power. Along with biomedical developments, these are the things likely to drive the long-term deflationary boom of the 21st century, which in its own way will rhyme with its 19th century equivalent that brought us a great many of the modern things we today take for granted.