Tuesday, November 24, 2009

Can Fed Defeat Dollar Carry Trade?

I wonder if Fed is accounting for dollar carry trade in their models. Because if not, we are all in a big, like Great Depression 2.0, trouble.

First, a little bit about money. Fed is creating money, true. But then it lends money to the banks, which lend money to other banks, businesses and people. There is multiplication effect on the way, because most of the borrowed money falls back into bank accounts and then available for borrowing again, with a 10% taken by Fed as a reserve. Usually every dollar lendt by Fed creates about 9 dollars in circulation.

By the way, the fact that almost all money in the country is a credit money, has interesting consequences. For example, to keep prices stable in expanding economy, country needs more money. Which means more credit. Which means that all calls to borrow less and save more are only good for contracting economy. People, calling for that, including our President, are calling for Great Depression 2.0, plain and simple.

There is a lot of talk about coming inflation. Sure, Fed wants to create some inflation. That's because alternative is so bad. Deflation is awful. Unfortunately, only very old people remember it in this country. Most of the people remember inflation of 1970s and fear it the most. But deflation is much, much worse than inflation. Again, all money in the country is on loan. In deflationary environment, money returned to the creditor worth more than it was when borrowed. Which adds to the interest rate you pay for the loan (somehow negative interest doesn't exist). As a result, money mass is contracting in deflationary environment, enforcing the deflation (deflationary spiral).

For more than a year, Fed keeps interest rates at almost zero. It seems that a lot of money is pumped into economy. Why don't we see inflation, which is "always a monetary phenomenon"? Because prices depend on money supply, money velocity and amount of goods sold. Money velocity dropped faster than money supply grew, it's that simple.

Can Fed increase money supply even more? That's a trillion dollars question. Remember, of 9 dollars of money mass, 8 are created by banks, not by Fed. Actually, 8 dollars should be created by banks, but looks like that's not working right now.

Enter dollar carry trade. Businesses are borrowing dollars with almost no interest rate and either lend money in other currencies or buy some stuff which supposed to grow up in price. Most of this money leaves the country or gets frozen on margin accounts, not creating new money in circulation. This is what was killing Japan in the last 10 years: Central bank was giving away yen, but borrowers didn't lend it inside the country, money mass was not increasing, country was (still is) in deflation and depression.

It's too soon to say if dollar carry trade would have the same effect. Yen carry trade, while negating Japan Central Bank policies, funded mortgage bubbles in US and Europe. Currently a lot of dollars went into commodity futures, funding possible mining bubbles. Some went into developing countries. China looks more and more like a bubble now. Bubbles pop sooner or later, as we know well. The question is: sooner or later?

Even if bubbles don't pop, carry trade can prevent Fed from pumping money into US economy. The main question is: can Fed fight dollar carry trade effects? Or we are going Japanese way?

Seeking Alpha Certified

No comments: