The Carry Trade Explained

Want to know one of the reasons why the movements of exchange rates can be so pronounced at times?

There are many reasons why exchange rates move.

The first thing to remember is that there are two sides to any currency story.

For example the current strength of the Australian dollar (the Aussie) is a product of Aussie strength and greenback weakness.

Now Aussie strength has a lot to do with the price of commodities, with the Aussie traditionally seen as a commodity currency.

The Aussie is also important as a trading currency because of its position in Asia, that is between the North American close and European opening. It's also important as an 'Asian' currency.

But another vital factor is the carry trade.

Despite being at so-called 'emergency' levels, Australian interest rates are actually high by international standards.
Japan 0.10%
Canada 0.25%
United States 0.25%
Switzerland 0.25%
Sweden 0.25%
UK 0.50%
Europe 1.00%
Taiwan 1.25%
Norway 1.50%
Korea 2.00%
New Zealand 2.50%
Australia 3.50%
Poland 3.50%

So if you borrow money in Japan at low rates of interest and then invest it in Australia at high rates of interest and the Yen-Aussie exchange rate either stays constant or the Aussie appreciates against the Yen, you end up making a truck load of cash.

But ...

If the Aussie falls against the yen as it did from late last year then you're stuffed and everyone runs for the door at the same time. This adds to what is often called 'momentum' in currency trades. Right now the 'momentum' is for a higher Aussie.

Anyway the following graphic from the Financial Times explains it much more neatly than I can do.
http://www.ft.com/cms/s/0/f3aec6c2-b99e-11de-a747-00144feab49a.html

See also Nouriel Roubini (2009) "Mother of all carry trades faces an inevitable bust", Financial Times, 1 November <http://www.ft.com/cms/s/0/9a5b3216-c70b-11de-bb6f-00144feab49a.html?nclick_check=1>

Roubini outlines what he calls 'the mother of all carry trades' involving US interest and exchange rates. The major financial issue at the moment is the growing financial bubble that has been reignited by low interest rates.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Now short dollar positions mean that investors are borrowing greenbacks to sell now ('going short') and pay back later when the greenback is (hopefully) lower. Of course the more that investors short the greenback the more likely it is to be lower. So what is the effect of low interest rates, quantitative easing and massive purchases of long-term debt instruments (the metaphorical printing of money)? According to Roubini it is

seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

But like all bubbles eventually they get pricked.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

The question for risk-takers is how long should you stay in the market and what will cause the reversal.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

The thing for investors to weigh up is timing.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

Bubble Trouble

As I've long said I may just be a negative vibe merchant but everywhere I look I see bubbles - in China and in Australia, and the US stock market. While a few months ago it appeared that many had learned the lessons of boom times - that they don't last forever and that they nearly always end badly - we are back in boom time territory and the phrase 'this time it's different' (TTID) has truly made a comeback. The TTID mentality extends right across the spectrum from the property spruikers to the governor of the Reserve Bank and the Head of Treasury.

Latest figures from the ABS on Housing Finance show a seasonally adjusted rise of 4.8% for the month (that's an annualised rate 57.6%). Now it's obvious that govt grants to house buyers (really a grant to venders) have bolstered these figures and many people who believed (like me) that house prices would have fallen by now are thinking "I better get in the market now" or "I'll be paying even more soon". One truly wonders how high house prices can go.

Now there is one intervention that govts could do to restrict house price growth and that's increase supply. One of the original aims of public housing was to keep a lid on the private market, particularly for rentals.
But govts and much of the population associate rapidly rising house prices with prosperity when really they are drag on prosperity both present and future. Firstly they make one of the most significant costs in our lives more expensive and they divert investment away from potentially productive endeavours.

The next bubble or set of bubbles that indirectly could concern Australia are in China. As Rowan Callick (one of the best writers from The Australian) observes today there are worrying signs in Hong Kong and the rest of China:

Last week a flat on Conduit Road in Hong Kong's mid-levels was bought for a world record of $51m - $135,626 per square metre.

The dominant element of Beijing's anti-GFC stimulus package has comprised the rampant return of the "policy loans" to state-owned enterprises, plus the opening of credit to individuals with privileged access, thanks to party or other connections, to the state banks.

Interest rates are not only paltry but notional. This is more than low-cost capital, or even no-cost capital. Hardly anyone's thinking about repaying the billions of bucks involved. Most of it has swiftly found its way into property and shares. Within China, house sales have surged 70 per cent this year.

This raises interesting questions about the fulsome praise that has been lavished on the Chinese stimulus package, in Australia as elsewhere. Some of the spending has doubtless found its way to useful projects where investment will be returned, in a socially and economically beneficial way, for some time to come.

But it's more difficult to see what's gained from printing heaps more money and telling the government's banks to shovel it out to mates.

I highlighted the worry that no thought is being given to repayment. Debt is serious and right now we've forgotten that much of the GFC was built on a cavalier attitude to debt.

Property and share markets can easily develop bubbles - as prices go up, investors pour more money in and prices go up further, attracting more investment and so on. But eventually everyone realises that the bubble is really just air and sentiment changes.

Just remember one phrase:
The unsustainable cannot be sustained ...
Actually another one is worthwhile as well:
This time it's not different ...

Debate on the Current Account Deficit

The following article might be quite helpful for those wanting to understand the debate about the current account deficit in Australia.

Balance of power
TIM COLEBATCH
THE AGE


October 24, 2009
http://www.theage.com.au/business/balance-of-power-20091023-hdgu.html

IN THE wake of the global financial crisis, a crucial question confronting policymakers is why Australia seems to have got away with so little damage?

Was it a lucky escape, which should be a wake-up call for us to tackle our persistent current account deficit before it brings us down? Or was it, rather, evidence that the quality of our economic policies has made us invulnerable to the shocks dealt out by global financial markets?

This week, two of the economists Kevin Rudd listens to most carefully delivered sharply different readings of what has been dubbed "Australian exceptionalism", and its implications for the current account balance.
In one corner is Ross Garnaut, one of Australia's most influential economists since the 1980s, as economic adviser to then prime minister Bob Hawke, author of the 1989 report that led to the virtual demolition of the tariff wall, and more recently, the man Rudd commissioned to draft his policy on climate change — albeit, a draft he then rejected as too rigorous.

Garnaut, of course, also has a considerable sideline in corporate Australia, as long-time chairman of Lihir Gold and former chairman of what we now call Bankwest. Add in his time as ambassador to Beijing, where his staff included a young Mandarin-speaking workaholic who went on to achieve great things, and he brings an unusual range of experience to bear.

In the other corner is Ken Henry, secretary of Treasury since 2001, Rudd's main adviser on the Government's fiscal stimulus package, and a man now bearing a very heavy workload as chairman of its tax policy review at the same time as running a Treasury that now finds its work constantly in the spotlights of a bitter political debate.

On most issues, Garnaut and Henry see eye to eye. Both are mainstream economic liberals who believe that free markets are a powerful force for good. But both temper their faith in markets with a strong social and environmental conscience. They look to the long term, share a global perspective — and are men of subtle minds.

Yet now they are in sharp conflict over the question of whether Australia can afford to go on running the most persistently large current account deficit in the Western world: a deficit that has now averaged 4 to 4.5 per cent of our gross domestic product for the past 30 years, and driven our net foreign debt from $8 billion to $633 billion, or 53 per cent of our GDP.

It is a concern to Garnaut. With co-author David Llewellyn-Smith, he has just published an absorbing account of the crisis, The Great Crash of 2008 (MUP, $24.99), which is rich in reflections on its implications for global power relationships, for the future development of the financial system, and for key countries, not least Australia.

Garnaut sees the crisis as vindicating his warnings during recent years about "the great complacency" in Australian policymaking: the belief that the current account deficit and the associated build-up of foreign debt don't matter, but simply reflect the confidence with which foreign investors see us.
Australia's growth in recent years, he argues, has been unsustainable, because so much has been funded by increasing foreign debt — and you can't increase foreign debt forever. "Australians," he says, "were the spendthrifts of the commodities boom".

"If expenditure, both government and private, is allowed to expand too much when commodity prices are exceptionally high, there will be dreadful problems when it becomes necessary to adjust to lower living standards as prices fall to more normal levels.

"Australia has two strikes against it: its huge current account deficits before the crisis, and the deterioration in its terms of trade. They mean that Australia will have to reduce average consumption levels more than most countries if it is to restore full employment on a sustainable basis."

Henry strongly disagrees. In an unusually passionate speech in Brisbane on Thursday, the Treasury chief voiced strong confidence in Australia's economic future, along with equally strong fears about what it might mean for our environmental future, and for our wildlife, if Australia adds another 13 million people by 2049, as Treasury now projects.

Without naming Garnaut but clearly targeting his critique, Henry argued that Australia faced "a set of structural changes more profound than anything in its history": the ageing of its population, tackling global warming and adapting to it, the spread of the IT and communications revolution to the delivery of services — and the rapid growth of China and India, and their demand for Australian minerals.

"China and India are only in the early stages of catching up with the living standards of the developed world, and this process could have a very long way to run," Henry declared. "We should get used to the idea that we could have structurally higher terms of trade for quite some time — possibly for several decades."
We should also get used to the fact that Australia will keep borrowing and running current account deficits far into the future, Henry said. All the big changes we face will require higher investment. And our population is too small to be able to adequately fund "an abundance of investment opportunities".

"Australia's sustained high current account deficits reflect high national investment rather than low national saving," Henry declared, flashing a graph showing the national savings rate soaring between 1990 and 2008. "And national investment levels could remain elevated for several decades."

Let's pause for a word of explanation. Current account deficits can be viewed on two planes. The deficit measures the gap between what you sell the world and what you buy from it (the trade deficit), plus the gap between what you pay to foreign investors here and what you earn from your own foreign investments overseas.

For Australia, both gaps are substantial. Over the past decade, our trade deficit has averaged 1.3 per cent of GDP, or $16 billion a year in today's money. Since 1980, Australia has run 25 annual trade deficits and only four surpluses — in the slumps of 1991-92, 2000-02, and 2008-09. Our income deficit has averaged 3.4 per cent rising, as mining profits and interest bills on the foreign debt have swollen.
But in analytical terms, the deficit can also be seen as the gap between Australia's savings and investment — which is the way Treasury prefers to view it. Since mining is capital-intensive, and our population is growing rapidly, Australia invests more than other Western countries. But despite the spin in Henry's speech, we are mediocre savers, consistently in the bottom half of the OECD in national savings to GDP, and in the bottom third for household savings.

(His graph used one of the oldest tricks of speakers flashing graphs: start your graph in the bust, and end it in the boom. Had his graph begun in 1987 instead of 1990, and ended in 2009 rather than 2008, it would have looked very different. Even at its peak in 2008, Australia's national savings rate was less than 20 years earlier, and it has plunged in 2009.)

Whichever way you prefer to view it, the solutions are the same. There are four ways to reduce the current account deficit. Export more. Import less. Save more. Or invest less.

Garnaut, a mining industry veteran, sees the high prices of recent years more as a transient phase, in which miners worldwide were caught unawares by China's rapid growth in demand. He also argues that China and India are going through a growth phase that is particularly resource-intensive.

Back in 2005-06, he argued in vain for the Howard government to save the windfall revenues from higher commodity prices, rather than handing them back in tax cuts and new spending. His book does not expand on this, but one option, advocated recently by Saul Eslake of the Grattan Institute, is to establish a sovereign wealth fund where temporary surges in company tax revenue could be stored for use in harder times.
Henry denies that policymakers have been complacent about the deficit. He argues that compulsory superannuation and a tradition of budget surpluses were established to lift saving rates and make Australia "able to sustain a sizeable current account deficit". His tax review is also expected to propose new tax breaks for savings, especially in the banks.

But can we sustain deficits of this size? No one can live indefinitely by borrowing. As your debts rise, so does the cost of servicing them. Henry's deputy, David Gruen, has estimated that Australia's debt-GDP ratio could be stabilised if the trade balance shifts by about 2 percentage points of GDP, from consistent deficit to consistent surplus. But there is no sign of that.

Henry's speech dismisses fears that one day financial markets might decline to roll over Australian debt, leaving borrowers stranded. "It would be difficult, I suggest, to construct a more demanding stress test of this vulnerability than that posed by the global financial crisis," he said. "The fact of our having passed that test provides grounds for some confidence, though certainly not complacency, in the strength of our policy frameworks and decision-making."

Yet as Garnaut points out in the book, it was precisely the refusal of foreign market to roll over bank debt in the panic of last October that led the Australian Government to guarantee the banks' wholesale borrowings. "Banks had become heavily reliant on foreign borrowing and suddenly they were unable to borrow abroad," he says. Had the Government not given the guarantee they sought, Australia would have faced an "enormously disruptive and costly" recession.

Was Henry's comment just a slip by an overworked public servant? Or did it imply that from now on, Australian banks' borrowings will carry an implied government guarantee, to be called on whenever needed?
As shadow trade minister in 2005-06, Rudd took up Garnaut's critique, advocating a higher priority for exports. Then as mineral prices surged and a trade surplus emerged, the issue faded from his priorities. But with export prices down 32 per cent this year, and trade now back in deficit by more than $1.5 billion a month, the current account deficit is back to haunt us.

Public Debt (for Nerds)

Public debt is going to be a big issue in the coming years and the following is a summary of an excellent article from 3 economists at the Treasury, with some additions and updating with some recent statistics from the 2009-10 Budget and 2009-10 MYEFO.

From Treasury A History of Public Debt in Australia by Katrina Di Marco, Mitchell Pirie and Wilson Au-Yeung


The International Monetary Fund (IMF) Government Finance Statistics (GFS) manual defines gross debt as:

All liabilities that require payment or payments of interest and/or principal by the debtor to the creditor at a date or dates in the future. Thus, all liabilities in the GFS system are debt except for shares and other equity and financial derivatives [paragraph 7.142].

The main component of gross debt on the Australian Government’s balance sheet is Commonwealth Government Securities (Treasury Bonds) outstanding.

Gross debt does not incorporate amounts that are owed to government by other parties. Also governments, like an individuals or businesses, hold assets which can be sold to meet their financial obligations. To capture the asset side of equation, net debt needs to be considered.

Broadly speaking, net debt is equal to gross debt less a related pool of financial assets.2 Table 1 gives a simple representation of the main components that are included and excluded from the Australian Government’s net debt calculation.

Table 1: Components of net debt

Source: The Australian Treasury


Compared with gross debt, net debt is a better measure of a government’s overall indebtedness as it also captures the amount of debt owed to the government. Still, like gross debt, net debt is only a partial indicator of the government’s financial strength, as not all government assets or liabilities are included. As an example, unfunded superannuation is not included in the calculation of net debt. On the other side of the ledger, the equity holdings of the Future Fund are also not included as an asset in the calculation of net debt.

Australia has had historically low levels of net debt over the past two decades compared with the G-7 economies (Chart 2). In the early 1990s, Australia, along with the major economies, experienced an increase in net debt largely because of the global downturn. But in contrast to other economies, after 1995, Australia experienced a significant fall in its net debt.

Other measures of financial position

Over time, the demand for greater public accountability has led governments to publish more comprehensive sets of fiscal data. This has resulted in a trend towards using accrual accounting measures. By introducing a balance sheet into the primary Budget documents from 1999-2000, the Australian Government has been able to measure net financial worth and net worth.

• Net financial worth is defined as total financial assets less total liabilities.

• Net worth is defined as total assets less total liabilities.

Both measures are conceptually better than gross debt and net debt at capturing the Australian Government’s financial strength, as they are more comprehensive.

From MYEFO 2009

Definitions from the 2009-10 Budget

Measurement of the Government's financial position

Net debt is the most commonly quoted and well known measure of a government's financial strength. One of the reasons is that it is part of everyday life for business and households. Another reason is that, historically, it was the only available stock measure for governments that were recording financial information in a cash based accounting system. Net debt provides a useful measure for international comparisons, given most OECD countries report on it.

Net worth provides a more comprehensive picture of the Government's overall financial position than net debt. However, the valuation of physical assets can be problematic as they are typically valued without consideration of their potential use. Also, the Government may not be in a position to sell certain non financial assets, and therefore these assets would not be available to meet the Government's financing requirements.

Net financial worth is used by the Government as the primary indicator of balance sheet sustainability, because it provides a more effective and intuitive indicator of the sustainability of the Government's finances. It is a broader measure than net debt as it includes government borrowing, superannuation and all financial assets, but is narrower than net worth since it excludes non financial assets. There are advantages to excluding non financial assets since they are often illiquid and cannot easily be drawn upon to meet the Government's financing needs.

The projected deterioration in net financial worth is largely driven by the sharp downward revisions to tax receipts over the forward estimates resulting from the deterioration in the global economic outlook.

From Treasury A History of Public Debt in Australia by Katrina Di Marco, Mitchell Pirie and Wilson Au-Yeung

The difference between the two measures is the inclusion of non-financial assets in net worth. Given concerns surrounding the valuation of non-financial assets and their liquidity in the face of adverse shocks, the Australian Government has decided to use net financial worth as its primary indicator of balance sheet sustainability.

During the First World War, gross Australian Government debt increased from around 2.2 per cent of GDP to around 50 per cent of GDP (Chart 5), with around one-third of this increase met through loans issued in London (AOFM 2003-04). By comparison with the First World War, the financing requirements of the Second World War were met largely through domestic borrowing. Gross Australian Government debt increased from around 40 per cent of GDP in 1939 to around 120 per cent of GDP in 1945. During both wars, War Savings Certificates, targeted at retail investors, were the primary instruments used to raise funds.

Australian Government debt was progressively reduced after the Second World War and largely eliminated by the beginning of the 1970s. In the decade following the Second World War, relatively tight fiscal policy halted the growth in gross debt, while high inflation underpinned the sharp reduction in gross debt as a share of GDP. By 1974, gross debt had declined to around 8 per cent of GDP from a peak of around 120 per cent of GDP in 1946.


There were two further episodes of debt accumulation, and subsequent reduction, during the 1980s and early 1990s driven by periods of weak economic growth and associated budget deficits. From the mid-1990s, as the Australian Government’s fiscal position improved, gross debt declined steadily as a share of GDP.

The Australian Government historically had a significant proportion of its debt denominated in foreign currencies, but foreign-denominated debt is now negligible (Chart A).

For the first 30 years after Federation, foreign currency debt made up around 35 per cent of total debt on issue. A large portion of this debt was financed from London. Between 1940 and 1950 the amount of foreign currency debt fell as domestic markets grew in size. After the Second World War, the value of foreign currency loans began to rise to finance balance of payment deficits (AOFM 2002-03).

The share of foreign currency borrowings of the Commonwealth Government Securities (CGS) portfolio remained around 30 per cent from 1970 until 1988. In 1988, the Government decided to concentrate debt issuance in domestic markets to maintain liquidity and efficiency.

Capital account liberalisation has underpinned an increase in foreign holdings of Australian dollar-denominated CGS since the early 1980s (Chart B).

Chart 6 shows that the Australian Government has historically had a positive net debt position — that is, the value of debt liabilities has exceeded the value of debt assets. Since 1970-71, net debt has averaged 5.7 per cent of GDP, reaching a peak of 18.5 per cent in 1995-96, and a low of -3.8 per cent of GDP in 2007-08. Changes in net debt have largely been driven by changes in the government’s budget position.7 Especially in the 1990s, asset sales have also been a significant contributing factor (Box 2).
 

 
During the early 1970s net debt was mainly negative and reached lows of -3.1 per cent of GDP. During the first half of the 1970s budget surpluses averaged 1.7 per cent of GDP, while in the second half, there were budget deficits averaging around — 1.6 per cent of GDP. By 1979-80, net debt was around 4.7 per cent of GDP.


During this same period, the current account deficit was on the rise and reducing the Government’s call on foreign capital was an important driver of fiscal policy (Kennedy, Luu, Morling and Yeaman 2004). As a result, in 1988, the government decided to concentrate its debt issuance in Australian dollars (Box 1). In 1987, 30 per cent of total borrowings were in foreign currencies. By 1990-91 it was around 21 per cent.

In the early 1990s recessions in many advanced economies caused a marked slowing in the world economy. The government implemented a more expansionary fiscal policy that was funded by borrowing. Net debt reached a peak of 18.5 per cent of GDP in 1995-96.

From 1995-96 onwards, the government undertook a program of fiscal consolidation (Kennedy, Luu, Morling and Yeaman 2004). The government also undertook significant sales of Public Trading Enterprises around this period (Box 2).

The combination of successive budget surpluses and asset sales led to the elimination of net debt. Net debt as a proportion of GDP gradually declined to its historical low of -3.8 per cent of GDP in 2007-08.

Conclusion

A government’s balance sheet comprises both assets and liabilities. This article has demonstrated that only considering gross debt can result in an incomplete picture of public finances. By taking into account assets the public sector owns, a more accurate view of a government’s ability to respond to economic conditions can be determined.

This article has shown that Australia has undergone several periods of debt accumulation, followed by periods of fiscal consolidation. Periods of strong economic growth following episodes of debt accumulation have helped support relatively quick improvements in the public sector’s net debt position. Australia has a low level of net debt both historically and when compared with G-7 economies.

Debt

Steve Keen has long been the dangerman of Australian economic debate. I think Keen may have got a bit carried away with the time frames of his concerns about debt and about the immediate severity of any debt damage. Despite some arguments that Keen has been ignored in Australia in my estimation he's been given a fairly wide scope and got carried away with an 'end is nigh' message. It's more likely that debt damage in Australia will be slow moving rather than a rapid rupture. Australia may be vulnerable but it is not facing catastrophe.

Anyway, the following is a fairly humorous episode in Australian economic debate.

http://www.abc.net.au/pm/content/2009/s2688011.htm

MARK COLVIN: Dr Steve Keen of the University of Western Sydney was one of the doomsayers of the global credit crisis. He argued for years that the Western world was running up an unsustainable bubble of debt and asset-price inflation which was bound eventually to cause a crash.
He might have got that right, but he's lost another bet. He made the wager about house prices with another economist, Macquarie Bank's Rory Robertson. The loser has to walk 220 kilometres - from Parliament House in Canberra to the peak of Mt Kosciuszko.
And he has to do it in a shirt with the words: "I was hopelessly wrong on house prices, ask me how."
Steve Keen spoke to economics correspondent Stephen Long.
STEVE KEEN: Well it's intriguing how governments around the world really realise we're in an incredibly serious crisis and the scale of expenditure governments have gone into has been simply unprecedented.
There's reasonable estimates to say that the level of spending that's been put in the last year and a half to fight this crisis is equivalent to the inflation-adjusted cost of the entire World War II campaign and as a result what would have been a 5 or six 6 cent fall in our output for a lot of countries, has ended up being between a 0 per cent and a 2 per cent rise.
But we can't keep on spending at the rate of World War II every year for the rest of the century.
STEPHEN LONG: Do you concede though that policy made a difference and perhaps you under estimated that the impact that policy could make in combating the situation?
STEVE KEEN: Yeah I did. I think the scale of reaction was greater than I expected. The stimulus is certainly papered over the beginning of the downturn but it's not a long-term solution.
STEPHEN LONG: Well can you tease that out for me. Why don't you see it as a long-term solution?
STEVE KEEN: Because we have a Government which has given an enormous stimulus to the economy and yet at the same time, you have a credit system which has been stimulating the economy for the previous 40 years by increasing debt levels.
And we are suddenly going to have an economy where rather than increasing debt, adding to demand, we're going to have an economy where people's attempt to reduce it is going to subtract from demand so the Government's going to be pushing against a headwind of private sector deleveraging from now on.
STEPHEN LONG: So your argument is that if America and Europe can't continue with debt-fuelled consumption and they don't have export markets that can make up the difference, there's really no way for their economies to spark a genuine recovery?
STEVE KEEN: If you look in America, you've got a business sector with the biggest level of debt its ever had in its history, a household sector with three times as much that it had back in the 1990s crisis, the biggest in its history as well, and a financial system again with the biggest level of debt its ever had. Who can there be left lend to? The only people, group they haven't lent to in America so far are already behind bars.
Now in Australia, there's a couple of differences and that scares me because I can now see a lot of property spruikers pushing for access to superannuation funds so they can lend to the superannuation funds. If that happened, we'd restore lending here but it would be a recipe for the biggest Ponzi crash in the future after a short period of apparent prosperity.
STEPHEN LONG: OK, well speaking of Australia and property, one of your predictions was that we would see a 40 per cent fall in house prices, it hasn't happened. Why not?
STEVE KEEN: Because I said over 10 to 15 years. This is one of those things where sometimes you'd like to bite your tongue afterwards for saying things like this because it's always taken out of context.
I was asked what would happen to Australian property prices in a crash and I said, I see no reason why we won't go through the same fate Japan has gone through where prices have fallen 40 per cent over a 10 to 15 year period. The statute of limitations of that prediction is 2025. We're still a few years away from then.
STEPHEN LONG: Now Steve Keen, you've got a bet with a market economist, Rory Robertson of Macquarie, involving house prices, men and mountains. Do you want to explain that bet and how it works?
STEVE KEEN: OK. Now this was sprung on me by Rory to talk at parliament house. The basic details are that if I'm wrong, I have to walk from parliament house to Mt Kosciuszko, if Rory's wrong he's got to do the walk. The conditions that Rory put forward were that if prices fall by less than 20 per cent, I have to walk. If they fall by more than 40 per cent, he has to walk, and there's a dead band in the middle.
The bet from my point of view was always peak to trough. Whatever the peak ends up being, to whatever the trough is over a 10 to 15 year period I expect it to be at a 40 per cent fall. For the sake of closure, we also agreed that the house price index was 131 on the ABS since September 2008. If it breaks that level before 2010, then I will take that as me having lost the second stage of the bet.
STEPHEN LONG: In plain and simple terms then, if house prices have gone up by the end of this year, then you have to walk from Canberra to Mt Kosciusko?
STEVE KEEN: That's right and if they then end up falling later than that stage by 40 per cent from whatever their peak is to whatever the trough ends up being, then Rory has to do a walk and he's a slightly older man than he is now.
STEPHEN LONG: And what do you reckon your prospects are at the moment?
STEVE KEEN: Virtually 100 per cent certain I'll be walking and I'd say exactly the same for him in about 10 years time. The boost to house prices courtesy of what I call the First Home Vendors Grant has been substantial.

It hasn't only pushed up lower level prices below the $500,000 mark, it's also boosted prices up to $1 million or more because when those vendors sold the houses to the first home buyers, they got an extra $30,000 or $40,000 in cash which they leveraged up to an extra $200,000 to go and buy houses in the medium to high price range.

So it's boosted prices right up and that's why I'm going to be wearing a walk to Kosciusko next year. But as the old joke line says "the harder they come, the harder they fall". We'll hit a higher peak and I think we're going to have a larger fall courtesy of that.

MARK COLVIN: The debt doomsayer Steve Keen, with Stephen Long.

Global Imbalances

The NY Times recently had an op-ed piece by Nouriel Roubini on the global imbalances (GIs) - an issue I've been following for years due to my interest in current account deficits (yes dull I know).

Nouriel Roubini achieved fame as the man who predicted the global financial crisis and there is no doubt that his speech in 2006 to the IMF was generally dismissed because Roubini was like a few others a permanent negative vibe merchant or prophet of doom. The financial markets call such commentators permabears. The NY Times' Stephen Mihm ran a profile in August 2008 titled Dr Doom:

On Sept. 7, 2006, Nouriel Roubini, an economics professor at New York University, stood before an audience of economists at the International Monetary Fund and announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.

The audience seemed skeptical, even dismissive. As Roubini stepped down from the lectern after his talk, the moderator of the event quipped, “I think perhaps we will need a stiff drink after that.” People laughed — and not without reason. At the time, unemployment and inflation remained low, and the economy, while weak, was still growing, despite rising oil prices and a softening housing market. And then there was the espouser of doom himself: Roubini was known to be a perpetual pessimist, what economists call a “permabear.” When the economist Anirvan Banerji delivered his response to Roubini’s talk, he noted that Roubini’s predictions did not make use of mathematical models and dismissed his hunches as those of a career naysayer.

(See also David Hirst's piece in The Age in August 2009)

Since then, however, Roubini's predictions have been seemingly less accurate, especially on the US economy and stock market in 2009. And he continues to attract criticism. The US stock market has done better than most imagined and the US economy just recorded annualised growth of 3.5 % (In Australia we record growth for the quarter ... so US growth was roughly 0.9 % in Australian terms). [While writing this I'm fittingly listening to Albinoni's adagio in G Minor]. There is still a chance that the end result of 2009 will be worse than is now being predicted. I, for example, remain a negative vibe merchant about the prospects for sustained growth in the short-to-medium-term (1-2 years).

In his op-ed piece Roubini defines the GIs as:

Global imbalances — roughly defined, the different emphasis the world’s leading economies place on savings, spending and debt — is a phrase much used and little acted upon.

He then notes that they have been on the international policy agenda for quite some time. This is true, while writing my book I was intrigued by the literature that increasingly argued that there was no real problem with the huge imbalances. (see Chapter 3)

While there has been some narrowing of the GIs over 2009 partly due to the recession in the US and the huge stimulus in China and the collapse of Chinese exports, the GIs remain a problem.

the financial crisis has contributed to a significant narrowing of global economic imbalances. Consumers in so-called “deficit countries” — states like the U.S., Britain, Spain and the countries of Eastern Europe that have huge trade deficits — are saving more as the crisis has exposed the dangerous extent of their indebtedness. Meanwhile, in China and other large export-driven economies, fiscal stimulus spending and some other policy moves have encouraged more domestic consumption.

As Roubini points out changing ingrained habits - too much saving in Asia (particularly China) and too much debt-fuelled spending in the US (and Australia) - is very difficult.  And so the idea that the GIS will naturally lessen as a result of market forces is a dangerous assumption. While US consumers have been forced to tighten their belts to an extent, it's difficult to make people in China save less and spend more. Even the stimulus has not been sufficiently aimed at consumption to change habits. Roubini argues that the rebalancing is temporary "the result of reactive policy measures among exporters and retrenchment among the profligate."

China, the world’s sovereign wealth machine over the past decade, is a case in point. My colleague, Rachel Ziemba, projects China’s current account surplus will likely narrow to $350-370 billion depending on the import trajectory, down from a record $420 billion in 2008. China’s trade surplus was just under $100 billion in the first half of 2009. A trade surplus of about $30 billion in the third quarter of this year is expected, which is well below 2008 levels. Increased spending at home rather than savings could further reduce the surplus. Yet with China reluctant to allow currency appreciation, reserve accumulation has resumed at a strong pace.

Although the export-oriented growth model has been shaken by the crisis, many countries seem reluctant to recalibrate. The beginning of inventory restocking has buoyed Asia significantly, as companies that cut back sharply have now increased output. Avoiding currency appreciation will exacerbate this trend, adding to reserve accumulation and distortions.

The question becomes who will take up the slack of Chinese surpluses in the absence of the US continuing its status as the 'buyer of last resort' par excellence. Roubini notes that the IMF suggests a diffusion of the GIs.

where surpluses of Germany and Japan will remain in shrinking mode even in 2010, while the deficits of Canada and Australia, as well as emerging economies like Brazil, will offset the growth of China’s surplus.

Roubini points out that the GIs are back on the policy agenda of the G20 but probably can't be solved by communiqué. What is required instead is a organisation with teeth to force adjustment. This is an idea of long standing going back to Keyes view in the Bretton Woods negotiations that both deficit and surplus countries should be made to adjust.

Global imbalances are back on the policy agenda with the G-20 agreeing to create a peer review of macroeconomic policies including imbalances to avoid another crisis. The details are limited so far, but focus once again on an agreement that the U.S. will consume less and save more; Japan, Germany and China will spend more and will reallocate investment away from the export sector.

These are the right goals, to be sure. But a joint communiqué from a nascent international organization isn’t much to hang the world’s hat upon. The I.M.F. needs teeth, perhaps along the lines of the W.T.O.’s authority to prod member states toward “out of court” settlements, in order to enforce these difficult political and economic goals.

Basically there is no chance of this happening unless there was another severe economic downturn and even then it is unlikely that countries would agree on the causes of the crisis, thus negating a sound solution (just think of the many and varied views on what caused the current crisis.

The problem is that the GIs provide an impetus for the creation of crisis and bubbles. While Roubini correctly points out that the GIs did not cause the crisis they did provide the liquidity backing for it and are part of the crisis equation.

While imbalances did not cause the current financial crisis — I believe lax regulation bears a far greater onus — these imbalances certainly helped create the conditions for this crisis. Easy money and low long-term interest rates created an incentive to invest in seemingly-safe high-yield assets. An orderly unwinding of imbalances might put a lid on global growth during the adjustment, but is fundamental to achieve sustainable global growth.