Notes From Underground

As expected, the G-20 communique was more insipid blathering about global growth, BIS capital regulation and the enactment of some new macroprudential regulations to ensure global financial tranquility. To reflect on the lack of consistency in this communique, let me quote from point 20: “We welcome the OECD report on addressing base erosion and profit shifting and acknowledge that an important part of fiscal sustainability is securing our revenue bases.” This is pure nonsense for it reflects the great divide that exists between the old line powers of the G-7 and the more broad-based and emerging economies found within the structure of the G-20.The old line (developed) economies want to preserve their tax bases so as to have enough revenue to maintain previous promises of retirement and pension programs for their aging populations.

Frequently, demographic arguments are entering the debate on the growing divide between economic growth in the developed nations versus the emerging nations. Countries with growing populations and higher GDP growth can be more aggressive in maintaining lower tax rates, especially as the newcomers have younger work forces making less demands upon the government Treasury. The outcome is that the more dynamic economies have lower tax rates, which attracts more global capital. The G-7 nations can wish for “TAX HARMONIZATION” on a global scale, but it is not going to happen. The pre-G-20 summit talk was rife with commentary about ending the “Global Currency War.”

In point five of the communique: “We reiterate our commitments to move more rapidly toward market-determined exchange systems and exchange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments and in this regard, work more closely with one another so we  can grow together. We reiterate that excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability. WE WILL REFRAIN FROM COMPETITIVE DEVALUATION (emphasis mine). We will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open.”

Again, this is so much nonsense but I am glad that they are at least honest enough to use “REITERATE” because there is nothing new in this discussion. The G-20 came to the conclusion that domestic demand creation is a positive and if the lowering of interest rates to stoke economic growth results in currency outflows, that is merely collateral damage. So in a wink and nod to the Japanese government of PRIME MINISTER ABE and the U.S. FED, it’s party on Ben; party on Shinzo.

Following the G-20 communique, there is an article in Tuesday’s Financial Times by Lorenzo Bini Smaghi, previously a member of the ECB executive board. Mr. Smaghi has been one of the better commentators on the European banking scene, but had to be removed from the ECB board once Mario Draghi became ECB president. (The French wanted to maintain a seat on the Executive Board and thought two Italians in key policy positions was inappropriate.) In the FT piece, titled, “Why the Currency-War Deniers Are Wrong,” Professor Smaghi notes: “Despite interest rates at record lows in all advanced countries, economic activity has been disappointing. The reason is that economic agents are burdened by an accumulation of too much debt.”

Thus the need to deleverage is of a greater necessity than borrowing. In order to keep the pressure on savers and creditors, central banks embarked upon the financial repression that Carmen Reinhardt and Ken Rogoff have consistently have written about over the last few years. As Smaghi states, “… the central bank given the task, and accepting, of doing whatever it takes to stimulate growth, even if it entails wealth redistribution by implementing financial repression, the central bank conducts covert fiscal policy.”

Financial repression partly entails keeping interest rate low to enforce a negative real yield on savings. Investors will have to look elsewhere for higher returns on capital, be it in stocks–Bernanke’s Portfolio Balance Channel–or, as Smaghi maintains, investors trying to escape the financial repression in their domestic market will search for foreign assets with a positive yield. This results in a depreciation of the currency in the repressed financial system and an appreciation in the financial environment paying a positive yield. This is the outcome of what has been referred to as the CARRY TRADE. I exchange an asset with a negative real yield for one that pays a positive return. If an investor spots this opportunity before the herd, it can yield very robust returns. A classic example was the Brazilian real. As the currency appreciated, investors were paid a very high interest rate. The Brazilian real carry trade ended once the Central Bank of Brazil began to repress foreign investors by lowering interest rates  and placing restrictive taxes on foreign depositors.

The only way a currency war can be prevented according to Smaghi is “at that point … the later start acting like the former and also repress holders of financial assets. The most likely outcome of the currency peace, which would result from a global attempt by central banks to repress holders of financial assets and would be a new bout of risk taking all over the world. And, sooner or later, a new financial crisis.” It seems that the previous ECB Executive board member is at odds with the G-20 and most certainly with the former SNB head Philipp Hildebrand, who claimed last week that there was no “currency war.” The FED wants to believe that its policies don’t have a global fallout. Mario Draghi, what say you?

***Last week, FED VICE-CHAIRPERSON, Janet Yellen delivered a speech to an AFL-CIO conference, “A Trans-Atlantic Agenda for Shared Prosperity.” Ms. Yellen’s speech was titled: “A Painfully Slow Recovery For America’s Workers: Causes, Implications, and the Federal Reserve’s Response.” I found this speech very troubling as it revealed much about Yellen’s views on the role of the FED and she makes it seem that the FED is an advocate for American workers. When Chairman Bernanke’s term expires next January the White House will want the FED dominated by a pro-labor policymaker and Yellen has staked out her position. Janet Yellen maintains that the high is cyclical and thus the ultra-low rates and large-scale asset purchases will stoke demand and bring unemployment down. If the unemployment situation is structural then she admits that current FED policy will have little effect and the result will be to raise–and solely raise inflation.This speech troubles me for several other reasons:

This is a very dangerous view for the FED has no control over the economy and should not strive for control. The FED should only attempt to provide the backdrop for healthy economic activity. When did its job become control over the outcomes of economic activity? This speech is very bothersome, but nah, no currency wars from the Fed’s effort at financial repression.

Tags: Ben Bernanke, Brazilian real, carry trade, ECB, Fed, FOMC, G-20, G-7, Janet Yellen, Lorenzo Bini Smaghi, OECD, Shinzo Abe, tax harmonization

This entry was posted on February 18, 2013 at 7:36 pm and is filed under Currency, Debt Market, ECB, Fed, G-20. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.