Global Macro Commentary

…exceptionally low levels…for some time…

…3 more minutes to go.

Business cycles are a natural phenomenon of human behavior within a free market economy; this is the hallmark of the Austrian Business Cycle theory. The Fed was created after the Great Depression to smooth out future business cycles. Setting history aside, today’s Fed has done everything but smooth out market fluctuations. The two charts below show how the Fed slashed rates in response to the bursting of the Tech bubble, only to realize (too late) that they created yet another bubble in the housing market. Unfortunately, the housing bubble also created many other bubbles in the economy (retail, auto, manufacturing, services, banking etc.) Bubble, bubble, bubble…too many are popping right now, causing a 1930s deflationary scare.

A prelude to tomorrow’s ECB meeting (25bp hike all but certain).

From Macro Man

Indeed, the ECB is fighting a lonely battle. Despite risk to growth stability, I guess they are doing the right thing. As the German finance minister during the 1960’s once said:”price stability may not be everything, but without price stability, everything is nothing.” A rate hike by the ECB, coupled with weak payrolls, will probably send euro to record highs.

From CitiFX Technicals:

William Poole, the president of the St. Louis Federal Reserve Bank, recently denounced any concerns regarding the US current account deficit. Many economists in fact agree that there is no real concern for a ballooning current account deficit. They argue that it is a sign of strength in the US economy and high foreign demand for US assets. In the short term, this argument may hold as it did during the 1980s. But the real question is whether the current account deficit can be sustained over the long run.

Before we talk about the current account deficit, it is important to go over the definition of the balance of payments (BoP). The BoP accounting is simliar to most balance sheets, with every item booked as a credit or a debit. Post-gold standard BoP is always zero, and the “deficit” we hear in the news can only show up in the BoP’s major sub balances.

CA (current account) = net trade in goods + net trade in services + net investment income + unilateral transfer
CF (capital/financial account) = capital imports – capital exports

BoP = CA + CF – ΔR = 0
BoP = CA + CF = ΔR (change in reserve account)

A current account deficit simply means that a country is spending more than it produces in a given period. This extra spending is only possible when there is a surplus in the capital account. Of course, a current account deficit may not be completely offset by a capital account surplus. During the gold standard, the capital account was strictly tied to the central bank’s gold base, which provided an automatic mechanism for keeping the BoP of each country in equilibrium. Therefore a deficit in the BoP required readjustment in the current account, whereas today, ΔR is seen as a form of compensatory financing (negaitve sign in the equation because it implicitly represents capital exports).

Murray Rothbard on David Hume’s price-species flow:

As the philosopher and economist David Hume pointed out in the mid-eighteenth century, if one nation, say France, inflates its supply of paper francs, its prices rise; the increasing incomes in paper francs stimulates imports from abroad, which are also spurred by the fact that prices of imports are now relatively cheaper than prices at home. At the same time, the higher prices at home discourage exports abroad; the result is a deficit in the balance of payments, which must be paid for by foreign countries cashing in francs for gold. The gold outflow means that France must eventually contract its inflated paper francs in order to prevent a loss of all of its gold. If the inflation has taken the form of bank deposits, then the French banks have to contract their loans and deposits in order to avoid bankruptcy as foreigners call upon the French banks to redeem their deposits in gold. The contraction lowers prices at home, and generates an export surplus, thereby reversing the gold outflow, until the price levels are equalized in France and in other countries as well.

In the post-gold standard economy, not only can deficit financing be achieved through foreign direct investment (FDI – raise equity), but the US can also discharge its deficit by accumulating debt through its own currency. The US “borrows” by selling dollars to foreign central banks (mainly Asian), who in turn buy US debt. These central banks will gladly stock up dollar reserves, as it is the international reserve currency and allows their domestic currencies to be artificially low (think RMB). These dollar reserves will eventually purchase dollar denominated US assets, especially US government bonds and agency debt (only 30% go into FDI). It is important to note here that foreign sales of US treasuries implies additional liquidity, as the US is tapping into foreign credit and not domestic savings. Furthermore, this type of expansion allows creditor nations (i.e. China) that stock up forex reserves to flood the global market with cheap goods, implying that instead of a price inflation, a bubble emerges in the asset markets. Indeed, the buying and selling of debt instruments are at the core of expanding global liquidity.

In today’s dollar standard, a lagging capital account is offset by ΔR, which depicts central bank acquisition of dollars to achieve balance. Therefore, changes in market prices for currencies and interest rates are supposed to provide the necessary equilibrium mechanism for the BoP. This assumes that all countries have a floating exchange rate regime, which is in fact far from reality. The dollar has indeed depreciated since 2000, but this is only minimal considering the fact that most Asian countries, especially China, have their currencies hard-pegged to the dollar.

Finally, it is important to look into the somewhat neglected portion of the current account – international investment income. The first graph depicts US net international investment position (NIIP), where foreign investments in US assets were worth $2.5 trillion more than foreign assets owned by the US in 2004. Despite this massive gap, however, the US still earned $30 billion dollars more investment income than foreigners in 2004. This was possible because the US mainly invests in foreign equities, whereas foreign countries (i.e. Asia) mainly invest in US government bonds and mortgage-backed federal agency debt (a la Fannie Mae). Considering the massive gap in NIIP, however, this scenario will not last long. In the second quarter of this year, US income payment has already exceeded income receipt by $455 million. This red number is registered as a debit in the current account. Therefore, as the trade account continues its deficit, a negative investment income will exacerbate the current account deificit. Not only will this have a serious consequence on the value of the dollar, but it will also raise many doubts on the dollar’s role as the international reserve currency.

On a side note, we believe that ΔR of the BoP formula may provide a good reference to global liquidity, and thus global demand. We have been hearing news of declining global demand based on year over year data. We therefore intend to formulate a difinition of money supply that incorporates M3 and ΔR in order to make sure that our long positions don’t get squeezed by a fall in global demand.