The trader benefits only as long as asset prices remain close to their current levels. Volatility can wipe out a position, and the financial losses can spill over to the economy. Those negative consequences bring central banks into the financial markets. Their intervention may reestablish stability, but it allows those who would have suffered a loss to transfer that loss to the public sector. Central bankers acting as lenders of last resort, the authors write, “…underwrite some of the losses associated with carry. This encourages further growth of carry, and a self-reinforcing cycle develops.”
The authors investigate the spread of carry trade and its broad scope, including the transformation of global financial markets. Firms in emerging markets use capital markets to obtain finance from cheaper foreign sources. Changes in the VIX measure of volatility have international reverberations and engender global financial cycles.The Federal Reserve’s use of swap facilities to help their counterparts in other countries assist domestic institutions that face a dollar liquidity squeeze demonstrates that carry crashes require global responses.
The authors also claim that the carry trade increases income and wealth inequality, as only those with sufficient assets engage in carry and profit from central bank intervention. The continuing returns from these transactions flow to those who know how the system works and how to exploit it. These rewards act as an incentive to draw more people to finance, contributing to the growth of the financial sector.
The book was written before the events of this year, but the analysis is very relevant. In March, financial markets crashed as the global extent of the pandemic became evident. Stock prices plunged and foreign capital fled emerging markets. This outbreak of volatility engendered a massive response by the Federal Reserve that dwarfed their actions in the 2008-09 crisis (see here and here for overviews of central bank policies). The markets responded by regaining lost ground, and the Standard & Poor’s 500 has set new highs.
After the latest meeting of the Federal Open Market Committee, the Federal Reserve reiterated its pledge to keep the target range for the Federal Funds Rate at 0 to ¼% “…until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” The Fed’s commitment to low interest rates provides an incentive for more carry trade activities, and these are appearing. Special Purpose Acquisition Company (SPACS), for example, are pools of money that are established to purchase privately-held firms and take them public, profiting from the IPO price. The SPACS investors do not know which company will be acquired or when, and they may not realize a return for years. But they are providing liquidity, and at minimal cost due to the Federal Reserve’s interest rate policy.
Lee, Lee and Coldiron convincingly demonstrate that the carry trade has contributed to the financialization of the economy, which has grave and disturbing implications. As the subtitle of the book indicates, the suppression of volatility leads to lower growth and recurring crises. When a vaccine for the coronavirus is available, there will undoubtedly be a burst of financial activity that will prepare the way for the next crisis. We will not be able to say that we were never warned.
An interview with the authors is available on the podcast Hidden Forces.
2019 Branko Milanovic, Capitalism Alone: the Future of the System That Rules the World
2018 Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World
2017 Stephen D. King, Grave New World: The End of Globalization, the Return of History
2016 Branko Milanovic, Global Inequality
2015 Benjamin J. Cohen. Currency Power: Understanding Monetary Rivalry
Those remits back to Treasury are a real tax on regulated banks. Actual armed guards collect it as bank fees and carry it in truck to Treasury, just like any other tax.
So leave the money on reserves and it is not taxed, then sign a contract to let the hedge fund have access to the reserves as needed. So hedge funds are flush with potential liquidity.
Another term is shadow banking. Money is not cheap, rates may be low for government but that is only because out bank accounts are taxed.
Two policy implications here:
1. Limited Liability should mean limited leverage by law. If you want to gamble fine, but do it with your own money
2. The tax advantage of debt finance has to be removed, it has extremely deleterious effects, and that applies not just to business but private real estate as well. I’m all for more flexible depreciation (you get a certain amount of depreciation allowance and can choose when to claim it) but not for any tax write-off for interest.
There is a myth floating around, still, that the central banks can trick their own balance sheets and inflate away debt. Dunno where the idea came from, Bank of England, i think.
Every step in money exchange by regulated banks gets hit with the remit tax. We get central bank taxes, deflationary value added tax. Thus we have a deflationary force which prohibits velocity from growing as it earns taxes. Amazon moves all the exchanges inside the corporation, avoids the Fed value added tax.
The regressive tax is inherent in the power of coinage. This ‘central bank sales tax’ will be about 1.5 to 2 percent of the economy over the next cycle. But almost all of our cities rely on a sales tax to a large extent, those taxes can only be collected from regulated sales as opposed to shadow sales. All of the online sales and shadow bankers have this tax advantage.
Maybe this is a good idea is you like sales taxes. But the House does not like them and at some point the taxing power in coinage comes in conflict with the House taxing power. The conflict usually occurs right after the progressives at Angry Bear notice the problem. Once Angry Bear notice then we have Wile E Coyote moments among our favorite macroeconomists. The result? An enormous quarter long tax battle.
And that is where we are, one of our regularly scheduled humongous tax battle. So, welcome aboard, it is 2011 all over again.
Keep going, see and outcome.
We got here, same thing same issue nine years ago. Same people (just about everyone noticing we did the same thing twice (likely forever in the past) and they all all looking at this cost, this residual error, the unpriceable lose from unbalanced structure in government. It is unpriceable becsuse it is the last thing partitioned out by the accounting system, there is no two axis market, we are all looking and no one is at fault.
It is about one percent, not large. This is not the ex ante reserve any smart governor sets aside, it is the tiny micro shocks that governor cannot see. It is the inflation tax, it is exactly those tiny losses that are meant to be paid with a general inflation tax by having the treasury double spend a bit, as needed.
That authority is enforced on a contract that frees the Fed to forget completely about government finances for a ten to fifteen years. Regulated banks no longer responsible for seigniorage, that becomes a fixed, quarter point monopoly fee, until contract renewal.
vaccine for the coronavirus is available, there will undoubtedly be a burst of financial activity that will prepare the way for the
the consensus estimate for when we get enough vaccine for everybody who wants it is about 6 months down the road.
here is what happens before that six months has passed :
according to the Johns Hopkins Morning Report on the 1st of November we confirmed 76K of new cases but on the 12th of November, 11 days later we confirmed 153K; that is 153000 new cases. apparently the spread of the virus doubles each 11 days. this means that in 55 days from now, less than 2 months we will have about 40 million people dead and 320 million cases of covid-19 in the US. As the virus runs out of victims and disappears in less than 2 months there will be many younger Folk who become heirs to their grandfather’s fortunes. The inheritance will increase spending. people will be getting out to restaurants where employment will rise, and the FED Governors will likely sell off the balance sheet and raise rates to stem the
sudden burst of
Not sure who anonymous is but he is talking nonsense (today the vast majority of transactions are electronic). We need more general education these days, people puck up strange ideas from dubious sources. It also annoys the hell out of me that people don’t understand the competing and different functions of money and macro-economic distinction between private and public debt. Please everybody read Between debt and the Devil to understand that rheytoric has distorted everybody’s understanding. Milton Friedman thought that public debt should grow roughly in line with nominal GDP and that private debt should be kept under control. Public debt is a part of private nominal wealth. The idea that more private debt and less public debt is a good idea is idiotic.