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