Global Markets: The Dragon stirs

The ongoing spat between the US and China over the rate of yuan appreciation has boiled over into something more interesting.

Last night Chinese officials threatened the possibility of selling down their US treasury holdings and thereby consigning the US$ to the trashcan. The Chinese are experts at promoting the maxim “don’t throw stones in glasshouses”. They are very astute at pointing out inconsistencies in arguments no doubt employing age old Confucian wisdom.

How the relationship between China and the US will pan out is anyone’s guess but we can be clear about one thing and that is the balance of power has shifted ever so slightly. The phenomenal success of the Chinese economy, based mostly on a large manufacturing base, has given the Chinese are strong foothold in global affairs. Whereas once it was a sleeping dragon content to rule its own domain now it is a major player.

At the same time it has built a strong domestic economy and plays host to the Olympics next year. It seems the US may need China more than China needs the US.

The situation doesn’t look too good for the US. Collapsing credit markets need a steady government security base to hold it all together. Any sell of in the US Treasury market would be a real disaster sending stocks down as well as the dollar.

To some extent we’ve been through this before with the Japanese. In the mid 90s Fred Bergsten hit the headlines calling for a stronger yen. This caused the $ to fall to a record low of 79.65. He was still making this call back in 2002 when he outlined strong reasons for abandoning the Clinton “strong dollar” policy.

This delicate game was fictionalised by Tom Clancy in his book “Debt of Honour” which told of a plot to destabilise the US economy by crashing the Treasury markets and the $. Of course the US won in the end but in real life who knows what would happen. The US authorities run some major interference in the markets when required and i am sure that any severe destabilisation of financial markets would see national security considerations apply (well if they haven’t got that sorted they should!). Sadly many of Clancys’ novels end up happening in real life.

The Chinese are very tactical and astute in their political strategy and very protective of their sovereignty. It will be interesting to see how this plays out but more weakening of global markets cannot be ruled out and with the end of the credit fuelled asset price boom added into the mix cash will be king.

Internet Banking: Coming Soon

I’ve been following the spread of microfinance for a while and have been getting involved with Kiva which has been a great experience. I have also noted the rise of social lending businesses such as Zopa, Prosper and even Facebook. Jason has written a good piece on the rise of new forms of financing.

What interest me further is whether all finance can move to a P2P platform and seriously eat into the major lending markets currently controlled by the commercial banks.

I think it could do. This crosses the web with money and complimentary currencies.

Remember that anyone can create “money” if they really want, it just can’t be in the form of bank notes issued by the Reserve Bank. Commercial banks create bank loans by a simple bookkeeping entry. Only 2% of the money supply in NZ is in the form of notes and coin so banks don’t actually hold any money other than a bit of cash.

My point is that P2P finance could take off in a very big way once we get the hang of it. My guess is that the firms currently involved don’t realise how big this could be.

Expect the central banks to cast their beady eyes over these operations once they get a roll on. For now it’s just some web bizness but this feels like 1694 all over again.

Hedge Funds and Global Liquidity

Oh dear it seems as if Bear Stearns may be in a little trouble as it coughs up $3.2bln to support one of its hedge funds exposed to the US subprime market.

This is not good news at all but the market has been through this before with the Long Term Capital meltdown in 1998 and of course the 1995 collapse of Barings Bank by Nick Leeson. So it won’t be in complete panic but this is a big move to Bear Stearns and perhaps just a taste of what can go wrong when the music stops.

Hedge funds are heavily leveraged and so when a big move goes against them the losses can be astronomical. In theory risk models are supposed to flash warning lights at set points but the reality is that these models are not foolproof (after all we designed them) and traders can often disguise bad positions. And from my experience all risk is underpriced since it is based on average volatility and not the heavy meltdowns that come with increasing regularity.

The last 10-15 years has seen a huge amount of money created by the worlds’ banks and much of that finds its way back into the financial markets to be invested or used as speculative margin. The numbers are so huge that the Fed in the US has decided it would rather not publish money supply numbers anymore.

So when the market goes into reverse it can cause major losses which have knock on effects around the whole system.  It will be interesting to see how this situation pans out but at some point there will be a serious contraction unless new demand can be conjured up.

RBNZ: Have They Lost the Plot?

There has been a lot of hand wringing over the recent Reserve Bank’s intervention in the currency market. So what’s the story here?

Well the RB has a clear mandate to keep inflation, as measured by the CPI, between 1-3% on an annual basis. According to them they also say that,

“The Bank is required to ensure that, throughout the economy, money works as well as possible as a mechanism for making transactions, storing value, and keeping account.”

So let’s say they are also responsible for price stability in a general sense i.e. no serious asset bubbles or major deflationary shocks.

So how are they doing?

Since 1998 the CPI has risen 20.7% to December 2006. So an average of 2.5% per annum which is within the prescribed band.

But the key worry, or so they keep repeating, has been the housing market which in the same period has risen 143%.

So what have they done about it?

From Mar 04 to Dec 06 they raised interest rates by 2%, from 5.25% to 7.25%. That doesn’t sound like a great deal by historical standards and clearly has not had any impact.

From Mar 04 to Mar 05 rates went up 1.5% as inflation took off towards 3%. However, they stopped when they should have kept going. When CPI hit 3.4% and stayed above, the bank should have got really serious and jacked rates up very quickly.

They didn’t. CPI was above 3% from Sep 2005 to Sep 2006 and they moved only 50bp. This was their big mistake. With house prices on the march as well they should have had rates up to 8% by June 06. They are a year behind the curve and that could cause some major problems.

Alan Bollard has been soft in his approach and this may well stem from the false comfort that low global rates has brought. The great inflation crush of the late 1990s has seen global rates fall into ranges not seen for many a year. Central bankers have been playing in a very small range and have been lulled into a false sense of security.

All around us we witness the asset price bubble caused by cheap global credit. The Japanese are still at it pumping out cheap yen that no one really wants. This is a major disaster waiting to happen. We’ve seen it before when USD/JPY fell to 79.65 back in 1995 on the back of US trade concerns and Asian Central banks dumping their US$. For now the flow out of the yen and into the kiwi continues with a rise of over 15% in the last 6 months.

Yesterday Winston Peters called for an amendment to the Reserve Bank Act asking that the Reserve Bank take a more rounded approach to managing monetary policy. I have to agree with him that a major review is needed and that simply using the OCR to control the economy is not working.

Submissions for the inquiry into a future monetary policy framework close on 19th July. I will post my submission up here in due course. It’s a great opportunity to throw open the arcane nature of our monetary system and make proposals that may lead to a more productive and stable economic system.

The Nature of Money

In a previous post Does Money Grow on Trees? I looked at how money comes into existence, but in a broad sense of the word.

In his paper, The Nature of Money, John Kutyn examines in detail what money is starting from the late 16th century. He explores the development of what we know as bank notes from their early days as accommodation bills and the establishment of the Bank of England as a way of funding a war against France.

He follows the development of money and banking primarily through the legal process andlooks at numerous cases in law of challenges to the meaning of money and the transactions it is used for.

He challenges the banking system to show that it is not acting fraudulently in law when it uses deposits as money and actually creates money via new loans. Of course only a Reserve Bank can create money or so the law states. So is true? Well i suggest you read his paper and draw your own conclusions but he makes a compelling case.

Not content with that he then moves on to looking at the economic impacts of the current system which has a built in imperative for growth resulting in continued boom bust cycles. He argues that this is down to the interest burden and that debt free money is the only way a stable economy can be achieved.

As we approach yet another global bust and possible depression it is worth relfecting on the themes in this paper.

Incoherent System

Professor Peter Brown from McGill University in Canada is here in New Zealand speaking about our dysfunctional economic system.

He’s not wrong there. He was speaking on Radio NZ but the interview never really got going. He had enough time to talk about the incoherent nature of our economic system, how GDP measures income and consumption but not well being and how triple bottom line accounting was a waste of time. Agreed!

What we need is a better connection between our biophysical system and our economic frameworks like Trucost for example.

We also need to ask ourselves some basic questions such as

- what is our economy for? speculation or sustenance.

- what size should it be? as big as possible or big enough.

Simple questions but rarely asked. The mantra of economic growth at all costs is intellectually flimsy. Its lazy thinking……..the assumption that GDP growth is all that matters is quite clearly false.

What about crime, illness, pollution? What about the increasing gap between rich and poor.

As individuals we search for coherence but as a global economy we struggle to find that because there are no tools to do so. So perhaps by becoming more coherent ourselves we will aid and enable a global coherence.

As the Mahatma said “Be the change you wish to see”.

Let’s keep asking questions of our system.