Monday, November 02, 2009

Roubini Forgets the Riskiest Asset of All (the US$)

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stableNouriel Roubini

Mr. Roubini, whose views I usually find most enlightening, was one of the few prominent economists who forecast the financial crisis of 2008.  Recently, however, perhaps due to a 2005 forecast of an unraveling of Bretton Woods II and sharp decline in the US$ that didn't pan out (at least so far), Mr. Roubini, judging by the above argument, assumes that the US$ is "here to stay" at least in the medium term. 

I disagree (and think he and Mr. Setser should have stuck to their earlier views- sometimes such things take time).

In A Brief History of Time, Stephen Hawking relates the story below which is quite germane to a discussion of Mr. Roubini's view.
A well-known scientist (some say it was Bertrand Russell) once gave a public lecture on astronomy. He described how the earth orbits around the sun and how the sun, in turn, orbits around the center of a vast collection of stars called our galaxy. At the end of the lecture, a little old lady at the back of the room got up and said: "What you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise." The scientist gave a superior smile before replying, "What is the tortoise standing on?" "You're very clever, young man, very clever", said the old lady. "But it's turtles all the way down!"

The question, on what belief(s) does your argument rest, gained increased importance ever since David Hume pulled the rug out from under those who assumed any "real-world" arguments were validly based on pure reason. Hume's argument, never refuted, at least to my knowledge, is that "always being followed by" is not the same as caused by. We might infer such, and certainly act on the view that what has happened in the past will happen again, but as we didn't make the rules of the universe, we don't really know. At best we can believe.

On what turtle does Mr. Roubini's view rest? It rests on the view that the US$ has intrinsic value. As he argues: First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts.

I ask, why can't the value of the US$ fall to zero? From the long view of History, the odds of a currency of virtually no intrinsic value declining to that value is high, which might explain Voltaire's quote on paper money.

Perhaps, however, Mr. Roubini was speaking of the medium term, and using the value of the Japanese Yen as a "turtle" to support his argument. Alas, the US is not Japan. Despite their fiscal woes, Japan runs a current account surplus- last month's surplus came in at $13B. The world is not awash in Yen, on the contrary, Japan is awash in US$s, as are quite a few other nations- China comes to mind.

When the Yen was the carry trade vehicle of choice, the risk, which manifested from time to time, was of a sharp rally due to the lack of Yen in international markets. If Japan ran a current account deficit this risk would be much diminished. I suspect if Japan was running a C/A deficit when it opted for a zero-interest-rate-policy (ZIRP) the Yen would have quickly lost a good deal of its value.

The US has both a C/A deficit and a ZIRP. While I agree with Mr. Roubini that the US ZIRP is inspiring the mother of all carry trades, which can inspire sharp corrections, that risk is, in my view, more than offset by the mother of all long positions in the riskiest "asset" of all, the US$. The ZIRP makes holding US$s a losing proposition, as Mr. Roubini notes.

The turtle on which Mr. Roubini's view stands is the notion that the US$ is an asset, when, in my view, it is a liability. By statute there is no fixed exchange rate between the US$ and anything other than US$ debts.  Each time an adjustment arises such that there is a shortage of US$s, the Fed rides in to "add liquidity" because they are more interested in keeping the big banks afloat than the currency. Until that changes, the mother of all carry trades will, despite the odd setback, continue to grow.