Weblog
Blame Japan - The Root Cause of This Whole Mess
The root cause of the global financial meltdown is now clear: Too Much Money. Where did all of this money come from, and why is it a problem? The answer will take us far beyond sub-prime mortgages.
Turns out that the current worldwide economic catastrophe and impending recession is Japan’s fault. OK, it’s not quite as simple as that; Greenspan is partly to blame too. You can think of sub-prime mortgages as the straw that broke the camel’s back. They are only a symptom, not the underlying disease.
Somebody had to be buying these sub-prime mortgages, and that somebody had to get money from somewhere. The Bank of Japan is where they got that money, or at least a lot of it. The disease that has the economy on its back is caused by Too Much Money (too much liquidity for you wonky types). And you thought that was just a problem for athletes and movie stars.
Let’s learn about the “Japanese Carry Trade,” which created much of this poisonous money.
Since 1995 the Bank of Japan has been loaning money at 1% or less. From 2001 to 2006 the rate was 0.1%, and the rate today is 0.3%. This created the Japanese Carry Trade, whereby hedge funds and investment banks borrow money from Japan for practically nothing, and then carry that money over to the US and other countries and invest it in whatever strikes their fancy.
You might think that the Bank of Japan is taking a horrible risk by loaning money for free, but the Bank of Japan is responsible for Japan’s economy, and that economy depends on exports. By loaning money at 0%, the Bank of Japan creates a ton of yen. This is because the 0% rate is very attractive, and many investors bite, creating many loans and trillions of new yen (estimates of the carry trade range from 100-300 trillion yen, or $1-3 trillion).
Remember the laws of supply and demand: if you have a lot of yen, then yen aren’t worth as much. Cheap yen means cheap Japanese electronics, which means jobs for Japanese people. With lots of Japanese people employed, the Japanese economy continues to grow. To the Bank of Japan’s way of thinking, a few bad loans is a small price to pay for a growing economy.
For those involved in the Japanese Carry Trade, there is of course a risk: that whatever you buy with your free yen will decrease in value, leaving you scrambling to find the yen to repay the Bank of Japan, because 0% interest still means that you owe them 100% of what you borrowed.
As the free money piled higher and higher in the global economic system, far outpacing increased production of actual stuff, two things happened:
- The prices for things of real value, like stock in real companies, went sky-high.
- A market sprung up for complicated things that had no underlying value, such as sub-prime mortgages, because people were so much less diligent about what they were buying, because everything was going up..up..up…
Why would people buy things of no value? The tide of money had been rising for so long that investors became less thorough in their evaluation of new investments. Many of the people making recommendations on what to buy were getting paid to be middlemen, and they frankly didn’t care about the underlying value anyway. Kind of like a bad investment advisor who suggests you “try” something you don’t fully understand and don’t need because it went up in value last year…
Where is Greenspan in all of this? He was busy emulating Japan and lowering the US interest rate, which dropped from 6% to 1.25% after the stock market crash in 2002. While the rate did pick up for a few years between 2005 and late 2007, it’s back down now to just under 1%. This created a boom in re-financing, as people took money out of their homes and speculated with their new capital, in a domestic version of the global Carry Trade. This had the side benefit of keeping the US dollar low, which “helped” our economy.
Back to our story on the Japanese Carry Trade. Let’s assume you posted some collateral with the Bank of Japan, and now that collateral has fallen in value, as it did over the past year. You’ll have to rush to sell whatever you own so that you can pay the Bank of Japan. If you own US Equities, and they’ve gone down in value, you’ll have to sell a lot of them.
This is basically what just happened, and the results are now visible: with the value of collateral down, the amount of outstanding yen loans is down, and there are less yen around. This has driven the yen to an all-time high in value, with $1 US buying only 97 yen versus the usual level Japan has preferred of around 120 yen. (Remember that when you can buy more yen for $1 US, you can also buy more Japanese electronics for $100 US, which as we said keeps Japanese people employed.)
So, where does that leave you and me? The current instability and panic has everyone fleeing to US Treasuries, and this has created some highly unusual mini-bubbles, including one that is especially compelling in municipal bonds.
Right now tax-free municipal bonds are paying in the 5-6% range for longer durations. Compare this to the 10-year Treasury rate of 3.84%. Since munis are tax free, for most people this is an effective yield of almost 6.5% versus taxable investments. That’s well over the best CD rates, and is just plain crazy good interest. For my part I’ll continue to move high-tax-bracket clients into munis for the fixed income portion of their taxable portfolios. If you own bond funds or have a messy portfolio of government and corporate bonds, now is a good time to rationalize and redeploy.
