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Tuesday, December 8, 2009

What if Roubini's Right: A Thought Experiment

Nouriel Roubini, known as Dr. Doom, is a renowned economist. He made a name for himself by predicting the mortgage, financial, and oil crisis currently going on.

"In 2005 Roubini said home prices were riding a speculative wave that would soon sink the economy. Back then the professor was called a Cassandra. Now he's a sage."[1] In September 2006, he warned to a skeptical IMF that: "The United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining
consumer confidence, and, ultimately, a deep recession."[2]

He also foresaw "homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt". The New York Times labeled him "Dr. Doom", whereas, in hindsight, IMF economist Prakash Loungani has called him "a prophet".[2]

Now, the same Roubini is predicting a dollar carry trade bubble.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

Roubini believes that the weak dollar has been fueling a rush to risky assets as investors try and take advantage of a weak dollar. Roubini specifically identifies "risky global assets". Risky global assets are especially plentiful in the third world and the developing world.

In other words, domestic investors are borrowing at cheap domestic rates, moving out of dollars, and going into the third world with the potential of massive returns. One important characteristic of any bubble is the presence of a stimulant outside of fundamentals. In this case, the stimulant is the weak dollar itself. So, investors aren't making massive bets in the third world necessarily because of the fundamentals, but rather, because they're taking advantage of the weak dollar. So, once the dollar strengthens, they'll move out and back into dollar assets.

So, what we'll see is the rapid investment into the developing world and then that investment will move out, and the bubble will burst. Now, the U.S. has had its fair share of bubbles. They're difficult even at their mildest. Looking back, 2001-2003 was a relatively mild recession following the internet bubble. Yet, while it occurred, there was plenty of pain. In the third world, bubbles are much rarer since they don't experience as many booms.

Roubini isn't merely calling for a dollar carry back asset bubble but the MOTHER OF ALL dollar carry back asset bubbles. That means that third world economies will see economic pain on scales we've never seen before. After experiencing growth that will give their populations hope, they'll experience pain on scales they thought they'd never see again.

We often look at economics strictly economically. There is however a cultural, societal, and geopolitical aspect that is often overlooked. A massive bubble that hits the third and developing world all at once would lead to a sort of geopolitical instability that's frightening. In those nations, economic pain leads to coups, governments falling, and dictators rising.

Since this bubble's nexus will be tracked to a weak dollar, tracked to U.S. policy, you can bet that despots and opportunists will use the crisis to blame America. So, what we will have is a dictatorial takeover all over South America, some parts of Asia, and parts of Africa. Anti American depots and opportunists will look to use the crisis to support leftists to fill the vacuum for falling governments all over the world.

There will of course be plenty of civil wars. That's what happens in conjunction with falling government, often, in the third world. We'll see death, looting, and mass chaos all over the place. This will also give opportunities for terrorists and other American enemies like Hugo Chavez, Russia, and Iran to install governments sympathetic to their beliefs.

Chavez will almost certainly be the big winner in South America in such a scenario. He, more than anyone else, would ride the Anti American card as developing countries have their governments fall. Africa would see multiple civil wars all at once. Parts of Asia will have their governments fall. In the geopolitical climate that will likely be in place before all this, this sort of scenario is a recipe for disaster.

1 comment:

frog said...

Interesting. This caught my interest and is perhaps related to what you post;