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Eagle Eye

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Ben Chu: Prick those bubbles now

Posted by Eagle Eye
  • Friday, 30 October 2009 at 01:26 pm
When Nouriel Roubini, the man who spotted the credit meltdown, calls a bubble, we should pay attention. And he's calling one now: the carry trade. Roubini says investors are borrowing dollars and other currencies (which are abnormally cheap thanks to low interest rates) and using the funds to buy higher-yielding equities and commodities around the world. That would certainly explain why equity and commodity markets are booming while underlying economies still look very sickly. It would also explain why investment banks - traditionally big players in the carry trade -are reporting fat profits.

With economies still in a fragile state, there is an overwhelmingly powerful case for low interest rates. But what Roubini's analysis suggests is that the activities of investment banks in response to those loose credit conditions are increasing the risk of another crash. As Roubini says, when interest rates do rise, there is a likelihood that those involved in this carry trade will "rush to the exit" at the same time, prompting a new asset price meltdown.

This raises a very interesting question. The consensus is that, henceforth, central banks and economic policymakers need to be proactive about pricking asset bubbles, and that targeting inflation alone won't cut it any more. But most people expected the next bubble to come several years down the line. But if Roubini is right, the bubble has already begun - and before recovery has properly bedded down. So policymakers have a dilemma. They can raise interest rates, prick the bubble, and sink the recovery. Or they can keep rates low, nurse the recovery, and carry on feeding a potentially catastrophic bubble.

I would suggest there is a third way: keep interest rates low, but put a lid on the carry trade through tighter controls on leverage and intrusive prudential regulation. Isn’t it increasingly clear that there will never be a sustainable recovery until governments tame the investment banks?