The yellow submarine

Yellow_submarine

The Yellow Submarine. Courtesy of Howie Green.

I’m loving this post already. So many fond memories…

First, the music,

Then, the lyrics, courtesy of sing365.com…

[…]

We all live in a yellow submarine,
Yellow submarine, yellow submarine,
We all live in a yellow submarine,
Yellow submarine, yellow submarine,

weird sounds

As we live a life of ease,
Everyone of us has all we need (has all we need)
Sky of blue (sky of blue) and sea of green (sea of green)
In our yellow (in our yellow) submarine (submarine. Blaha)

We all live in a yellow submarine,
Yellow submarine, yellow submarine,
We all live in a yellow submarine,
Yellow submarine, yellow submarine,

[…]

So appropriate for the subject at hand, the case of global market liquidity.

You get one little piece from here, then, another from there… and then you realize that the puzzle is beginning to add up to something; and that’s what I’d like to expose in this occasion, if for no other reason than clearing the chip.

The labor arbitrage
I think we can trace the root of the currents that move the world economy to the ongoing extreme labor arbitrage. Globalization has allowed millions of low wage workers to incorporate themselves to the world’s labor pool, mainly from China and India. CBs in the US, EC and Japan have countered this effect by injecting liquidity to their economies to stimulate the perceived local lack of growth.

This is the background. On the one hand, emerging countries which are staking their ground in world trade, embarked in a one-way adventure into prosperity, from which they cannot turn back, else there would be political hell to pay. And on the other, developed countries whose jobs, in general, are either lost or salaries reduced, with waning pressure for wage increase –where outsourcing is the mighty foe for local employment.

The investment geographic arbitrage
Again, lower wage areas attract investments in detriment to the rest of the world. An investor does not have the luxury of doing otherwise in order to survive. As a consequence, a bottle neck of competing investors is found at these lower wage areas, resulting in a glut of idle liquidity looking for a place to park itself.

Credit risk insurance
A new breed of derivatives which allow credit insurance, or allow banks to pay a premium to cover their loan defaults, has taken the risk out of bank lending (someone else is taking this risk… more on this later); allowing banks to grow their loan portfolio by leaps and bounds, where CBs and their low rates have undoubtedly helped, acting as the source of funds.

Asset appreciation
There are too many reasons to explain asset appreciation due to high liquidity. How about inflation, or too many bills chasing the same assets? Or, low discount rates imply a higher value of present discounted assets, and investing and riding the bubbles in assets… As a consequence, CB reserves are not only large in low wage area CBs, but also in CBs of commodity exporting countries, exacerbating the glut.

The credit and carry trades
Derivatives have also been used to great advantage by traders who are playing the low volatility side of the trade, or that the high liquidity scenario will continue, and they have done very-very-well. In other words, traders have been taking the credit risk away from the banks, and since liquidity is high and volatility is low there are very few loan defaults –hence, they’re making a killing.

Also, the carry trades, sell Yen buy gold, or sell Yen buy Brazilian Real… have also brought a pretty penny to traders. And, if we pause for a moment to think about it, both tend to exacerbate and continue the global increase of liquidity.

Triangulation
I’ve read a lot about the USD demise as a consequence of the deficits. It is incredibly important to understand that, willing or not, CBs are forced to act to depreciate their currency if it has shot up for whatever reason; otherwise, their high local currency prices their goods out of the market, and then they suffer deflation and a hard to bear loss of jobs –which is what happened to Japan during the ’90s. In other words, CBs have a strong motivation and tendency to sustain the currency status quo, which I think will catch up with the current appreciation of the EUR, I’m sure.

Conclusions
The high liquidity, low volatility scenario should continue for as long as the labor arbitrage turns a profit, which means it’s in for a long, long time. Unless, of course, something unexpected surprises and dislodges the ongoing journey to wage equilibrium.

Or,

As we live a life of ease,
Everyone of us has all we need (has all we need)
Sky of blue (sky of blue) and sea of green (sea of green)
In our yellow (in our yellow) submarine (submarine. Blaha)