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E. Polster 2

This paper will provide the tools necessary to analyze the international carry trade with respect to the United States: its mechanics, its effects on an economy, and the role of the US dollar in the international carry trade. Implications for the US and world will then be derived, with particular attention paid to the prospect of a possible crisis in the foreign exchange market. Though an international financial crisis due to the collapse of the carry trade is possible, such an event is contingent on the actions of the Federal Reserve Bank and unlikely to occur under current circumstances.

E. Polster 3

The carry trade is the ‘most widely-used currency speculation’ in the world.1 It takes advantage of the foreign exchange market, commands trillions of dollars worldwide, and yields extraordinary profits to those who speculate in it. Yet this phenomenon can hardly be described as a miracle. The carry trade has a wide range of detrimental effects that are imposed upon the currencies involved. Many economists believe that these effects are building the foundations of the next great international financial crisis. There is some evidence indicating a growing bubble in the foreign exchange market, and the bursting of this bubble could be catastrophic. Further, involvement of the US dollar as a funding currency for the carry trade would worsen the consequences of such a crisis. The following sections break down the mechanics, effects, and implications of the international carry trade with particular attention paid to the role of the US dollar since 2009. The purpose of this paper is to analyze the carry trade with respect to the possibility of its collapse, and evaluate predictions of an ensuing financial crisis stemming from such a breakdown. This assessment concludes that despite evidence of a bubble in the foreign exchange market and precarious domestic economies, a largescale financial crisis resulting from the collapse of the carry trade is improbable considering the current state of the world and US economies.

Arbitrage from currency trading has yielded substantial profits since the collapse of the Bretton Woods system in 1971. The worldwide regime of floating exchange rates

E. Polster 4 made the carry trade possible: under this system, investors are able to take advantage of interest and exchange rate differentials between and among countries for profit. Floating exchange rates allow investors to exploit the differences between exchange and interest rates between countries in two ways. First, an investor can borrow some amount of money in a low-interest rate currency, convert these funds into a highinterest rate currency, and lend the funds in the latter currency at the higher interest rate, generating profits from this rate differential. This is the most common carry trade strategy. A second, comparable tactic involves purchasing currencies that are at a forward discount (currencies for which the future exchange rate at a specified date are lower than the current exchange rate) and selling currencies that are at a forward premium (currencies for which the future exchange rate at a specified date are higher than the current rate).2 The investor can therefore reap the benefits of arbitrage as the currency is exchanged. This second version is comparable to the first because the currencies at a forward premium are essentially serving the same function as a low-interest rate currency, and currencies at a forward discount are acting as a ‘target’ currency in the same way that a high-interest rate currency would. These versions can be referred to interchangeably and yield equivalent results.2 The profits from both types of speculation are essentially an exploitation of interest and exchange rate differentials across countries, and can produce high returns with relatively little risk. Craig Burnside has estimated that the carry trade investments experience only two-thirds of the volatility but comparable returns to investments in S&P 500 stocks.1

E. Polster 5 It is easiest for this type of speculation to occur when there is government interference in the market.3 The central bank of an economy can choose to keep interest rates unnaturally low or high with the purpose of easing or tightening financial conditions and manipulating unemployment. 4 The central bank thus inadvertently guarantees that carry trade investments will yield the desired returns without risk of volatility for some time. Though floating exchange rates have technically prevailed since the fall of Bretton Woods, most countries have a system of ‘managed floats’ in which the government intervenes in the market and influences exchange rates to pursue its monetary policy objectives.5, 6 The distortion of both exchange and interest rates by governments worldwide creates an ideal environment for the carry trade. It is difficult to estimate the scope of the carry trade both within individual countries and internationally. Tim Lee of piEconomics, a renowned economist who has worked in asset management around the world for more than twenty years, estimated that $2 to 3 trillion USD was involved in the carry trade worldwide in 2008, $1 trillion of which was a part of the yen carry trade (Economist ‘Financial Stability’).7, 8 This sum implies huge payoffs for investors that play this game. For this speculation to work, there must be a ‘funding’ currency and a ‘target’ currency.9 Popular funding currencies in recent years have included Japan, the Eurozone, Sweden, and Switzerland: these economies have all sustained low interest rates for years. Popular target currencies include Australia, New Zealand, Turkey, and a number of emerging economies, all of which are marked by higher interest rates.8 Thus, a trader will borrow yen from Japan at a low interest rate, turn around and lend that money in Australia at a high interest rate, and yield a profit from the interest rate differential.

E. Polster 6 Burnside, et al. have found that there are especially large gains from diversifying carry trade investments across a number of countries.1 The role of the yen in particular must be noted when mentioning the funding currencies of the carry trade. The yen has for decades been the carry trade’s most prominent and popular funding currency: it is regarded as a ‘safe currency’ because low interest rates are guaranteed for extended periods of time. Japan maintains low inflation and a trade surplus, which further encourages investors to use this market. 10 As mentioned earlier, the yen may have been involved in one-third to a half of all carry trade activity in recent years, with totals amounting up to $1 trillion USD.11 The carry trade has been traditionally analyzed using standard international finance models. Two such models, the ‘uncovered interest parity condition’ and ‘traditional risk factor’ models, are often used to evaluate the carry trade. These models are commonly employed to predict financial trends, especially in the foreign exchange and asset markets, and they break down the mechanics and effects of the carry trade within the confines of theory. The uncovered interest parity (UIP) condition states that ‘the interest rate differential between riskless assets denominated in foreign and domestic currency is equal to the rate at which the foreign currency is expected to depreciate against the domestic currency.’9 While this condition predicts that high interest rate currencies will depreciate when involved in trade, we find that the opposite occurs in reality. It is assumed that under this theory, the difference in interest rates between two countries reflects the rate at which investors expect the high-interest rate currency to depreciate against the low-interest rate currency. All currencies should ultimately move towards an

E. Polster 7 equilibrium in which they equally offer the same expected rate of return to investors.12 If this condition were to hold, the carry trade would not be profitable: investors engaging in this speculation would receive no net payoff. However, this is not the case in reality. We find that this traditional model fails to explain the carry trade; in fact, it contradicts it.2, 9,

In his research, Craig Burnside analyzes traditional risk factor models such as the CAPM, Fama-French three factor, and the consumption-CAPM models and finds that risk-based explanations of the carry trade are uncorrelated with its returns. Burnside concludes that there is no unifying risk-based explanation of returns for the carry trade, especially in relation to the stock market.13 These models, which are customarily used to explain the returns to investments such as stock market ventures, also fail to describe the profitability of the carry trade. According to these economic models, the carry trade should not yield profits. However, the volume of money involved in the carry trade suggests that these predictions do not hold, and that the carry trade is in fact profitable. As these prominent models have failed to explain the carry trade’s success, economists can only form hypotheses for alternative explanations. Several additional theories could serve as potential explanations for the carry trade’s high rate of return, including the chance of a ‘peso event’ or crash/disaster risk, and the inevitably disastrous long-term strategy of the carry trade. Burnside’s most promising offering in describing the high returns to the carry trade is the possibility of a ‘peso event’. This alternate explanation relies on extreme risk aversion to events that have not yet been observed. Essentially, there could be an external disaster so severe that it would wipe out any profits from the carry trade, and the chance

E. Polster 8 of this happening in the future is enough to yield investors high returns now. Such an event would likely have to occur when there are losses elsewhere in investors’ portfolios.13 Measuring the usefulness of this model is difficult due to the inherent complications of analyzing rare or hypothetical disasters, and it is difficult for this single theory to justify the consistently high returns to the carry trade. Perhaps more reasonably, Brunnermeier and others have found that currency traders are subject to ‘crash risk’: there is a chance that carry trades can suddenly unwind if risk appetite and funding liquidity decrease.9 Because the carry trade relies on these two factors in order to be successful, the sudden loss of either or both would result in huge losses within the foreign exchange market. The possibility of such an event may justify some of the returns to carry trade investments: it is estimated that disaster or crash risk may account for about a quarter of the excess returns in the carry trade.14 Similarly, some data show that the carry trade will be successful only in the short run. In the long run, yields would be wiped out in a currency devaluation or inflation.15 Either of these events would negate the carry trade’s profits, because the carry trade relies on currency and interest rate stability. Even if they do not happen suddenly, as supposed in the crash risk theory, these events will inevitably occur in the long term. Therefore, the carry trade is profitable only in the short term. The probability that currency devaluation or inflation will occur increases not only in the long term, but additionally so in countries with weak economies. The potential danger of losing all profits in the case of an external disaster, a sudden loss of funding, or long-term currency devaluation and inflation could explain at least part of the high returns of the carry trade.16 However, the carry trade remains the

E. Polster 9 ‘unsolved puzzle’ of currency markets. While economists still struggle to find a plausible explanation for the success of this type of speculation, the carry trade has continued to yield high returns worldwide for more than thirty years.2

Engaging in this type of speculation is not without consequences. The carry trade will affect the currencies involved along with other areas of the economy. It has both affected and been affected by the global financial crisis of 2007. Many have also predicted that the carry trade is driving a foreign exchange market ‘bubble’ and will eventually cause widespread financial crisis. The conditions necessary for the carry trade to exist will preemptively create an unhealthy environment for the economy as a whole even before the carry trade becomes involved. In order to stimulate growth, central banks often purchase their own bonds in order to inject money into the economy, lower interest rates, give banks more money to lend, and fuel borrowing and spending. Such policies occurred on a large scale following the onset of the global financial crisis in 2007. However, by attempting to stimulate the economy, a central bank can cause some damage to the economy and can also set up the economy for unhealthy speculation through the carry trade.12 Once interest rates (or the value of the currency) are lowered in a country, investors may flood in to take advantage of artificially low rates. When the carry trade takes hold and gains volume, it will continue to exacerbate preexisting unstable conditions. Contrary to the UIP condition, the carry trade will put downward pressure on its funding currency (causing it to depreciate) and upward pressure on its target currency

E. Polster 10 (causing it to appreciate).2, 17 Essentially, because they involve selling funding currencies and buying target currencies, carry trade investments on a large scale can cause additional excess supply of the funding currency and excess demand for the target currency.2 This results in added exchange rate movements: the low interest rate currency depreciates further, and the high interest rate currency continues to appreciate.8, 18 Recall, these trends have already begun because the central bank implemented monetary policy to manipulate the interest and exchange rates. After the carry trade takes hold, such movement becomes self-perpetuating: the appreciation of the high-interest rate currency will encourage investors to enter the carry trade, causing the exchange rate differential to expand further away from equilibrium.2 By aggravating interest and exchange rate movements, the carry trade will affect other areas of the economy. Lowering the exchange rate, increasing in the domestic money supply, and causing a depreciation of the domestic currency means that it will take more of the domestic currency to buy a unit of foreign currency, and the domestic currency will become ‘weak’ relative to the other currency. The result will be cheaper domestic products for foreign consumers, and more expensive foreign products for domestic consumers. Exports will be encouraged and imports will be suppressed.12 Though this may be beneficial for consumers of domestic products, domestic producers will suffer as their products must sell at lower prices. Overall, these trends lead to economy-wide imbalances. Importantly, a depreciation of the domestic currency in this way will also make it more difficult for domestic debtors to repay their foreign debts, which can have particularly severe consequences under certain circumstances. In the near future, as many economies slowly recover from recession, the ability to repay massive

E. Polster 11 debts will be increasingly important. The consequences of such a divergence in the interest and exchange rates from their equilibrium are therefore vital to consider. Throughout the years the carry trade has been a driver of not only economy-wide but global financial imbalances.19 In fact, some sources see evidence that the carry trade was an important factor behind the 2007 credit bubble. According to Lee, high currency misalignments caused in part by the carry trade created enormous current account imbalances. Deviations from fair, equilibrium market values are reflected in a number of industries, most notably credit and real estate.20 It is possible that the carry trade helped drive divergences between money and credit growth in the US prior to 2007, which only exacerbated the oncoming crisis.21 However, the onset of the global financial crisis weakened the carry trade to some degree. This was evident in Japan in 2008: the yen gained strength after the start of the crisis, signaling risk aversion and an unwinding of the yen carry trade.22 After this initial stumble, the carry trade found growth during the crisis. Data show a ‘new appetite’ for risk after 2009, especially in the Eurozone.23 The European Central Bank raised interest rates across Europe in 2011, which reinvigorated the carry trade by widening the gap between the yen (as the funding currency) and the euro (as the target currency). 24, 25, 26 Since 2009, there has been further evidence of a return of the carry trade.26, 27 Though the carry trade may have helped to drive the global financial crisis, we are now seeing its return despite worldwide economic downturn. As previously mentioned, investors are again taking advantage of distorted interest rates between depressed economies in search of profit.

E. Polster 12 It is clear that the carry trade can have detrimental effects on individual economies and the global financial system as a whole. Some theorists therefore predict that the next big financial crisis will occur in the foreign exchange market. Because the carry trade causes its target currencies to appreciate and its funding currencies to depreciate, if enough money is involved in speculation, a bubble can be formed in the foreign exchange market from this movement.28 The exchange rate is always moving to eventually converge on one of two possible equilibria: its fundamental equilibrium or a ‘bubble’ equilibrium. As the exchange rate starts to move in one direction, it will attract investors (such as speculators in the carry trade) to reinforce the movement. As speculators hold on to their carry trade investments, the currencies involved are prevented from returning to their fundamental equilibria. This continuous acceleration leads to the build-up of an exchange rate ‘bubble’, which will continue to move away from fundamental exchange rate values. After a noticeable spike, the upward movement slows and fundamentalism becomes the more profitable option. Speculators will ‘unwind’ their carry trades and a decline is triggered to return to fundamental equilibria.9, 29, 30 The severity of such a crash would depend on the volume of the carry trade and foreign exchange market, but Lee has estimated losses at $30 trillion worldwide if such an event were to occur in the near future.20 Is it possible that this type of financial crisis could occur? Many economists have seen evidence that a foreign exchange bubble is forming. The actual collapse of the global carry trade would occur when there is a credit contraction or a correction of imbalances (when target currencies begin to depreciate and funding currencies begin to

E. Polster 13 appreciate).31 A negative shock to the interest rate differential could trigger a liquidity crisis in the funding economy and amplify a financial crisis in the recipient economy.32 These sudden shocks would likely also have to occur during a period of great uncertainty in the foreign exchange market due to some political or economic event.30 Some are beginning to expect such an event in the near future. There is evidence that foreign exchange imbalances have increased in the last two years, perhaps sending the market closer to its tipping point. Recipient currencies are overvalued and current account deficits are increasing, likely due to both central bank distortions and the carry trade.31 A sudden correction of these imbalances could trigger the start of the decline of the carry trade, leading to a foreign exchange market crash. It is important to note that a foreign exchange market crisis will only be exacerbated the larger the bubble grows. Additionally, the carry trade has helped to provide funding to some emerging economies (those serving as target economies) during the global financial crisis, and the loss of this funding in a foreign exchange crisis while these countries still need support would only cause greater economic collapse worldwide.8 Has a hint of these dramatic effects been evident in the past? Because the regime of floating exchange rates has prevailed since 1971, we only have several decades to examine for examples. In his 1987 analysis of the foreign exchange market, Wing Thye Woo found that there had been only two speculative bubbles in the foreign exchange market since the fall of the Bretton Woods system, the most notable occurring from 1978 to 1980. These bubbles had occurred in periods when there was both significant change in foreign exchange fundamentals and great political or economic uncertainty. Woo

E. Polster 14 concluded that ‘destabilizing speculation does not constitute the behavioral norm in foreign exchange markets.’30 Therefore, though foreign exchange market bubbles have occurred in the past, they have deflated without worldwide financial crisis. It is possible for divergences to occur between currencies without creating an immense bubble or a catastrophic fall in the foreign exchange market. Nevertheless, it is important to

continuously monitor this market and the carry trade, especially if there is evidence of a speculative bubble, in order to predict its course and ultimate end. It is not impossible for an international foreign exchange market crisis to occur.

The role of the dollar in the international carry trade in recent years must be discussed. The dollar’s involvement in the carry trade is particularly crucial when

considering a potential foreign exchange crisis because the dollar holds a distinctive position as the world’s reserve currency. Since 2009, economic data supports the conclusion that the US has, like the yen in recent decades, become a funding currency for the carry trade. This is evident from extended low interest rates and a significant movement of investors shifting from the yen to the dollar. US benchmark interest rates dropped from 5.2% in 2007 to 0.125% in 2009, when the Federal Reserve Bank cut interest rates to stem off the effects of the recession. These rates have remained ultra-low ever since.33 Though the Fed hopes this sustained policy will encourage lending and spending and eventually increase exports, the immediate effects of this ‘easy money’ policy include not only ease of borrowing, but a depreciation of the dollar and quelling of imports.34

E. Polster 15 The Federal Reserve accomplished its suppression of interest rates by three methods: the reduction of the discount rate, an increase in bank reserves, and (most importantly) ‘open market operations’, wherein the Fed purchases massive amounts of US Treasury Bonds, increasing their price, lowering their yield to artificial levels, and increasing the domestic money supply. These actions have suppressed interest rates beyond their natural levels, and the subsequent easing has been described as ‘unprecedented’ and even ‘experimental’.35, 36 The ramifications of the Fed’s suppression of interest rates are essential to analyzing the possibility of future crisis. By implementing these ‘easy money’ policies, the central bank may be doing more harm than good, and setting the economy up for future damage. Through open market operations, the Fed essentially monetizes the government’s debt by buying government securities and injecting cash into the market. These operations put downward pressure on the dollar, causing it to depreciate, and lower the relative price of US goods. US consumers will benefit in their ability to borrow more at a lower interest rate and from relative lower prices, but domestic producers will lose profit from having to sell at these prices. Though consumer borrowing and spending is increased, an increased money supply will lead to inflation in the US economy.12 Thus, the implications of a manipulated money supply and interest rate can be detrimental for a number of reasons. Such movement can also encourage unhealthy growth through the carry trade. The US’ abnormally low interest rate (close to Japan’s rate of 0.10%) is the first indication of a carry trade episode.37 Since this low rate was set in 2009, speculators have flooded the market34 with the purpose of borrowing money at a very low rate and likely

E. Polster 16 re-lending it in a higher interest rate currency. Indeed, the International Monetary Fund observed in 2009 that the US dollar had begun to serve as a funding currency for the carry trade, with the Eurozone and emerging economies as target currencies.23 Many South American economies, along with Turkey, India, and others, have sustained interest rates above 7.5%, providing markets for investors to lend in.37 Economists have thus observed carry trade speculators shifting from using the yen to the dollar as their funding currency. The yen carry trade lost two-thirds of its value from 2007 to 2009; using Lee’s estimation of the yen’s carry trade, this would mean a loss of around $600 billion.19 Similarly, Forbes estimated the volume of the US carry trade at $500 billion around the same time.38 The evidence suggests that there has been a clear increase in the dollar carry trade since the reduction of US interest rates in 2009. Any distortions in the dollar caused by either the Federal Reserve or the carry trade are especially significant when the dollar’s role as the world’s reserve currency is considered. The dollar is held internationally by central banks and other financial institutions as a means of paying international debt or influencing exchange rates. Usually, holding the dollar as a reserve currency will minimize other countries’ exchange rate risk.39 However, the depreciation of the dollar and the creation of a foreign exchange market bubble, both of which can be caused or exacerbated by the carry trade when the dollar is used as a funding currency, may have a dramatically more detrimental effect when considering the international community’s reliance on the dollar. In short, a potential foreign exchange crisis would be significantly worsened if the dollar is involved.

E. Polster 17 Evidence shows that these exact movements have taken place in recent years. The IMF noted that the dollar has depreciated since the US interest rate was lowered in 2009, and popular target currencies for the carry trade (notably the euro and the currencies of some emerging economies) have appreciated.23 Though a number of central banks caused a distortion of exchange rates by using monetary policy to manipulate growth after 2007, it is not unreasonable to assume that some of this movement may also be the result of intensified carry trade activity. Growing interest and exchange rate divergences can be found worldwide. However, because the US dollar holds a unique position in the world economy, the consequences of the carry trade using the US dollar will have additionally severe implications for both the US and world.

Data have shown that the carry trade can worsen preexisting unstable domestic economic conditions, exacerbate a foreign exchange market crisis, and potentially cause an international financial crisis; it is also clear that the US dollar is now involved in the carry trade as a prominent funding currency. The question must therefore be asked: is a foreign exchange crisis imminent, and will the dollar play a principal role in such a crisis? The following discussion examines the likelihood of such an event and its global consequences. Low interest rates in the US have created a global dollar carry trade that is ‘driving capital flows into emerging markets’ and could lead to the creation of asset bubbles in those economies.36, 40 As discussed earlier, divergences in exchange rates are

E. Polster 18 causing movement towards an exchange rate bubble equilibrium, consequent growth of a foreign exchange market bubble, and acceleration toward crisis.29 It is likely that a bubble has been formed in the foreign exchange market in recent years due to low interest rates and heightened carry trade activity in the US, and increased investment and currency appreciation in the carry trade target economies. If US interest rates remain low for an extended period, the dollar could continue funding a growing foreign exchange market bubble. It is possible that this bubble could build but not burst for some time.23 In the meantime, carry trade activity would continue to contribute to the assets of banks in those economies involved, but any growth would be unhealthy and speculative. This ‘growth’ would essentially feed the foreign exchange bubble.36 There will be several indicators of the potential bursting of the foreign exchange market bubble. After the foreign exchange market spikes, acceleration will slow and speculators will begin to look toward fundamentals for a more profitable investment. The crash will begin.29 Therefore, a spike in the foreign exchange market may indicate the final stage of the bubble. Several events could cause the collapse of the global carry trade and therefore the bursting of the foreign exchange bubble: the correction of exchange rate imbalances, a negative shock to the interest rate differential, or the rise of long-term interest rates in a prominent funding currency such as the US dollar or Japanese yen. Because the carry trade relies on an extended interest rate differential between countries, a correction of the currently distorted interest rates (or, similarly, a correction of exchange rates to their fair floating values) would trigger a liquidity crisis in the funding currency and deliver a huge shock the carry trade.30, 31, 32 A central bank could

E. Polster 19 have a number of reasons to correct the interest rate differential or revalue/devalue its currency, some of which will be discussed in the following section, using the United States’ Federal Reserve as an example. Though such action is unlikely, it could occur under certain circumstances, and a central bank would be wise to pursue a very gradual (rather than sudden) correction of imbalances in such a situation. In addition to a sudden adjustment, the rise of long-term interest rates (especially in the US or Japan, as these economies provide the primary funding currencies for the carry trade) would wipe out investors’ carry trade yields, result in a rush to sell investments, and deliver enough of a shock to the foreign exchange market to cause the bubble to burst.38 Foreign exchange imbalances have increased since 2010,31 along with the US dollar’s prominence in the global carry trade.38 It is likely that if exchange rate imbalances or the interest rate differential were to correct in the current environment, the world would experience a financial crisis as a result of the collapse of the global carry trade. There is little incentive for exchange or interest rates to return to their natural values during the current recession. As the US barely begins to recover from the global financial crisis of 2007, and much of the rest of the world still flounders, central banks are likely to keep interest rates low to stimulate lending and spending in their economies. Policies of ‘quantitative easing’ or ‘easy money’ are maintained in order to give an economy a chance to gain strength during recession. 41 Since many of the world’s economies still have much recovering to do, it is very unlikely that interest rates will be abruptly raised. The US Congressional Budget Office’s interest rate projections show at least two more years of sustained US short term interest rates at 0.125%.42

E. Polster 20 By involving many different currencies, the potential of collapse in the international carry trade puts much of the global economy at risk. Though a purposeful sharp correction of interest and exchange rate differentials is unlikely, the balance of the foreign exchange and money markets has been significantly distorted by domestic monetary policies and exacerbated by the carry trade, making these markets increasingly susceptible to crash. This precarious setting has particular implications for the United States, as this economy holds the most power to tip the scales either towards safety or crisis.

The role of the US dollar in the carry trade is decisive because of its status as the world’s reserve currency. Adverse consequences to the dollar will be amplified internationally because of this status. Therefore, the Federal Reserve Bank’s policies in addressing a foreign exchange bubble are imperative to averting disaster to the global economy. This final section will review the dollar’s critical function in the global economy, its already weakened position, and its role in the international carry trade before analyzing the policy decisions available to the Federal Reserve Bank to lower the risk of a future financial crisis stemming from the carry trade. As previously discussed, the US dollar has a critical function in the global economy. Foreign monetary authorities worldwide hold large dollar reserves as a means of financing their own debt or influencing exchange rates. 43 This system customarily helps balance the foreign exchange market and minimizes the risk of exchange rate aberrations.39 However, the dollar’s role as a reserve currency also bears heavy

E. Polster 21 responsibilities for the Federal Reserve Bank, whose actions affect the value of the dollar in the global economy. The dollar must remain relatively steady in order to support the exchange rates of other countries. A sudden appreciation of the dollar, together with rising interest rates in the US, would cause the relative price of imports to fall in the US but rise in foreign economies, as the relative price of exports would rise in the US and fall in foreign economies. The overall consequences of such movements in these relative prices would be deflation in the US and inflation in foreign economies.43 Sharp movements in the dollar exchange rate will thus have consequences not only for the US, but for economies that trade in the US dollar as well. In some ways, the Federal Reserve Bank has already employed hazardous policies and failed to keep the dollar steady, harming both the US and world economies. In order to stimulate growth after 2007, the Fed lowered interest rates by purchasing bonds and increasing domestic money supplies. Thus, the domestic money market in the US was falsely inflated in order to drive down the interest rate. By manipulating the supply of money, the Fed also caused the dollar to depreciate against other currencies.12 This setting allowed speculators to take advantage of a depressed interest rate and dollar for profit in the carry trade. Since 2009, the low interest rates imposed by the Federal Reserve have stimulated the use of the dollar in the carry trade. Because the exchange rate is largely set by supply and demand for a currency in the foreign exchange market, and the carry trade warps the supply of its funding and target currencies, involvement in the carry trade will cause the dollar to depreciate further.2, 44 There has been clear evidence of a weakening dollar since 2009, and Lee predicts that the dollar will continue to depreciate as long as US interest

E. Polster 22 rates are held artificially low and the carry trade exploits the dollar for funding.19,


number of economists see these conclusions as reason to believe that the dollar is bringing the carry trade close to the disastrous edge of a foreign exchange market bubble. The potential international consequences of a collapse in the carry trade and foreign exchange market will be drastically more severe if the carry trade is supported by the US dollar rather than another funding currency (i.e., the Japanese yen). Though any low-interest rate currency is able to serve as a funding currency, the yen has been the carry trade’s primary funding currency for decades. Economists previously believed that an unwinding of the yen carry trade (caused by a rise in the value of the yen or a rise in Japanese interest rates) would cause market chaos because the yen was so deeply involved in the carry trade.11 However, such an event has not taken place so far, and Woo shows that the foreign exchange market has been able to deflate past bubbles without serious damage.30 It is essential to keep in mind that past foreign exchange market bubbles occurred while the yen and other currencies funded the carry trade. Because the yen is not the world’s reserve currency, Japan is able to manipulate its exchange rate without severe international consequences. Policies involving the US dollar have more significant implications. The dollar’s exchange rate movements will be felt worldwide through the reserve currency holdings of foreign banks, and an appreciation of the US dollar will have repercussions in the many countries with dollar reserves. Since the dollar began to weaken due to the Federal Reserve Bank’s ‘easy money’ policies since 2009, other economies have tried to depress their currencies to stay competitive with the dollar as it continues to depreciate.42 A drastic increase in the US dollar would thus generate a huge shock to the foreign exchange market and these individual economies.43

E. Polster 23 Such a shock would not only trigger a global financial crisis, but would have severe consequences for the US economy itself. If the global carry trade were to collapse due to a sudden correction of interest or exchange rate differentials, extreme inflation would take hold outside the US. Because the value of the US dollar would reverse, the price competitiveness of US products would fall, and deflation would take place at home.45 A sharp appreciation of the dollar, the consequent drop in export demand, and high interest rates in the US would inhibit growth and result in severe economic downturn.46 Because the dollar holds a position as both the world’s reserve currency and the carry trade’s primary funding currency, the consequences of a collapse of the foreign exchange market bubble would be catastrophic to both the US and global economies. The responsibility of the Federal Reserve Bank to maintain balance in the foreign exchange market is therefore unparalleled. This weight has become particularly severe since 2009, as the US carry trade feeds a growing foreign exchange market bubble. Implications for the United States now include the responsibility to help return current exchange rates to their fundamental values without sparking a financial crisis. Therefore, it is necessary for the Fed to raise interest rates very gradually in order to avoid an international financial catastrophe. If the interest rate differential is steadily corrected, the US economy will maintain growth as it pulls out of the recession, and investments will remain intact.47 The carry trade will not experience a spike and collapse as speculators abruptly unwind their investments. As with past bubbles in the foreign exchange market, unhealthy speculative growth will slowly deflate and return to its fundamental equilibrium.29, 30 It is far more likely that this situation – the gradual increase

E. Polster 24 of interest rates and slow deflation of the foreign exchange market bubble – will occur rather than the alternative, a sudden correction of imbalances and collapse of the carry trade. However, it is difficult to predict the Fed’s decisions in such a problematic setting. Though it would be foolish for the Fed to rapidly increase interest rates, the bank may have reason to do so in the near future. Since the economic downturn of 2007, the Fed has kept interest rates low with the purpose of stimulating growth, and has vowed to do so until the unemployment rate falls to a healthier level. However, despite years of ‘easy money’ policies, the US has not yet seen dramatic economic growth or a healthy unemployment rate. Because holding interest rates artificially low continues to depreciate the dollar and hurt US producers, the Federal Reserve may begin to raise interest rates before it has achieved its goals to avoid further injury to the dollar.48 If the Fed were to reverse its monetary policy in this way, the abrupt revaluation of the dollar and an increase in interest rates would be detrimental to the US economy independent of a crash in the foreign exchange market. If the Fed stopped buying

government securities in order to raise interest rates it would become harder to borrow within the US. The dollar would suddenly appreciate, and this revaluation would make US goods more expensive for foreigners while foreign products became cheaper for US consumers. Foreign investors would face a higher cost of entering the US market, and US consumers would be hurt by higher prices and low export demand. The result would be deflation in the US and inflation in foreign nations.12, 49 Though the United States has inadvertently caused unhealthy speculation through ultra-low interest rates and a depreciating reserve currency, it is possible for the Federal

E. Polster 25 Reserve to prevent future financial crisis in the foreign exchange market by avoiding a sudden correction of interest and exchange rate differentials and gradually seeking to return these rates to their equilibrium market values. It is imperative that the Federal Reserve practice the utmost caution when implementing monetary policy under the current circumstances to avoid severe damage to both the US and world economies. Careful and very gradual action could lead the foreign exchange market away from the brink of a speculative bubble and towards healthier fundamentals.

A thorough analysis of the carry trade’s mechanics and effects taken with respect to the US and the current global financial crisis yields a prediction that the collapse of the global carry trade and a subsequent foreign exchange market crisis is possible but largely dependent on the future actions of the Federal Reserve Bank. The carry trade, which defies economic theory and generates inexplicably riskless and high returns, can be detrimental to the economies it works within. Distortion of currency supply will force the carry trade’s funding currency to depreciate and its target currency to appreciate, resulting in the formation of a bubble in the foreign exchange market if enough money is involved in the trade. The eventual bursting of such a bubble would cause financial catastrophe worldwide. The severity of such a crash would be exacerbated considering the role of the US dollar, the recent prominent funding currency of the carry trade, as the world’s reserve currency. A foreign exchange crash could be caused by the sudden correction of exchange or interest rate imbalances, which the carry trade relies on for its success. A

E. Polster 26 revaluation of the US dollar would be additionally detrimental to the US economy independent of the foreign exchange market. It is unlikely that these imbalances will be suddenly corrected given the circumstances of the global financial crisis of 2007, as many central banks are keeping interest rates unnaturally low in order to stimulate growth and recover from the current recession. If the Federal Reserve Bank very gradually raises interest rates, growth can be maintained and the bursting of the foreign exchange bubble can be averted. Therefore, if the Fed exercises caution, a devastating collapse of the carry trade is unlikely to occur under current circumstances.

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