Bailout

Shorting reserves

By Felix Salmon

Michael Pettis does a good job of systematically dismantling this idiotic line from Tom Friedman:

First, a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves.

In fact, if you decided to short only countries whose foreign exchange reserves reached some large proportion of gross world product, you’d be batting 2 for 2 right now as you started shorting China. First you would have shorted the USA in the 1920s, and then you would have shorted Japan in the 1980s.

Writes Pettis:

It was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.

One of the scariest aspects of the most recent financial crisis is that far from addressing the biggest and most potentially destabilizing global imbalances, it actually exacerbated them. If and when those imbalances unwind chaotically, the global effects will be highly unpredicatable. But it’s far from clear that China will be any kind of safe haven.

Full post as published by Macroprudential on February 03, 2010 (boomark / email).