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Wednesday, June 20, 2007

Herd Behaviour in Austria

Just a quick afterthought on my last post on the Swiss Franc carry trade. As I note there, Claus Vistesen had a post earlier in the week on Japanese housewives shorting the yen. Now interestingly a guy called Wim from the Netherlands immediately posted a comment pointing out that this isn't only a lucrative activity for the Japanese housewife, and that he was effectively able to do the same from his own living room:

"As a retail investor in Holland it is easy to short yen and invest in something else. You only have to open a brokerage account with InteractiveBrokers and you can do the same yen carry trade as these japanese house wives. I am doing it myself and invest the money in gold, commodities and mining companies. Gold expressed in yen is certainly in a bull market. JPY JPY LIBOR1 (Spot-Next rate) 0.613%"

So why is this important, well let's go back to what happened in Austria in the late 1990s. Dimitri Tzanninis explains the situation like this:

The practice of borrowing in foreign currency (mainly Swiss francs) began in the western part of the country, where tens of thousands of Austrians commute to work in Switzerland and Liechtenstein. This partly explains why the share of these loans was higher in Austria, even during the 1980s. Word of mouth and aggressive promotion by financial advisors helped spread the popularity of these loans to the rest of the country. By the mid-1990s, newspaper ads placed by banks began to appear, fueling public interest.

Now Dimitri Tzanninis refers to this as an example of "herd behaviour" (see note at foot of post), in the sense that the process is clearly non-linear, and subject to some kind of press driven and "word of mouth" process. The following charts of news stories in the Austrian press sum the situation up pretty well:

Now all of this could simply be though of as anecdotal, until we take a look at what is happening right now in New Zealand:

The New Zealand dollar rose to its highest against the U.S. currency since the central bank intervened on June 11 as the yield advantage enjoyed by the nation's debt widened.

The yield spread between New Zealand's December 2017 government bond and 10-year Treasuries rose to 1.68 percentage points, from 1.49 points on June 12, after a report showed a drop in U.S. home building. New Zealand's 8 percent benchmark interest rate is the second-highest after Iceland's among Aaa- rated countries, fueling a 22 percent gain in the currency in the past year.

The New Zealand dollar also rose to its highest in almost 20 years against the yen. It has gained 31 percent against Japan's currency the past year, buoyed by so-called carry trades, where investors borrow at Japan's 0.5 percent rate, the lowest of the major economies, to buy higher-yielding assets elsewhere.

Japanese individual investors, who have set up 600,000 accounts to trade currency with borrowed yen, stepped up purchases of the New Zealand dollar after the Reserve Bank said it sold the currency.

600,000 individual accounts, and from Japanese retail investors who are allegedly conservative and exhibit historically "home bias" (just like the Austrians in the mid 1990s?)! Clearly we have a "herd-type" phenomenon in Japan right now, and one which increasingly places central bankers under a lot of difficulty when they want to intervene. The long term implications of what is happening are hard at this point to foresee, but they surely are going to be important. Financial de-regulation plus the internet seems to constitute some kind of "killer-app". As Keynes famously said, in the long run we are all surely dead.


Herd Behaviour

I reproduce below the explanation of the herd behaviour phenomenon offered by Dimitri Tzanninis.

Herd behavior occurs when people do what others do rather than rely on their own (incomplete) information, which might be suggesting something different (Banerjee, 1992). The suppression of private information could lead to “information cascades” when decisions are made sequentially and a large enough number of people choose identical actions. In such settings, the decisions of a critical few people early on are enough to tilt group behavior toward a certain direction. Mimicking the behavior of others might be rational because of uncertainty about one’s own information as well as the need to economize on information-gathering costs. Rational herd behavior is the subject of a recent strand of behavioral finance (see Montier, 2002, for an introduction).

Herd behavior can arise in a variety of environments, including in financial markets. However, it is difficult to disentangle empirically the effects of macroeconomic or other fundamental determinants from those caused by herd behavior. Herd behavior often results in volatility because it is susceptible to abrupt shifts or reversals, and thus has the potential to destabilize markets.

Empirical studies have shown that the dynamics of herd behavior often resemble an S curve: initially only a few adopt a certain behavior, but, past a certain critical mass, a take-off state takes hold where a rapidly growing number of people adopt this behavior. Toward the end of this process, a moderation of the dynamics takes place as the potential pool of adoptees is exhausted.


Banerjee, A. V., 1992, “A Simple Model of Herd Behavior,” The Quarterly Journal of Economics, Vol. CVII(3), pp. 797-817.

Montier, J., 2002, Behavioural Finance: Insights into Irrational Minds and Markets (Chichester: John Wiley & Sons Ltd.)

Waschiczek, W., 2002, “Foreign Currency Loans in Austria—Efficiency and Risk Considerations,” in Financial Stability Report 4, OeNB, pp. 83-99 (Vienna: Oesterreichische Nationalbank).


Anonymous said...

i was curious to know some detail about carry trade.
Lets say i live in japan, and i can get home equity of say 1 million yen. how do i invest in New Zealand?...do i buy NZ mutual funds/stock or NZ government bonds...or NZ bank deposits??

this means Japan is fuelling inflation all over the world by giving ultra cheap credit.

how can other countries fight this?

Anonymous said...

I too don't really understand how this carry trade works. Which countries are the winners and the losers in this transaction? What's the catch? This sounds too good to be true for the Japanese. It this some kind of bubble that will eventually explode?

Edward Hugh said...

Hi you two,

I understand your bemusement.

"I too don't really understand how this carry trade works."

Well don't feel alone, since I don't think anyone really does. Of course the mechanics of it are probably reasonably simple at the individual level, you open a trading account somewhere and go to work.

The margin trading is an interesting phenomenon, because it seems that people are able to borrow money on the basis of the notional gains that they have in their portfolio. This is rather like doing mortgage refinance on the basis of the book value of the equity in your home.

"how do i invest in New Zealand?...do i buy NZ mutual funds/stock or NZ government bonds...or NZ bank deposits??"

Well I don't know for sure, since this is not my area - I am certainly not a trader - but I imagine you chose the instruments you want, and then press the buy button, and then again the sell one when you want to change. The key cost determinant is probably the transaction charge (commission) that you pay.

I would emphasise here that I am NOT a specialist in any of this. I am a macroeconomist, but what I am finding is that it is impossible to understand "macro" phenomena any more if you don't factor in financial flows somehow.

This is to do with the traditional notion of "capacity" we have been working with (each economy is assumed to have a certain capacity for trend growth). Globalisation of both labour (migrant flows) and financial markets means that these old ideas of capacity are rather out of date, and we need to start thinking about the supply and demand for labour and capital on a global scale. ie we need a change of mindset.

Perhaps the first person to raise this question in any systematic way was Richard Fisher of the Dallas Federal Reserve, and this early speech of his still makes interesting reading. As Fisher says:

Globalization is an ecosystem in which economic potential is no longer defined or contained by political and geographic boundaries. Economic activity knows no bounds in a globalized economy. A globalized world is one where goods, services, financial capital,machinery, money, workers and ideas migrate to wherever they are most valued and can work together most efficiently,flexibly and securely.

I think that it is important to note that individual (retail) carry trading is only one part of the picture here. There is also a fairly large institutional carry trade (although no-one really knows how large), then there are remittances from migrants, and last but not least, there is inter-bank borrowing between countries, which is a rapidly growing phenomenon.

The BIG implication of all of this is that central banks are steadily losing control over monetary policy, or, better put, the traditional instruments of monetary policy are becoming less and less effective.

"this means Japan is fuelling inflation all over the world by giving ultra cheap credit."

Well it isn't just Japan, as I am noting in this post, the Swiss Franc is also a significant part of the picture.

In Eastern Europe it is the euro that is playing an important role in foreign currency denominated lending in Eastern Europe (70% of housing loans in Latvia, eg, are now in euros). The Eastern Europe situation is particularly important since the central banks there really do seem to be losing the battle.

"It this some kind of bubble that will eventually explode?"

Well I wouldn't call it a bubble, but it does form part of a huge readjustment process. Essentially we need to think of a global, rather than a local (national) economy here, and think about Global capacity. The global market is gradually moving towards a new equilibrium. Basically, in this context, national states, national policies, and frontiers, constitute market imperfections.

Will the transition to a new equilibrium be a smooth one? What will the final end state look like? This is all impossible to tell at this point. If you have a scientific mind, and are curious, then all of this constitutes an incredible experiment, if not, well......

Of course the bottom line about this transition is that we are moving from a situation where roughly one billion people out of a global population of 6 billion could have been considered "rich" to a situation where 20 years from now 5 billion out of 7 billion might be considered to be so.

Limits to this? Well one limit on global capacity, with births rates falling almost everywhere is going to be labour (this is why we will find a new equilibrium), another capacity constraint - as we are seeing - is the supply of raw materials and food (as living standards rise, people are all eating more), and also as all this growth continues there are likely to be climatic implications.

Back to this for a moment:

"this means Japan is fuelling inflation all over the world by giving ultra cheap credit."

As I say it is Japan, Switzerland and (via the Eurozone) Germany. Claus Vistesen and I are working a Modigliani type life cycle model of savings and consumption to try and identify how it is that these countries are able (and even condemned, at least for the time being) to have very low interest rates. Basically this issue is why there is a lot of pressure on the ECB and the BOJ from the G7 to keep raising rates.

As we are seeing this is proving very difficult indeed for Japan, and there are now real questions about how far the ECB can go, and whether rates there will need to turn south at some point.

Well, this has been bitty, but I hope some of it was helpful.

how can other countries fight "this?"

Don't fight what you can't fight, and go with the flow. And remember all those poor people in the third world who are so obviously benefiting.

And, BTW, I severely doubt that the impact of all this globalisation is going to be inflationary aside from local housing booms and an upward pressure on commodity prices in the main it is likely to be disinflationary.

Edward Hugh said...

Brief Update:

Wim was back in again on Claus's post, and made the following observation:

Yesterday I had not so much time and copied and pasted the benchmark rate which is today 0.608% I pay on top of that 1% ; in total 1.608%. This you have to compare with 7.3% for debit in dollars and 6.07% for euro's.

He also gives the following link if anyone is interested in exploring a bit more the kinds of financial services which are on offer.

He makes this point:

1.608% is of course laughable; however valuta risks certainly not. That's the reason I am interested in your weblogs. How and when will this insane interest rate in japan end?

to which Claus responds:

And then to the more serious thing, when will it end in Japan? Of course, your guess is as good as mine but in order to understand my position on Japan you need to think about demographics. I mean, this is basically it and since Japan is the oldest society in the world (in terms of median age) I think this has a very strong long term effect on capital flows and thus interest rates. At the end of the day I don't see how the fundamentals of the carry trade is going to change any time soon and really the only way it can stop (IMHO) would be for financial globalization somehow to kick into reveres and put a limit on how much/many leveraged short positions and FX crosses you can make with Yen and any given other currency. I don't think this will happen so this show will go on for some time I think.

Of course the BOJ might raise to 0.75% and even 1% but that would hardly budge the carry trade I think. Basically, I think that the interest differential between Japan as an old and ageing economy and a comparatively young economy such as for example NZ will remain pretty wide for some time ahead albeit not as wide as it is now. Incidentally, I think that it is much more likely that central banks (ex the BOJ) will go south rather than the BOJ continuing its normalization process.

Edward Hugh said...

I also sent Claus some thoughts in a mail, and I am quite happy to share this. They are, I emphasise, simply thoughts, musings....

Again, we need to think financial market efficiencies, markets as self-organising systems etc etc. here. Basically the "Austrian" view (in the economic theory sense) has never been a fully "free markets" one, since it has been a weird combination of economic liberalism and social conservatism, with the Central Banker playing the role of moral judge. This is the ideological configuration which I think is now falling apart.

Remember Joaquim Fels MS and inner circle at the ECB) and some of the key people at the BIS are Austrians. So they have a moral panic about liquidity, but if you really believe in markets you should actually be helping all this flow towards its natural equilibrium point (but to do this, I think, you need to understand demographics).

The G7 meet last summer seems, in hindsight, to have been like a kind of Alamo last stand.

Maybe they will try again, but they are surely on a losing battle.

One thing that does strike me is this idea of the savvy Japanese housewife , or retired European (like Wim perhaps) who spends their free time (thus housewives and early retirers) playing the game against the institutional investors AND WINNING. I don't think this is at all impossible, since what you need is some basic idea of macro, and to best guess the next move of the institutional investors, who in this context are more like dionosaurs.

So could we see individually managed pension funds as a growing trend (I mean it only needs the first big pensions crisis to put the fear of god in people here). If people found that they were successful could they live from this? What would it do to labour market participation rates in ageing societies?

Basically this may be another example of how the internet has empowered the small guy. Maybe in self-organising systems without externalities of scale (openness of information changes this somewhat) small IS beautiful.

CV said...

In terms of the very specifics on the carry trade, wikipedia as ever is pretty informative ...


Remember that in order for this to work it has to be leveraged which essentially means borrowed. As such it does not work for a japanese retail investor to just take out money from his bank account and invest them in Kiwis (New Zealand Dollars). I mean this would just amount to a normal exchange. No, he needs to borrow at 0.5% or whatever and reinvest in an assset denominated in NZDs. In this respect Techy2468 government bonds are the favored weapon of choice.

All in all, what you need to understand is that it is the leverage which makes this potentially very profitable since as long as the interest rate differential (i.e. relative currency fluctuation) remains in favor of the trade you can earn a lot of money. Of course if the tide turns and the shorted currency appreciates then you need to pay up and the more you have leveraged, the more you need to pay. This is then what makes it a bit worrying, I think, that retail investors are doing this since they could, litterally, get bankrupted if they don't know when to exit and of course if they leverage too deep.

To give you a concrete example here the basis Saxo Bank trading account (of which the minimum deposit is 2000 US dollars) allows 20:1 leveraging. This means that for 2000 USD you can command a position of up to 200.000 USD in the market. I am not sure what the internet based trading accounts offer in terms of leverage, probably less but still enough to wreck havoc in many households I imagine.

In order to ram this home I want to show you a post by Steen Jakobsen from Saxo Bank. Now, Steen is the head of the banks macro hedge fund and over at his blog (see link below) he posts about market strategies and plays.

For our purpose here, his latest post is very interesting ...


Now, try to scroll down to the screenshot of the 'G-10 carry basket' and you will see a textbook example of a carry trade basket in this environment which of course changes on a daily basis but let us leave that one out now. Given the percentage values let us assume that this carry basket has an intrinsic value of 100 USD. SO what does it mean then.

As you can see, the short end of the carry basket which is of course leveraged but we don't know with how much consists of all the usual suspects, 33% Yen (JPY) 33% CHF (Swiss) and 33% SEK (Swedish). I am not sure about Sweden did they not just raise rates :)?

Ok, then have a look at the long basket; 25% USD, 25% NZD, 25% AUD, and 25% GBP.

Immediately you should note the degree of hedging here too. Of course, Steen knows that for all his experience he might be wrong which means that in any given context it could be very risky (but also profitabel) to go say 100% short Yen and 100% long AUD. In this way, this is not much different then from going down to your local bookie placing bets on Premier League matches ... you will have a tendency to hedge your bets.

Now, in terms of the game itself it is all about math and I won't go into this here. E.g. what if JPY appreciates against the USD and depreciates against the NZD during the duration of the play etc? All in all, this bet is more or less hedged unless of course the whole system cracks down on Steen and the ENTIRE long basket depreciates against the ENTIRE short basket.

Ok, I hope this helped

Edward Hugh said...

Very interesting Claus. In the Steen Jakobsen link I couldn't help noticing this:

I firmly believe that when Central banks decides to make a stand, the do make a stand ... remember 2000 and EURUSD intervention ? That the market tests them is only natural, ultimately ALL central banks and politicians who believe they can CONTROL the markets will fail and pay the price.

Going back to what I was saying earlier, if the BoJ is structurally unable to raise due to weak domestic demand the it is harcd to see what the CBs can do.

Now according to supply and emand theory this could go on till liquidity in Japan starts to feel the strain and there is upward pressure on internal interest rates coming from this trade. This is still a very long way off I think, but it does represent a theoretical limit.

The interesting thing is that the BoJ would then lose control over ITS own monetary policy, and the deflation issue would become quite large, especially if the trade steadily unwound and the yen was pushed back up again in the process (which would only sink deflation deeper). It is important to keep in mind that Japan has fallen back into some small deflation despite the impact of rising oil prices in yen terms and the very low value of the yen. This doesn't augur well.

At the end of the day this is all a kind of payback for those who refused to think seriously about why the deflation problem existed in Japan, and what the implications of its continuation would be. I think people ignore this issue in Japan at their peril.

Obviously there are still a lot of things we don't understand here, and the scientific mind has a lot to learn going forward.

Of course, one other way in which all this can eventually unwind would be via an easing process lead by the federal reserve, since if global interest rates started to fall, then the advantages of this trade would reduce in proportion.

But this will bring us back to the whole issue of the CA surplus and CA deficit nations, and to just how much of the burden of the global imbalances unwind it is reasonable to expect the US CA deficit and the US consumer (in terms of indebtedness) to withstand.

Anonymous said...

i am not an economists, so please excuse my ignorence.

1. few countries like usa, india etc.. cannot lower interest rates because of inflation.

2. I still dont know how china is managing a growing economy with low interest rate, will that not fuel rampant inflation, unless they have restricted banking (no easy loans).

3. Japan is keeping rates low to keep its currency weak and to help its economy and they have substantial export earnings hence they dont care if their currency keeps falling.

so in other words they dont care if their cheap yen is getting exported by the tons (they are happy to supply more by their printing press, since its not leading to inflation in their economy).

If japan wants to stop this its pretty easy, put restriction on outflow...

but maybe it is profiting from this (earning interest on infinite money, who will not like it.......too bad i cannot print money it will be a crime)

india is fighting this kind of inflow by putting restrictions on inflow.....but i am not sure they are tight enough.

lets say japan does not increase their interest rate and NZ and AU cannot put inflow restrictions....

which means that NZ and AU cannot control inflation in their economy because their interest rate is ineffective....cheap money is flowing in from somewhere else...

unless they try to sop all the excess liquidity by issueing sterlizing bonds.....which means that NZ & AU CB is paying interest to the carry trader who is paying interest to BOJ.

its kind of funny....BOJ keeps sending money to BO-NZ, even though BO-NZ do not want it.....what a nice way to earn some free bucks.
(or i am totally off, please comment)

in a way this means that central banker's policies are not going to have any effect....unless they all work in unison.

Edward Hugh said...


"i am not an economists"

Hi, yes, I appreciate this. As it happens you have stumbled upon one of the most complex topics in contemporary economics. So don't feel too bad if you are having a hard time with this.

All I can suggest is that you just keep reading around.

But see the latest post on the carry trade, and remember the discussion we had about indebtedness and consumption in the US. Clearly Japan in some senses needs to export liquidity, and while I am sure that there is no plan here, it is quite a fortuitous "unintended consequence" for them.

"its kind of funny....BOJ keeps sending money to BO-NZ, even though BO-NZ do not want it.....what a nice way to earn some free bucks."

Well, it isn't actually the BoJ that is consciously doing this. They have a given problem set. They are fighting inflation and trying to help Japan get the growth it needs to maintain its debt (remember that with a growing % of elderly people this fiscal pressure is only going to grow and grow).

The only other alternative - almost literally - is to raise interest rates to international levels, fall back into serious deflation (and remember reversing the flow of funds would push up the yen and add to deflationary pressure (a double whammy). This would almost certainly produce an eventual sovereign default, and this really would be a major global financial markets nightmare.

So you need to remember that the options here are limited. Very limited.

"in a way this means that central banker's policies are not going to have any effect....unless they all work in unison."

I'm not sure that even acting in unison they can do very much here. They have after all been trying for a year or so now, and you can see where we are.

I think the key here is going to be to watch Germany as the ECB tightens. If Claus and I are right and there is an eventual problem in Germany the who cb united front will collapse rapidly, and then we are into a whole new "game play".


"few countries like usa, india etc.. cannot lower interest rates because of inflation."

are you by any chance Indian? I am in the camp which is rather less worried about the whole India "overheating" discourse". I am rather tired of continuing to see so many children under 5 dying in Northern India. If the trade off is to have a bit more of a bumpy ride on inflation in India, but get faster growth and bring down child mortality etc rather more rapidly, I am for taking the risk.

I posted something on Japan and India on the India economy blog here, this piece by Nandan is also interesting.

Balaji Viswanathan is also a techy and not an economist, but has a very interesting take on the India inflation issue with which I am in SOME agreement.

Anonymous said...

yes i am a indian in USA, still have plans to go back to india (due to extended family).

right now i am really concerned about india.
1. despite all the growth, they are all export driven due to undervalued currency
2. they have all been funded by cheap credit from abroad.
3. i have still not heard of domestic consumption getting off in a big way (compared to asset inflation)
4. asset inflation has gone out of bounds, and it will be painful for the masses when it crashes (like japan)

5. infrastructure is still built/maintianed by government, which is very very inept....since they dont care for the country other than more money for themselves.
6. private sector cannot get into infrastructure due to red tape and bureacracy.

i still have no clue how the common man is going to survive the current inflation, since wage increase will not follow the inflation rate due to high unemployment in all sectors excluding IT/ITES

Anonymous said...

i will like to add that a violent social unrest may follow since common man is losing his life to this rampant inflation....induced by export driven industries of few people