Monday, April 18, 2016

Feds should compensate for hypothetical hostile Saudi transactions

The L.A. Times printed a sensible story about the threats by the powerful men in Saudi Arabia who dislike a new bill passed by the U.S. Congress.

The bill removes the immunity from some folks – Saudi politicians seem to be the most likely targets – who could be found responsible for some damages on 9/11. Saudi Arabia could sell up to $750 billion in U.S. assets, America was told, and that could be very bad, we're encouraged to believe.

Now, I find it a matter of basic justice that the people who demonstrably participated at the preparation of "things like 9/11" must be held responsible. There are surely numerous Saudi citizens in this list. It would be interesting to estimate the percentage of the powerful wealthy men who feel bad conscience – that they had done something wrong leading to the September 2001 attacks.

You know, it's damn rational for people who have done something like that to get rid of the U.S. assets and buy some other assets instead – because these assets may very well be frozen or confiscated. They are at risk. So this "fire sale" wouldn't really be a powerful revenge, as the L.A. Times correctly notice, but a matter of a rational (and perhaps a bit desperate) defense by the Arabs.

Do these evil 9/11-linked Arabs own the majority of the wealth related to the U.S. and owned by the Saudi citizens? Has the whole Saudi financial elite dirtied its hands before 9/11 in some way? Or is is just several black sheep who are sufficiently liked by the remaining Saudis so that everyone in Saudi Arabia will act as a team?

There are lots of questions like that – what is the actual relationship between the 9/11 evil people and the wealthy Saudi men.

And there are the questions about the impact of the interventions. The L.A. Times conclude that the Saudis only own the U.S. Treasuries (bonds) and their volume is probably smaller than those $750 billion unless other Arab nations are added etc. That could be some 10% of the bonds held by foreigners. Would this fire sale damage America? Would it damage the Saudis?

It's often being said that the owners of lots of stocks have extra easy tools to manipulate the markets and make a profit etc. I don't actually believe this general lore at all. In my opinion, it's the other way around. If you own lots of stocks, namely \(N\) stocks where \(N\) is large, you can't quite assume that you own the amount of money equal to \(N\) times the price of one stock.

If you try to sell too many stocks at the same moment, you will face liquidity problems i.e. you will run out of demand (of buyers). The 1,000th stock you need to sell will have to be sold to someone who isn't thinking about buying at the current price. You will have to allow the price to drop, and sell the average stock for a lower price than the first one.

(A big stockholder may have one genuine advantage – the control over the majority of the company. But that isn't possible for the holder of treasuries.)

Even if the Saudis managed to sell something like $750 billion in U.S. bonds or stocks, they would be pretty much guaranteed to lose. As I said, the average stock/bond would be sold for a lower price than the current one. On the other hand, the depressed price would be a buying opportunity, so the prices would almost certainly start to regain parts of the losses. If the Saudis wanted to buy their old stocks/bonds again, they would probably have to buy things at a higher price than the price at which they were selling – it means a loss for them.

The previous paragraph assumed that they wouldn't ignite a mass hysteria that would encourage other holders to sell as well. If this were the case, their activity could be very dangerous.

But I think that the danger is minimal. Even if they did such a thing, the Federal Reserve or other central banks or governments may intervene. If I simplify things, they may pretty much buy everything that the Saudi holders have sold. So if it is known that $750 billion of Saudi-held U.S. Treasuries are suddenly pumped into the market, the Federal Reserve could simply buy exactly the same amount, or buy the amount needed to return the price to the level that existed before the sale by the Saudi.

The Feds could allow a day or two at a lower price, to guarantee that the Saudis make a loss, and even announce this plan in advance so that no one panics too much.

If the Saudis sold the U.S. Treasuries, they would first hold U.S. dollars because the Treasuries are denominated in the U.S. dollars. They could sell these dollars as well. It could lead to a weakening of the U.S. dollar. If this happened to be an excessive swing in the currency exchange rates, it could be compensated as well. The currencies that the Saudis would buy – assuming that they would buy currencies – would strengthen due to the increased demand, and the corresponding central banks would probably not like it too much.

For example, if the Saudis sold the U.S. dollars and bought lots of euros (or Czech crowns), I think that it would be sensible for the European Central Bank (or the Czech National Bank) to print the euros (crowns), sell it to the Saudis, buy their dollars, and increase its dollar reserves. Again, there could be a few days in which the rate is allowed to be distorted by the Saudis' operation.

But my basic point is that if there are macroscopic interventions by others into rates and prices etc. that are basically known; and that are known not to be driven by market considerations but e.g. by politics, I do think that it's basically right for the central banks to protect the stability of the market and simply compensate the external perturbations as accurately as possible.

As you know, I am not in favor of interventions as a matter of principle because the invisible hand of the free markets is the most skillful hand that knows how the prices should be moved. But the hypothetical Saudi sale discussed above is a "hostile intervention" by foreign agents, and it sounds sensible to me that the central bank makes a reaction to this action – according to the third Newton's law – because it should ultimately be a task for the central bank to keep the domestic markets relatively stable and safe against big financial earthquakes.

Even if the central banks haven't written down clear plans how to protect the markets in similar situations, I think that there is a general expectation that they would act in a similar way if a similar "attack" (the second wave of 9/11 focusing on the financial markets) took place. And because the market participants generally do expect the Feds or other central banks to react as defenders, it's a reason to think that they will not react hysterically by joining the Saudis' fire sale, and that's an additional reason to be convinced that the fire sale would mean nothing else than a significant loss for the Saudis.

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