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Sometimes economic theory and reality don’t really match (stop laughing, will ya! ;-)). Carry trades are an example of such discrepancy. If you take out a loan in a currency that offers low interest rates and invest the money into a currency that offers high interest rates, you “carry trade” the money from one currency to another. Theoretically, this shouldn’t work in the long run. Let me explain to you why.
Higher interest rates result from either higher inflation or higher real returns on capital, which occur as a result of a scarcity of capital or of a more productive economy. If the reason is higher inflation, then the exchange rate of the currency should weaken until any gains from your carry trade are erased. If the reason is higher real returns on capital, then the carry trade should expand the availability of capital in this economy and thereby lower the returns on capital, realigning the interest rates between the two currencies.
In the real world, there have been cases in which something different happened. For instance, Japan has ultra-low interest rates since 10 years or so. Carry traders took the opportunity, especially between 2003 and 2008. Nevertheless, the Yen exchange rates got weaker and weaker during that rather long time period. The same happened with the Swiss Franc during the same time period. The Euro became stronger between 2005 and 2008, although interest rates rose to over 4%, making it a destination currency for carry trades.
Some people go so far to argue in favour of regulations to ban carry trades. They call them irresponsible, detrimental actions against the economies that are suffering either too high or too low exchange rates. Fact is, the examples that I have given are few special cases. I can give you counterexamples: The US dollar had relatively high interest rates during 2005-07 and it depreciated as it should, according to theory. The same goes for Japanese Yen and the Swiss Franc between 1998-2002, but in the other direction. The behaviour of the Euro between 1999 and 2005 also fits the theory more or less.
Furthermore, carry trades have to adhere to basic principles of economics, too. The exchange rate is determined by trade flows and capital flows (e.g. investments). Investors would behave irrationally if they drove the exchange rate far away from some kind of “equilibrium” level that arises from the trade and capital flows. Someone has to explain to me why all investors should behave irrationally in currency markets. The incentive to make a profit out of such an exchange rate deviation would be very large. The only irrationality that I can think of would be the market panic of 2008, when the US dollar rallied, but that has been a short-term phenomenon (which is basically a synonym for irrationality, in my opinion).
I think that carry trades simply speed up the process of curreny adjustment in most cases. I know that the so-called Uncovered Interest Parity hypothesis has been empirically falsified. But the reason for this is that people are risk averse and that high-interest currencies appreciate because they have higher real interest rates, not higher inflation rates.