Even Greenspan Knew Of the Dangers
While the world awaits the white smoke of quantitative easing from the Jackson Hole conclave, the banking system persists in a state of chronic disorder. This is no benign disorder, either, as it threatens the general welfare of the global economy in much the same way as 2008. So much attention about this persistent, incurable financial malady centers on the general perceptions of south European countries and their tenuous ability to service or repay laden debt. While there is certainly merit to that line of inquisition, it misses the central diagnosis of our dying monetary age.
It is very easy to believe that European banks are currently pressed into relative illiquidity via simple overexposure to PIIGS. It fits the narrative quite well, answering many of the rudimentary questions that complacent or reticently optimistic investors ask.
If we look in more detail at the general landscape of intercontinental credit, we see a system increasingly defined by another funding desert. Rather than learn a valuable lesson from 2008 regarding the potentially fatal rollover risk, banks have simply switched out of "toxic" assets in favor of the regulatory definition of "safety". But that migration away from mortgage structures and products did nothing to address the fundamental weakness of modern bank funding models.
The larger American and European systems are still defined by their general adherence to wholesale money market sourcing. If anything, this method of operational funding has been expanded in the wake of the last existential crisis. Despite a very robust corporate bond market, it has been limited almost exclusively to non-financial firms. That has left the wholesale money markets as the sole source of operational liquidity, with its embedded, unsolved rollover risks. The primary reason for this is quite simple; the mechanics of central bank monetary policy is conducted here. The rise of interbank money markets is the ascendancy and primacy of global monetary policy.
In as much as the European Central Bank has intervened in its own domain, the Federal Reserve is the king of the monetary mountain, reigning over the vast dollar-denominated banking kingdom. The largest European banks have achieved enormous size relative to their home countries by feasting on the once plentiful eurodollar market.
Eurodollars are simply the Wild West of interbank liquidity. Deposits are created, sold and dispersed solely on the whims of the firms that operate within its loose construct. The eurodollar market is the international method for circumventing local regulatory structures and rules, including American bank participants seeking "relief" from the Fed's own requirements. The development and growth of this vast wholesale money market is entirely a product of the banking system's collective desire to expand and grow as big as humanly and hubristically possible.
As little regulatory structure as there is, that does not mean that eurodollars are completely lawless. Indeed, as a dollar-denominated market of overnight and very short-term funds, there is a well-defined relationship between the Fed funds rate (the eurodollar market's U.S.-based equivalent) and LIBOR. That means the Federal Reserve's monetary policy holds a great deal of sway on the mechanisms of cross-border interbank exchanges - interest rate changes domestically get transmitted globally into all dollar-denominated segments of the wider credit system.
When the financial system collapsed in 2008, the eurodollar market was its epicenter. Banks in Germany and Holland failed because of overpriced real estate in Florida and California, yet hardly anyone questions the link between these incongruent geographical realities. For the most part, there was no housing bubble in Bavaria or Amsterdam, yet long established banking concerns were stricken, and then failed by one a world away.
For the most part, bank risk managers will prudently match their asset structure to their liability structure to the best of their abilities. In addition to managing overall durations and interest rate spreads, this also means a sensible policy of matching asset and liability denominations. So large funding exposures denominated in dollars leads to pointed acquisitions of dollar-denominated credit assets.
While this explains the global spread of a dollar-based credit bubble, it has also led to another anomaly currently plaguing the beleaguered banking system. For example, the big Swiss banks have been rumored to be in significant liquidity difficulties, which they, of course, deny. Being based in a currency that is viewed favorably by international investors in light of dollar and euro debasements gives rise to counterintuitive financial problems.
Since they are Swiss banking concerns, their operations are valued in Swiss francs. That means foreign assets and liabilities are marked to the franc. When the asset side of their balance sheets exhibit cross currency harmonization, default risk of credit obligors is the biggest potential problem that can lead into rollover risk. If, however, assets and liabilities are not balanced in terms of currencies, there exists another hidden risk.
If a Swiss bank has proportionally far more dollar-denominated assets than liabilities, for example, a sharp decline in the dollar leads directly to a solvency crisis. The dollar's decline, for the Swiss bank, reduces the "value" of those dollar-denominated assets in terms of francs without enough of an offset to the liability side of the equation. A decline in assets in proporation to liabilities means an erosion of the bank's equity capital buffer, threatening the bank's creditors (who expect to be paid in Swiss francs, not devalued dollars).
As the current crisis continually deepens without any realistic expectation of a complete resolution, investors are fleeing both euros and dollars for the perceived stability of gold and, ironically, Swiss francs. That means a huge inflow of franc-denominated liabilities for the banks, widening and worsening their currency mismatch. From the standpoint of liquidity, it seems like a good problem to have, access to billions in additional deposit monies, but, coming during this currency storm, it enlarges this disconnect between the currency of assets and the currency of liabilities. And this likely explains the recent activation of the Fed's dollar swap arrangement with the Swiss National Bank (Switzerland's central bank), who passed on those dollars to one of the country's financial, but dollar/euro overexposed, giants.
The more the dollar and euro sink, the more trouble it creates for Switzerland. While most commentators cite potential problems for the Swiss export sector as the main reason for the Swiss National Bank's penchant for currency interventions, the real reason behind the moves is the strain these cross currency banking systems are inherently saddled with. When bank asset structures tower over the entire country's economy, even seemingly small moves relative to that overall asset size create growing unease about overall solvency.
We like to talk about bank leverage within the context of the operations of the bank itself, but, in the case of the Swiss banks and many of their European brethren, the banks themselves are nothing more than leveraged expressions of too much money for their respective economic bases - banks are over-leveraged to the real economies of the nations that house them.
As I mentioned above, this leverage is possible only through the existence of eurodollars. Going back to the early part of the last decade, the Federal Reserve fought the dot-com bust with its first experimentation with ultra-low interest rates, through the Fed funds market. We know conclusively that the Fed funds rate directly impacts LIBOR (the Fed itself has studied this link). In other words, the Fed was stimulating interbank credit (and thus wider credit production throughout the rest of the banking system) in both the domestic wholesale money market and the eurodollar market simultaneously. Further, it did so with full knowledge that eurodollar participants would respond to its domestic-based actions - in fact, the Fed counted on global participation in the growing housing credit expansion.
Putting this in terms of the current crisis, the Fed intentionally created the conditions where European banks would overgrow through dollar exposures (since banks want nothing more than to get bigger - give them a path to size and they will follow it every time) to achieve its domestic economic aims. The current crisis, then, is an extension and evolution of the trend our central bank began and fostered a decade ago. I think it is safe to assume that this current situation was never a part of the larger discussions at that time, meaning the Fed was totally unprepared for unforeseen circumstances and side effects to the purposeful, and ultimately miscalculated, interventions into credit. All this in the name of "managing" the economy, under the illusory guise of mathematical precision.
From the minutes of the June 24 & 25, 2003, FOMC meeting, we know that Federal Reserve policymakers were at least thinking about some consequences to their actions. Because their interest rate policy at that time brought record-low short-term rates, they began to contemplate the mysterious and frightful zero lower bound, particularly how that might constrain monetary policy in the future. This opened the discussion for thinking about future episodes where quantitative easing might be used to overcome that zero border, and what forms such a policy might take.
A lot of the discussions settled on the need for inflationary expectations, as well as the perceived mistakes of Japan in the early 1990's and the Federal Reserve in the 1930's. A good deal of thought, however, involved the idea of moving monetary policy outside of the short-term interest rates it has traditionally used for the operational levers of credit control.
Alan Greenspan, Chairman of the Federal Reserve System at that time, correctly and disturbingly noted that, "In other words, we are not by statute or practice restricted to affecting only the overnight rate, which would obviously mean that, when that rate gets to zero, we're out of business." This amounts to an accurate prediction of where we are today. Anticipating this possibility, though the entire committee stressed repeatedly they believed this to be an extremely remote possibility at any point in the future monetary operations of the United States, they introduced several novel approaches to enforcing monetary policy beyond short-term rates.
Among the most interesting, and perhaps will eventually be noted as the most infamous in the future, was the idea of "influencing" of "targeting" long-term Treasury rates through derivatives:
"For example, we could sell a sequence of options on term RPs [repos], covering interlocking time segments that collectively extend as far into the future as desired. In this way, longer-term yields could be influenced and a visible signal of the Fed's desired path of interest rates could be demonstrated. Forward operations in term RPs could be structured in a similar fashion. Alternatively, we could sell put options on longer-term Treasury securities at strike prices associated with desired longer-term yields."
Many have speculated (myself included - without any possibility of confirmation short of a full audit of the Fed's $135 billion in "other assets" on its balance sheet) that this has already become a part of the current unconventional monetary directives. It is a small leap to make, considering the central bank has already engaged large scale outright cash purchases of treasury securities all over the yield curve. Such a powerful statement of monetary resolve would likewise have powerful implications that the public simply does not fully grasp.
In anticipating the possibility of such an irregular policy prescription, Greenspan himself made perhaps the most important observation contained within the entirety of that meeting (the minutes of which run 162 pages):
"My own judgment is that, if we actually tried to target interest rates anywhere along the curve, we would be courting remarkable uncertainties. It was perhaps possible to do it back in the 1930s or '40s or even in the '50s when financial markets and market participants didn't have the degree of sophistication they have today." [emphasis added]
To me, that is the central observation to all of this monetary madness, made by the man probably most responsible for the current path of monetary overuse and financial domination of the real economy. To Alan Greenspan, of all people, blatant monetary manipulation comes at a real cost to financial functioning: uncertainty.
Intentional destabilization, such as willfully devaluing the dollar, can pyramid new problems on top of the old tribulations policymakers are attempting to solve. If the first rule of medicine is to do no harm, then perhaps we should adapt that to monetary policy using Alan Greenspan's own words. In the surrealistic butterfly effect that we see in today's ongoing crisis, the efforts of the Fed to "stimulate" the economy out of the long ago dot-com bubble have led to a frantic fight for survival in Switzerland, of all places, a decade after the policy was planned and implemented.
More important to our discussion here, the same central bank that cleared the path to unbelievable credit-based heights through eurodollar stimulation, has now turned against the very banks that helped it blow the housing bubble by intentionally destroying the dollar to their collective misfortune. Unfortunately, the Fed is still seemingly unaware of just how much its own policies are coming full circle to create the very problems it is always trying to solve. This circular knot of our current predicament cannot be unwound, however, until policymakers move beyond simple questions of monetary interventions to the larger question of whether any interventions are at all or anywhere appropriate.
In discussing those Japanese interventions of the 1990's, the FOMC committee back in 2003 came to another extraordinary and unreal conclusion. The committee felt that the Bank of Japan's biggest mistake was in repeatedly admitting failure , and then responding to those failures by changing policies. The committee felt that this lack of fortitude (or honesty, in my opinion) led to a collapse in confidence of both the Bank of Japan and monetary designs.
This idea is surreal because the Federal Reserve in these last four years has taken this "lesson" to heart by never admitting any mistake nor changing course. Yet despite avoiding Japan's perceived policy errors in this way, monetary policy has arrived at the exact same place: economic stagnation and rapidly diminishing monetary credibility. At no point does the FOMC in 2003, 2008 or 2011 seem to grasp the bigger picture, the one Alan Greenspan fleetingly stumbled upon, that monetary interventions are, and have been all along, a major part of the problem.
