The Monetary Monster That Is Flight to Safety
The European Central Bank (ECB) undertook Longer-Term Refinancing Operations (LTRO) as means to quell the global banking crisis that had re-emerged in the latter half of 2011. The massive size and scale of the operation, in addition to its unconventional 3-year term, was supposed to send a strong signal that monetary authorities finally received the message "markets" had been sending since mid-2010. To pile on the monetary message, the Federal Reserve cut the cost of its dollar swap line arrangements by half, opening the door for a period of sustained $100+ billion in momentary usage. The message was sent out that Europe would be firewalled and contagion had been forcefully confronted.
In light of such policy positions and the inference of forceful will such policies seek to exude, it is little wonder that the nationalization of Bankia (Spain's third largest lender) this week was met with more than a little surprise and angst. Of course, the Spanish government will deny that Bankia was insolvent, merely resting from a period of illiquidity undeservedly forced upon it by the mess of weak-willed individual investors. And that sums up the dogma of central bank policy in this age of bank-first solutions - illiquidity is derived from irrational investors following the wrong course, so liquidity measures that cajole individual investors back into the fold are the only proffered solutions.
Liquidity measures certainly have bought time for the struggling financial system, as the propping and pegging of prices and interest rates has grotesquely interfered with markets' collective abilities to discover inefficiencies and clear them. This has been accomplished due to the vain ideal that banks are the economy, and the economy is the banks. That expensively purchased time has allowed struggling institutions to simply get into further trouble, doubling down on the very mechanisms that brought about dysfunction in the first place. Spanish banks buy more and more Spanish government debt with this temporal space afforded through LTRO's and dollar swaps, while Italian banks buy more and more Italian government debt (or the Italian government guarantees Italian bank debt so that Italian banks can offer that as collateral with the ECB so those same Italian banks can then buy more Italian government debt). This is a rigid trap by which no real progress can be made since it is really market prices that bring about such progress. Central banks are intentionally disabling the mechanism of self-correction.
Whenever these liquidity solutions inevitably fail, however, there is an apparently unshakable notion that in times of turmoil investors run to the safety of America and the US dollar. It is a myth that serves to undermine the true cause of all this unending financial turmoil. As long as this myth persists in the public mind, US dollar policy is never viewed in the true light of factual clarity. That clarity disposes of any notions of responsible stewardship of our nation's currency (and by extension, the economy).
The single-biggest complaint of the gold standard in the 1930's, from the perspective of central bankers looking back at the series of historical mistakes that made up the period, was that its rules and mechanisms imposed rigidity on the global monetary system. That rigidity served to blunt any stimulative impulses from individual or collective central bank action (Chairman Bernanke calls this central bank flexibility). Worse, though, the gold standard, as this line of thinking goes, was the primary mechanism for transmitting financial and monetary distress all over the world. Given the immense academic effort to demonstrate all this, we are left to infer that the system that was rebuilt in the wake of the Great Depression and Second World War incorporated knowledge of this rigidity, improving the actual function of the global monetary system.
The final solution to the rigidity problem was enacted in 1971 when President Nixon ended gold convertibility of the US dollar. All vestiges of the shackles of gold were swept into the past. From that point forward, the Federal Reserve had both no more excuses and full powers of flexibility to remit monetary imbalances toward whatever ends the Fed saw fit. That flexibility has changed over time in methodology (from a system of targeting bank reserves to a system that now tenders unlimited bank reserves to maintain an interest rate target) as has the Federal Reserve's willingness to assume a primary economic role. Indeed, the ascent of interest rate targeting has been directly proportional with the expanded role assumed by the Fed.
Interest rate targeting itself was an open invitation to financialization, and a death knell (at least marginally) for depository banking. The mechanism for controlling or growing the banking system shifted from deposits of actual cash to accounting notions of ledgered money and equity capital, all greased by financial collateral. The source of the pyramid of fractional lending would be the interbank wholesale money markets - Fed funds and eurodollars. Since both are really nothing more than accounting items on the central bank or primary dealer ledger, control was easy (so was reckless growth), at least in theory. Central bank control over the supply of credit would not be hindered by a system where gold was pyramided into various forms of money and credit, this new system would allow money to be conjured almost on-demand, but closer to the end user.
To punctuate this point, we need only to go back to a July 1971 paper by Milton Friedman, published in the Federal Reserve Bank of St. Louis' Review magazine. The introduction to the piece, ironic in that this paper was nearly exactly contemporary to the end of gold convertibility, describes fully the magnitude of the change in money:
"The Euro-dollar market is the latest example of the mystifying quality of money creation to even the most sophisticated bankers, let alone other businessmen. Recently, I heard a high official of an international financial organization discuss the Euro-dollar market before a collection of high-powered international bankers. He estimated that Euro-dollar deposits totaled some $30 billion. He was then asked: ‘What is the source of these deposits?' His answer was: partly, U.S. balance-of-payments deficits; partly, dollar reserves of non-U.S. central banks; partly, the proceeds from the sale of Euro-dollar bonds.
This answer is almost complete nonsense... The correct answer for both Euro-dollars and liabilities of U.S. banks is that their major source is a bookkeeper's pen."
Before the gold window was ever closed in 1971, as Milton Friedman himself was describing in his paper, the global banking system was fully on its way to becoming nothing more than a phantom of accounting. Closing the gold window was not the beginning of the fiat age, it was simply the final acknowledgement that the banking system had already moved on or "evolved". The banking system had become almost fully unanchored by "tradition" (whether that was a gold or physical cash-based system, both ideas were well on their way to being historical anecdotes by the dawn of the 1970's), meaning that the clearing of any monetary imbalance would also require the work of a bookkeeper's pen. The problem with now being nearly fully reliant on accounting, particularly as the system "progressed" in the late stages of the 1980's and into the 1990's when the Federal Reserve moved fully to interest rate targeting, is that traditional mechanisms for self-correcting imbalances were now as historical as the banking standards that they were related to. And that was by design.
Gross monetary imbalances would now rule the game, as politically they were used as a methodology of "defeating" or "smoothing" the business cycle. Imbalances were no longer problems in need of solutions, they were solutions to or for the utopian ideal of the never-ending engineered economic boom.
The greatest and most persistent imbalance has been those eurodollars. The regulatory attractiveness of eurodollars was itself an invitation to grow global monetary imbalances to massive levels, heights that were guaranteed to be unchecked by central banks in "full economic control" mode. That meant the US was the primary beneficiary of this growing credit production machine, but it also meant that global banks would be chronically short US dollars due to their maturity transformation of "money".
The eurodollar market led to a complete revamping of banking operations all over the world, turning global banking concerns into "hub and spoke" operations - where local branches were the spokes that generated local currency deposits which would then be forwarded or transferred to the hub, usually in London. The hub would "invest" those deposits through fractional dollar creation. US dollar assets would be the beneficiary of these phantom dollars - phantom in that they were never issued nor "blessed" in any way or by any form of official US source (are they even legal?). Dollar prices of everything, including the systemic cost of money, were inflated by the bookkeeper's pipeline of new money. The nearly unlimited potential of phantom dollars drew out the desire for securitizing anything and everything to match actual scale to that potential.
On the "good" side of the asset bubbles, no one really knew nor cared to know just how much of an imbalance in US dollars there were. We still don't really know the scale of the dollar imbalance, but it keeps showing up annually during each new phase of the same old banking crisis.
The Bank for International Settlements, in an October 2009 paper, tried to calculate this imbalance, but could only estimate upper and lower bounds, and came up with a wide range at that. At the lower bound, the BIS authors suggested that:
"...the major European banks' US dollar funding gap had reached $1.0-1.2 trillion by mid-2007. Until the onset of the crisis, European banks had met this need by tapping the interbank market ($432 billion) and by borrowing from central banks ($386 billion), and used FX swaps ($315 billion) to convert (primarily) domestic currency funding into dollars. If we assume that these banks' liabilities to money market funds (roughly $1 trillion, Baba et al (2009)) are also short-term liabilities, then the estimate of their US dollar funding gap in mid-2007 would be $2.0-2.2 trillion. Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion."
The global banking system was short at least $1 trillion, but perhaps as many as $6.5 trillion - more likely some number in between, but that mid-range number would still be mind-boggling. The acuteness of that shortage was felt in the full brunt of crisis in 2008. What was really a dollar shortage of Eurozone banks became a nasty feedback loop of financial disaster everywhere, finally forcing the Federal Reserve to officially acknowledge some responsibility for all these phantom dollars in its belated creation of dollar swap lines to various other central banks. It was an unmitigated disaster, yet the dollar overhang remains largely unchanged by all the events of the past four years.
The supposed stewards of the currency of the United States (including the Treasury Department), purportedly still adhering to a strong dollar policy, allowed the global banking system to create, on its own, a system where as much as $6.5 trillion in US dollar assets were supported by nothing more than the stroke of private, global bank bookkeepers' pens. The mythical flight to safety results when that shortage fuels an unthinkably destructive short covering spree - phantom dollars actually disappear even more easily than they were conjured. Medieval alchemists were looking in the wrong place, they needed only to invent bank accounting.
Alchemy, in the modern monetary sense, took the form of this massive dollar imbalance. By the 2000's, just after the supposed golden age of monetary engineering, the Great "Moderation", phantom dollars were amok. The Federal Reserve thought it had everything under control, while the public was hypnotized by the monetary apathy engendered by rapidly rising asset prices. The scale of imbalance was/is amazing, and should have been a wake up call that control was really an illusion, and such apathy was dangerous. Again, from the October 2009 BIS paper:
"The origins of the US dollar shortage during the crisis are linked to the expansion since 2000 in banks' international balance sheets. The outstanding stock of banks' foreign claims grew from $10 trillion at the beginning of 2000 to $34 trillion by end-2007, a significant expansion even when scaled by global economic activity. The year-on-year growth in foreign claims approached 30% by mid-2007, up from around 10% in 2001. This acceleration took place during a period of financial innovation, which included the emergence of structured finance, the spread of ‘universal banking', which combines commercial and investment banking and proprietary trading activities, and significant growth in the hedge fund industry to which banks offer prime brokerage and other services."
This cannot be described any other way than as an intentionally imbalanced system that was allowed to fester solely because it was achieving the short-term political ends of central banks. This was not partisan political maneuvering either, it occurred amongst all parties and amongst different types of global governance across the face of the globe - even across different decades, as I have tried to briefly chronicle here. No one in a position of power challenged this paradigm because asset prices were artificially rising, especially the two largest bubbles in human history ($34 trillion in foreign claims will do that to global asset prices). As long as some of this phantom money led to some marginal short-term economic activity that made the global economy appear to be robustly expanding, intentional imbalances were celebrated as genius.
Greece may be a small economy, but the ripples of global bank dysfunction through these massive monetary imbalances end up with a crash in the US stock market (May 2010 & July/August 2011). That is the rigidity these imbalances have imposed upon the banking system, a system that is in no way an improvement over the conventional critique of the gold standard. At least under the classical gold standard (not the gold exchange standard that existed in the 1920's and "permitted" or encouraged central bank sterilizations) the massive imbalances would never have gotten so out of hand.
Rather than allowing self-corrections to alleviate massive imbalances, we are left with sudden shocks of attempted self-correction. Wholesale money markets become a deadzone of liquidity, dollars become short because of this massive global overhang, and stress is globally transmitted in every global marketplace as at least semi-panic (if not full-blown panic) selling of dollar assets, followed closely by FX turmoil as investors get rocked by confusion. And central bankers then decry the irrationality of individual investors. But it is this massive imbalance of US dollars that assures contagion, not the supposed weakness of free markets - truly free markets would never have seen nor allowed such disproportion. It is the illusion of control that combines the worst aspects of a bank panic with a currency disease unique to the modern, fiat age. And what we have seen since 2007 is that the bank panic can actually be located anywhere, it need not be the US or even Europe. So long as eurodollar participants catch the disease in some distant location, it will become the scourge of the global marketplace. Massive imbalances, particularly of the scale we see still today, tend to end up in asymmetrical or amplified fits of dysfunction and despair. Tiny Greece rocks Wall Street and London. Now Spain is on deck.
I have no doubt that when interest rate targeting was being studied for implementation in the 1980's that this never crossed the minds of its proponents, even though the eurodollar market imbalance was "blooming" at that time. As Milton Friedman demonstrated with his 1971 anecdote of the clueless international financier, none of this was dreamed of or even thought possible then either. In this very important sense, the entire age of fiat has been an academic experiment in the incomplete science of monetary economics. The theory that central bank flexibility would rid the global system of gold's rigidity was unquestioned in the "evolution" of modern banking - evolution is unconsciously associated with forward progress, never believed to be anything other than positive.
The imbalance and overhang of global dollars was apparent in the 1980's, yet the literature of the period expressed no lack of confidence in the ability to control it, a hubris that still exists even today (Chairman Bernanke still believes he can turn off inflation in 15 minutes). Monetary imbalances, contrary to centuries of established knowledge, came to be believed as both useful and manageable. Perhaps they might have been on some small scale, but from $10 trillion to $34 trillion in a 7-year period! Given the context of this transformation and all that has happened since that growth ended in 2007, it is absolutely clear that control was nothing more than an illusion, that the financial system as it "evolved", broken from any tether by the end of the gold era, was a Frankenstein's monster that will not, cannot be brought to heal without massive collateral damage.
As events now unfold along much these same lines in 2012, the myth of the flight to safety of US assets will again be reported as an uncontroversial fact. The rise in the relative price of the US dollar against "competing" currencies is not a flight to safety, however, it is confirmation of the financial Frankenstein rampaging without any restraint. It looks like the world still loves the safe harbor of American resilience, and is spun as such, but it is nothing more than the mark of economic experimentation gone horribly wrong. The dollar's rise during crisis, counterintuitively, is a clear indication of its intentional debasement and an indictment of all those that were tasked with responsible stewardship. The myth of the flight to safety is not a source of solace or pride; it is a mark of extreme and international shame.
As it turns out, the shortage of dollars is directly proportional to the smash in asset prices, something that was left out of the academic textbook. Mr. Friedman's international financier would never have figured this out, but I have little doubt that his descendants are well aware of it now.
