Financial Imbalance In Search of Inevitable Reckoning
It must have been heartening this week for the world's orthodox economists to see that the most basic conception of rational expectations theory borne out in Russian domestic "demand." At its heart, the economics profession views "inflation" as somewhat synonymous with economic growth because of this adherence to "aggregate demand." Thus, as the thinking goes, if inflation expectations were to rise, economic agents would act upon those expectations today by purchasing or building before costs actually do rise.
The Russian example this week was likely more toward an extreme than any economists might admit comfort, coming closer to hyperinflation rather than something like a positive economic agent. There were long and apprehensive lines pretty much everywhere to buy almost anything because the ruble was collapsing - rational expectations theory in action. Aggregate demand is after all aggregate demand, as the demand side devotees never seem to care much about how and why.
While mainstream monetary treatment does not explicitly aim to destroy its own currency in one swoop, there is much to be said about the distinct lack of "demand" in the past six years as it pertains to trying to engineer sustainable economic forces with "just a little" currency destruction. That, of course, calls into question exactly which currency is at the center of all of this.
In terms of the ongoing Russian debacle, it stands to reason that Russians would be the problem. There are sanctions, the heavy hand of government and a multi-year lack of forward economic progress, but the same could be said about the US on two of those accounts. Indeed, it is interesting to view the ruble in the more appropriately broad context that includes the "dollar."
The ruble's descent began conspicuously enough in late June, a particularly noteworthy time as that part of the calendar is clustered with no end of asset prices and currencies peaking at the exact same moment. Whether that would be the Russell 2000 stock index, the German DAX, Brazilian real or even the S&P/LSTA Leveraged Loan Index, they all found their near-term tops in the last days of June and first days of July. That was also when the "dollar" began its rise and oil its collapse.
The global financial standard after the end of gold convertibility has been misnamed ever since it began. Some call it the "petrodollar" standard due to the prevalence of cyclical flows into crude trade that is almost fully denominated in dollars. But that misses the essence of what has taken over the global financial framework, which is as much a new "currency" all its own than an actual "dollar." This is, of course, the eurodollar standard that features a shocking (upon first acknowledgement) dearth of actual currency in favor of a much more efficient arrangement (for banks) of ledger balances.
If you tried to find the Patient Zero of the eurodollar market you will be wasting your time. There is no beginning nor is there an end; it just is. "Dollars" are created when banks collectively expand their balance sheets and disappear in contraction of the same fashion. The governing principles are almost purely mathematical finance of the highest order, as balance sheet "capital" and "risk management" are far more of primary importance than "reserves" (which are statutorily limited to domestic perception) or hard currency.
That is to say the essentially "supply" of "dollars" in this global financial standard are figments, delivered through an account based on debt. Under the old gold standard system trade partners had London banks move physical bullion from one vault to the next (that oversimplifies it somewhat, there were derivatives and warehouse receipts and even currency, but convertibility was taken literally) whereupon the trade self-extinguished. In other words, at the end of the transaction both parties have exchanged one form of property for another (a commodity or resource in exchange for actual money) with no trailing entanglements.
The eurodollar system is far different, as, again, its basis is debt created out of ledger-based liquidity. There are no reserves, no currency, just balances that need to be electronically cleared at the end of each business day. When counterparties get together now, a eurodollar bank is "necessary" as intermediary because there will be a loan at the end of the transaction, one that is to be maintained by the obligor (paying interest and principle) and the bank (funding the arrangement in wholesale "markets"). After an economic trade is concluded across geographies, far from self-extinguishing and freeing parties to move on to the next, the eurodollar market now becomes paramount.
Eurodollar banks have to, again, fund their lending operations while domestic banks are used as the links between the eurodollar market and each national system. A Brazilian company, for example, will typically contract with a Brazilian bank for "dollars" in which to engage in global trade markets. The Brazilian bank will "find" them through any number of conduits, all of which are some form of interbank credit. In this case, rather than the self-extinguishment of gold-based commerce, we now have any number of "dollar" debts created and outstanding (most of which can be used as collateral for further "dollar" financing arrangements) which have to be maintained and accounted (both literally and figuratively in terms of "capital" considerations).
It is not atypical in this endless chain of "dollars", nothing more than bank liabilities, for there to be a total American absence, either of banks or currency. The Brazilian bank obtaining dollar funding through eurodollar wholesale is as likely to find them from a German or Italian counterparty that itself has funding arrangements from a Japanese, UK or Swiss bank (all, again, in "dollars"). Throw in some derivative transformations and global finance is the furthest thing from the common perception of the "dollar" as is humanly possible given the current state of technology.
The development of all of this in the 1980's and especially the 1990's was, as I mentioned a few weeks back, Alan Greenspan's "conundrum" upon which Ben Bernanke interjected his "global savings glut." The massive expansion of eurodollar debt was never taken as such, which is why Mssrs. Greenspan and Bernanke were so utterly confused (and why Mr. Bernanke would be so far behind the times in 2007 and 2008, only coming to grips with the geographical location of the "dollar" panic after it was all over). Instead, all these foreign accumulations of "dollar reserves" were praised as the perfect expression of anti-gold.
This was particularly true after the first run of the "dollar" shortage in 1997, colloquially known as the Asian "flu." It is ironic, then in 2014, to see the same participants in that near-panic episode (and there was much by way of economic carnage throughout the globe) finding themselves on the short end (pun intended) once more. Each of these "flu" victims was applauded for their actions thereafter whereby they began to store up and accumulate massive "dollar" reserve balances.
Here again we have that same misconception. The terminology is ancient and thus contributes to the ignorance. There are no vaults full of $100 bills, Federal Reserve Notes as it were. Instead, these "reserves" that have been accumulating are ledger balances of eurodollar banks. The fact that portfolio balances are invested in US Treasuries or some other credit asset (or equities and, more likely, equity futures) does not change the fact that the basic eurodollar arrangement survives - that eurodollar banks are short "dollars" and the accumulation of foreign reserves is actually a big reason for the global dollar short in the first place.
Some things simply never change, but the appearance of it is enough to convince the easily convinced - those ideologically predisposed. While orthodox economic history always seems to begin in October 1929, the buildup of financial imbalances in the 1920's, especially after the French franc crisis in 1926, stands as a testament to the dangers of overconfidence in "reserves" and debt-financed liquidity. For most of these economists, none of that matters as "price stability" was believed to have been achieved throughout the 1920's and such that any increase in "money supply" was entirely appropriate.
Yet, for anyone making that assertion, I have never seen an explanation for "call money." Interbank markets existed then, with the first federal funds transaction in 1920, though not quite as they exist now. Given the correspondent banking system of that time, there were large bank balances that existed in somewhat "idleness." A country bank needing to maintain a correspondent balance with a city bank would have little option for alleviating the inefficiency, but central reserve city banks (largely NYC and Chicago) had developed a highly sophisticated, if ultimately nascent, wholesale system in call money.
The funding in this interbank market was not other credit positions, predominantly, as it is now. Instead, most call money, as the name suggests, was limited to highly liquid assets that could be sold easily at a moment's notice should the interbank loan be "called." That meant stocks.
However, the intersection of global "flows" in New York City during this time of a softened gold-standard (the exchange standard was itself limited in comparison to past "rules of the game" while there were no end to manipulations and interventions, especially French, going back to 1914 when this first global fiat age began in conflagration) meant that call money funding was as much foreign as domestic. By late 1927, not only were call balances skyrocketing, as "sterilization" by the Fed took place, the proportion of Street Loans (call money) "for others" (as the Federal Reserve of the time classified them) exploded from 29% to almost 60% through the middle months of 1929.
The technical definition provided by the contemporary Fed literature of "For others" were NYC bank loans made on behalf of non-bank entities. That included several domestic categories of financial participants, such as just plain wealthy individuals, but also foreign banks and central banks. Without spending too much time in the details, these years after the British pre-war parity drive in 1925 and the end of the French franc crisis in 1926 (before the Monetary Law of June 1928) meant massive central bank swaps and reserve "creation" flowing all over the world - with billions ending up in NYC banks.
From the Federal Reserve Bulletin of February 1928:
"The Bank of France in the course of the month paid off a debt to the Bank of England and thereby regained control of about $90,000,000 of gold which had been pledged as partial security for the loan, and had thus not been a part of the world's available stock of monetary gold. The gold thus released was offered in the market, and $30,000,000 of it was exported to the United States on private account, while $60,000,000 was purchased by the Federal reserve banks and kept in London. Later in the month the Bank of France decided to convert a part of its rapidly growing foreign exchange holdings into gold, and for this purpose purchased large amounts of gold in New York to be earmarked for its account. In June and July the Federal reserve banks sold the gold held in England, and at first held the proceeds abroad, but later disposed of these foreign balances to purchasers in this country."
Since these were global "liquidity" tools, the only "appropriate" place for them, other than idleness, was placing them in interbank call money markets. By the time of the crash in October 1929, Street Loan balances were just shy of $7 billion, of which $4 billion or about 60% were "For others." On the liability side, these imbalances were even larger. The amount of "Broker loans", which included collateralized stock and security arrangements not incorporated into the asset side classification, reached $8.5 billion right before the crash. Of that, almost $7 billion was "From others." In terms of acceleration, the growth of call money balances (Broker Loans) from the start of 1927 until the crash was an incomprehensible increase of about $5.3 billion - all of it coming from "From others."
To put these figures into proper perspective still doesn't do them justice, but it is appropriate nonetheless. At the time of the crash in October 1929, call money loans outstanding were equal to an unthinkable one-quarter of all member deposit balances outstanding for the entire Federal Reserve System. And somewhere between 60-75% of the funding of those call money balances were from "non-bank entities" especially "reserve" accounts of foreign banks and central banks - none of which have to do, directly, with price "stability" in the United States or domestic demand for funding. Rather, this was all financial engineering on a global scale to circumvent any kind of even relaxed gold-based restrictions.
The reckoning came, of course, in the form of not just a crash but waves of bank failures all over the world. This primitive wholesale model for funding and "disposing" of idle balances created a very narrow bottleneck. Correspondent banks were no longer as willing to keep correspondent deposit accounts with central reserve city banks who were trying to prop up the call money market. And withdrawal in the call money market itself was being instigated by foreign "reserve" demand.
From the 1930 annual report of the Bank of France:
When on various occasions they [French banks] were confronted with large demands for francs in their own market during 1930, they naturally preferred to repatriate part of those unproductive [overseas, largely USs in NYC] balances rather than have recourse to the rediscount facilities obtainable at the Bank of France.
Global liquidity imploded upon itself as these "funding mechanisms" tied the globe together in an arrangement wholly different than prior periods where economic considerations were primary. There is a world of difference between funding arrangements (and re-arrangements, thus liability chains) created out of organic expansion and demand, and those derived from intrusive and distortive engineering.
It wasn't gold that caused worldwide depression in the early 1930's, as total gold stocks (the amount of bullion and coin) available for liquidity rose by 18% between 1927 and 1933. The problem was its distribution (heavily weighted toward the US and France, the former as a legacy of fiat during WWI) and the means for "flow"; i.e., reserve balances and wholesale funding.
Since those reserves formed the pillar upon which even so much domestic liquidity was built, the reversal in October 1929 meant a transmission effect. When the first wave of bank failures began in October 1930, Street Loans outstanding had declined by more than half; a total of $3.6 billion was withdrawn, $3.2 billion of which was "For others" in what the Bank of France was referring to in its annual report that year. However, that wasn't the worst of it, since an additional $1.1 billion was withdrawn by "Out-of-town" banks as the correspondent system was inverting. And what were NYC banks doing during this first year between the crash and the start of the bank panics? They were adding $800 million in call money balances trying to prop up the whole interbank system that was falling apart.
That offers a partial explanation (and a good deal of it) as to why the first wave of failures began and expanded so dramatically and rapidly. NYC banks, which were the top of the liquidity pyramid in the correspondent system, had no spare liquidity capacity to meet rising demand for currency. They had been drained so drastically of foreign "reserves" while at the same time committing so much of their own resources into the black hole of call money left behind. The means by which the bubble propagated was the same by which it amplified on the downside.
That isn't the tale offered in the mainstream, though, as gold is used as an explanation for hampering central bank "liquidity measures" and restricting Federal Reserve flexibility (to use Bernanke's terms). However, as the 1930 Bank of France report more than suggests, it wasn't gold that prohibited successful mediation. Banks in France (and this was not limited to France; even correspondent banks in the US were doing the same thing) were not drawing upon central bank accounts as they could have and were expected to. In other words, central bank plans for that period were unlike how actual events turned out, as if they didn't really understand the incentives and even mechanisms they themselves had a big hand in creating. This should sound very familiar.
It likely would not have mattered if central banks had been afforded unlimited flexibility in 1930 as they didn't know what to do in the first place. They were, as they are now, obsessed with nothing but the quantity of liquidity (of whatever form) rather than how it got from A to B (and then to C, D, E and F). There is a world of difference, as I said, between organic systems and those cobbled together out of international and government "expedience."
The net result of all of this has been an end to any form of private limitation on central bank actions anywhere. The total fiat arrangement in effect since before 1971 has erased all forms of private money (as property) to the point where even currency is an anachronistic concept (though there is really great promise in private currency arrangements like ApplePay and Amazon's card reader system; a very important topic for another time). The benefits of doing so were supposed to be eradication of 1929-style "events" or bouts of global and connected illiquidity.
The "lessons" of the Asian flu were that, to the orthodox view, an accumulation of "reserves" would be inoculation against geographically specific illiquidity. Neither of those recognize the eurodollar system and its total dependence on inextricable liability chains for "flow." Instead, as in the 1930's, total central bank emphasis remains on "money stock" to the point that even Ben Bernanke (and his compatriots) could not/cannot recognize the difference and downright existential distinctions. That is why, starting in 2007, the FOMC's standard practice of interest rate "stimulus" and quantified "money supply" measures aimed at the non-existent "global savings glut" were totally and embarrassingly ineffective - they are still in 1930.
So we've replaced these earlier entanglements of NYC reserves and "For others" with a eurodollar system whereby reserves are funded by eurodollar debt itself in total conformity with the orthodox view of moving away from gold limitations. And in the end, as Russia, Indonesia, Thailand, Brazil, etc., will attest to today under the vise of currency crises, further highlighted by central bank activities in Norway, Brussels (ECB) and, the newest entrant into negative nominal interest rates, Switzerland, it all ended up in the same place anyway. Global illiquidity has dawned, starting in June when the ECB first panicked and tried negative rates, whereby the mechanisms and arrangements are superficially different now than 1929, but the principles and artificiality are all-too-familiar - most especially the "dollar" bottleneck created by the primacy and "necessity" of eurodollar banks and their balance sheet mechanics.
Gold was never the problem, at least not in where it was allowed to be freely flowing. The wider economy may have stayed true to convertibility, but interbank and international "flows" were entirely fiat. Some things never change; artificial flow based on artificial arrangements do not lead to robust foundations, exhibiting a frightening fragility that is actually heightened the longer it appears to work (Minsky). Instead, that "appears to work" is nothing short of immense financial imbalance in search of inevitable reckoning, typically taking the form of global depression. Japan might have been first, but Russia is certainly taking the brunt at the moment. Whatever the idiosyncrasies of those nations and their financial arrangements and economic particulars, including massive piles of "reserves", you can be assured that they are all still very heavily linked and shorted by the almighty eurodollar.
