Very Little Has Been Done to Address the Money Gap

Very Little Has Been Done to Address the Money Gap
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On August 21, 2001, the IMF announced that it was likely to augment its stand-by credit facility to Argentina.  At that time it was figured the South American country needed an $8 billion boost, but only weeks later the credit facility was expanded instead by $21.6 billion.  By December 1, amidst grave political turmoil and social unrest, a bank run had begun forcing the Argentine central bank to impose a 98% reserve requirement for any additional deposits cleared after that date.  It would only get worse, as the government saw three different Presidents in the space of two weeks, and a great deal of rioting and mayhem during that stretch.

Its currency, the peso, was backed one for one by dollars.  The triggering of the Asian flu several years earlier was not strictly an Asian affair, and its ripples continued to flow through the global dollar system even though at that time it was rapidly expanding elsewhere.  On January 3, 2002, newly sworn in President Eduardo Duhalde ended peso convertibility, effectively devaluing the currency.

Prior to that point, Argentinians attempted to deal with the gross monetary shortage in different ways. Local provinces had attempted to pay wages and vendors with lecops, federally guaranteed provincial bonds.  The province of Buenos Aires in June 2001 started remunerating some of its obligations, including retirement benefits, with what it called a “treasury letter in cancellation of obligations” denominated in values from one to 100 at par to the dollar. The people of Buenos Aires called them derisively “patacons.”

The chief monetary problem for Argentina as a whole was the lack of dollars. Without them, the central bank could do nothing to alleviate the intensifying money shortage.  They could not print any more pesos than they had available dollars.  In response to the money shortage, these forms of quasi-money appeared as they always seem to under similar circumstances.

There have been several more recent examples of quasi-money, including so-called pharma bonds employed in Greece during its crisis. In California as budget deficits loomed, the state in 2009 issued vanilla IOU’s in lieu of cash it didn’t have or couldn’t use.  Long before the Federal Reserve was created to end these sorts of dollar problems, in the bank panic of 1907 bank clearinghouses would issue their own certificates for use from among bank members whose deposits of cash had been drawn dangerously low (so long as that bank was in good standing by thorough clearinghouse audit).  The appearance of quasi-money in this fashion has always accompanied monetary shortage, even though the success of the various instruments throughout history and geography is decidedly mixed.

When conditions are at their worst, people will do what they have to even if it means turning toward the untested or what only a short time before believed unwise.  Quasi-money is a leap of faith, a bridge that is almost always a difficult one to cross unless there is no other way

It is necessary to define what we mean by quasi-money, because in the mainstream the term has been used, ironically, as a substitute for near-money.  Economists and authorities have always held an obsession over defining what does and what does not qualify as “base money”, or simply money, a limitation that private enterprise does not have.  The technological evolution of the 1950’s and 1960’s brought about a plethora of “near money” substitutes that were in practice every bit as monetary as what authorities defined.  The point of the “missing money” 1970’s was in trying to catch up to what the free market was already treating as money without the expressed blessing of authorities.

In the modern wholesale world, substitution is a practical fact of life.  The difference between near money and quasi-money are therefore almost inverted; the private system defines for itself was is near-money, really money, and leaves it to authorities to occasionally institute quasi-money when things break down.  Official distinctions about base or near-money just don’t apply, one reason why the Federal Reserve never could solve the 2008 crisis or its aftermath, all because orthodox treatment has the money system reversed.

Even the Fed and the US Treasury Department engaged in what I would call a perfect representation of quasi-money as I define it. In mid-September 2008, the two agencies came up with the Supplementary Finance Program where the Treasury Department would sell debt securities to US banks, not regular US Treasury obligations but those in addition to them, placing the funds in a special account with the Fed.  The idea was to drain reserves from domestic institutions (which tells you a great deal about the nature of the crisis, and it wasn’t what they thought it was) while supplying surplus US debt securities to banks during the collateral shortage/repo meltdown.  Whether it was intended or not, and the FOMC transcripts suggest it wasn’t, the program was a quasi-money addition to where the monetary shortage took the form of vital collateral.

It is in these individual parts of that crisis where we can best calibrate these definitions.  That starts with the dollar shortage itself, or as defined by collateral as currency, “dollar” shortage.  It is commonly believed that the interest rate on money markets is supposed to give us a sense of “accommodation” or “tightness.”  By convention, if the money market rate is low, especially ultra-low, there is no shortage; conversely, if it is high, there at least could be one (depending how we define “high”). 

Yet, the federal funds effective rate was 5.27% on August 8, 2007, 5.41% on the 9th, and 4.68% on August 10 (against a Federal Reserve target rate of 5.25%).  Of those three days, it was clear by action that the worst conditions were experienced where the effective federal funds rate was the lowest.  Further, on October 2, 2008, the effective federal funds rate had fallen to 0.67%, way below the 2% target policy.  Despite the fact that the primary money market rate had dropped considerably between August 8, 2007 and October 2, 2008, would it have been correct to have characterized the period in between as at all “accommodative?”  It was indeed as the opposite of that as one may ever hope to witness again.

What that suggests, proves, really, is that monetary substitutes in the wholesale system superseded whatever form of base money conceptualized in academic schematics devised by authorities who display all the time a curious incuriosity.   From that view, we can easily observe how some forms of wholesale money become more “valuable”, that is relatively more scarce, than others. Collateral, for one, became extremely scarce as a matter of supply; MBS securities were being marked down (haircuts) or repudiated altogether, increasingly repo ineligible at any price.

Other forms of “dollar” money were made scarce not by supply but by demand (usually as desperation moved from one substitute to another).  Interest rate derivatives, gross notionals, jumped by 12.5% in Q3 2007 over Q2, fell in Q4, and then jumped again by nearly 10% in Q1 2008.  Even credit default swap notionals were growing at the time, up 3% in both Q4 2007 as well as Q1 2008.  But demand for CDS was so high in response to liquidity as well as credit fears that pricing was all over the place leading to massive irregularities that looked every bit like the shortage of capacity that it was.

If scarcity is defined by price, what in the wholesale system would be the singular price of “dollars?”  The closest unique value would be the dollar itself.  While the federal funds rate steadied throughout the summer of 2008, then right near the target of 2%, the dollar’s exchange value began to rise and then exploded higher. As I wrote last week:

“In late July 2008, the index of the trade-weighted exchange value of the dollar had been 95.028 but was 103.949 the second week of October in full panic. By the time the swap spread 30s had turned negative in late October it was nearly 108. And when the spread between federal funds effective and the federal funds target was at its maximum, it neared 111.”

The best signal we have for global “dollar” fluidity is the exchange value.  It is not the only indication, of course, but you can bet under the wholesale reality of the 21st century world that if the dollar is rising there is some problem with either supply or distribution (which amounts, essentially, to the same thing). 

Like Argentina before 2002, China’s monetary base is the “dollar.”  Though the exact composition of its foreign “reserves” is not exclusively dollars, they are wholesale eurocurrency meaning creations of the credit-based global reserve system.  The difference between Argentina in 2001 and China in 2016 is that the Chinese gave up on direct convertibility (the peg) in 2006.  Though CNY is allowed to float, it is so within a very narrow range set daily by the People’s Bank of China (PBOC).  Thus, in practice, there isn’t actually so much difference between Argentina then and China now when it comes to the “dollar” base.

The level of foreign reserves on the PBOC’s balance sheet peaked in May 2014 at just over RMB 28.1 trillion.  That represented 85.4% of all assets held by the PBOC, signifying that China’s currency was backed by 0.85 “dollars” for every RMB. And like Argentina after the Asian flu, China has in the years since then experienced a reduction in available “dollars.”  It was at first slow, but by November 2014 the level fell below RMB 28 trillion – just as the exchange value of the dollar begun to rise at a 45 degree angle. 

To compensate for the loss of “dollars”, the PBOC attempted to let the private banking system float RMB.  They reduced interest rates as well as the Required Reserve Ratio (RRR) so that the Chinese banking system might compensate for the reductions in bank reserves China’s central bank accepted as a consequence of fewer “dollars.”  By December 2015, the level of RMB bank reserves in China had fallen by more than RMB 2 trillion, just about 9%.   Their plan for private sources to alleviate the monetary shortage simply did not work.

To start 2016, the PBOC instead began to use “targeted” liquidity methods in order to inject cash into the Chinese economy, which at that time was in grave danger of falling apart, not exactly a surprise given the monetary conditions.  But, as the RMB injections increased the “dollar” restrictions did not, meaning that effectively the Chinese currency has been more and more stripped of its “dollar” backing. As of January 2017, the proportion of foreign reserves on the asset side of its balance sheet had fallen below 65%, almost all of that reduction coming just last year. 

China has done almost exactly what Argentina did (just not to that extreme), and for the very same reasons. Economists will no doubt object, but the issuance of RMB first by private banks (lower RRR) and then by the PBOC itself was no different than the appearance of patacons fifteen years earlier.  It was the reluctant attempt of indigenous monetary authorities to overcome a dire but external monetary shortage in way that just a few months before would have been thought unwise and dangerous. We know that because Chinese authorities in the first half of 2014 said so.

The only meaningful difference between them is that patacons or lecops (or pharma bonds in Greece) were not immediately acceptable by all prospective agents; the New York Times wrote in late August 2001 about one Argentinian policeman’s experience of being compensated by the state with patacons, and then being able to pay his electric bill with them but not the one from the phone company or his credit card debt.  Chinese don’t have this difficulty with the introduction of what is pure fiat RMB.

A few days ago, from the release of its Quarterly Review, the BIS (thank you to M. Daya) published an extract of an article which declared, “No aggregate dollar shortage is evident here.”  The authors note the record high level of on-balance sheet funding of non-US banks and therefore conclude, “In aggregate at least, non-US banks are not suffering a dollar shortage as in 2008-09.” I have little doubt that the PBOC would passionately disagree with them; it’s stamped in balances right on its balance sheet.

The BIS calculates that total funding by non-US banks in eurodollars was about $9 trillion. But the authors treat the eurodollar as if it were a thing, in this case mostly in the form of reported eurodollar deposits.  This is exactly the weakness of broad money M3 which caused the Fed to shut it down more than a decade ago.  In other words, even the Federal Reserve knew that M3, which at that time consisted in its eurodollar segment of eurodollar deposits but little else, was so incomplete as to be either misleading or worthless.  Rather than expend the effort to rectify its coverage weaknesses, or even just study the various new formats for global monetary exchange (especially FX), they gave up on it entirely as “too costly” to do so.  In that decision, they stuck instead with Bernanke’s utterly ridiculous “global savings glut” as a disingenuous way to reconcile what was actually happening (rapid monetary expansion not captured by traditional statistics) in the world with their own ideology that prevented them from honestly investigating not quasi- but functioning wholesale broad money. 

So the BIS now declares no eurodollar problem using the same means as those that were not even good enough for the Federal Reserve, who had and still hold no interest in global money. The BIS is measuring eurodollars on the narrowest form of near-money, rather than the more appropriate standard of comprehensive broad money which might include quasi- forms as they arise and become further substitutable (such as FX) at the discretion solely of the eurodollar market.  This is a failure of imagination as well as measurement or definitions.  Because it is extremely difficult to define the eurodollar system, that does not mean we should leave it at boundaries that were unacceptable in pre-crisis period. 

The system itself has never been, as I wrote above, constrained by academic definitions.  It is what it is, and it is the job of people in places like the Fed and BIS to address what it is in total rather than what they can see of it.  We are witness to a renewed “missing money” period because in large part authorities of the last one never truly made sense of it nor peace with it.

This is a vastly more difficult challenge than any monetary shortage of bygone eras.  During the gold standard, the classical gold standard, defining shortage was easy as bullion was packed on ships or carts and physically transported outside the local jurisdiction.  How do we know that whatever eurodollar supply there might be now in whatever forms do exist but are not observable is not the “correct” amount of supply?  This is no small matter, as any free market adherent should rightly recoil at the question. It is for no one to make such a judgment.

And yet, we know without argument that there is “something” drastically wrong with the global economy.  Having resisted the mountain of evidence (and predictions that have come true), even economists around the world have finally come around to this reality after protesting for full recovery year after year and finding none.  Their answer to the “something”, however, is further of the absurd; Baby Boomers and heroin addicts. Even if that were true, it wouldn’t be true for the rest of the world, including China.

There has been a globally synchronized decline that just would not have been possible outside of something like a world war that devastated so much capacity in rolling, continuous fashion.  In 2008, the global economy shrank, which by itself would not be all that unusual.  It was a severe reduction more so in the developed world than the emerging one, but uniformly a serious contraction.  By every orthodox prediction and expectation, that condition was to be only temporary for all locations afflicted.   It hasn’t been.

For one, the global economy fell off again in 2012 after already being conspicuously shallow (lack of symmetry). It then fell off one more time starting in late 2014.  Econometrics is predicated far too much on randomness, but there is no need for us to make the same mistake.  Should we not note how each of these inflections, globally, follow perfectly massive problems in “dollars?”  If this was all just coincidence, it would be the biggest of all time.

I could endlessly recite the statistics and provide dozens perhaps hundreds of charts and data points, but with the “surrender” of central banks last year it is no longer even necessary.  There has been and still is “something” very wrong in the global economy. It should be good news that central bankers in particular have accepted it, except that in doing so they blame retirees and the opioid epidemic (or whatever foreign equivalent) which amounts to total submission to depression. It’s their way of saying “that’s just the way it is” and there is nothing that can be done.  I cannot accept that, nor can the world.  One lost decade is far more than enough, as I doubt unlike Japan we get to two.

Up until now, the BIS has done perhaps more than any other mainstream outlet to actually investigate and honestly attempt to understand global money under the eurodollar.  They published both PBOC Governor Zhou Xiaochuan’s March 2009 call to action correctly identifying, for once, the credit-based reserve system.  It was also the BIS who published what is surely one of the best academic papers ever to deal with the “dollar” subject.  From its Quarterly Review, perhaps not coincidentally also from March 2009 (it is in the coldest light of turmoil that suppressed honesty has a way of intruding whether wanted or not):

“The current financial crisis has highlighted just how little is known about the structure of banks’ international balance sheets and their interconnectedness. During the crisis, many banks reportedly faced severe US dollar funding shortages, prompting central banks around the world to adopt unprecedented policy measures to supply them with funds. How could a US dollar shortage develop so quickly after dollar liquidity had been viewed as plentiful?”

In the eight years since that passage was written, very little has been done officially to address the intellectual as well as “dollar” gap.  In 2007, Ben Bernanke said subprime was contained, which was another way of claiming currency elasticity on his part. In 2017, the BIS says there is no eurodollar problem.   At both ends, however, there are only globally synchronized abnormalities that can only trace back to one of two things.  It’s either war or money, and the former if left unaddressed in the darkness usually follows the latter.  

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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