Unstable Money Usurps Our Rights, Wrecks Our Economy

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On July 20, 2012, the European Central Bank (ECB) suspended collateral acceptance for sovereign Greek debt within its own liquidity programs. On the surface, it seemed like it would amount to a death blow to the struggling financial system in the Greek Republic, but it was really nothing more than a risk management tool for the ECB itself. Getting thrown out of the ECB general programs simply meant that Greek banks, those relying heavily on Greek government obligations to make up the bulk of their collateral liquidity regimes, were switched to a central bank backdoor. Instead of direct assistance, these Greek institutions took their tainted collateral to the Bank of Greece (the country's national central bank) and obtained liquidity through the Emergency Liquidity Assistance program (ELA).

The ELA itself, though directly "funded" by the Bank of Greece, is managed and ultimately derives liquidity from the Eurosystem headed by the ECB. Facing a potential second Greek default, the ECB was simply managing its own risks of Greek exposure by placing primary liquidity responsibility, and thus default risk, on the Greek central bank without sacrificing actual liquidity (the ELA does carry a higher interest cost, but for insolvent Greek banks that was little consideration).

In the wake of a second Greek default recently, now openly declared by Standard & Poor's, the ECB is contemplating a restoration of Greek collateral. Apparently collateral acceptance is only a matter of chronology and features little actionable consequence outside of those temporal appearances for the sake of appearances. Prudence is but a default or two away inside central bank risk management schemes since liquidity is nothing but the transfer of digital units of account, and no meaning is conveyed, positively or negatively, by those transfers.

Relatedly, we are treated to the unsurprising "news" that Deutsch Bank intentionally mis-valued (allegedly) derivative securities in its credit portfolio. According to three separate whistleblower actions, the biggest bank in Europe was apparently within a black box computer model manipulation from perhaps the most spectacular bankruptcy in human history. There was considerable stress on a super senior slice of delicious structured finance stuck warehoused at the bank in the wake of collateral and funding breakdowns in 2008 and early 2009. Amounting to a reported $130 billion notional, apparently losses may have been as high as $12 billion, enough to push the bank's capital levels to dangerous lows that may have precipitated another dollar crisis.

It should be odd that this German behemoth found itself ensnared in the liquidity crisis raging in US dollar denominations of US-synthesized credit instruments on US real estate, but unfortunately that is the modern system as it has evolved over time. The US Federal Reserve found itself bailing out banks all over the globe in 2008 and 2009, as US dollar liquidity imbalances nearly destroyed the modern global system. It was the methodology of that system that allowed countries like Greece to become insolvent, as the traditional means of clearing imbalances before such extreme events were lost in the rising ocean of dollar liquidity in the second half of the twentieth century.

For any attention paid to historical economics, the brightest lights and focus remain narrowly on only the most extreme periods. The Great Depression still captures much of what remains of the economics profession, while the Great Inflation served as the theoretical basis for the transformation of central banks from monetary agents of real money flows to pyschologism masquerading as economic management and soft central planning.

As appropriate as it is to study those periods with due care and attention, those great crises were not possible had it not been for massive monetary imbalances that were created from the progressive evolution of money itself. It is these "hidden" periods that provide us with the direct path for understanding the financial and economic world as it exists, frozen in dysfunction, today.

To my mind there were three great monetary evolutions. The first was the wide acceptance of paper money as a near or equal substitute to real money or specie. The second evolution took place after the "lost decade" of the Gilded Age, the 1890's. In my missive last week I highlighted the underappreciated decade of the 1900's and its role in the development of money from publicly owned to central bank-determined elasticity, the political removal of the public check on currency inflation. The last great monetary evolution has been total removal of any real check on currency inflation through the wholesale change of money to virtual reality beginning in the 1960's.

The dramatic consumer inflation of the 1970's was but one symptom of monetary imbalance that occurred in the wake of the technological, philosophical and regulatory changes that began in the decade before. But rather than just impact the immediate years after that change, it was a paradigm shift in the function of financial intermediation that realized the worst nightmares of the Founders of the American political system: the close alignment of financial concerns with fiscal authority.

In 1965, President Lyndon Johnson began to ask for a voluntary reduction of credit flowing overseas. He said,

"Let me make clear that the Government does not wish to impede the financing of exports, or the day to day operation of American investment abroad. But loans and investments that are not essential must be severely curtailed.

"Specifically, I ask the bankers and businessmen of America to exercise voluntary restraint in lending money or making investments abroad in developed countries."

This impulse to restrain American credit flowing to overseas destinations was born out of the growing use of the US dollar as a global reserve currency in the Bretton Woods system. In the context of the early and mid-1960's, the US had begun to run a balance of payments deficit. Despite a large merchandise and trade surplus, capital and money was flowing overseas in great quantity. The European continent, in particular but not exclusively, had returned to a measure of stability after rebuilding where investment returns were much higher compared to the low return, regulation bounded environment in the US.

This situation led to what is now known as the Triffin dilemma where a reserve currency finds itself at odds with national monetary needs. As the volume of dollars flowed overseas to meet the demands of global finance as the reserve currency, faith in the dollar necessarily declined as dollar holders eventually came to realize that there were far too many dollars to convert to gold (the Bretton Woods system pegged the US dollar to gold). To restore that faith meant that US monetary policy would have to be overly restrictive, but that would cause a money-driven collapse in finance globally. The dilemma, then, was that if the US wanted the dollar to be the reserve currency it must necessarily run a payments deficit knowing full well that doing so would risk the dollar's stability and therefore its place as reserve currency (this is sometimes called Triffin's paradox for that contradictory reasoning).

The result was, of course, a series of runs on the dollar and gold reserves in the US, the first in November 1960. That led to what was informally known as the London Gold Pool where eight major Western nations pooled their gold in an attempt to manage dollar convertibility. At the same time, the US government began what were essentially capital controls.

In 1963, the Kennedy Administration implemented the Interest Equalization Tax (IET) that discouraged foreign bond obligors from attempting to float bond sales, in US dollar denominations, in New York City. The result was that money simply shifted from New York investment houses to commercial banks. The commercial banks then circumvented the IET by lending to those foreign obligors directly in largely syndicate credit format.

It was the actions of commercial banks that caught the attention of the Johnson administration. In late 1964, the Voluntary Foreign Credit Restraint program (VFCR) was devised and "asked" that, under guidelines issued in March 1965, commercial banks limit their lending to foreign obligors to 105% of levels reached in December 1964. Within the VFCR, as President Johnson noted, it was made clear that credit intended to finance US exports would be exempt. In addition to the VFCR, there was another voluntary restraint called for in the area of direct investment overseas. Again in 1965, the Johnson administration implemented the Foreign Direct Investment Program (FDIP) asking that banks and businesses limit the dollar flow outside the US to help close the balance of payment deficit.

In July 1966, British Prime Minister Harold Wilson found that country in the midst of a Sterling crisis. He observed that:

"Action taken by the United States' authorities has led to an acute shortage of dollars and Euro-dollars in world trade and this has led to a progressive rise in interest rates and to the selling of sterling to replenish dollar balances."

In the words of the Prime Minister, the US was attempting to settle the payment imbalance by using the dollar status of reserve currency to enforce adjustments on trade and finance partners rather than the domestic economy. At the same time these capital controls were being voluntarily called, the US government began to borrow massive sums in the twin financing of escalation in Vietnam and the rollout of the Great Society welfare/redistribution system. Financing of these programs was increasingly tied to dollar debasement in the form of bank reserve creation through the Federal Reserve's "even keel" policy.

At first, banks in the US were seemingly onboard. But as the flow imbalance grew in proportion to imbalances abroad, money opportunities were presented in these overseas flows. In particular, what is now called the eurodollar market, deposit rates were far higher than what domestic banks could offer due to a Great Depression leftover called Regulation Q. It prohibited payment of interest on sight deposits and enforced a low ceiling on demand deposits. In London, by contrast, banks that served non-British counterparties were almost completely exempt from regulation. That meant they were not restricted by Regulation Q, but it also meant that these London-based bank branches were not in any way encumbered by capital reserves.

This more efficient arrangement allowed banks to operate on a smaller net interest margin, and thus it became a preferred destination for both depositors and intermediaries. Since the US dollar was the reserve currency, most of this "money" was denominated in the US dollar. As funding tightened domestically in the US, US banks began to raise funds increasingly through this London-based eurodollar system for transfer back to the United States.

But the eurodollar market was also unique in that it relied heavily on interbank transfers for liquidity flow. As an interbank market, each individual participant would be free from the encumbrance of maintaining a large stock of liquid currency because the liability counterparties operating here were also banks that disfavored currency. Unlike banking regimes that were traditionally funded on deposits of real persons, this interbank market had little need for currency since each of the interbank counterparties were better served with just changes to accounts. That ultimately meant that transfers inside the eurodollar market were nothing more than bookkeeper entries on balance sheet ledgers rather than the actual transference of physical currency (let alone gold). It also meant that these "dollars" were themselves intangible bookkeeping entries far removed from anything resembling legal tender.

This kind of leap in innovation made eurodollar functioning the most efficient (in terms of profitability) means of banking in the world. Not only was it largely devoid of the limitations of maintaining currency stocks, the traditional intermediary function was changed toward collateral arrangements. In the traditional bank system, credit flowed most often to a bank's own customers, who were likely already in a depository relationship with the bank. This familiarity formed the basis of intermediation between deposits and ultimate credit creation, but that was impossible in eurodollars.

Instead, eurodollar participants turned first to syndicate-type lending and then to collateralize lending arrangements in the absence of obligor familiarity. Collateral arrangements had been a part of banking systems since the beginning, but here they began to develop in shorter and more liquid terms that offered banks a significantly reduced funding cost - making them even more interest efficient.

Again, as a result of this profit efficiency, US commercial banks began to open overseas branches, particularly in London. Despite the voluntary capital controls of the Johnson administration, indeed largely because of them, the balance of payments deficit grew over the decade from $1 billion to nearly $11 billion by 1970. As you might expect in all things with government, those voluntary controls became compulsory on January 1, 1967, by Executive Order 11387 which authorized the Commerce Department to impose penalties on "excessive" direct investment abroad (ironically, since the Johnson administration was trying to curb monetary flows to ostensibly our allies, the authority for the executive order rested on Section 5(b) of the 1917 Trading With The Enemy Act).

By June 1969, the Federal Reserve finally moved in to curb the practice of raising "dollar" funds in London to "repatriate" back to commercial bank headquarters in the US. First, the Fed imposed a marginal reserve requirement of 10% on eurodollar transfers above levels reached in May 1969. That was pushed up to 20% in November 1970.

However, by 1971 the entire system fell as the Nixon administration abandoned dollar convertibility altogether. This is the moment that conventional wisdom has assigned as the beginning of the age of fiat, but that sentiment ignores the primary importance of this third evolutionary phase in the 1960's. The rise of eurodollars as an engine of global liquidity and transference was at first resisted by both fiscal and monetary authorities under the gold convertibility standard as incompatible with traditional global finance. Once gold convertibility was removed, the eurodollar market became the embraced and de facto global clearinghouse of liquidity.

In early 1973, the Federal Reserve re-interpreted Regulations K & M to include foreign activities. By May 1975, the Fed again reconstituted Regulation M and added changes to Regulation D to reduce the reserve requirement on eurodollar borrowings to 4%, which was completely eliminated in 1978. The reserve requirement and subsequent regulations have changed since, but the Federal Reserve system clearly began to accept eurodollars as a normal course of US bank finance in the 1970's, a sharp divergence from policy in the 1960's. The figments of bank balance sheets became "real money" by default.

Because capital controls in the 1960's were focused on, in President Johnson's words, "not essential" investments and loans, the eurodollar market itself was, particularly in its growth phase, unattached to global trade. It was simply a means for unrestricted bank funding for any and all purposes. That meant that credit inside the interbank system would not self-extinguish and would simply rollover in perpetuity. Second, and more importantly, this global currency market devoid of actual currency became the liquidity buffer against economic adjustments. In the age of floating currencies, countries with payments deficits could and did simply raise funds in the global marketplace through dollar-denominated bonds (and later euro-denominated bonds as European governments sought to capture their own share of all this liquidity in their own currency).

Trade imbalances no longer directed currency flows and imbalances themselves were no longer tied to economies. Under the old gold standard, a balance of payment deficit had to be settled by an outflow of gold, what the US was attempting to avoid in the 1960's, meaning the inevitable and painful money-driven economic downturn. But at least in that temporary despair the imbalance would self-extinguish. In this new liquidity clearinghouse of floating currency arrangement of eurodollars, trade imbalances posed no monetary threat to national economic systems. Deficits could be absorbed through liquidity, i.e., sovereign debt issuance. Imbalances could now grow without much if any restraint, and certainly without official restraint, under the cover of moneyless money.

The growth of this liquidity clearinghouse would develop along the lines of collateral availability and, more importantly, definition. The placement of sovereign OECD debt at the head of the "risk-free" spectrum simply aligned the banking interests of elasticity and currency inflation with the desire of various governments and political impulses to spend and be fiscally profligate without any monetary restraint. Because there was only a quasi-official acceptance of these "dollars", political authorities, including the Federal Reserve, were at least one step removed, making this seem as though the free market were operating and underwriting all this government expansion. The misunderstanding of the nature of eurodollars, particularly the common misperception that they were and are tied to US trade, seems to place all of this inside the realm of normal capitalist operation.

But these markets are not anything remotely related to the concept of capitalism. They are the fullest, unrestrained representation of the desire of bankers to always and everywhere expand and inflate as much as humanly and technologically possible. The advent of money without money removed any true power the citizens of each respective democratic nation had over the banking system. Indeed, in the decades since the 1960's, the domestic banking system in the US and Europe now mirrors almost exactly the eurodollar system rather than anything remotely like the traditional depository system that still captures popular thought.

The banks won the battle of the 1960's by showing the political powers that be a means to have it both ways (or so they thought until 2007) - profligacy and inflationary currency without the need for painful adjustment. In 1990's parlance, Greenspan defeated the business cycle. In a system that depended on actual currency or actual money, these imbalances would have never gotten so far or so dangerous to the point of existential turmoil because physical currency and physical money are, in the end, the public restraint on banking. But that is incompatible with the stated goal of elasticity, and the age-old desire of bankers to dominate and scalp unlimited and leveraged rent from the real economy.

The pathway of banking and financial evolution was not technological advancement, per se, it was the final removal of all obstacles to inflationary currency in the inexorable realization of phantasm monetary units. In those phantasm units, the powerful interests of government and bankers re-aligned in a seemingly permanent co-dependency. Not even the economic destruction of an entire continent seems to be able to dislodge it, as we hear time and again that the real economy cannot survive without the moneyless banking regime and all the increasingly ridiculous and lawless means by which it is intended to be preserved. Only a determined political desire can wrestle control over the affairs of both the political and economical from elite, vested and entrenched interests that no longer service the greater societal good of human economic, social, and, ultimately, political freedom. The usurpation and growing domain of government has been prepaid by the evolution of money and banking. The malaise in the economy is concurrent and causally related to the erosion of individual rights by way of financial or fiscal elasticity, the path of monetary progress laid down more than a century ago.


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

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