No Amount of QE or Rate Control Can Fix What Is Sick
Mary Mallon was an Irish immigrant working as a cook in a rental house on Long Island when in 1906 Charles Henry Warren's family vacation was interrupted by typhoid fever. Six of the eleven people visiting the house at the time had become sick, and Mr. Warren was determined to figure out why. He turned not to a doctor or even scientist, assuming he might find one available to the task, but rather civil engineer George Soper. It wasn't long before Soper focused in on Mallon, at first demanding physical samples from her to confirm his suspicion only to be thwarted by way of liberal use of kitchen utensils. He returned with police and health department officials and soon after Typhoid Mary was born in popular imagination.
On and off since then, pandemics often play out in public with both trepidation and hope, the latter due, in part, to the optimism over scientific ritual in identifying Patient Zero. Epidemiologists don't appear to be uniform in warming to the determination, as some claim there is great benefit to finding the "source" while others downplay any advantages. Whatever the case, it remains somewhat of a fixation, certainly in popular culture.
Even the last global ebola outbreak delivered its own Patient Zero. A 2-year old boy from a remote village in Guinea has been identified as the first; passing away as far back as December 6, 2013, before his 3-year old sister and grandmother did as well. The location of the town may have been helpful in at least suggesting the disease's unchecked spread, as a study in the New England Journal of Medicine reasons that geography as relatively easy egress into greater Guinea and both Sierra Leone and Liberia.
This kind of detectivism is not limited to disease and medicine, as malfunction of any serious and spreadable nature is going to create desire toward locating a single and primary source. Isolation and any quarantine that may follow may be gratefully accepted given the character of the outbreak. For instance, investors, analysts and economists are still trying to figure out the exact nature of what happened in August in global financial markets. The best that is often described is "devaluation" in China, a cursory and overly simplified excuse rather than enlightenment.
As time has worn forward, that point is emphasized by everything else that has followed, especially and particularly the actions and activities of the PBOC itself. This week it was revealed what I had long suspected, namely that the Chinese central bank had been forced into a form of deception that reveals the folly of "devaluation" rhetoric. Local Chinese banks had been "selling" spot "dollars" in August at the behest of the PBOC who were issuing forwards for the back end of that "trade." This is almost classic response to a wholesale "dollar" run, as has been practiced time and again, most recently in Brazil.
The idea is simple enough even if it follows along far more complex tactical deployment. In general terms, private "dollar" markets were disrupted (the run) which then led the PBOC to three unappealing options of varying danger. First, the central bank could actively supply "dollars" itself in various forms, which is what the PBOC had clearly been doing for some time before the break (essentially pegging the CNY/USD to no variability for five months). Second, they could do nothing and allow rollover defaults in the local and offshore eurodollar markets. Or they could widen the trading band of renminbi/dollar exchange in order for the private, onshore "dollar" market in China to bid for liquidity at whatever cost. They chose the last option after being exhausted and beaten by the first, which proves the seriousness of the malady itself.
Yet, that does not reveal the Patient Zero of the eurodollar problem. As it is, the disease was so intense that the PBOC has been engaging in those forward transactions (the deception) that have an undesirable side effect - spreading the contagion further and farther. In basic wholesale terms, the use of forwards rather than, or alongside, actual and available "dollars" (from the Chinese assumed stash of forex "reserves") is essentially bidding Chinese banks already "short" (synthetically) the "dollar" to become much more so. To treat those with a "dollar" sickness in this way invites further menace (see: Brazil).
We know full well, of course, what has started and amplified this global and increasing "dollar" shortage; eurodollar banks have been, for several years, testifying to their growing disdain over money dealing. Wholesale or shadow banks that once offered themselves only rapid growth have been transformed into shriveled husks seeking out instead "efficiency" and less unwieldiness. That the "dollar" would break as it has in the past year and a half is only confirmation to take them at their word. That includes the latest wave which has seen the few contrarians that stood their ground in trying to find the opportunity in global recovery economists have been assuring these past few years turn against it as belated and costly denials of the mainstream recovery idea.
But as liquidity in the eurodollar system is multi-dimensional, so must be the analysis of its opposite. The specific case of China's "dollar" forwards suggests just this inquiry, which might be, in the end, the more relevant and serious consideration. In other words, we may know which banks are pressing the "dollar" to lumpy and wrinkled runs here and there, but that doesn't itself aid in recognition of the other primary consideration - the "what." In terms of the forward contracts that Chinese banks are basing their inclined precariousness within, you have to ask what exactly is the PBOC promising to deliver at maturity.
This is the most difficult concept to turn on and appreciate of the wholesale system. You might spend your life looking for Eurodollar Zero, but you will not find it. That factor just doesn't compute in traditional analysis because we have been conditioned to look for a "thing" at the middle of it all. In banking, there is always some kind of convertibility, whether deposit claims into gold or physical cash or even bank claims, interbank, on at least an account balance with the Federal Reserve (or what passes for bank "reserves" these days). This is the money multiplier concept, and it has been obliterated many times over these past four or five decades.
The transformation began in the 1960's, maybe even the 1950's, and the fact it cannot be pinpointed suggests this impracticality. The first eurodollar is a mystery, even to those who have studied the system and contemporaries who tried (such as Milton Friedman). The mechanics of it trace much further back in time, as in the US the first interbank transaction of this ledger nature was made in 1920 (though I haven't seen anyone or their research specify exactly which banks).
It was simple and innocuous and had little to do with developing what might be considered modern wholesale principles. Some reserve system bank issued a check to a non-system bank who returned their own check in the same amount (plus interest). Since, however, the reserve check was drawn on a reserve account, a meaningful, technical distinction, it was cleared same day, while the non-reserve check in return was available to clear only the next. Since either bank was familiar and usually closely located, risks were judged minimal. The effect was to help the non-reserve bank balance its reserve requirements, thus opening up more actual reserves to be deployed in actual banking. It should be noted, that it was also intended to help spread the purported benefits of joining the Federal Reserve System since at the time banks were split on it.
And so it seems like a great long journey from that point to the wholesale or shadow banking system that exists now; except that it wasn't truly much of a leap in terms of process, more so of technology. The benefit, greater efficiency, was all the motivation necessary. Instead of holding much larger correspondent balances (deposits made with upper tier banks that process money movements from checks and such) even smaller banks might be able to instead use the federal funds process to thin out that liquidity margin. Less held in actual reserve meant more deployed in credit expansion and securities (thus, the 1920's boom in at least one aspect; especially call money and the stock bubble).
Conceptually, that still preserves money and actual deposits as the center-point of the system. Fractional lending was still fractional at that point, given that ultimately there were claims on some kind of cash or money encompassing all these activities, and thus preservation of convertibility. The break of the wholesale model is thus one of category rather than just process; the wholesale system converts what was a marginal tool of balancing reserve balances of actual reserves and claims into a system of funding entirely distinct from all that. Money and even cash, as well as traditional reserves, are transformed alongside it; they become just one possible liability among many.
Again, the eurodollar system just began. Nobody truly knows how, why or even where, but at some point banks began trading dollars and at least dollar liabilities and claims. There are stories that implicate the Soviet bloc as trying to gain global liquidity from at least recycling contraband, stolen or even counterfeit physical Federal Reserve notes, while others have suggested cash flowing from foreign nations experiencing the dollar business of US servicemen stationed in Europe (and Japan, as that country would form the second largest node of the eurodollar network). Apocryphal or not, those stories recount that by the later 1960's the eurodollar market was just there and operating.
What followed was great expansion aided by technology and regulatory initiative. Where there might have been actual, physical currency deposits at some point, by the time the eurodollar system matured it was almost entirely ledger transactions - unspecified claims that a bank could deliver dollars if pressed to do so. The fact that it almost never happened meant that banks could increase that "fraction" and even multiply it multi-dimensionally (into different forms of liabilities, including forwards that had been around for a long time before the wholesale system took root).
In September 1971, coincidentally very shortly after the final US default on gold (Nixon and the "gold window"), the city of London and UK banking received a perhaps unintentional boost in the wholesale direction (it was certainly intended as a boost, but it is not at all clear that the Bank of England was expecting let alone suggesting what was about to occur). Presaging monetary evolution that would follow in the US (always England to America), the British central bank shifted to interest rate targeting. Prior to that, UK banks were subjected to quantitative and qualitative controls intending to govern the supply of credit. Unleashed domestically, London banks became also a great center of unrestricted currency transactions and liquidity; and at an important juncture where gold was no longer the centerpiece of global liquidity and trade transactions. The eurodollar would replace the Bretton Woods standard, shifting not just banking but the whole global financial network from a reserve currency to a credit-based reserve currency.
There was a proliferation of interbank "supply" thereafter, as you would expect of banking, as essentially a combination of major factors that had already favored offshore trading of various currencies were synergized, especially the dollar as still the primary reserve in at least denomination. According to the Philadelphia Fed, total euro-currency assets of reporting institutions grew 27% annually (compound rate) in the 1970's compared to just 8% for large, commercial domestic institutions' assets. By June 1980, net eurocurrency "supply" was one-tenth of domestic M3 - and that was just what was reported.
The difficulty in incorporating this wholesale system into a traditional framework has been a constant one, intellectually as well as operationally - perhaps even more so the former to the growing exclusion of the latter. For example, in the fourth quarter of 1979, the Federal Reserve Bank of New York's Quarterly Review examined the euro-currency market along these lines; and found nothing but more questions. That started with serious debate over whether euro-currency and eurodollars were money at all:
"It has long been recognized that a shift of deposits from a domestic banking system to the corresponding Euromarket (say from the United States to the Euro-dollar market) usually results in a net increase in bank liabilities worldwide. This occurs because reserves held against domestic bank liabilities are not diminished by such a transaction, and there are no reserve requirements on Eurodeposits. Hence, existing reserves support the same amount of domestic liabilities as before the transaction. However, new Euromarket liabilities have been created, and world credit availability has been expanded.
"To some critics this observation is true but irrelevant, so long as the monetary authorities seek to reach their ultimate economic objectives by influencing the money supply that best represents money used in transactions (usually M1). On this reasoning, Euromarket expansion does not create money, because all Eurocurrency liabilities are time deposits although frequently of very short maturity. Thus, they must be treated exclusively as investments. They can serve the store of value function of money but cannot act as a medium of exchange."
That last distinction may have been valid in 1979, (and it was, as FRBNY notes then, arguable) but was annihilated when surely the Fed shifted, as the Bank of England, to interest rate targeting whenever in the 1980's. No longer controlling for a particular quantity of money (M2 by then), the transition between eurodollar liability and domestic money and deposits was almost seamless. This much we know without doubt by close experience of the housing and dot-com bubbles, with credit flowing into the US without hitch via European bank balance sheet expansion - funded all or mostly by eurodollar liquidity coming from foreign banks and their offshore operations. It is here, I will emphasize one more time, the full weight of Alan Greenspan's 1996 "irrational exuberance" speech yet again applies; he recognized then that "something" was wrong in monetary behavior without looking to London for it, or if he did look, he didn't do anything about it.
In that respect, and for what actually happened in 2007 and 2008 (the geographic revelation of this "dollar" distinction), what FRBNY wrote in that 1979 article has proven disconcertingly and frustratingly correct:
"One of the traditional responsibilities of any central bank is to act as lender of last resort - to supply funds to a solvent bank or to the banking system generally in an emergency that threatens a sharp contraction of liquidity. This role normally has been framed with respect to commercial banks in the domestic banking system. But the emergence of the extraterritorial Euromarket created ambiguities about which central bank would be responsible for providing lender-of-last-resort support for overseas operations.
"No final resolution of those ambiguities has yet been reached, and it is doubtful that central bankers will ever codify their respective roles or lay down conditions for lender-of-last-resort assistance."
The author goes on to cite several contemporary efforts about where the Fed stood ready to do at least something, including a "declared readiness" to extend dollar liquidity to any foreign or domestic parent operating in eurodollars. As we know of, again, the true nature of 2008 that "declared readiness" wasn't worth the paper printed in the winter of 1979-80.
But the fact that central banks were planning then (more realistically, planning to plan) suggested the full transformation already at that point - eurodollars were at least a form of money, a new, unappreciated and misunderstood form (to this day, thirty-five years later), extended in ways and manners that did not fit within the rigid and confining box of traditional monetary understanding. That conversion is the entire basis for the global "dollar short." What FRBNY was scratching at all those years ago was the basic truth of eurodollars today, that there is no Eurodollar Zero. As such an amorphous and pulsating blob, it is distinctly impossible to find its beginning or its end - it just is.
Because of that reality, difficulties are not just, well, difficult they are amplified and arrayed far beyond the simple mechanics and understanding of current monetary ordering. There was a call to action in the late 1970's as the eurodollar and eurocurrency markets exploded in size and scale (and forms) but all that simply died down as the Great "Moderation" came to be taken as if it all just worked because it worked. It was not just taking these great potential pains for granted; it was total negligence for not even bothering to understand them in the first place. To this day, even after 2008, central banks refuse to see these distinctions, not just for what they are but at all!
Into that void has flowed QE after QE after QE, piled onto ZIRPs and even NIRPs; and to what gain? None of those had or have a prayer for success because they are secondary and tertiary to the eurodollar. In the 1990's, eurodollars were not just one form of money in the modern wholesale sense, they became the form of money. Global "dollar" balance sheets swallowed up all that intervention of inert and useless bank "reserves." Central banks don't even supply liquidity anymore in this construction, they offer only one form of liability that eurodollar banks don't even want. Lender of last resort? Not a chance.
And so central banks appeal instead to having become markets of last resort, controlling prices of assets in order to bypass their continued traditional weaknesses. As with any form of central planning, it is and has been distinctly inefficient and scattered, far too often causing more harm than benefit. In truth, central banks have been wasting our economic time with their harmful and anachronistic theories; the most precious and valuable factor in the human economic arrangement. It starts with economists refusing to see eurodollars for what they are, looking for a Dollar Zero that doesn't exist, either.
The truly tragic part is as FRBNY wrote way back then, namely that there was impetus and effort to make wholesale banking an incorporated whole; to evolve understanding and relationships as banking evolved. Instead, blind ideology stood starkly against it, all in the name of soft central planning that accomplished some illusory control for a time. Recognizing and dealing with wholesale complexity would have muddied, if not outright ended, the fantasy of such control and centralized management. In fact, that is what really occurred, only a couple decades too late.
Japan is working on its third straight "lost decade" with the US and Europe closing in on completion of each their first. That is an enormous amount of unnecessary waste, especially when properly viewed under terms of compounding. Wholesale money may have been, and may remain, dauntingly complex and often counterintuitive but not so much as to have been impossibly excluded and ignored. The financial epidemic is of the wholesale strain. Health and recovery lie there, and no QE or interest rate control can reach it now as the clock continues to tick.