We Already Went Through All of This Last Year
On September 21, 1998, the Federal Open Market Committee (FOMC) held an unscheduled conference call just one week before the scheduled regular policy meeting. Then-Chairman Alan Greenspan was concerned about a good number of things, but in this case that included something he had said a few weeks earlier in Berkeley, CA. The transcript, of course, does not record whether or not Mr. Greenspan at that moment appreciated the irony of his unease, given that "Fed speak", as it came to be known, was usually an intentional act of his own obfuscations.
The Chairman was worried that certain comments he made in California weren't clear enough. Someone had asked him, apparently, whether or not he had been in consultation with other central bankers around the world on the prospects of coordinated intervention; Greenspan indicated that he had not. From that, his word was taken to mean that there would be no forthcoming response from anywhere.
Given the events of that September, it was a troubling development especially in global credit markets, but also domestic ones. To perhaps alleviate some of the stress of this instance of for once badly received "Fed speak", the Chairman wanted to get the Committee's unofficial approval for more innuendo. He had been invited along with Larry Summers, then Deputy Secretary of the Treasury Department, to appear before the Senate Budget Committee the following day. It was Greenspan's idea that he would "signal even indirectly" that the FOMC was seriously considering a rate cut at the regular gathering the next week.
In his view, by doing so the idea of forthcoming policy action would soothe a great deal without having to actually hold an emergency FOMC meeting in order to vote an intermeeting cut. Such would have been the prospects for even greater market turmoil had the FOMC felt it necessary to go that far. But balanced against it was more general alarm the members were feeling that if things continued to spiral monetary policy could risk being put "well behind the curve with respect to taking action." Having already consulted privately with a good many of the FOMC voting members, Greenspan knew in advance that their votes for a cut were all but guaranteed, so by making it unofficially official and working it into Senate testimony in his Greenspan sort of way he felt he could accomplish the effects of a rate cut almost a week in advance of it actually happening.
It is in the passing of almost two decades perhaps hard to imagine such emergency inside the Federal Reserve during the late 1990's. Popular imagination about the time, at least my sense of it, is more aligned with uninterrupted euphoria and prosperity, false and artificial as it may have been. But sitting right in the middle of the second half of that decade was a serious interruption that threatened a great deal beyond words.
Some called it the East Asian Financial Crisis, others the Asian flu (I personally prefer the latter given its genesis and transmission much like a disease), but in the late summer of 1998 it had already cast a long and dark global pall. As Chairman Greenspan said of his motivations on that call:
"I am particularly concerned that given the international financial turmoil that continues to increase, the general sense of persisting deterioration with no policy responses, and a widespread perception of policy incoherence coming from the G-7 and others, that we could run into a major problem, especially given Japanese developments."
Always Japan. It makes, however, for a huge contrast to the regular FOMC meeting from September 1997, just a year earlier. Thailand had drawn itself into massive funding problems, in dollars, it needs to be restated, in June of that year but practically no one really gave it much thought beyond localized concern. In the August 1997 FOMC meeting, for example, there was a very brief conversation with staff economist Ted Truman about Thailand, but nothing beyond that country. In September, there was no discussion at all about any of the Asian countries that were at that very moment cracking under the pressure.
To say that the Asian flu snuck up on US monetary officials would be perfectly accurate. The next month, October 1997, Taiwan stopped intervening in its currency markets, dropping its dollar peg which had the effect of depriving that nation of dollar liquidity. A week later, Hong Kong was brought into the widening circle of illiquidity, where in fighting for its dollar peg the Hong Kong Monetary Authority allowed interbank rates one day in late October to explode above 250%; resulting in a Hong Kong stock market crash of nearly 25% in total that induced a 10.4% drop in the Hang Seng Index on October 23, 1997 alone.
While most people, including US policymakers, were at that time still wondering what all the fuss was about overseas in these Asian hinterlands, four days after the Hong Kong markets were rattled the Dow Jones Industrial Index plummeted 554 points, triggering for the first time in NYSE history the circuit breakers put in place after the Crash of ‘87. Trading was halted at 2:35 pm that afternoon, and after briefly reopening halted again at around 3:30 pm and prematurely ending the session. After the US close, Treasury Secretary Robert Rubin told the gaggle of reporters gathered just outside the Treasury Department doors that, "It is important to remember that the fundamentals of the United States economy are strong and have been for the past several years and the prospects for continued growth, with low inflation and low unemployment, are strong."
Those were also the assumptions that prevailed up to that point in almost every mainstream and policy outlet, and continued to do so right on through most of 1998 until that summer. Dallas Fed President Robert McTeer in February 1998 confidently declared to the other assembled FOMC members, "... given the strength and momentum of the Eleventh District economy, if we are going to be hard hit by the fallout from Asia, this is a good time to have it happen."
There was reason to suspect that might actually happen, as earlier in that February discussion the head of the Open Market Desk, Peter Fisher, described an operation with the Bank of Japan that was full of holes. I don't mean that Mr. Fisher's argument was unwieldy and malformed, rather that the transcript actually leaves out the most important details. I have read through far more of these than I care to recall, and this is one of the very, very few instances where parts are redacted. Why twenty years later this part of the official record is to remain secret is anyone's guess, but given what they were talking about it isn't difficult to speculate. This is how it remains transcribed:
"We took [blank] of bills into the SOMA account, selecting bills that we would be able to run off in the course of January so as not to make our need to drain reserves any worse at the end of the month. We sold [blank] for them in the market and took another [blank] out of the repo pool, where we have had an elevated cash balance for them, to help them in effect to meet their cash needs. We also actually arranged a transaction between the Bank of Japan and the Ministry of Finance during the period; one wanted to sell bills and the other to buy."
The Fed was intervening covertly in dollars on behalf of the Bank of Japan whose banks were at that time in desperate need of them. While the Asian flu started in Thailand, by November 1997 after the fireworks in October 1997 several Japanese banks and securities firms had failed. The fact Japanese banks had been questionable since that country's great crash earlier in the decade did not lessen the blow to global financial networks, particularly since Japanese banks had historically filled a large role in eurodollar markets. In that way, the growing concern about Japan afterward was more than strictly an issue for the smaller Asian "tigers" as it suggested the risks of further contagion through disturbed dollar redistribution.
Part of that had to do with the ambiguity of interest rates, even money market rates. Published and widely accepted money market rates are not "real" in the sense that they are actual transactions; they are an aggregated average of actual trades (or more often offers) among member institutions. The posted LIBOR rate, for example, does not necessarily reflect what Hinterland Asian Bank A might be able to bid for dollars from Sanyo Securities in Tokyo, who bids for dollars in London as a standing member.
At the end of October 1997, Japanese institutions were quoted dollars without any detectible premium, as Peter Fisher recited to the FOMC at its November 1997 meeting. By the 12th when the meeting was held, and just five days before Hokkaido Takushoku Bank would fail, Fisher noted the "Japan premium" in dollars had risen to 25 bps for eurodollar deposits. By December, that premium had risen to 100 bps for one-month funds. These don't sound like much, but in the fuzzy world of interbank "dollars" they are enormous.
There were other aspects of the "Japan premium" that would persist well into 1998 even after whatever level it was the US Federal Reserve did on behalf of the Bank of Japan that January. One of the ways in which dollar problems were analyzed was in various decompositions of money market rates. The reported LIBOR rate of Bank of Tokyo-Mistubishi (BOTM) was compared to that of Barclays to get a sense of at least a baseline dollar difference; BOTM as one of the premium Japanese banks with implicit government guarantees representing therefore the best of what Japan could pay for dollars; what the rest of Japanese banks might be paying was anybody's guess. In late November 1997, as the failures of Hokkaido Takushoku, Sanyo, and then Yamaichi roiled global markets, the spread between just BOTM and Barclays was an enormous 110 bps, so what was it for the any number of anonymous minor Japan institutions that had been lending heavily in Indonesia?
As is often the case, markets begin something like a triage where in the initial "puke" (pardon the language) everybody is treated with mostly the same disdain, though over time dollar lenders come back in at least piecemeal fashion as they get a better sense, they hope, of who actually might be the problem names. Thus, while the dollar spread for BOTM may have come back, as it did to around 20 bps by January 1998, nobody could say what it really was for Hinterland Asian Bank B especially after its former Japanese dollar connection was forced into some unknown "Japan premium."
In presenting some of these decompositions to the FOMC in May 1998, Open Market Desk chief Peter Fisher remarked, "Let me say in advance that I am presenting this to show you how skeptical I am that we really understand the Japan premium phenomenon."
Money markets are often thought of and even modeled as monolithic "things", as a sort of solid block where arbitrage opportunities govern, with lags, these kinds of irregularities. If BOTM is being offered dollar funding at best 110 bps above Barclays, then that is an opportunity for someone or several someones in eurodollar markets to earn that pretty much guaranteed spread. Thus, it is believed that over some small amount of time the "market" will sort out the good from bad, where the bad are but small in number and size even where they create disruption far above their stature.
But that isn't how money markets actually work, given that there are far more constraints than just arbitrage opportunity. In reviewing the Japanese dollar situation in May 1998, Fisher described one of them:
"What interests me is that when I talk to bankers, many of them will tell me very frankly that their credit lines to their Japanese counterparties are completely full. That is, their traders are taking maximum advantage of trying to capture this premium and arbitrage it. But the bank credit departments are now in charge on an individual trade-by-trade basis, and they are up against their limits."
Arbitrage isn't so simple, especially in the modern, wholesale bank where balance sheet governance isn't strictly about opportunity. From the standpoint of math-as-money, you can easily appreciate the difference; bank traders were salivating at the prospects to lend as much as they possibly could to BOTM at whatever premium BOTM would accept, but credit departments had to factor, meaning model, all sorts of explosions in volatility across funding, credit, and beyond. In one sense, the capacity of the "market" to address its shortcomings is directly and greatly affected by those shortcomings.
Into that shortfall is supposed to be central banks, but as is often the case they are no substitutes even where they have come to perform market-of-last-resort functions. In the case of Japanese dollar problems in 1998, Alan Greenspan didn't do much of anything until September that year when domestic credit markets started to "run a fever." It wasn't as if Federal Reserve officials were unconcerned, but yet they remained spectators reviewing academically the travails of far off financial agents conducting business all their own. As Greenspan remarked in May 1998 as the FOMC discussed the Bank of Japan and the possible results of the Japan premium, he said, "It is getting scarier and scarier. At least, I am getting more scared."
In the space of seven months, the Federal Reserve had gone from not discussing Asia at all to being "more scared" about how the rest of Asia was affecting Japan, and thus, potentially, the whole world (I have left out Russia and LTCM). Despite recognizing the cracks in money market regimes especially across boundaries, geographical and otherwise, the sum of their actions was to express growing discomfort. How elastic is a currency under these conditions?
We have to understand what "these conditions" actually mean. The Federal Reserve does not view these eurodollar markets as explicitly part of their mandate. They will act in conjunction with other central banks when called upon by request to stem the after-effects, even to some unknown, secret degree, but unless that irregularity shows up in federal funds they are spectators at worst, interested observers at best. In terms of overall policy, it doesn't become an official policy matter for the US central bank until the after-effects start to affect the US economy.
The eurodollar is the eurodollar and the Fed is the Fed. They share common interests but little else. They may together be bonded by the common denomination of "dollar", but in the orthodox sense there is the dollar and then there is the "dollar." To monetary authorities, only the dollar matters.
The Federal Reserve would cut rates two more times in addition to the indirectly pre-confirmed September 1998 move, each at 25 bps, bringing the federal funds target down from 5.25% to 4.75%. For its part, the US economy experienced a near-recession in 1998 that lingered into the early months of 1999, but otherwise the episode seemed to further burnish the reputation of the "maestro." His 75 bps in "stimulus" was given the credit for the economic result here which was far different than the dollar disaster that spread throughout East Asia.
It would not go so well, however, the next time "foreign" "dollar" problems suddenly appeared. Starting in 2007, "overseas" dollar issues were also treated as overseas concerns until they began to disrupt both domestic dollar markets (but in the wrong way after August 9, 2007) and the domestic economy - which, obviously, they did and then some. What was, then, the actual difference between the near-recession of the Asian flu and the full and immense contraction of the Great "Recession"?
In just a few words the answer is balance sheet constraints. In 1997 and 1998, money markets were fragmented but there were still dollars to be found on offer, even if unusually and harmfully (for those Asian countries) limited. In 2007 and 2008, balance sheet constraints were more total so that in spurts, such as March 2008 or October 2008, there were none anywhere. Balance sheet factors had starting in 1997 shut off a great many dollar conduits into Asia, where starting in 2007 they were shut off practically everywhere.
The Asian flu being a template of sorts for what would become the Great "Recession", there is no possible way it could be repeated a second time, right? Improbable as it all sounds, it has been in almost every way except the modes of transmission. Where in the late 1990's the eurodollar system was operated upon eurodollar deposits tied to LIBOR rates, in 2015 it was FX markets and derivatives like cross currency basis swaps tied to factors that we have yet to fully untangle. At the center of both, however, sits Japan; always Japan.
The Fed, if you hadn't noticed, has taken again a more dispassionate stance on the goings on of the "rising dollar." Like Greenspan's Fed, the Yellen Fed is of the position that overseas is overseas unless it affects the federal funds market (where nobody is anymore) or the US economy. As to the latter, guided by the inappropriate denominator of the unemployment rate it will be impossible for the FOMC to consider economic effects unless and until they are already considerable - as they were in 2015 and to start 2016 and still all they did was cross their fingers and hike no more (so far).
But there are grave differences that we must consider where monetary officials still refuse. In 1998, the near recession in the US was as much a product of continued explosive monetary growth of the eurodollar system everywhere but Asia. Was 4.75% for the federal funds rate instead of 5.25% really the saving grace for the US economy? I have no doubt that it was as insignificant as it sounds, as with the eurodollar as a whole at his back Greenspan was an accidental beneficiary of forces well beyond his control and understanding.
The events of 2008 should leave no doubt as to that contention, which only raises the significant problem of 2016. The Asian flu had for outside of Asia the eurodollar heading up toward its housing bubble, EM debt zenith; in 2016, the "rising dollar" is actually an indication of its continued fall on the other side of that peak.
We already went through all this just last year. Up until last summer, stock indices were at or near record highs, markets complacent, and Fed officials reassuring everyone how strong and resilient the US economy was. I even wrote an article in this very venue on June 19, 2015, under the title Americans Are Sheltered And Wholly Unaware. For the most part, the buildup to the "global turmoil" that knocked the global economy, US economy with it, to a still lower state starting last August was just ignored despite several warning signs leading up to it.
"If there were some less benign ignition now, a spark of selling that was the other half of the panic run, what support would there be for orderly pricing?
"The answer to that, given already by October 15, December 1 and January 15, isn't very encouraging. To a great extent, Americans are both sheltered and wholly unaware, but the rest of the world is very much alerted to the continued downside of the eurodollar standard. Stocks may be at or near record highs (though broader stock indices, such as the NYSE composite, have gone nowhere since the "dollar" started to rise), but Brazil is in a state of total economic and financial chaos while China flirts with what was never thought possible (growth at Great Recession levels, a massive housing imbalance and now a stock bubble that in some ways puts the dot-coms to shame). There was a "dollar" system somewhat in place, largely before the middle of 2013, which supported all those but no longer does."
The "spark of selling", as I put it, was provided not even two months later upon (what else?) Asian ignition, this time China (though Japanese banks are involved with those "dollars", too). In November 2016, Chinese money markets are acting once more unsteadied and even Hong Kong money markets now being drawn in to end the month, but still the blissful state of "overseas" is done all over again here as if the desperate times earlier this year were just some unwanted dream easily discarded as everyone is awakened from their dismal QE slumber by the sounds of "different."
The Asian flu was not really Asian; it was eurodollar fragmentation, a process that has been repeated and is repeating again right now. While nobody is paying much attention, the "Japan premium" has returned, only this time in basis swaps at new record negative lows again this week. One of the lessons of the Asian flu was thought to be by removing currency pegs it would allow local currencies to float against the dollar to remove some or all of the stress. Floating currencies have helped, just not in that way; what they do allow is for us to easily discern which countries are having the most "dollar" problems because the "dollar" problems remain.