Central Bankers Know Nothing About Modern Money

Central Bankers Know Nothing About Modern Money
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It is late August and for central bankers it means Jackson Hole on the itinerary.  The somewhat apocryphal story of the Wyoming gathering’s beginning traces it to Paul Volcker’s affinity for fly fishing.  To get out of the stifling heat of DC, in more than just the summer swampy temperatures, in the late seventies the head of the Fed would go West.  Other economists and central bankers began to follow, the result of which is still with us today.

Before the 2007 conclave, practically no one outside of the political class of Economists paid much attention. One reason is simply that much of what is said there is forgettable. For the deep academics who are invested in this thing, that might not be true.  But the rest of us don’t really care about exchanging theories of World Agricultural Trade: The Potential For Growth. 

That was actually the first topic for what would actually become the Jackson Hole convention.  In May 1978, Kansas City Fed President Roger Guffey spoke to 200 attendees crowded into the Crown Center in KC to hear him talk about just that.  He told the audience:

“[This] symposium on agricultural trade represents the first of what we hope will become an ongoing series of conferences on important economic issues. As we developed this program, our major objective was to consider an economic topic about which important public and private decisions will be made during the coming years. We also wanted the topic to be of significant concern not only to the Tenth Federal Reserve District served by this Bank, but also by the nation as a whole. A related objective was to bring together, in a suitable setting, a group of top-level decision makers from business, government and academia who have considerable expertise in the selected topic.”

One other reason Jackson Hole remained far outside the mainstream consciousness was that for a very long time most people didn’t care what central bankers talked about because it was widely believed they knew their stuff.  So long as they kept the world on track, who needed to know how?

All that started to change in 2007.  The topic picked for that year was, unsurprisingly, housing.  How could it have been anything else?  But in choosing to dissect the semi-official view of our housing stock and the history of its finance, especially in the 20th century, these Economists thought themselves utterly brilliant for merely discussing what everyone else was. 

“I remember the early reaction to the 2007 topic on housing finance,” [then KC Fed President] Hoenig said. “We were told it was irrelevant and not something necessarily of interest to central bankers.”

Who, exactly, would ever have said such a thing?  Most people had been talking about housing for years already by that time, and many would often wonder where in the world this clear mania had come from.  They would often surmise, correctly, that money had something to do with it, and therefore it might be of some interest to some central banker somewhere.

Speaking in Wyoming at that particular forum, then Federal Reserve Chairman Ben Bernanke delivered a speech in which he was hastily forced to acknowledge what had just weeks before become not “contained.”  The event was held on August 31, 2007, just two weeks after the Fed’s first of many emergency measures reduced the Discount Rate “ceiling.”  That followed nine days earlier a full systemic break on August 9, and two days before that the regularly scheduled FOMC meeting that found nothing at all of serious concern.

The majority of Bernanke’s speech was about the history of US housing reaching back to before the Roaring Twenties.  You might wonder, as I do, what the first draft of that speech might have looked like when it was surely written before August 9 (from the speech he did actually give, it is very likely it was something about how the housing industry and real estate market are always bumpy but that in modern times variations are of little concern). 

Attention to Jackson Hole reached its current feverish devotion in 2010.  The global system had suffered a panic, then only a partial and weird recovery marked more so by aftershocks than rapid growth.  It was in August 2010 when Bernanke all but confirmed QE2, without, of course, ever really admitting that if the FOMC felt they needed a second one the first one didn’t work. 

He said instead things like this:

“On the whole, when the eruption of the Panic of 2008 threatened the very foundations of the global economy, the world rose to the challenge, with a remarkable degree of international cooperation, despite very difficult conditions and compressed time frames.”

Typical of lawyerly Bernanke (who isn’t a lawyer), he places the Fed outside of the Panic of 2008.  When confronted and “threatened” by this external emergency our international heroes sprang into action amidst grave danger and personal difficulty (courage, as Dr. Bernanke would later characterize it).  He never bothers to address why there was this crisis to begin with.  Nor was much said about why it seemingly was continuing two years thereafter despite all the heroism, intellect, and genius.

Something was obviously missing then, and remains missing now.  A layperson can easily spot the error, how central bankers are always reacting to what never seems able to be solved.  Even if nobody will ever say what “it” is, its contours come to the front as a very visible shadow as if cut out of the official picture by purpose.  There is an enormous blank spot that can’t be rewritten by intentional omission.

That is perhaps the most striking feature of Jackson Hole; who has never been there to present.  One such person is famed Belgian/American economist Robert Triffin.  He is of course widely known for his 1960 deliberation about the flaw in Bretton Woods.  Called Triffin’s Dilemma, or alternately Triffin’s Paradox, there was an inherent contradiction between the desire for a global currency for global trade and the ability of a single nation’s money to feed it. 

The ultimate result would have to be where the US dollar, as that nation, would become too much for a global reserve to meet its gold obligation.  This is what happened, generally speaking, when in August 1971 the Nixon administration defaulted by ending dollar convertibility.  For many people, that was the end of the story, the beginning of the era of floating rate currencies “freed” from the chains of gold (from the perspective of economists and policymakers). 

There was so much more to it than that.  The global system still had to meet liquidity obligations in a world where the dollar was the reserve denomination.  Almost all theory on the subject places the burden on domestic dollar supply; almost all theory. 

The second official KC Fed Symposium was held on September 27 and 28, 1979 (in Colorado; it wasn’t relocated to Jackson Hole until 1982).  It was during the height, the absolute worst of the Great Inflation.  Many people, including many officials, believed that the whole system, even the dollar itself, was in desperate danger.  The topic in the Rockies, however, was Western Water Resources: The Coming Problem and Policy Alternatives.

Back East and a month later, Robert Triffin was instead speaking in Pennsylvania at the invitation of the Philadelphia World Affairs Council.  On October 31, 1979, Triffin warned:

“My major thesis ... is that neither stable, nor floating exchange rates can function satisfactorily in the absence of any international control, and restraints, over the fantastic explosion of international liquidity provided to the market, in recent years, by the monetary authorities and the commercial banking system.”

The emphasis on this passage as well as the rest of his presentation was “international liquidity.” He was at that time actually hopeful that the initiation of the European Monetary System, a precursor to the European Union, would prove stabilizing.  The EMS linked several major currencies together in order to reduce, they hoped, fluctuations in them.  To be required in this way less than a decade after floating currencies were introduced suggested something else was going on. They were supposed to be the answer, but were proving just as flawed as Bretton Woods.

One man who worked closely with both systems was Guido Carli.  His name does not provoke much sentiment today even in his native Italy, but for two generations he was a dominant figure in Italian monetary politics; if largely because as head of the Bank of Italy he had kept politics from money.

Carli was one of Italy’s representatives at Bretton Woods in 1944 at the ripe old age of thirty.  Just three years later, in 1947, he was appointed to the IMF’s Managing Board.  The International Monetary Fund was meant to be the constraint and cure for any of the gold exchange system’s inevitably profligate members.

Among that class was Italy.  In 1964, with lira in crisis, Mr. Carli was received a hero on his return from Washington with $1.2 billion in aid.  In 1974, amidst raging inflation, he managed to rescue Italy one more time from the brink of catastrophe.  As the New York Times described it upon his resignation from the Bank of Italy in 1975:

“A year ago the whole country appeared, as does New York City today, on the verge of bankruptcy. Oil prices had quadrupled and Italy has no domestic reserves. Inflation was, approaching 25 per cent a year. The city of Rome was often paralyzed by strikes. Deficits in the balance of payments were running in the trillions of lire, or a staggering $5‐billion in the first six months of 1974.”

Carli’s solution?  He was Volcker before practically anyone had heard of Volcker.  The Bank of Italy put on monetary and credit restrictions while working tirelessly to get the government into fiscal austerity.  The same Timesarticle notes, “It was, some said, another Italian miracle.”

So when Guido Carli was invited to speak also in Philadelphia also in 1979 next to Robert Triffin, his message wasn’t some fringe raving.  Jello Ziljlstra , at the time the head of the Bank for International Settlements, the central bank’s central bank, called him after Italy’s miracle “the most brilliant central banker in the world.” The monetary system was at a crossroads and he wanted, like Triffin, to make sure people knew exactly what was going on during this Great Inflation.

“The first [source of global instability] lies in the fact that the process of creation of international liquidity triggered by the U.S. balance-of-payments deficit is not only due to the increase in the amount of the dollar reserves in the hands of other central banks, but also to the presence of an international banking system that multiplies U.S. liquid liabilities outside the control of any monetary authority. The problem is old: it has been ten years since I first pointed to the need for some kind of regulation of the Euromarkets.”

He did not mean “Euromarkets” as something related to the EMS, or even Europe in particular.  The word meant eurodollars, or offshore liquidity that was the true currency system that replaced Bretton Woods long before its official end in 1971.

Both Triffin and Carli were concerned about this monetary blackhole, a gigantic international shadow that had played some huge role in the destabilizing and destructive forces of the Great Inflation.  While at the behest of US central bankers others around the world gathered in Colorado to talk about water, these eminent economists wanted to talk about eurodollars. 

Triffin had written in an essay in 1978, a year before his appearance in Philadelphia, the central crux of the global reserve evolution.

“By definition, such contracts cannot be denominated simultaneously in the domestic currency of each of the contracting parties and are largely denominated in fact in a third currency—sterling in former days, dollars when I first wrote about the problem, and increasingly Eurodollars and other Eurocurrencies.”

Nobody ever gets around to defining what a reserve currency actually is.  It is far more than just denomination; it is instead a true medium of exchange that requires existence and volume. How much volume is a matter for debate still, but we certainly have an idea when that volume isn’t helpfully calibrated. He was talking about Bretton Woods (sterling and dollars) giving way not to floating currencies but something people did not yet really understand (eurodollars, primarily).

In fact, this kind of examination was actually quite common in the seventies (or at least more common relative to the rigid ideology that prevails today and of the last few decades).  The topic of external money was often raised and most of the time by economists who (rightly) wondered what was really going on out there.  A lot of carefully laid and constructed econometric models were failing, often spectacularly (see: Stephen Goldfeld, The Case of the Missing Money; 1976), and in genuine scientific pursuit many went looking for answers without a prejudiced disposition. 

In the eighties, however, it all practically stopped.  Research on eurocurrency markets essentially died out in the early 1980’s.  There was the stray academic paper here or there that maybe kinda sorta mentioned eurodollars, but it was nothing like the inquisition that only started to piece together global monetary operations as they really were.  The investigation of the shadows never really got going.

So why did it end? 

The short answer is Volcker.  Following Carli’s playbook, the Volcker Fed defeated (by ditching a federal funds target, it needs to be pointed out, for a direct money supply target) the Great Inflation for good (we are told). The dollar no longer threatened, interest in especially international monetary arrangements withered in a new age of monetarism without money.  Everyone simply assumed that the Fed knew what needed to be known.

That incuriosity lasted decades while the eurodollar system built up in so many other capacities.  The dot-com bubble was not the first, as there were global monetary inequities all along – starting with the Latin Debt Crisis in the 1970’s.  Nobody much cared about the real monetary details, because especially the Greenspan Fed had been given credit for generally “moderate” US economic conditions. 

If the Fed was as powerful as most believed by the demonstration of Volcker’s money targets, none of this would matter.  But something both Carli as well as Triffin alluded to would come back to haunt this blanket assumption.  When Volcker’s Fed “saved” the dollar, global reserve liquidity was more balanced.

By that I mean domestic dollar supply was still on more equal ground with international dollar supply (eurodollars).  What the Fed did to the domestic supply mattered a great deal internationally under those proportions. During the seventies, eurodollar growth was extremely rapid and contributing to the great monetary imbalance, but the eurodollar system wasn’t (yet) so large as to be unrestrainable by domestic policy. 

That balance clearly shifted and changed throughout the eighties.  When the pound crisis hit in 1992, central bankers were astounded by the massive offshore liquidity that easily dwarfed what they could answer with.  The balance of money had shifted, dramatically, yet economists and policymakers did not shift with it; they still assumed the Greenspan Fed was on par with the Volcker Fed.

It was a false assumption, and often demonstrably so. As the New York Timeswould write in September 1992 of the Bank of England’s increasingly desperate plight:

“The world's currency markets, it seems, are no longer governed by central bankers in Washington and Bonn, but by traders and investors in Tokyo, London and New York, as the chaos in the currency markets this past week has shown.”

And what were those Japanese, British, and American traders trading in (and out of)?  Eurodollars. 

In May last year, the head of the BIS’s Monetary and Economic Department, Claudio Borio, spoke at the Seventh High-Level SNB-IMF International Conference on the International Monetary System. 

“The question I would like to address today is whether a more pluralistic international monetary system – one with more international currencies on a more equal footing – would enhance global monetary, financial and macroeconomic stability.

“This is a perennial question. It was, for instance, just as prominent under the Bretton Woods system as under the arrangements that have followed – which some regard as a “non-system” (eg Padoa-Schioppa and Saccomanni (1994)). And it presupposes the answer to another, more fundamental, question: what is the Achilles heel of the international monetary and financial system (IMFS)?”

The Achilles’ heel, as it turns out, is economists and central bankers like Mr. Borio.  In his whole lengthy speech, the word eurodollar was never once said.  He never bothers to address where all these “dollars” really come from:

“According the latest BIS survey of foreign exchange (FX) markets (BIS (2013)), in April 2013 the dollar was on one side of no less than 87% of overall foreign exchange trades and of over 90% in the pivotal FX swap market. The other currencies followed a long way back, with the euro at 33%, the yen at 23% and the renminbi at only 2% or so. Similarly, the dollar is the FX intervention currency of choice, except on the borders of the euro area.”

These people merely assume that Paul Volcker’s successor, whoever that may have been or may be yet, will be able to do whatever it is he did.  The history of this lost decade since 2007, however, shows the folly of believing things, even money, would stand still for all that time. 

The dollar did not replace gold in 1971.  The eurodollar did long before 1971.  This is not mere trivia, as some number of economists contemporary to the change appreciated the distinction.  They even tried to warn authorities about the downside of unrestrained monetary ability. No one listened. 

The topic of this year’s Jackson Hole congregation is predictably absurd and offensive:  Fostering a Dynamic Global Economy. A better topic would be, How Can We Explain A Lost Decade?  That would have saved everyone the trouble of traveling so far out West and from far-flung corners of the globe, obviating any need for any conference at all.  The answer to such a question is for the world’s monetary authorities exceedingly simple; they know nothing about modern money and it shows.  

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

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