No Matter What They Say, the Future Isn't Inflationary
AP Photo/Karel Navarro, File
No Matter What They Say, the Future Isn't Inflationary
AP Photo/Karel Navarro, File
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As hard as it may be to unpack the tangled mess that is the global monetary system, something I wrote many years ago about an important early stage of evolution away from gold exchange and into a very different arrangement perhaps best describes the process as well as the drastic implications we’d be left to deal with nearing six decades afterward.

Everyone is taught that Bretton Woods ended in August 1971. No. The formal end was only that; the functional end came much earlier. In fact, that structure had only really made it to November 1961 before seriously breaking down into practical default. It was then several countries banded together with the United States to create what was known as the London Gold Pool.

Under Bretton Woods, the US was obliged to surrender gold reserves upon presentation of currency from foreign official holdings. A globalizing economy where growth in it – and of it – was far more rapid, robust, and beneficial than anyone had realized back in ’44 required an extra dose of dollar financing (sterling was already left unsuitable). Quite simply: more dollars were needed outside the US, except more holding dollars outside the US demanded gold conversion (France, mostly).

This was, of course, Robert Triffin’s famed paradox. No national currency, the economist surmised, would be able to survive as international reserve currency when national reserves were delivered upon demand. Eventually, the world would need more dollars than US gold holdings could back, draining American gold reserves to the point the whole scheme would implode.

In the final years of the fifties, it nearly did. Enter the Gold Pool. In response to massive outflows of gold (again, France) in ’58 and ’59 continuing right on into ’60, advanced economy nations in Europe banded together with the US to manipulate gold and currency values to ensure neither strayed too far from their assigned Bretton Woods relationship.

It was in every way a violation of Bretton Woods, even if a necessary one for that moment.

At the same time this was taking place, even more confusing developments rocked American monetary officials. Where had all these foreign dollars come from? Believing this overseas surplus a balance of payments issue, a deficit from the US perspective, monetary officials repeatedly tried to stem the tide with everything from currency controls to reserve requirements to interest rate hikes.

Nothing worked; always more dollars overseas. In September 1963, the FOMC observed (Memoranda of Discussion):

“Within this sector, there does not seem to have been much change on short-term account. The rise in U. S. short-term rates has not altered rate differentials in relation to major financial centers abroad: Euro-dollar rates have increased virtually as much as U.S. rates.”

The idea was simple enough, and consistent with existing doctrine and the (primitive) worldview behind all of it. Dollar outflows, they thought, were primarily a product of Regulation Q; put simply, the government’s ceiling on domestic money rates meant anyone with dollars could easily obtain a better rate of return in this unregulated overseas marketplace for dollars.

No consideration was given for why such a monstrous overseas marketplace for dollars had arisen in the first place.

One such anecdote from that same year provides much by the way of an effective answer. It begins in Italy.

The Italians in the early 1960’s were in trouble. Their currency, lira, or lire, was the sick man of Europe since it was tied to a malfunctioning economy beset by governmental problems along with too many on the private side to count. A real mess.

Normally, this kind of risky proposition would have sent speculative investments as well as legit financing running for cover – and it did. By 1963, Italy’s own rather more traditional balance of payments deficit was thought to be in the neighborhood of $150 million. It doesn’t sound like much today, but this was a huge imbalance and given that it was, anyone would’ve been forgiven for anticipating, even betting on the lira’s collapse.

Instead, the US dollar suffered the apparent “damage.” How? The Swiss National Bank and eurodollars.

Italian commercial banks had been let to borrow in the eurodollar market in increasingly unrestricted fashion in 1962. They then did; hand over fist. In the first three-quarters of 1963, it was believed these Italian financials had pressed the eurodollar market into lending about $150 million – curiously, the same amount as Italy’s capital deficit and thereby masking it.

So, $150 million, give or take, came in borrowed from eurodollars while $150 million in lira went out to, where? Switzerland, mostly, and a few other places. Outflows in lira forced the SNB to buy up the currency lest it cause Swiss private banks further trouble. What to do with the lira? Sell it for dollars, eurodollars, of course, which pressured the lira and leading to the Bank of Italy (central bank) stepping in to buy it back from Switzerland.

Thus, on both ends, the US dollar was used to support the huge Italian monetary deficit. In September 1963, again the FOMC was far from thrilled to find out this fact:

“But the dollar has been affected by these movements as the vehicle currency of most exchange transactions: when there are heavy shifts, say, of Italian lire into Swiss francs, the dollar should, in theory, become stronger against the lira and weaker against the franc, so that the combined impact would be neutral. But if, as has actually happened, the Italian authorities intervene in the market to prevent the lira from weakening, the dollar does not strengthen in Milan but it weakens in Zurich--with unfavorable psychological repercussions.” [emphasis added]

There are those who say the US dollar’s status as reserve currency represents a privilege the country shouldn’t ever trade away or give up. From its earliest stages here, while Bretton Woods was already effectively sidelined, “the vehicle currency of most exchange transactions” more often than not represents a burden for that currency.

But what currency? Called dollar, sure, but not dollar in any real sense.

This brings us back to that line I wrote years ago which, I think, still perfectly and briefly (not my strength) sums up all of these things:

“The SNB, for its part, informally rejected Fed overtures that perhaps the Swiss might be better served using their own currency to stabilize their own currency.”

Rebuffed by the miffed American monetary officials, the Swiss chirped back that their access to the eurodollar was by every means the best, most efficient vehicle currency by which to resolve monetary imbalances that might arise between otherwise completely disconnected and unrelated national circumstances. This was an Italian issue that grew into a Swiss issue ultimately settled by the eurodollar as it more and more dethroned Bretton Woods.

And it wasn’t just foreign banks and foreign central banks availing themselves of dollar-denominated currency floating around by the bushelful offshore; with nary a printed paper Federal Reserve Note in sight among the bushels. On the cusp of what would, just a few years on, become the Great Inflation, the blinded FOMC in June 1963 relayed another evolutionary truth which would come to define an entirely changed world:

“The Chairman [William McChesney Martin] said that personally he would be inclined to move modestly toward less ease. He added, parenthetically, that he questioned the use of the word ‘tightness’ at this juncture. Never had he seen a period when there was so much loose speculation with money. The practice of American banks in using the Euro-dollar market was growing all the time.” [emphasis added]

Far from American depositories, domestic securities dealers as well as American corporations were more regularly and heavily observed for dollars offshore. The increasing utility of the eurodollar system to serve each and every basic need any global reserve currency must was perfectly evident this early. Here’s the BIS in ’64:

“In addition, some lending of Euro-currencies has clearly had nothing to do with international trade; for instance, some US security dealers and brokers have been borrowing in the Euro-dollar market instead of from banks in New York. Incidentally, European branches of US banks have recently been shifting less of their Euro-dollar deposits back to head office than a few years ago and have been lending more to local borrowers, particularly foreign branches and affiliates of US firms.”

The eurodollar had everything almost from its origin; financing massive national capital shortfalls, and then the regional consequences attempting to manage or unwind them despite neither being original US$ problems; trade financing for otherwise domestic firms; speculative or “money financing” for also domestic securities dealers; foreign central bank acceptance and availing themselves of its broad purposes. And so on and so on.

Among these latter, the Japanese enter our story as sort of a collateral consequence to Italy and Switzerland’s dealings. Still 1963, that November while the US and rest of the world’s attention was focused on political assassination in Dallas, partly related to the heavy borrowing by Italian banks in eurodollar markets as well as the SNB’s other end settlement strategy, Japanese banks – themselves a large early participant in eurodollars – struggled to secure $200 million in funding rollovers.

In other words, one day like every previous day they easily arranged $200 million in short-term financing (there isn’t any record whether it was secured or unsecured, though I would imagine a mix of both) badly needed because the Japanese yen was itself a little too lira-like at the time.

Another example of this “vehicle currency of most exchange transactions”, only on the next day, so to speak, that $200 million was no longer offered on the same terms. Too much currency risk or credit risk from the eurodollar lenders’ perspective, so they shut it down leaving Japan’s biggest and most reputable institutions impossibly short (thus, why it's called a synthetic short position; they aren’t betting against the dollar, rather a funding mismatch which leaves them with the same kind of risk) a huge dollar burden.

Unwilling to see any eurodollar default posted to the Japanese system, the Bank of Japan ordered its American reserve custodians in New York City to liquidate the same $200 million in Treasury bills being held on behalf of the Japanese government (the responsibility of BoJ). The proceeds from the sale were used to close out the eurodollar short, establishing a precedent that remains, and remains misinterpreted, to this day.

Vehicle currency, sure, but it’s not always smooth and easy. Markets, even reserve currency markets, tend to be lumpy and occasionally problematic. So it was for Japan in late 1963, meaning that these collectively short a mammoth $200 million were bailed out by the central bank liquidating reserve assets, US Treasury bills, to supply the necessary liquid answer (below from the December 1963 FOMC):

“It was reflected, however, in transactions in the New York money market; the Japanese government, for instance, was selling U. S. Treasury bills to provide funds for Japanese commercial banks to repay Euro-dollar loans they were unable to renew.”

None of those things showed up on the US balance of payments statistics, either, because the eurodollar’s ascendancy was never really a product of US$s being created within the US and then “sent abroad” by whatever means. This was a system, denominated in dollars, that dominated the global monetary space due to its own independent factors.

The very same “conundrum” as would lead Ben Bernanke in the first decade of the 21st century to absurdly surmise some “global savings glut” in order to describe the fact foreign governments, central banks, and private financial firms had accrued so much in US$ reserves and assets particularly parked in safe US government forms – UST’s as well as GSE issues – despite the practice having prevailed from almost the very beginning of the system.

The pattern Italy, Switzerland, and Japan all illuminated in the single year 1963 was how the eurodollar had already attained global reserve status, in that while the US$ label may have prevailed, the actual and necessary functions were provided by this offshore arrangement of reserve-less bank liabilities. It further established and linked the use of foreign reserves especially UST’s to conditions in the eurodollar market.

When eurodollars are plentiful, all the things Italy, Switzerland, and Japan did were done without much fuss and bother (even these considerable Japanese funding issues were quite easily resolved by the simple sale of T-bills in NYC). When eurodollars are not plentiful…

For one thing, countries like El Salvador legalize something like Bitcoin.

And we observe the often-largescale selling of US$, primarily US Treasury, assets by foreign entities of all stripes. But not just foreign government sales, also a good many private holders join in, and not by choice nor because they allegedly hate those assets.

On the contrary, like Japan 1963, faced with a eurodollar shortfall the rest of the world collectively sells its reserve assets “to repay Euro-dollar loans they were unable to renew.” Even the ’63 FOMC had that much figured out, even if Ben Bernanke nor any of his successors ever could.

According to the latest Treasury Department TIC figures, oh boy, a whopping (net) $40 billion in net sales struck in May 2021. Just two months ago! It may not sound like much in the 21st century sense, but that’s a relatively big number, too. To begin with, a net negative for any month has been exceedingly rare, reserved only for the worst eurodollar (read: not plentiful) cases.

These are the kinds of declines in TIC associated with months like December and June 2018, October 2015, November 2008, and August 2007.

Were foreigners of all kinds selling US Treasuries, principally, two months ago because they thought Biden’s government was being reckless? Or because they believed US inflation was about to go insane (like the mainstream interpretation of the CPI’s are saying)?

Answering those questions is the bond market; yields on UST’s really began to fall during this particular month, only adding to the public’s confusion. With foreigners selling bigtime, how would Treasury prices go up?

The interest rate fallacy. And not for the first time, either.

The global reserve system, the real one, just isn’t anything like what the textbooks say. The domestic dollar never solved Triffin’s Paradox; the eurodollar did and in doing so allowed the whole matter to simply fade into history. Yet, it is history we now have to draw on just to make some sense of the present, and therefore hope to piece together any realistic, plausible idea as to the future.

It's still nowhere close to an inflationary one by any account that matters.

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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