The Eurodollar Giveth, and the Eurodollar Take Away
AP Photo/Burhan Ozbilici
The Eurodollar Giveth, and the Eurodollar Take Away
AP Photo/Burhan Ozbilici
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Fred Schultz was Vice Chairman of the Federal Reserve during one of those watershed periods that come up consistently throughout history. No Economist, he was a Korean Army vet (artillery officer) before jumping into (actual) banking as well as investment services. Whether or not he was some star-crossed addition to the Fed’s top-level roster, some kind of monetarily jinxed influence is probably unlikely.

The possibility, however, was raised by Mr. Schultz himself at his last FOMC meeting. This was February 1 and 2 of 1982, and things were neither going well for the central bank nor in America. Caught in a deep recession, one that began the previous summer under the still swirling heated winds of the Great Inflation, looking forward to his own retirement the Vice Chairman saw in it a possible change in fortunes for both.

“MR. SCHULTZ. This is the last time I'm going to be with you and it's very clear that when I came on board things got worse and now that I'm leaving things are bound to get better!”

True enough, the poor guy took to his office in 1979 amidst a further escalating monetary catastrophe creating an historic economic disaster. No one had answers for what was by February 1982 in its seventeenth year which also hit with one of the worst recessions on record. Correlation is never alone causation, of course, but what else did they have to lean on at the time?

Despite deep recession which had decimated especially the American labor market throughout the last half of 1981, and more still to come (though, I should point out, unlike 2008 and after the labor force itself never retreated since American workers have understood the vast difference recession vs. depression in a way Economists apparently aren’t capable), the FOMC was suddenly in a tizzy by early 1982. Seemingly out of nowhere, money growth accelerated wildly for several months at the end of ’81 up to that particular February ’82 confused gathering.

The central bank was running, its voting members and staff believed, a tight money policy. Yet, this bulge in the money aggregates threatened to throw their plans for the rest of 1982 asunder.

“MR. AXILROD. Well, so far as we could tell, in the last 2 or 3 months we have had this very sharp run-up in the money supply, which partly was expected, given interest rates, and partly unexpected.”

This was back when the Fed targeted a range for money aggregates, M1, M2, and a primitive version of M3. Forced into the habit by Congress and its Humphrey-Hawkins impeachment, those produced, set, and publicized for the calendar year ’82 would be in danger of breach (to this upside) given what was already happening at the year’s beginning.

Worse, still totally committed to the fight against the inflationary monster, appearing to “allow” high money growth way above published targets threatened to leave the economy with yet another recession followed by possibly more uncontrolled inflation repeating the “stagflation” pattern established during the entirety of the decade prior.  

San Francisco branch President John Balles adequately laid out the proportions of their dilemma:

“MR. BALLES. It just seems to me--if we're willing to bite the bullet in terms of what might be a reaction among the general public or superficial observers of our policy that we are going to be accelerating monetary growth--that a range for M2 of 7 to 10 percent versus the 6 to 9 percent we've been talking about tentatively and a range of 8 to 11 percent for M3 instead of the 6-1/2 to 9-1/2 percent we've been talking about would simply be more realistic.”

Caught already between the proverbial rock and a hard place, officials couldn’t even get much of a handle on what was actually happening. They didn’t know for sure if “this very sharp run-up in the money supply” was a statistical figment of seasonal adjustments, minor technical demands, or if and how it might be real.

As Robert Black, President of the Richmond Fed branch at the time, pointed out, the Committee itself was getting conflicting money data in more up-to-date calculations on M1. New York said such had declined while others said the balance had gone further upward. To which the Fed’s mythical Chairman immediately responded:

“CHAIRMAN VOLCKER. Neither of them knows anything!” [exclamation in original transcript]

Truer words rarely ever spoken in more than a century of our nation’s central bank.

It wasn’t just they could hardly get a handle on which M1 was doing what, policymakers were flummoxed by contrary conditions and signals between the aggregates, too. M1 was doing something M2 wasn’t, and when M2 did something else M1 went still another direction.

Furthermore, it wasn’t as if money was flipping around only between those two traditional-type definitions of it; there was the primitive M3 necessitated by grand money evolutions which just so happened to have coincided with the Great Inflation (in this sense correlation and causation are very close alike). And even then, money in the real economy wasn’t limited at all to M3.

Or something partially developed called “L.”

These people were having a hell of a time trying to sort all this out on the fly. How this could be after seventeen years, well, you’ll see. Stephen Axilrod, who was a Staff Director, tried to describe it this way:

“MR. AXILROD. Mr. Chairman, it's very difficult to isolate the structural changes as they're occurring now…there was a downward shift in the demand for M1, where people were taking money out of currency and demand deposits and putting it into a lot of other assets, some of which were in M2. But that was a substitution that didn't affect M2 itself. So actually, on the level of M1, the downward adjustment in M1 that occurred was a structural change that was evolving.”

But if money was coming out of M1 because of lower demand for that kind of it, where else might it have been ending up if not M2? Taking things to the next step, why was money demand for what wasn’t defined (by these bureaucrats) so high in the first place?

Yes, eurodollars and repo. But these were realities even by 1982 officials really didn’t take seriously at all. Despite, you know, the Great Inflation as well as by then more than a decade of wrestling with, and being constantly led astray by, M1 and M2, when it came time to assess monetary policy they always stuck with what little bit of money they (thought they) knew.

I’ve clipped some from this portion of the conversation, but what quotes I’ve pulled out are a reasonable summation (you can read the full transcript for yourself):

“CHAIRMAN VOLCKER. All right, I do not detect any other course that is more acceptable at this point. We reviewed these targets; considerable concern was expressed about the recent developments in M1 which suggest that some relationships could be developing that we did not anticipate. We think it is too early to make that judgment…On M2, we say we think it is likely and desirable that growth be toward the upper end of the range…And we just leave the M3 range [unchanged]. Does it make any difference to anybody where M3 and bank credit are?


“VICE CHAIRMAN SOLOMON. But suppose we get a switch from large CDs to Eurodollar financing?


“MR. GRAMLEY. Well, nobody pays any attention to those targets.”


But why? Why didn’t anyone pay attention, very close attention, to some of those like eurodollars or repo? Again, Great Inflation; inflation is out of control money; they had just spent several hours, after much the same for many years, discussing how money was nothing but confusing – and these were the people who we’ve been told by hindsight to have been the most proficient about that very topic and this very issue.

To find the rationalization, we can go backward to some earlier products of inside academic research – particularly when it came to eurodollars. Banks – domestic banks - may have been funding their credit activities in the eurodollar market, but the Economists at the Fed (and elsewhere) believed either of those nothing more than investment choices.

Here's what the Fed's New York branch staff had written up about the subject in 1979:

“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.”

In other words, in order for anyone to use eurocurrency at some point they would first have to transfer these time deposits into domestic currency: “…if Eurodollars must be converted into United States demand deposits to be used in purchase of goods, services, or assets…then national monetary authorities could in principle influence those expenditures by controlling the domestic money supply.”

Under this set of major assumptions, you then wouldn’t bother about most of M3 let alone eurodollars. But were they correct assumptions?

Not a one.

To start with, it was never once true that “all Eurocurrency liabilities are time deposits.” And for anyone at the Fed to make such a definitive determination, accepted as fact up and down the line, was belied by even contemporary scholarship; let alone the actual fact the Federal Reserve had hardly kept concurrent with any of its proliferation of developments since the eurodollar’s unknown origins.

Economists Duffey and Giddy had even described these very proportions and functions in detail in February 1981, just a year prior to the FOMC’s struggles:

“The remarkable feature of this use of forward contracts in the Eurocurrency market, for example, is that it enables banks to offer deposits or loans in any currency for which there is a forward exchange market, even if no external money market exists in that currency. The result is that the Eurodollar is the only full-fledged external money in existence; other Eurocurrencies are often simply Eurodollars linked to forward exchange contracts.”

That had meant this truly was a monetary element in the medium of exchange (as well as unit of account) function in whichever system might have been connected to it. Since it was global reserve currency, that had meant everyone – including the domestic US dollar system in which domestic banks operated eurodollars inside and out.

The banking system – this international eurodollar banking system – wouldn’t necessarily need to convert into (or out of) traditional monetary forms in order for their customers (or the banks, in the case of asset markets) to make use of what was funded from it. The lines between credit and money had blurred long before, with the FOMC holding on to the very outdated dogma blinding their meager efforts.  

Reminded of Robert Roosa in 1984, this was a full-fledged monetary system that spread monetary effects (and not just of the inflationary kind) globally: “…the enormous expansion in markets for U.S. dollars offshore, and the new networks of interbank relations that made possible the creation of additional supplies of dollars outside the United States and beyond the control of the Federal Reserve.”

It was that last part – “beyond the control of the Federal Reserve” – which explains so much about the Federal Reserve’s continuous insistence to look the other way no matter how much monetary trouble would arise and how much difficulty its people would have attempting to explain everything going wrong around them. Better, from their perspective, not ours, to always look the other way.

This intellectual black hole was never illuminated, instead a new set of assumptions was offered in its place: The Volcker Myth.

Switching over from real monetary policy to now expectations policy, Economists and this new generation of central bankers (more and more as Economists) decided they wouldn’t need to know the money details. That’s the only real thing about it: they knew nothing and knew they knew nothing. They’d play around instead with a single interest rate and let the banks work out the details.  

And it all stemmed from this idea that a determined central bank can at least heavily influence if not outright control what banks do when it comes to this impenetrable mess of money. Volcker, after all, had, the myth goes, intentionally provoked not one but two serious recessions and that is what it had taken to finally defeat the Great Inflation.

So was born afterward: don’t you dare fight the Fed!

No. Gaslighting, pure gaslighting to sell the world on the myth. At the time, back when it was all unfolding, policymakers including Volcker had no clue what was going on; not just money, but also economy (from the same February ’82 meeting):

“MR. BALLES. Very briefly, the reason is that, as I looked back to last July [1981], we hadn't known about the weakness now emerging in the economy. We had expected--I think more than we do now--the prospect of a further downward shift in the demand for money, and that downward shift seems to have slowed pretty considerably…But given the fact that we now are in a fairly serious recession that we hadn't really anticipated in July…”

It was all an accident as these “best and brightest” were just winging it as they went along – and letting the real economy, the public pay the price for quite purposeful ignorance. And then after what happened happened, theythen went back and created this idea it was all done on purpose. That policymakers had creatively discovered some simple control from out of clear chaos.

Our heroes!

And they got away with it because of the Great “Moderation”, policymakers like Volcker and Greenspan riding the coattails of that very same eurodollar system and claiming credit for any if not every one of its positive outcomes. Including that initial one.

What that had meant was this new form of no-money monetary policy correlated with favorable outcomes (low inflation, rising productivity, and globalization driving some very real prosperity) quite by accident. Only later did those at the Fed, in particular, claim without evidence (see: Stock and Watson) some serious proportion of causation. Even Alan Greenspan cautioned against taking this claim too far (the actual point behind his 1996 “irrational exuberance” speech).

The correlation, of course, broke down violently beginning in August 2007 (though it began to fall apart earlier in late 2006, once, appropriately, eurodollar futures signaled its likely end). No matter how many QE’s since, trillions in bank reserves, not a single predicted correlation in the real economy (or real markets, for that matter) has been met.

Very much like the Great Inflation. The eurodollar giveth; the eurodollar taketh away.

While the public – through no fault of its own, the fault lays with Economics – knows nothing of this, the system itself has become all-too-aware of what expectations policy really means for today and tomorrow as it has meant for forty-plus years of yesterdays. We’re meant to be more than impressed by Jay Powell’s (and now the ECB’s) taper for reasons that don’t associate with the very world we actually inhabit.

Some things truly don’t change.

Though Fred Schultz passed away in November 2009, maybe he has a living relative the current Federal Reserve could bring on and see if maybe they can resurrect the former’s correlation. At least that one hasn’t yet been so thoroughly falsified.  

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

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