Sunday, November 1, 2009
Money Talk Continued
We had a good discussion on the concept of money developing after the last three posts. Here are a few of my comments, re posted by request:
This first one was a response to a question about a potential dollar rally during another global liquidity crisis...
Hello Anonymous (6:05PM),
Here are some thoughts and comments as you requested:
We need to keep a few principles in mind in order to understand what is being discussed in these confusing discussions about a liquidity crisis, currency swaps, and supposed dollar strength. My apologies if I simplify this too much for your taste, but my thoughts are simple ones...
1) First of all, what are all banks and bankers afraid of? A run!
2) Hyperinflation coincide with a multiplication of the monetary base (which is the natural response to the market devaluing "broad money", near-cash credit assets), not with the credit expansion of broad money through commercial bank lending.
3) The USDX measures the supply and demand of actual base money needed for transaction clearing, not the willingness of banks to stick their necks out further. Base money is the "reserve" in the term "fractional reserve banking". We could call it "fractional base money banking".
4) Currency devaluations are long term and permanent. USDX quotes are short term and temporary.
5) There is no difference between the $ and the $-financial industry ($-FI). What is bad for one is bad for the other. A run on the system is just as bad as a run on the banks, or a run on the dollar. Any run screws them all.
6) Much of what we all think of as money (dollars) is not really dollars in the same sense as the dollars needed in a liquidity crisis. We think of money mostly as M2. But a liquidity crisis requires MB (Monetary Base, or base money)
7) "The system", meaning the worldwide financial industry is divided into sub-systems; The Federal Reserve system, the Eurozone system, the British system, etc... What differentiates these sub-systems from one another is their own currency, which can be created on a whim by the central bank and lent to banks that need extra funds with the CB taking collateral from the borrowing bank in the form of assets denominated in that currency.
8) Each sub-system is a completely interconnected network of financial institutions, including commercial banks, investment banks, brokerages, etc... 99% of all transactions within each sub-system clear without ever having to move money (dollars). For example, within the bigger banks, most transactions clear in-house. One person might buy a house, taking out a new loan for $100,000 while some other bank customer sells his house paying off his $100,000 loan. These two transactions cancel each other out in-house. Inter-bank transactions cancel each other out as well. For the most part, finance and banking is a zero-sum game within each sub-system, from stock transactions to bond transactions to new loans to settled loans to you writing a check to your dentist. If one bank ends up with more at the end of the day and another with less, then the central bank clears the trade with a book entry transferring "reserves" from one bank to the other. Even new loans do not really create the kind of money that is needed in a liquidity crisis. They create credits issued by the bank, liabilities that are counterbalanced by the debt papers you signed. Those credits entitle the bearer to dip into the bank's actual dollar reserves, but do not create new dollars. The only new dollars that get created are when the bank must move funds to cover fractional reserve requirements. Those funds then become new monetary base. THOSE are the kinds of dollars needed in a liquidity crisis.
9) Each sub-system has a TREMENDOUS amount of flexibility since the CB acts as the ultimate clearing house between all the financial institutions in that sub-system. And since we are now on a purely symbolic fiat currency, the CB can create any liquidity the system needs. If one bank comes up so short at the end of the day, owing another bank more reserves than it has, then the CB just creates new reserves and lends them to the bank that is short and the CB takes assets (from the borrowing bank) onto its own balance sheet to counterbalance and collateralize the loan of fresh new money. This flexibility has virtually eliminated all banking liquidity problems within any given sub-system. Only an actual bank run on physical cash within a sub-system presents a real threat. And if that run happens to only one bank in that sub-system, then that bank is sacrificed. If a sub-system-wide run on cash were to happen, we would have a bank holiday while they figured out the best way to devalue the monetary base and increase it.
10) Viewing the whole worldwide financial system, in which the BIS acts as the ultimate clearing house, there is much less flexibility because the BIS does not print the currencies it clears. The BIS would prefer ITS central clearing to be done in gold bullion, stored in its vaults and moved from one countries slot to another when necessary. But the $-system doesn't want to play that game. Even still, 99% of the worldwide transactions clear without the need to transfer any funds around... as long as it is a "business as usual" day.
11) Problems start to arise in the international clearing house when daily transactions become unbalanced, meaning too many people trying to do the same thing all at once, with no one willing to do the opposite thing. The two sides of a zero-sum game are never in perfect balance, but they are usually close enough that market pricing takes care of the difference. (If there are too many sellers then the price drops until the sellers equal the buyers.) But sometimes an event happens that spooks the markets and sends everyone to one side of a trade all at once. Prices go into free fall which spooks the markets even more. Then the exchanges are shut down "to let cooler heads prevail". But this only spooks the market further. Finally, at the end of the day, the clearing house is left with a big one-sided mess to clean up.
12) Here is the big problem. Each of these sub-systems has its own currency which its CB can print at will... flexibility! But with the dollar being the global reserve currency, there are lots and lots of dollar-denominated assets held by financial institutions in many non-$ sub-systems. So when there is turmoil in the dollar-denominated markets, the non-dollar sub-systems run into a clearing problem because they can't print dollars to help banks that owe other banks more dollars than they have. So they turn to the BIS, who also can't print dollars. Only the Fed can. So the Fed ends up being the de facto CB to the world. But it is not the clearing house for the world, and it does not take assets onto its books from those foreign banks that got into trouble. Instead, it lends directly to the other CB's which print some of their own new currency and send it to the Fed in exchange. This is why it is called a "swap" instead of Quantitative Easing. They are swapping freshly printed currencies instead of assets for currencies. All base money! The same as cash. TWICE as potentially inflationary as QE on a global scale because two sides are now exposed to currency risk.
13) When the Fed makes these international currency swaps, it doesn't send pallets of hundred dollar bills on a plane. It simply makes a contract with the foreign CB and a book entry. The contract is a two-way promise to later provide pallets of physical cash if anything goes wrong and cash is needed. And with this promise in hand, the foreign CB makes a similar contract (promise) with the European bank that got in trouble. The foreign CB promises to later provide physical cash if necessary (if something goes wrong), and the bank submits assets to the CB as collateral. Next the troubled bank passes those dollar promises (IOUs) on to the bank it owes the dollars to and that bank credits its customer's account with dollars it doesn't have, but now has indirect access to (if needed). The idea is that as things return to normal and transactions start clearing in a more balanced state that ultimately the dollars that were needed will be able to be gotten on the open market without causing a spike in the price and they can work their way back to the foreign CB. The troubled bank, for example, can later trade assets for dollars and pay back the foreign CB which will then pass those physical dollars on to the bank holding the IOU. And now that the European problem has been cleared, the foreign CB can cancel that portion of the two-way swap agreement with the Fed. And no physical dollars need cross the ocean. And that portion of the currency risk is eliminated.
14) Base money is either physical cash or a liability (IOU) that traces directly back to the Fed, which includes reserves held at the Fed. In other words, it is physical cash, or the promise of physical cash from he who can print physical cash. The Fed is willing to issue these promises willy nilly but hopes it doesn't actually end up having to do the printing.
15) The USDX is a measure of dollar exchanges with other currencies that happen on the open market. The Fed can counteract a rise in open market dollar demand by providing a supply of dollars directly to banks within its own sub-system, or indirectly to foreign banks through swaps with other CB's. Last year the Fed had a lot of practice doing this fast. I am sure the contractual transaction with the foreign CB's took several hours and included recording video teleconferences in which the agreements were legally bound. But now that they have experience doing this in a crisis, next time it will probably be almost instantaneous.
16) So as long as there is more demand for dollars than supply, the Fed can control the price of the dollar on the USDX by its own willingness to lend dollars at zero interest with toxic assets or foreign currency as collateral. This costs the Fed nothing, except currency risk and bad PR at blogs like mine. But where the Fed loses control is when there is more supply than demand. And that is what is coming because of this very inflationary policy of providing dollars to save the system at any cost.
17) The problem is with the assets that are being swapped around for dollars, whether with the Fed or with the foreign CB's. These assets are becoming less and less liquid because they are not valued correctly. If they were valued correctly, the banks would be insolvent and have to file bankruptcy. They wouldn't even have enough assets to settle their debts by swapping with the CB's. This is why the assets need to remain marked to myth. But this makes the assets only sellable to the CB's. The open market doesn't want them. So the clearing mechanism that is needed to reverse the flow of supposedly temporary base money into the system is breaking down. The Fed tells us with a straight face that it can reverse everything it has done so far. But that is only the case if the free, open market is willing to take up all the slack the Fed put out there by private investors buying toxic assets at marked to model prices.
18) So the next time the Fed has to create a trillion new dollars of liquidity, it is likely going to stick in the system as base money that cannot be removed. Ultimately the Fed will be contractually obligated to print actual bills and supply them to the banks and CB's that hold the contract for them. And this is what devalues the dollar.
Conclusions: The USDX is a rather poor metric by which to judge the dollar, even in the short term. As long as there is a demand for base dollars, like there is in a panic or a crisis, the Fed has total control over whether it wants to let that demand bid the dollars on the open market, or provide them itself. And the Fed cares more about the financial system than the value of the dollar, so it will surely provide any liquidity that is needed.
The next crisis, if it is mainly in the US financial system, will likely not spike the dollar because the Fed has total control and flexibility within its own system. If it is spread throughout the world it may spike as foreign banks bid up dollars on the exchange, but the Fed is now more experienced than it was a year ago and will likely put a lid on it very quickly.
But this next dollar shock will probably be irreversible, unlike the last. And in such, it will increase the global supply of dollar monetary base by a large percent. Perhaps by 100% or more. This alone will devalue the dollar and be the cause of the next shock which will require a similar response by the Fed, perhaps increasing the base by another 50% as China and others dump the last of their bonds onto the open market in a highly one-sided transaction sending the value of the bonds to zero, US interest rates to something so high they are non-existent, and the purchasing power of the dollar down into the stinky, Zimbabwe dirt.
So in short, I guess I agree with David Bloom. Of course it COULD rally, but I don't think the Fed will let it (unless it happens to have some T-bonds to sell that week!). Letting it rally too high would crush the financial system (by driving asset values into the dirt) which the Fed wants to save at any cost. Even though the cost will be the crushing of the system. The ol' Catch-22.
Sorry if this seemed a bit simplistic or a little elementary. Of course there are more complicated issues involved, like the $ carry trade and cross-currency investments. Derived foreign exchange activities become very complicated very fast! Too complicated for the banks, obviously! But I hope I at least covered the basics of the problem, enough to explain my answer. You all will be sure to let me know if I got something wrong... I am sure of that! ;)
PS. This is the big secret that George F. Baker didn't want to tell Congress in 1913. That most all of what we think is money is really just promises issued by banks to supposedly credit-worthy entities giving them the right to withdraw value from a small reserve of actual money, but at the same time praying to God that they don't! It's like saying, "here you go, it's all your's, whenever you want it come and get it" with their fingers crossed behind their backs hoping you won't ever actually "come and get it".
But whatever happens in the short term, the USDX will ultimately collapse just as Jim Sinclair says because ultimately it DOES represent a preference of currencies for use in international trade. And we know where that is heading, especially while the Fed hyperinflates the monetary base trying to save its own precious global $-FI!
And in response to "Then why is the FDIC closing so many banks?"...
The FDIC is closing banks because they are insolvent. This is actually a system-wide problem as so much of the asset base is built upon the housing and commercial real estate sectors. But the bigger banks are being protected by accounting rules that let them lie about the value of their complex derivatives.
The smaller banks still hold a lot of raw mortgages, not yet securitized. These losses are harder to conceal. Many banks are still lying by not foreclosing even on badly delinquent homeowners. But this is only making the problem worse and "kicking the can down the road".
These smaller banks don't have the assets to acquire the loans they need to cover their liabilities. They are insolvent, just like the big banks, but they can't hide it anymore, thus they get closed.
This is what people mean when they say, "this is not a liquidity crisis, it is a solvency crisis". "Liquidity" means being able to get money for your assets from the CB (or from the open market). "Insolvency" means you don't even have the asset values to do that!
Some comments on Fekete's latest...
Wouldn't it be great if they just did away with all legal tender laws? Perhaps they could just keep one stating how they want you to pay your taxes. But let the courts defend any and all contractual agreements no matter what they are denominated in. And open the mint to free coinage! Of course this is all part of the world that SHOULD be, not the one that WILL be. So it doesn't give us much guidance for preserving (and increasing) the purchasing power we have NOW.
Isn't it interesting that the legal tender laws came out in 1909, just two years after the panic of 1907? As Fekete says, they led to the governmental ability to finance the world wars. But is legal tender really the problem? Or is it that the people continued to confuse the store of value function with the other monetary functions? If we now return back to the system of 1906, are we not returning to a system that has already reached a less than ideal end several times? Perhaps it would be better to embrace the separation of monetary functions as this will take away the ability to finance wars the same as a new gold standard would. Right?
Is it really the forcing of paper to be used as money (medium of exchange/unit of account) that allows the collective to rob the citizens? Or is it the conning of people into holding said paper as a store of value?? I think it is the latter much more than the former. Both to some extent, but more so the latter.
If people only hold the currency for the short time period of the medium of exchange function, then there is much less for the inflation tax to tax. The higher they turn up the inflation tax, the shorter the time people will hold the paper. In this case, the inflation tax would only be on the difference between your work contribution to the economy and what you could buy with your paycheck two weeks later. And the tax base would be limited to the amount of currency in circulation. But if people hold paper as wealth, the taxable base is orders of magnitude larger, and the inflation tax can be administered more slowly and surreptitiously because of the larger "tax base".
Imagine if every saver in 1909 started holding only gold coins in his possession as soon as they passed the legal tender laws. The parity between paper and physical gold would have snapped long before even the roaring 20's. Roosevelt would have confiscated gold valued in the many hundreds. But people trusted their governments back then. So it was easy to CONvince people that it was better to hold paper with a "yield"!
Fekete notes that no one hoarded gold until AFTER war started in 1914, at which time gold "went into hiding". But imagine if gold went into hiding in 1909 right after the legal tender laws were introduced. Perhaps then, there would not have been war at all. Or at least it would not have been so well funded!
It would sure be nice if Fekete would apply his brilliant mind to this Freegold concept! But alas, he is advocating for a new gold standard. A non-inflationary system, so we can all hold the same money we use in trade as a store of value.
Perhaps the next step in monetary evolution after a period of Freegold will be the elimination of legal tender laws in certain zones in order to gain economic advantage. This would likely be followed by the re-emergence of Fekete's "real bills". Of course I am only speculating way out into the future.
My point is that I like Fekete's analysis. It has great value! Hopefully he can help steer the direction that economic study turns as we pass through this crisis. But what are the odds that the governments of the world will suddenly listen to Antal Fekete and reverse the course of the Titanic in time? Zero perhaps? And even if they did, what would be the immediate consequences? The unintended ones?
My only point is that any superficial differences between Fekete and this blog boil down to the perspective with which we attack the problem. As you say, Shanti, "another angle"!
Fekete takes an activist approach while I take a passive one. Fekete would like to fully remonetize gold, locking it into all three monetary functions. I, on the other hand, can see that we are already in the process of fully DEmonetizing gold, which will unlock a tremendous hidden value that is desperately trying to bust out of its shell. In the end, Fekete says that he wants people to have "the right to park their savings in gold coins, as they did before 1909." But they DO have that right already! They just haven't realized how good it will be... yet!
On "is it possible that most of what we think of FED is mistaken?"...
You are inching closer to the truth than you may think. The whole system is an elaborate, global illusion. The money itself is an illusion. Why do you think banks are now offering CD's with no early withdrawal penalty? It is a gimmick. It is a carefully constructed illusion. The main goal is to keep people from withdrawing their perceived value from the system. And to create a believable illusion, they have to say, "look, you can withdraw it whenever you want". Study the logical reasoning behind Certificates of Deposit and you will see that a CD that you can close at any time is an oxymoron. It is a new gimmick for desperate times. The whole system and all Fed statistics are a gimmick now, to keep you in their system.
And finally, a little bit from FOA...
It is the dollar and all of its flaws that have led us to this place in history. Because of the dollar's obsession with gold, we are now entering a period where for the first time the monetary functions will separate out of necessity. It didn't have to be this way, but now it is. As FOA said,
"To their amazement, it turns out today, that digital use demand was the best function that supported their efforts all the while; by increasing the world's use and need for currency. Had they understood this modern economic function early on, they could have somewhat printed the currency outright with almost the same result while arriving at today's destination. They could have let gold float, not to mention they could have skipped a large portion of the debt build up that will now end the dollars timeline."
What he meant was that the post 1971 "purely symbolic dollar" architects thought they needed to cap the price of gold in order to keep the dollar in use. But in fact, it was the dollar's ease of use in the trade function that kept it in demand. Not its illusion of being a store of value. And had they realized this concept then, we could have had freegold soon after 1971 and the dollar would have lasted well beyond 2010. But instead, they set in motion a sequence of events that could only end one way, in the permanent backwardation of the gold market, meaning the emergence of a physical-only gold market at a much, much higher price, and also the end of the dollar's use in global trade.
This is where we are today. And as you watch the volatility in the markets (look a the Dow over the last few days!) think about this statement FOA made eight years ago...
""""""It's not that price inflation may erupt --------- It's not that the massive dollar debts won't be paid--------The risk is; that our money system requires dollar (goods prices) and debt stability -------- so without said stability the currency system fails""""""
Without an international floating gold reserve pricing, to balance against their devaluing debt reserve, the entire dollar banking system can only rely upon extreme dollar inflation to float its accounts. Price inflation will have to be ignored. To this end the group of dollar supporting countries, we refer to as the dollar faction, has locked itself into a box. It must find a way to float gold prices"
"The entire dollar banking system can only rely upon extreme dollar inflation to float it's accounts."!!! It must ignore the (hyperinflationary) consequences of this policy and just do it. This is what S(herlock Holmes) uncovered!
Please continue discussing.... :)