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A True Horror Tale

Summary:
The “maestro” was neither the monster’s creator nor its handler, but he did preside over much of what followed the standard horror story template. Alan Greenspan said the words “proliferation of products” in June of 2000, now more than two decades ago. But the proliferation vexing him and monetary policymakers at the dawn of the 21st century had actually begun in the middle of 20th. And when the monetary paranormal really started cooking had been the sixties and seventies. As such, only now are monetary authorities taking a painfully slow interest in Greenspan’s noted products having spent the last thirteen years trying to sort out the rather monstrous consequences of their long-ago proliferation. With one foot still firmly planted in “it was subprime mortgages”, it proceeds at a snail’s

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The “maestro” was neither the monster’s creator nor its handler, but he did preside over much of what followed the standard horror story template. Alan Greenspan said the words “proliferation of products” in June of 2000, now more than two decades ago. But the proliferation vexing him and monetary policymakers at the dawn of the 21st century had actually begun in the middle of 20th. And when the monetary paranormal really started cooking had been the sixties and seventies.

As such, only now are monetary authorities taking a painfully slow interest in Greenspan’s noted products having spent the last thirteen years trying to sort out the rather monstrous consequences of their long-ago proliferation. With one foot still firmly planted in “it was subprime mortgages”, it proceeds at a snail’s pace – where it proceeds anywhere at all.

 

A True Horror Tale



Fine. But why and where did it fork? On the one hand, there was Greenspan’s accepted view. This was that monetary details had grown so amazingly complex in order to bring these proliferated products back under some new standard definitions the task would require an exhaustive, likely very costly, effort. Chances for success were not a given, either.

Thus, the fork in the road was an especially alluring one to take, primarily because it would be so much easier and simpler: care little to nothing about the monetary system and let the global banks who had been responsible for both the coming up with the products as well as making sure they proliferated sort out the sordid, messy details.

They’d never set some brutish monetary freak free on the world, would they?

Just to make sure, a central bank need only fly above them at 30,000 feet and signal down from on high – even so far as using what, as the years and decades flew by, would become an increasingly unimportant money market rate, federal funds, to send to the banks all the necessary policy gestures policymakers wished to communicate. Alan Greenspan would raise or lower the fed funds target a little here or there, and how the system’s internal organs were fashioned would be left to anyone’s guess.

Random good luck, as some would say.

In doing it this way, though, some policymakers began to shudder at the prospects for what they were really asking. As I chronicled the week before, while most did some could not ignore the mammoth conglomeration of proliferated products accumulated offshore. These eurodollars, at least those which were more of the straightforward variety, had already dramatically outpaced and outdistanced domestic money by the mid-eighties.

That left a whole lot of horror-sized “what-ifs” on the table.

The gross eurodollar size was in 1988 a third greater than the entire M2 stock would be three years afterward, while its net size was closing in on two-thirds of it. And this was three decades ago.

The data collection on eurodollar scale ended in 1988 because only one private firm, Morgan Guaranty, had been astute enough to make the effort. That it wasn’t the central bank tells you a lot about the choices which were made a very long time ago. Why can’t we just get in the running car?

A True Horror Tale

But, see, monetary authorities couldn’t just ignore these trillions offshore without first saying something about them. Before he comes at you with a chainsaw, the horror movie villain is rationalized down several times in each flick as if nothing more than some unworthy, trivial danger. To follow down Greenspan’s path to determined monetary ignorance (sorry, money-less expectations management) first required making a determination – and a huge mistake – about the multi-trillion (to tens of trillion by 2007) dollar ogre making unbearably loud noises just in the next room.

As usual, there were legitimate reasons for choosing to believe eurodollars represented a quirky bank investment rather than a true monetary system. For one, the system, the entire system and all its products, just didn’t look like money; Frankenstein meets skinwalker.

To central bankers and Economists whose beliefs were rooted in a 1960’s view of the 1930’s, this offshore world appeared a more appropriate place for investment professionals than monetary stewards.

The argument was thus made in the late seventies, settled in official terms from thereafter:

It has long been recognized that a shift of deposits from a domestic banking system to the corresponding Euromarket (say from the United States to the Euro-dollar market) usually results in a net increase in bank liabilities worldwide. This occurs because reserves held against domestic bank liabilities are not diminished by such a transaction, and there are no reserve requirements on Eurodeposits. Hence, existing reserves support the same amount of domestic liabilities as before the transaction. However, new Euromarket liabilities have been created, and world credit availability has been expanded.

To some critics this observation is true but irrelevant, so long as the monetary authorities seek to reach their ultimate economic objectives by influencing the money supply that best represents money used in transactions (usually M1). 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. [emphasis added]

This right here was the whole movie, the error which set everything else in motion; it was everything which would dictate the course of the following decades. The eurodollar was declared as non-money, therefore no sense in spending any time or effort keeping track of the psycho next-door. And when they couldn’t even figure out a useful M1 anymore, then fed funds targets were substituted to “reach their ultimate objectives by influencing…”

But in moving past the geographical boundary, the actual offshore system hadn’t become less money-like, it had transformed the very idea of money itself. That, more than anything, had been the crucial error, the villain’s pathos spun in motion long before the events of our current story had begun. The very one which removed central banking from the central bank model which followed.

And it was one that others at the time had warned authorities not to make (there’s always the hard-edged, wise character who appears and just spells it out for the central characters to laugh their way past only to regret in later scenes). In some places, like the paper from Dufey and Giddy I referenced last week, it was listed right out there for them in painful, gory detail.

Here’s the counterpoint made by Dufey and Giddy while they were actually cataloging the proliferation of products not all that long after it had occurred:

…the general principle is that the currency of denomination of an asset can be “converted” by contractually selling the future cashflows from that asset for another currency. Similarly, the currency denomination of a liability may be altered by contractually purchasing the foreign currency necessary to liquidate that obligation. 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.

The hell with eurodollar deposits! That’s kid’s stuff.

The actual monetary system had become even more derivative but had kept its monetary nature. This is the part central bankers didn’t understand because they lacked sufficient imagination (all their considerable intelligence would be focused instead on creating mathematical models to describe an economy and this eurodollar business would’ve made that impossible). Remember, this was the fifties, sixties, and seventies.

 

A True Horror Tale

The diabolical genius, if you want to call it that, of the eurodollar system was in taking money to its next phase. It moved from a system where money or currency in possession was that system’s overriding constraint to one in which the balance sheet factors balancing instead “future cashflows from that asset” reign supreme.

External money that is conjured up from across time boundaries as well as geographical ones and it settled – for the banking system, anyway – real world monetary obligations. Yep, real world bank liabilities could be liquidated or cleared based upon external, non-contemporary exchanges of potential future obligations. These would accomplish monetary aims, but it wouldn’t look like what money had always looked like before.

Not just a virtual currency of ones and zeroes flying around the world, but a virtual virtual currency, undead money where time as well as geography could be surmounted – at the right price.

Suddenly, banks would hungrily, speedily process payments for hamburgers eaten up today even though payments for them weren’t promised to arrive until Tuesday. In fact, depending upon balance sheet factors, the promise to be paid on Tuesday was the most lucrative part of the whole business (Why not? From horror movie template to keen Popeye metaphors, we’re way beyond traditional restrictions here).

A True Horror Tale

External money. Or, as I put it four years ago using Dickens:

The phrase Charles Dickens used to describe insurance companies can be refashioned to quite well characterize this monetary arrangement; a bank that holds no dollars gets another bank that holds no dollars to guarantee that everyone has dollars. It’s all a lie, but it works because nobody ever demands to be presented with dollars. Transactions are simply settled and worked out in the format consistent with that; Bank B used to have a number that said Bank B was owed a certain amount of dollars but then Bank B lent that number to Bank C so that Bank C could claim an ability to get dollars when neither bank has any interest in obtaining dollars just the whatever transformation that results from that transaction. Dollars are purely theoretical; thus “dollars.”

External and virtual, theoretical money. Alien meets Predator but also Poltergeist.  Not just a proliferation of products; that was merely the meat and potatoes, the details over how this was done. Rather, a true evolutionary step forward which so thoroughly confounded and fooled our distracted monetary authorities they then fooled themselves into thinking they could do monetary policy without any of it in their designs.

It all seemed to work (the so-called Great “Moderation”) compounding the error but only so long as the products kept proliferating: each global bank promising future dollars kept guaranteeing each other there would be future dollars…until August 9, 2007.

When the promises started vanishing, out came the 1930’s-style bank reserves which only made things worse right from the start (they really have no idea what they are doing).

This is why central banks aren’t central banks, as well as why they’ve been so slow to catch on. It isn’t a single error, subprime mortgages in 2008, that has been plaguing them and their multitudes of QE’s. A chain(saw) of errors which stretches back for decades, half a century and longer.

A monetary monster unleashed in true Frankenstein fashion. They even had a word for it once upon a time: benign neglect.

The monster’s unchecked pathology is what sure looks today like the impossible unit root root which is common to every beast’s origin; a permanent, widespread asymmetric shock that goes undetected. And the error has made sure that each and every effort to thwart the fiend’s attack upon 20th century globalized civilization instead sows the destruction of 21st century un-globalization – fragmentation in more than economy, finance, and money. The kind of widescale damage that we’d rather wish had been, this one time, fictional.

Happy 2nd Repo-ween!

A True Horror Tale

Jeffrey P. Snider
As Head of Global Investment Research for Alhambra Investment Partners, Jeff spearheads the investment research efforts while providing close contact to Alhambra’s client base. His company is a global investment adviser, hence potential Swiss clients should not hesitate to contact AIP

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