Greenspan - the Wizard of Bubbleland

Henry C.K. Liu

Part I:     Greenspan - Bubble Wizard
Part II:   The Repo Time Bomb
Part III:  How the US Money Market Really Works

Part 4:
The Global Money and Currency Markets

Appeared in Asia Times February 16 2006

Until the late 1950s, a currency’s money market was based in the issuing nation’s financial center: US dollars in New York, sterling in London, yen in Tokyo, Swiss francs in Zurich, etc. The Bretton Woods monetary regime of fixed exchange rates built around a gold-backed dollar did not consider unrestricted cross-border flow of funds desirable or necessary for facilitating international trade. At the height of the Cold War, the Soviet Union became concerned that its dollar deposits in New York might be frozen by a US hostile government, as happened to the funds held in the US by the People’s Republic of China after the Korea War broke out.  The USSR opened dollar accounts with European banks. Then in 1963 the US introduced the populist Regulation Q, which for subsequent decades imposed limits and ceilings on bank and savings-and-loan (S&L) interest rates. Regulation Q created incentives for US banks to do business outside the reach of US law, and London came to dominate this offshore dollar business.

Bank accounts in London are subject only to the laws of England and Wales, so US sanctions, restrictions and taxes cannot apply to the dollars deposited in them. British law on international finance is well developed on account of historical financial hegemony of the British Empire since the fall of Napoleon. In time, banks in London, often branches of US banks, started actively trading deposits in other currencies besides dollars as well, as it became possible for them to accept deposit in one currency in one country and lend in another currency in another country profitably. Nowadays, financial regulation has become even lighter, so money can be moved with little cost to and from London; therefore the price of London money generally tracks very closely that of domestic money in many countries. But there have been differences between domestic and London interest rates. These differences have had different causes at different times: tax laws, bank regulations, the possibility that a country might introduce exchange controls, and the differences between the creditworthiness of the banks in London and those in the domestic market.  The London money and foreign exchange markets are dominant for trading currencies, raising capital and selling debt.  In 1971, the US detached the dollar from gold and made it a fiat currency based on the strength of the US economy, which allowed the dollar to continue to perform the role of the world’s key reserve currency for international trade. This was the beginning of dollar hegemony.

The London money market is particularly active in dollars, sterling, euros, yen, and Swiss francs, with less liquidity (ease of trading in large size) in Australian, Canadian and New Zealand dollars. Deposits in other currencies are mostly traded only in their domestic markets. The terminology for London money is confusing. When dollar deposits started to trade in London, they were called eurodollars, the “euro” prefix then meaning that the currency was outside its home jurisdiction, mostly in Europe, despite the fact that the United Kingdom never considered itself part of Europe. And hence euromarks stand for London-traded Deutschmarks; eurolira for Italian lira in London, euroyen, euroswiss, and so on. The use of the “euro” terminology subsequently became more widespread. Much corporate debt is issued under the laws of England and Wales, even if the currency is that of the US, Germany, Switzerland or Japan. This convention traces back to the financial globalization of the British Empire. Thus tradable debt (bonds) issued in London became known as Eurobonds, even if they are not denominated in euros.  In 1999, Europe adopted a single currency and called it the euro. The words “eurodollar” “euroyen” and “euroswiss” become ambiguous. They still refer to London-delivery dollars, yen and Swiss francs, but now they can also mean exchange rate equivalents of euros in dollars, in yens and in Swiss francs. On rare occasions, one even hears the term “euroeuro” for London-delivery euros.

When Regulation Q was phased out by 1986, US banks were allowed to pay interest on checking account - the NOW accounts, to lure depositors back from the money markets. The traditional interest-rate advantage of Savings and Loan (S&L) banks was removed, to provide a “level playing field”, forcing them to take the same risk as commercial banks to survive. Congress also lifted restrictions on S&L commercial lending, instead of the traditional home mortgages, which promptly got the whole S&L industry into bad debt troubles that would soon required an unprecedented government tax money bailout of depositors in a S&L crisis. But the real-estate developers who made billions with S&L loans were allowed to walk away with their profits, leaving S&L banks with foreclosed properties with market values way below the values of their mortgages. State usury laws were unilaterally suspended by an act of Congress in a flagrant intrusion on state rights.

A political coalition of converging powerful interests was evident. Virulently high inflation had damaged the financial position of the holders of money, including small savers, created by a period of benign low inflation earlier, so that even progressives felt something has to be done to protect the propertied middle class, the anchor of political democracy by virtue of their opposition to economic democracy. The solution was to export inflation to low-labor-cost economies in newly industrialized countries (NICs) around the world, taming US domestic inflation with outsourcing employment overseas and exorcising the domestic inflation devil in the form of escalating US wages. Neo-liberalism was born with the twin midwives of dollar hegemony and unregulated global financial markets, disguising economic neo-imperialism as market fundamentalism.  The debasement of the dollar, dragging down all other currencies, finds expression in the upward surge of commodities and asset prices, which pushes down global wages to keep US inflation low.  This pathetic phenomenon is celebrated as economic growth by neo-liberals

An operating detail about money markets has emerged as windows of opportunity for speculative profit. In most currencies, including USD, EUR, JPY and CHF, the money market operates on “T+2”. This means that settlement, when delivery of funds takes place, occurs 2 business days after the trade date. The settlement date is also known as the value date. So if on Monday 13 August 2007 JPMorgan agrees to lend USD to CSFB for 3 months, JPMorgan would pay this money to CSFB two days after trading, on 15 August, and it would be returned with interest 3 months after that, on 15 November 2007. The main exception to T+2 is sterling, which is T+0, also known as same-day settlement. In sterling, standard practice is to settle a trade on the same day that it is agreed. However, counterparties can always agree to a non-standard settlement, but in the absence of such agreement, GBP is T+0 and almost all others are T+2.

There is a standard definition of the seemingly simple phrase “3 months”. For example, when is 3 months after 30 November 2009? It can't be 30 February 2010, because there isn't such a day. And it can't even be 28 February 2010, because that is a Sunday. As it is, the official definition from the International Swap Dealers Association (ISDA) says that 3 months after Monday 30 November 2009 is Friday 26 February 2010, but the point is that there is a precise trading definition. Payments in the real economy cause banks' balances with the central bank to rise and fall. A bank with a shortfall will want to borrow it from a bank with an excess, and hence there is an interbank deposit market (a money market).

This interbank deposit market exists, with maturities from 1 day to 1 year, in every currency, and in the major currencies it exists both domestically and in London. A market participant, by choosing to borrow or lend money at any particular maturity, is implicitly speculating against the forward rates implied by the spot rates. Banks also lend money against collateral; the secured nature of this lending reduces the credit risk, and hence it reduces the interest rate. Central banks have fiat control over short-term interest rates, motivated by monetary ideology and perceived forward-looking economic conditions. The euro when it was first introduced was a legal construct that made the national currency units in Euroland irrelevant to wholesale financial markets. A money market fund inn the US is a type of mutual fund that is required by law to invest in lowest-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a “money market deposit account” at a bank, US money market funds are not federally insured. Money market funds typically invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. Money market funds are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, particularly Rule 2a-7 under the Act. They attempt to keep their net asset value (NAV) at a constant $1.00 per share—only the dividend yield goes up and down. But a money market’s per share NAV may fall below $1.00 if the investments perform poorly. While investor losses in money market funds have been rare, they are possible in a financial panic.

The Nature of Financial Panics

A panic is a species of neuralgia. A financial panic is cured by having it starved, stopping the drain of confidence from a market that runs on confidence.  To cure a financial panic, the holders of cash reserves must, in contrast to natural instinct, be ready not only to keep the reserves for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to all market participants in need of liquidity whenever credit is otherwise good in normal situations. The hesitance is related to the unhappy prospect of unnecessary larger loss in the event the cure fails to stem the panic, resulting in throwing good money after bad. And the cure will fail if any entity in the chain of credit should decide to bail itself out at the expense of the system. In wild periods of alarm, one failure will generate many others in a falling domino effect, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.  This was easier to do when the number of counterparties in the distressed contract was relatively small, as in the case of Long Term Capital Management (LTCM) crisis in 1998, a large hedge fund, where they could all be gathered in one room is the New York Fed Building and work out a rescue deal.  But in the case of the Refco collapse in 2005, where counterparties are spread over 240,000 customer accounts located in 14 countries, it became a different problem. The identities of counterparties for over-the-counter derivative contracts are unknown as risks are unbundled and sold off to a variety of investors with varying appetite for risk. Dealers like Refco are intermediaries that earn their fees by providing the money to effectuate the performance of the contracts between remote and unidentified counterparties in synthetic collateral debt obligations (CDO). Rather than the traditional pools of assets such as bonds and loans, the pools of credit derivatives that back synthetic CDOs include instruments such as credit default swaps, forward contracts, and options. When Refco, a large foreign exchange and commodity broker providing clearing and execution services for global exchange-traded derivatives including futures, was forced into bankruptcy by alleged fraud in its parent holding entity, the funds and customer accounts in its unregulated over-the-counter derivative trading subsidiary were frozen. Reuters reported on October 20, 2005 that a fund that tracks a commodities index created by investor Jim Rogers, former co-founder, with George Soros, of Quantum Fund, said it was unlikely to allow clients to immediately redeem investments as 63% of its assets were held by nearly collapsed Refco Inc. Beeland Management Co. LLC, a Chicago-based manager for the Rogers International Raw Materials Fund LP, said it could not be sure if the fund would lose assets held by Refco Capital  Markets. In a letter to investors, Beeland said it was unable to provide an accurate value of fund units because of Refco's bankruptcy. Beeland, Rogers' middle name, is majority controlled by Rogers. In Refco's bankruptcy filing, the Beeland fund was listed as a creditor with claims of $75.2 million. Another Beeland-managed fund, the closely held Rogers Raw Materials Fund, has claims of $287.4 million.  What is not known is how many other funds are affected by the Refco bankruptcy.

The management of a panic is mainly a confidence restoring problem. It is primarily a trading problem. All traders are under liabilities; they have obligations to meet that are time-sensitive and unconditional, and they can only meet those obligations by discounting obligations from other traders. In other words, all traders are dependent on borrowing money as bridge loans until settlement of their trades, and large traders are dependent on borrowing much money. At the slightest symptom of panic, traders want to borrow more than usual; they think they will supply themselves with the means of meeting their obligations while those means are still forthcoming. If the bankers gratify the traders, they must lend largely just when they like it least; if they do not gratify them, there is a panic.  Fear generates more fear in a vortex toward abyss.

There a great structural inconsistency of logic in this. First, bank reserves are established where the last dollar in the economy is deposited and kept in a central bank. This final depository is also to be the lender of last resort; that out of it unbounded, or at any rate immense, advances are to be made when no one else can lend. Thus central banks posit themselves both as depositories of reserves and as lenders of last resort to the banking system. This seems like saying first, that bank reserve should be kept, and then that it need not be kept because in a real panic, the central bank will lend where bank reserve is insufficient. What is more problematic is that banks now constitute only a small part of the credit market.  The lion share is in the derivatives market. Granted notional values in derivative contracts are not true risk exposures, but a swing of 1% in interest rate on a notional value of $220 trillion in the current derivative market is $2.2 trillion, approximately 20% of US GDP.  When reduced to abstract principles, a financial panic is caused by a collective realization that the money in a system will not pay all creditors when those creditors all want to be paid at once. A panic can be starved out of existence by enabling those alarmed creditors who wish to be paid to get paid immediately. For this purpose, only relatively little money is needed. If the alarmed creditors are not satisfied, the alarm aggravates into a panic, which is a collective realization that all debtors, even highly credit-worthy ones, cannot pay their creditors. A panic can only be cured by enabling all debtors to pay their creditors, which takes a great deal of money. No one has that much money, or anything like enough, but the lender of last resort – the central bank. And injecting that amount of money suddenly after a panic has begun will alter the financial system beyond recognition, and produce hyperinflation instantly, because the extinguishment of all credit with cash creates an astronomical increase in the money supply.

David Ricardo (1772-1823), brilliant British classical economist and a Bullionist along the line of Henry Thornton (1760-1815), wrote: “On extraordinary occasions, a general panic may seize the country, when everyone becomes desirous of possessing himself of the precious metals as the most convenient mode of realising or concealing his property, against such panic, banks have no security on any system.”  Thornton in his classic The Paper Credit of Great Britain (1802) provided the first description of the indirect mechanism by observing that new money created by banks enters the financial markets initially via an expansion of bank loans, through increasing the supply of lend-able funds, temporarily reducing the loan rate of interest below the rate of return on new capital, thus stimulating additional investment and loan demand. This in turn pushes prices up, including capital good prices, drives up loan demands and eventually interest rates, bringing the system back into equilibrium indirectly.

The Bullionist Controversy emerged in the early 1800s regarding whether or not paper notes should be made convertible to gold on demand. But today, no central bank has enough precious metal (gold) to back their currencies because the global currency system is based on fiat money.  The use of credit enables debtors to use a large part of the money their creditors have lent them. If all those creditors demand all that money at once, their demands cannot be met for that which their debtors have used is for the time being employed, and not to be obtained for payment to the creditors. Moreover, every debtor is also a creditor in trade who can demand funds from other debtors. With the advantages of credit come disadvantages of illiquidity which require a store of ready reserve money and advance out of it very freely in periods of panic, and in times of incipient alarm.

Notwithstanding the fact that the global money market has already run away from the control of every central bank, the management of the global money market is much more difficult than managing banking reserves in any particular country by its central bank, because periods of internal panic and external virtual demand for gold bullion commonly occur together. The virtual demand for gold bullion in today’s fiat currency world  is expressed in the exchange rates of currencies. A falling exchange rate drains the global purchasing power of a currency and the resulting rise in the rate of discount, as expressed in a change in the exchange rate, tends to frighten the market. The holders of bank reserves have, therefore, to treat two opposite maladies at once: one requiring punitive remedies such as a rapid rise in the market rates of interest; and the other, an alleviative treatment with large and ready loans to combat illiquidity.  Experience suggests that the foreign drain must be counteracted by raising the rate of interest. Otherwise, the falling exchange rate will protract or exacerbate the alarm, generally known as a loss of confidence in the currency and the banking system and the functioning of the market. And at the rate of interest so raised, the holders of the final bank reserve must lend freely. Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not available, or that it may not be available at any price, only raises alarm to panic and enhances panic to madness with a total loss of confidence. Yet the acceptance of loans at abnormally high interest rates is itself a sign of panic. This is the fate that awaits the dollar going forward. Against such contradictions, no central bank has found the appropriate wisdom.  Greenspan’s formula has always been more liquidity at low interest rates which pushes the monetary system into what Keynes calls the liquidity trap. This transforms him from a wise central banker to a wizard of bubbleland

And great as the delicacy of such a problem in all countries, it is far greater in the US now than it was or is elsewhere because of dollar hegemony. The strain thrown by a panic on the final bank reserve is proportional to the magnitude of a country’s trade, and to the number and size of the dependent banks and financial institutions holding no cash reserve that is grouped around the Federal Reserve. There are very many more entities under great liabilities than there are, or ever were, anywhere else because of the emergence of the debt-driven US economy. At the commencement of every panic, all entities under such liabilities try to supply themselves with the means of meeting those liabilities while they can. This causes a great demand for new loans while loans are still available. And so far from being able to meet it, the bankers who do not keep extra reserve at that time borrow largely, or do not renew large loans, or very likely do both. The repo market relieves the need of any bank or institutions to hold extra reserves, as new loans are supposed to be always available.

Money center bankers in New York and London, other than the Fed and the Bank of England, effectuate this in several ways. First, they have probably discounted bills to a large amount for the bill brokers, and if these bills are paid, they decline discounting any others to replace them.

In the panic of 1857, the London and Westminster Bank discounted millions of such bills, and they justly said that if those bills were paid they would have an amount of cash far more than sufficient for any demand. But how were those bills to be paid? Someone else must lend the money to pay them. The mercantile community could not suddenly bear to lose so large a sum of borrowed money; they had been conditioned to rely on it, and they could not carry on their business without it. They could not handle it at the beginning of a panic, when everybody wanted more money than usual. Speaking broadly, those bills could only be paid by the discount of other bills. When the bills of a Manchester warehouseman which he gave to the manufacturer became due, he could not, as a rule, pay for them at once in cash; he had bought on credit, and he had sold on credit. He was but a middleman. To pay his own bill to the maker of the goods, he must discount the bills he had received from the shopkeepers to whom he had sold the goods; but if there is a sudden cessation in the means of discount, he would not be able to discount them. The entire mercantile community must obtain new loans to pay old debts. If someone else did not pour into the market the money which the banks like the London and Westminster Bank took out of it, the bills held by the London and Westminster Bank could not be paid.

Who then was to pour in the new money? Certainly not the bill brokers who had been used to rediscount with such banks as the London and Westminster millions of bills, and if they saw that they were not likely to be able to rediscount those bills, they would instantly protect themselves and would not discount them. Their business did not allow them to keep much cash unemployed. They paid interest for all the money deposited with them at rates often nearly approaching the rate they could charge; as they could only keep a small reserve a panic affected them more quickly than on anyone else. They stopped their discounts, or much diminished their discounts, immediately. There was no new money to be had from them, and the only place at which they could have it was the Bank of England. The same situation occurred in the 1907 banking crisis in the US which led to the creation of the Federal Reserve.  A panic can be caused by a number of developments. In the case of LCTM, it was an unexpected Russian default of sovereign debts. In the case of Refco, it appears to be a relatively minor fraud that might bring down an otherwise well-hedged operation.

A bank which is uncertain of its credit standing, and wants to increase its cash reserve, may have money on deposit at the bill brokers. If it wants to replenish its reserve, it may ask for it, suppose, just when the alarm is beginning. But if a great number of banks do this very suddenly, the bill brokers will not at once be able to pay without borrowing. They have excellent bills in their case, but these will not be due for some days; and the demand from the more or less alarmed banks is for payment at once and today. Accordingly, the bill brokers take refuge at the central bank, the only place where at such a moment new money is available.  The case is just the same if the bank wants to sell government securities, or to call in money lent on securities in the repo market. These the bank reckons as part of its reserve. And in normal times, nothing can work better. In England, there is a saying: “you can sell Consols (sovereign debt) on a Sunday.” In a time of no alarm, or in any alarm affecting that particular banker only, the bank can rely on such reserve without misgiving. But not so in a general panic. Then, if the bank wants to sell $50 billion worth of government securities, it will not find $50 billion of fresh money ready to come into the market. All ordinary banks are trying to sell, or thinking they may have to sell. The only resource is the Fed. In a great panic, Consols could not be sold unless the Bank of England would advance to the buyer, and no buyer could obtain advances on Consols at such a time unless the Bank of England would lend to him. The same is true with the Fed

The case is worse if the alarm is not confined to the money center banks, but is diffused throughout the economy and around the world because of the existence of Eurodollars and the systemic effects of dollar hegemony. As a rule, local bankers only keep enough cash as is necessary for their common business. All the rest they leave at the bill brokers, or at the interest-paying banks, or invest in government securities in the repo market. But in a panic they come to New York and London to find this money. And it is only from the Fed that they can get it, for all the rest of New York and London want their money for themselves

History tells us that the liabilities of Lombard Street (the name of the London money market, as Wall Street is the name of the US equity market) payable on demand were far larger than those of any like market, and that the liabilities of the country were greater still, the magnitude of the pressure on the Bank of England when both Lombard Street and the country suddenly and at once came upon it for aid. No other bank was ever exposed to a demand so formidable, for none ever before kept the banking reserve for such a nation as the English. The mode in which the Bank of England met this great responsibility was very curious. It unquestionably did make enormous advances in every panic.

Credit in business is like loyalty in Government. You must take what you can find of it, and work with it if possible. Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone. The whole rests on an instinctive confidence generated by use and tradition. A many-reserve system, if some miracle should suddenly put it down in Lombard Street, would seem monstrous there. Nobody would understand it, or confide in it. Credit is a power which may grow, but cannot be constructed. Those who live under a great and firm system of credit must consider that if they break up that one, they will never see another, for it would take years upon years to make a successor to it.  The Fed has been abusing this truism for too long. The damage Greenspan has done to the credit worthiness of the dollar monetary system would take decades to restore and would require much systemic pain

How Banking Evolved

Banking had not been consciously or rationally designed. It evolved as an institution by meeting the changing needs of stages of evolving economies that have later become obsolete.  The institution of banking is frequently trailing behind current financial needs of a contemporary economy. The earliest banks of Italy, where the name began from a bench for counting money, were finance companies. The Bank of St. George at Genoa, as with other banks founded in imitation of it, was at first only finance companies for making loans to and float loans for the governments of the city states where it operated. Money is an urgent want of governments in all times, and seldom more urgent than it was in the tumultuous Italian Republics of the High Middle Ages. After these banks had been well established as finance companies, they began to do what today is referred to as banking business but originally never contemplated. The great banks of Northern Europe had their origin in a want still more curious. The prime business of a bank was to give good coin. Adam Smith (1723-1790), Scottish moral philosopher, whose ideas so influenced US free marketeers, describes it clearly: “The currency of a great state, such as France or England, generally consists almost entirely of its own coin. Should this currency, therefore, be at any time worn, clipt, or otherwise degraded below its standard value, the state by a reformation of its coin can effectually re-establish its currency. But the currency of a small state, such as Genoa or Hamburg, can seldom consist altogether in its own coin, but must be made up, in a great measure, of the coins of all the neighboring states with which its inhabitants have a continual intercourse. Such a state, therefore, by reforming its coin, will not always be able to reform its currency. If foreign bills of exchange are paid in this currency, the uncertain value of any sum, of what is in its own nature so uncertain, must render the exchange always very much against such a state, its currency being, in all foreign states, necessarily valued even below what it is worth.”  Smith was giving an early description of currency hegemony, linking great statehood with sound money. It was the opposite of Greenspan’s approach of debasing the dollar through over-issuance to maintaining the economy of a great state, notwithstanding Greenspan repeated expression of fidelity to the ideas of Adam Smith.

Smith went on to observe that “in order to remedy the inconvenience to which this disadvantageous exchange must have subjected their merchants, such small states, when they began to attend to the interest of trade, have frequently enacted that foreign bills of exchange of a certain value should be paid not in common currency, but by an order upon, or by a transfer in the books of a certain bank, established upon the credit, and under the protection of the state, this bank being always obliged to pay, in good and true money, exactly according to the standard of the state.”  Thus fixed exchange rates set by government is a necessity for small states to overcome the disadvantages of market forces on the value of currencies.

Before the Bank of Amsterdam, also known as the Wissel Bank, was founded in 1609, an important date in banking, the great quantity of clipped and worn foreign coins, which the extensive trade of Amsterdam brought from all parts of Europe, reduced the value of its currency about 9% below that of good money fresh from the mint. Such good money no sooner appeared than it was melted down or carried away from general circulation, as prescribed by Gresham’s Law of bad money driving out good. Nobel laureate economist Robert Mundell asserts that the correct expression of Gresham’s Law is: “Cheap money drives out dear, if they exchange for the same price.” It is a proposition that defines the relation between paper money and the precious metals. David Hume, writing in 1752, went to great pains to demonstrate that the existence of paper credit would mean a correspondingly lower quantity of gold, and that an increase in paper credit would drive out an equal quantity of gold.  Hume goes on to explain why some countries have more gold - in proportion to population and wealth - than others; it is because there is no credit to displace gold.  Adam Smith developed the same idea in The Wealth of Nations with the use of paper money and applauded its use in the nation: “The substitution of paper in the room of gold and silver money, replaces a very expensive instrument of commerce with one much less costly, and sometimes equally convenient. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to maintain than the old one. . .”  By accepting the use of paper money, Smith was not necessarily advocating debased money.

Smith went on to say that merchants, with plenty of currency, could not always find a sufficient quantity of good money to pay their bills of exchange; and the value of those bills, in spite of several regulations which were made to prevent it, became in a great measure uncertain. In order to remedy these inconveniences, a bank was established in 1609 under the guarantee of the City. This bank received both foreign coin, and the light and worn coin of the country at its real intrinsic value in the good standard money of the country, deducting only so much as was necessary for defraying the expense of coinage, and the other necessary expense of management. For the value which remained, after this small deduction was made, it gave a credit in its books. This credit was called bank money, which, as it represented money exactly according to the standard of the mint, was always of the same real value, and intrinsically worth more than current money. It was at the same time enacted, that all bills drawn upon or negotiated at Amsterdam of the value of six hundred guilders and upwards should be paid in bank money, which at once took away all uncertainty in the value of those bills. Every merchant, in consequence of this regulation, was obliged to keep an account with the bank in order to pay his foreign bills of exchange, which necessarily occasioned a certain demand for bank money.  On this simple principle, the Bretton Woods regime set out in 1944 a gold-backed dollar as the reserve currency for post-war international trade. Since then, the central bank of every trading nation has been obliged to keep a dollar reserve account with the Federal Reserve to support the value of its currency, even when the dollar was taken off the gold standard in 1971.

An important function of early banks, which modern banks have retained, is the function of remitting money to facilitate trade. A customer brings money to the bank to meet a payment obligation at a great distance, and the bank, having a connection with other banks at that location, causes the destination bank to pay by debiting the account of the originating bank. The instant and regular remittance of money is an early necessity of growing trade. By providing these services, banks gained the credit rating that over time enabled them to make profits as deposit banks. Being trusted for one purpose, they came to be trusted for a purpose quite different, ultimately far more important, as depository and intermediary of money and credit. But these services only affect a small number of customers. The real function deposit banks perform is the supply of paper money circulation to the economy. Up to 1830 in England, the main profit of banks was derived from the circulation, and for many years after that the deposits were treated as very minor matters, and the whole of so-called banking discussion turned on questions of circulation. Today, most of the circulation is handled electronically as virtual money instead of paper money. Banks are in fact a retail network for the central banks for circulating the money central banks issue. The Federal Reserve, with its unlimited power to create money as a lender of last resort, is owned by its member banks, not by the people of the US.  This arrangement is the key obstacle to economic/financial democracy in the US.

The Fed and the Value of Money

The Fed, though not part of the government, and not collectively owned by the people, but by commercial banks, enjoys a monopoly on the creation of money. The Fed has some extra-constitutional power to fixing the value of money, through the setting of short-term interest rates and its control of the money supply. The Fed sets the minimum rate of discount from time to time that all banks must accept. Liberal economists view money as a commodity, and only a commodity. Why then is its value fixed by fiat and not the way in which the values of all other commodities are fixed, by supply and demand in the market? The answer is that the issuing of money as a legal tender is a government monopoly which gives government pricing power over money. But the Fed by its own definition of being politically independent, is not part of the government.  The Fed, owned by its member banks, is a living example of a financial oligarchy.  While the Fed claims that its monetary policy measures are designed to sustain the health of the whole economy, it sees the health of the economy’s financial heart, the banks in the Federal Reserve System, as the paramount objective.

In normal times, there is not money enough in the money markets to discount all the bills outstanding without taking money from the Fed. As soon as the Fed funds rate target is fixed, market participants who have bills to discount try to discount these bills cheaper than the Fed funds rate. But they seldom can get them discounted cheaper, for if they did everyone would leave the Fed, and the outer market would have more bills than it could handle and the rate would rise to the rate set by the Fed.

In practice, when the Fed finds this process beginning, and sees that its business is diminishing, it lowers the Fed funds rate target, so as to secure a reasonable portion of the business to itself, and to keep a fair part of its deposits employed. At Dutch auctions an upset or maximum price is fixed by the seller, and he comes down in his bidding till he finds a buyer. The value of money is fixed in the money market in much the same way, only that the upset price is not that of all sellers, but that of one very important seller, the Fed, some part of whose supply is essential. The notion that the Fed has a control over the money market, and can fix the rate of discount as it likes, has survived from the old days before 1844, when the Bank of England could issue as many notes as it liked. But even then the notion was a mistake. A bank with a monopoly of note issue has great sudden power in the money market, but no permanent power: it can affect the rate of discount at any particular moment, but it cannot affect the average rate. And the reason is that any momentary fall in money, caused by the fiat of such a bank, of itself tends to create an immediate and equal rise, so that upon an average the value is not altered. Also the amount of outstanding long-term debt is infinitely greater than short-term debt, making it difficult for short-term interest rates to dictate long-term rates. This is the cause of what Greenspan calls the interest rate conundrum.

If money of constant value were all held by its owners, or by banks which did not pay an interest for it, the value of money might not fall quickly. Money would, in the market phrase, be “well held.” The holders would be under no pressure to employ it all; or they might chose to employ part at a high rate rather than all at a low rate. Thus the three conditions that compel money to be constantly employed are taxes and interest and mild inflation. Taxes are not levied to finance government expenditure, but to keep the population productive.  Similarly, interest on money is not to reward the holders of money, but to keep the borrowers working for it. Prosperity is produced by work, not profits. But in the money market, money is very largely held by those who do pay an interest for it, such as money market funds, and such entities must employ it all to avoid insolvency. Such entities do not so much care what rate of interest at which they employ their money: they can reduce the dividend they pay in proportion to that which they can make, but they must pay something. The fluctuations in the value of money are therefore greater than those on the value of most other commodities. At times, there is an excessive pressure to borrow it, and at times an excessive pressure to lend it, and so the price is forced up and down.

These considerations define the responsibility thrust on the Fed and other central banks. The Fed cannot control the permanent value of money, but it can fully control its momentary value. It cannot change the average value, but it can determine the deviations from the average. If the Fed badly manages, the rate of interest will at one time be excessively low, and at another time excessively high. The economy will experience pernicious booms and busts. But if the Fed manages well, the rate of interest will not deviate much from the average rate. As far as anything can be steady the value of money will then be steady, and probably in consequence trade will be steady too at least a principal cause of periodical disturbance will have been withdrawn from it. This is the view of Milton Friedman who coined the slogans “money matters” and “inflation is everywhere and anywhere a monetary phenomenon.” Friedman advocated a fixed expansion of M1 at 3% long-term to moderate the runaway business cycle over-stimulated by Keynesian deficit financing measures. But economies can develop imbalances from monetary causes independent of inflation, as the US economy has from dollar hegemony.  Greenspan’s solution was to keep a steady expansion of the money supply to neutralize the imbalances with debt, thus postponing the day of reckoning by accepting a bigger crash that requires a bigger cleanup.

The rise of prices is the quickest way to improve the state of credit. Prices in general are mostly determined by wholesale transactions which are commonly not cash transactions, but bill transactions. Years of improving credit, if there be no disturbing causes, are years of rising prices, and years of decaying credit, years of falling prices. Deflation is the deadly enemy of outstanding debt. In the US, when house prices have generally tripled in less than a decade, it is evidence that the value of the dollar has decline by a factor of three in the same time period. Consumer prices have not risen by the same amount because of outsourcing of manufacturing to low-wage economies overseas also acts as a depressant on domestic wages. Imbalance in the economy appears if wages and earnings have not risen proportional to prices.  A homeowner whose house has increased 300% in market price while his income has risen only 30% has not become richer. He has become a victim of uneven inflation. He may enjoy a one time joy ride with cash-out financing with a new mortgage, but his income cannot sustain the new mortgage payments if interest rates rise and he will lose his home.  And interest rates will rise if his income increases because that is how the Fed defines inflation. Thus when his income rises, the market price of his home will fall, giving him an incentive to walk away from a big mortgage in which he has little equity tie-up.  This can become a systemic problem for the mortgage-backed security sector.

Under every system of banking, there will always securities dealers and who, by attending only to one class of securities, come to be particularly well acquainted with that class. The Fed recognizes them as primary dealers. And as these specially-qualified dealers can for the most part lend much more than their own capital, they will always be ready to borrow largely from bankers and others and in the repo market, and to deposit the securities which they know to be good as a pledge for the loan. They act thus as intermediaries between the borrowing public and the less-qualified capitalists. Knowing better than the ordinary capitalists which loans are better and which are worse, specialist dealers borrow from them, and gain a profit by charging to the public more than they pay to the lenders.

Many stock brokers transact such business on an enormous scale. They lend large sums on domestic and foreign bonds or infrastructure shares or other such securities, and borrow those sums from bankers, depositing the securities with the bankers, and generally, though not always, giving their guarantee. But with the development of deregulated capital and debt markets, banks are increasingly reduced to the role of market participants rather than intermediaries, by proprietary trading. By far the greatest of these new intermediate dealers are the bill-brokers. Mercantile bills are a kind of security that only professionals understand. In the US, they are called commercial papers, short-term obligations with maturity ranging from 2 to 270 days issued by banks, corporations and other institutional borrowers to investors with temporary idle cash.  Such instruments are unsecured and usually discounted, though some are interest-bearing.

In the US, the money market is a subsection of the fixed income market. A bond is one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money market investments are also called cash investments because of their short maturities. Money market securities are essentially IOUs issued by governments, financial institutions and large corporations of top credit ratings. These instruments are very liquid and considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower return than most other securities.

One of the main differences between the money market and the stock market is that most money market securities trade in very high denominations. This limits the access of the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this to the stock market where a broker receives commission to acts as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems.  Individuals gain access to the money market through money market mutual funds, or sometimes through money market bank account. These accounts and funds pool together the assets of hundreds of thousands of investors in order to buy the money market securities on their behalf. However, some money market instruments, such as treasury bills, may be purchased directly from the Treasury in denominations of $10,000 or larger. Alternatively, they can be acquired through other large financial institutions with direct access to these markets.

There are different instruments in the money market, offering different returns and different risks. The desire of major corporations to avoid banks as much as possible has led to the widespread popularity of commercial paper. Commercial paper is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivables and inventories. It is usually issued at a discount, reflecting current market interest rates. Maturities on commercial paper are usually no longer than 9 months, with maturities of 1-2 months being the average. For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and credit worthiness issue commercial paper. Over the past 4 decades, there have only been a handful of cases where corporations have defaulted on their commercial paper repayment. Commercial paper is usually issued with denominations of $100,000 or multiples thereof. Therefore, small investors can only invest in commercial paper indirectly through money market funds.  On December 23, 2005, commercial paper placed directly by GE Capital Corporation was 4.26% on 30-44 days and 4.56% on 266 to 270 days while the Fed funds rate target was 4.25% and the discount rate was 5.25% both effective since December 13, 2005.  Through the commercial paper market, GE has become the world’s biggest non-bank finance company.

February 14, 2006

Next: The Commercial Paper Predicament