The U.S. Dollar: The Modern Day Bancor

By Eugen von Böhm-Bawerk

According to Belgian-American economist, Robert Triffin the country whose currency have become the global reserve currency must be willing to supply enough liquidity to satisfy global needs. This obviously raises an interesting question for the Federal Reserve with regard to their monetary policy execution. On one hand, they need to consider the best course of action for the domestic economy, while on the other also take into account effects on global financial markets and corresponding capital flows.

The Federal Reserve Act of 1913 and its many amendments have obviously been interpreted by Congress to apply only to the domestic US economy. Specifically, the Federal Reserve’s statutory objective, as outlined in the Humphrey-Hawkins Full Employment Act of 1978, is to maintain long-run growth- and price stability, which will foster full employment. Note that there is absolutely nothing in the act about creating stable funding conditions for the estimated $9 trillion worth of credit issued outside the US to non-bank borrowers.

Still, in her latest press conference, FOMC Chair Yellen cited “global economic and financial developments” as the main reason for not starting raising interest rates at the much-anticipated September 17^th meeting. Why?

It all comes down to the liquidity of, and confidence in, Eurodollar markets. Offshore dollar deposits and collateralized securities dependent on cash flows stemming from international dollar flows that have become such a vital source of funding for global trade, debt and financial well-being; which is the global economy.

In many ways the Eurodollar is similar to Keynes’s proposed Bancor. Keynes envisaged a global currency that would give away local authority over monetary policy and hand it over to the “International Currency Union” which would make sure there would always be means of payment for countries with trade deficits.

The US government and its central bank have half-heartedly assumed this role since the Eurodollar market almost collapsed in September of 2008. Recent developments, withexpectations of diverging monetary policies across jurisdictions have once again led to Eurodollar strain. The reason for this is simple; the Eurodollar system is inherently unstable because it is essentially a great ledger with far more claims to dollars than there are dollars in existence.

As the upside-down pyramid below depicts, dollars (currency in circulation and reserves held at the Federal Reserve) is minuscule compared to all the claims circulating the world of finance. When trouble brews and counterparty risk increases, holders of these claims rushes to exchange them for actual dollars. With demand outstripping supply by a factor of 10, prices goes up id. est deflation and a stronger dollar.

This explains why, in times of market stress, the dollar gains value in foreign exchange markets. In order to ease dollar claimant’s fear of missing out, the Federal Reserve conduct QE and FX SWAPS with other central banks to satisfy need for fresh dollars.

The sheer scale of fiduciary media in the world compared to dollars are of such a magnitude that deflationary pressures abound throughout the world. In times of QE this pressure lessens, but reappear as soon as QE is scaled back. In theory, the Federal Reserve could “print” up enough to satisfy all demand, but at that point the rest of the world would certainly lose faith in the dollar and deflation would quickly turn into devastating hyperinflation.

Source: US Federal Reserve, Bank of International Settlements, Bawerk.net (note that the value of shadow banks and international dollar are only rough estimates)

The massive flows stemming from Eurodollar fear and greed help explain such conundrums as why US TSY rates move inversely to QE programs. When Federal Reserve buys TSY en masserates actually went up as confidence in Eurodollar counterparties increased and money started flowing back into the world.

When the QE stopped, deflationary pressure took over and rates started to fall.

Source: Federal Reserve Bank of St. Louis, Bawerk.net

The same principle applies to dollar valuation in FX markets. Some people believe it is a paradox that the US dollar rose in value relative to other currencies in 2008 when the recession started in the US after all. Again, this was a major shock to confidence in financial markets, a scramble for dollars from people with dollar claims ensued and the dollar thus strengthened. The fact that today’s dollar strength, which started soon after the Federal Reserve tapered of QE3, surpasses that of 2008 is testimony of severe ‘dollar’ strain in today’s markets.

Source: Federal Reserve Bank of St. Louis, Bawerk.net

As these effects, rates and dollar, affect Humphrey-Hawkins directly the Federal Reserve is increasingly becoming the global central bank in charge of the health of Keynes’s bancor. In other words, as the ‘dollar’ tries to get out of emerging markets the Federal Reserve must make sure it stays there. We like to think of the enormous build-up of ‘dollar’ liabilities since August 15^th 1971 as a tsunami lifting all boats. While it appears to be working wonders, the underlying damage, in terms of capital consumption and resource misallocation, is not revealed until the flow returns back out to sea.

Looking at the dollar index back to 1975, we clearly see that major moves in the USD have always been accompanied by some large-scale crisis in the world. This time it is emerging markets, especially commodity producers, which will endure the most of the pain. That said, as we have argued on these pages earlier, the US economy also looks like it will enter recession soon, and if it does another leg down in ‘dollar’ confidence will push the dollar higher on FX markets and wreak havoc with the remaining emerging markets dependent on USD denominated credit flows not already in turmoil.

Source: Federal Reserve Bank of St. Louis, Bawerk.net

Despite all this, the main problem for the Federal Reserve is that they think imposing enough financial leniency on markets the 30 year long credit fueled boom can be restarted and we can all return to the semi-permanent boom Keynesians are aiming for. This is flawed because 1) the US, and most likely the world economy, has reached peak debt, and as an extension of this argument, 2) the composition of outstanding debt is consumptive and not productive.

What this means is that there are not enough free cash flow in the system to service more debt and the reason for that is due to the consumptive nature of the very same legacy debt. In other words, viability of assets outstanding today depends on the liability holder productively investing the resources he can bid on as part of the credit extended. However, if those resources are consumed, the viability of the assets falls. If deflation takes hold within in this environment (which it inevitably must), it would mean that the worlds asset holders, be it depositors, stock or bond investors, must take huge write-downs.

How can we know that debt saturation has been reached? First, velocity of money are falling and are now down to levels last seen during the Great Depression and World War II.

Source: National Bureau of Economic Research, Federal Reserve, Bawerk.net

Secondly, the share of pure consumptive debt, unproductive or even counterproductive, has been growing exponentially, while that of a productive nature has remained stable.

Source: Federal Reserve, Bawerk.net

As the ‘dollar’ leverage cannot be boosted through what is now dubbed conventional QE due to debt saturation, the logical conclusion (from a Keynesian’s perspective) is negative interest rates (alongside cash ban) and so-called “Helicopter Money”

We have argued that there is a high probability of NIRP (at least first) to force banks to circulate their excessive reserves. When that turns out to be deflationary (as in Europe, albeit the US version is a bit trickier since the reserves will become a hot potato that logically ends up in the hands of the retail depositor) “Helicopter Money” will be the ultimate end-game.

The statements, views, and opinions expressed in this article are solely those of the author and do not necessarily represent those of EMerging Equity.

Courtesy of Eugen von Böhm-Bawerk