The new world of “global money”
IES Europe Aix Summer University 2019
Wednesday morning session
« The end of central banks ? »
Libertarians are rightly cheering to the rise of Cryptocurrencies. For the first time ever, with Bitcoin first, and now with Libra, central banks national monopolies are facing the prospect of a real market competitive challenge.
This being said, the idea of central banks having to face private rivalry is not as far fetched as many imagine. Libertarians don’t need a Libra project to give birth to such competition. It is something that already exists. It even has a name : the Eurodollar System.
You surely heard of « eurodollars ». Formally speaking, a eurodollar is a dollar account deposited in a bank located outside the United States – i.e. out of reach of american regulators.
Milton Friedman was the first economist to mention that central banks overlooked the monetary creation potential of eurodollars. In one of his articles dating from the seventies he showed how, with conventional bank accounting practices, chains of cross border money transactions and credits ended in a cumulative extension of the world float of dollar supply that owed nothing to the US balance of trade deficit. It is a pure bank money creation of off shore dollars (which are « dollars » in name, but not real US dollars).
About the same time, a Princeton economist went to London to study eurodollar transactions. He observed that corporate cash needs on that market were increasingly met with short term debt assets which did not qualify as money proper but offerered liquidity properties close to the traditional components of money included in monetary aggregates : commercial paper, repos, MMF shares, swaps, derivatives,… In a paper entitled « The Missing Money », he came to the conclusion that central bank econometric models were based on money statistics that missed a large chunk of actual payment instruments. They did not fit the standard definition of money. But they were increasingly used in the real world as alternative dollar instruments because they were characterised by a degree of « moneyness » close to that of true monetary instruments.
Over the years the use of these money-like instruments increased so much and so fast that it gave rise to a wholly new international banking structure (Gary Gorton): a global off shore dollar system. This off shore banking network has by now become the main source of access to dollar liquidity in the world – and thus the main source of dollar supply for the globalized economy.
But, because of accounting conventions and a short sighted definition of what counts as « money » most of this actual money creation does not appear in statistics. It is a shadow money.
Economists still depend on Keynes’ vision of the macro economic world. His representation basically remains that of semi closed economic islands, each with its own monopoly hierarchy of banking and money institutions ordered around a central bank that is sovereign. Within this mental universe, there is conceptually no room for such a shadow money.
Thanks to globalization, digitilization, financial innovation and the end of capital controls this common view is now obsolete. In the old world, to grow their business, banks basically needed to collect more deposits. That was a marketing job. When faced with a balance sheet mismatch they borrowed standard base money from other local banks with excess reserves at the national central bank. In the new globalized world they rather directly call the dealer desk of an off shore global bank department located in London or elsewhere. They will immediately be offered tailor-made eurodollar rolling repo loans or currency swaps obtained from large world cash flow pool aggregators (such as big multinationals with global value added networks, insurance groups, pension funds, mutual money and equity funds…). This is finance. Market refinancing.
As a consequence, to solve its liquidity problems, modern banking relies less and less on the traditional tools of national money markets. Even in the US, Fed funds and Fed reserves are no more the exclusive source of last resort funding. Repos markets have become the largest liquidity and refinancing choice of last resort.
(The following three paragraphs are off my oral presentation)
However there is a problem. This is not a market for everyone. This new global banking network is basically a wholesale money market whose main parties are very large institutions acting both as lenders and borrowers. What is usually transacted are exchanges of millions, hundred of millions, and even billions of dollars. Such accounts do not benefit from any statutory state insurance (as bank deposits usually do up to a certain limit). Therefore, this off shore system developed only because private markets spontaneously developed a highly complex and sophisticated hedging industry based on the use of collateral and derivatives techniques whose prototype is the repo contract.
The essence of a repo contract is not only the exchange of two promises : I promise you a loan of a certain amount for a certain duration while you promise me to repay the loan at maturity date; but the borrower also backs his promise by transferring to the lender the temporary possession of a portfolio of securities in exchange for the lender’s promise to return it to its legal owner (the borrower) when the loan is repayed. Moreover, repo legislation gives the lender the legal right to re-use these securities as collateral for obtaining to his own benefit another personal repo loan from a third party. This practice is known as rehypothecation. It is the source of a powerful leverage and multiplier mechanism (Manmohan Singh).
The best of all collaterals, the most searched for are USTs (United States federal bills and bonds). But they are only in limited supplies. Therefore markets had to find alternative private solutions. They came from the derivatives industry. Through securitization, tranching and other derived mathematical techniques that redistribute risk (like infamous CDS and CDOs) its role is to produce private securities which may qualify for collateral use and reuse. But this multi steps transformation process relies on chains and matrices of intermediated cross-border credits, loans and swaps that are themselves highly collateral intensive. It is this hyper complex financial architecture based on the central concept of collateral hedging – even overcollateralization – that nutured the explosive growth of modern finance and eurodollar markets.
As a result the current international monetary system is an hybrid which works in ways very different from traditional textbook presentations. Today national monetary systems are collectively capped and embedded in a new banking lyer of global dimension whose monetary output variations supersede and trump national monetary policies – even those of the american Fed.
Nowadays it is this wholesale eurodollar global money system, Global Money to make it short (Perry Mehrling) , that effectively rules the world economy tempo.
But who rules Global Money ?
Assembling and marketing highly rated securities that qualify for use as collateral backing is the backbone of modern finance. Thus, who finances and controls this process rules the show. Today, it is a handfull of huge global dealer banks (about twenty so called SIFIs – for Systemic Financial Institutions like Citibank, Bank of America, JP Morgan, Goldman, HSBC, BNP Paribas, Credit Agricole, DeutscheBank…) whose wholesale experience, dealership expertise in derivatives and market making activities put them in a position of turning on or turning off the flow of global liquidity.
This new monetary structure is the hallmark of a momentous revolution : central banks are being competed out in the supply of one of the most important attributes of money (liquidity). They are de facto no more central. They are no more the center of the system.
Failure by the central banks community to acknowledge and understand the reasons and the consequences of this change, means that their present monetary policies are totally disruptive. Consequently, after twelve years the crisis is still with us.
To fix it one may imagine some sort of new Bretton Woods. But there is nothing to expect from such a conference reset. To fix the system one must first understand the system. Politicians and central bank economists still don’t.
An alternative direction may emerge from the spontaneous innovation market process initiated fivety years ago. At that time it brought private shadow solutions to overcome the postwar structural dollar shortage (Triffin paradox). Since the end of the great recession we faced renewed episodes of recurrent dollar shortage as a consequence of the failed response of central banks (the current episode being the fourth in twelve years).
Digital alternative private payment platforms, bitcoin, blockchain, cryptocurrencies, « stablecoins » are today higher technology supplementary and evolutive solution tools proposed by the market process.
Let’s hope that with his Libra project Zuckerberg will not choose the side of monopoly hungry crony capitalism and obsolete central bankers. It would definitively jeopardize the future of these more freedom friendly experiments.
August 16th, 2019