Shadow Banking and the Eurodollar
(This is an experiment, of sorts i.e. the selection of a discussion topic that floats outside the mainstream but of possible interest to a subset of participants who might bring their expertise and/or independent research to the table . . . . if there is such an interest, we will look forward to an enlightening discussion; if not, I’ll enjoy the lunch hour talking to myself)
The so-called Triffin paradox: a national currency that additionally functions as a global reserve will inevitably lead to a conflict between that country’s short-term economic interests and long-term international objectives. Stated differently, no country whose currency is the global reserve can pretend to operate as a closed domestic system.
The fact we have pretended otherwise may be key to unlocking the mystery why so many things have seemed off-kilter ever since the Great Financial Crisis of 2008: a) long-term interest rates driven down to such a level that it has enabled the explosive national debt, vast wealth disparity, and the hollowing out of the middle class; b) transmission of confusing signals as to whether we’re actually in an inflationary or deflationary environment; c) playing a major role in that very financial crisis.
As background, our MM (6/8/20) WTC: What The Fed discussion centered around the proposition that the Fed, established in 1913 (after the market crash of 1907) to backstop the loans to companies facing liquidity issues (i.e. solvent companies facing the need for temporary access to cash), has morphed into an unaccountable institution largely unfettered in its ability to enable money creation, going well beyond its official mandate about price stability and maximum employment. We are, it is submitted, now grappling with the consequences of this unleashed power.
That proposition, it turns out, may be overshadowed by a phenomenon of even greater significance i.e. the operation of the dollar as the global reserve currency. Enter the Eurodollar.
The Eurodollar is the term for those dollars and dollar-denominated assets that exist outside of the United States (btw, the term Euro does not denote Europe but is a designation for any currency that resides outside its host country i.e. there can be Euro yen and even Euro euros). The size of this Eurodollar market is absolutely gargantuan, estimated in 2018 to have been $57 trillion, nearly three times the size of the US economy.
But the significance of the Eurodollar system -- regard it as a system rather than as simply an aggregate of dollars -- is far greater than even those numbers might suggest. It is the driver of global financial markets in ways that are largely invisible and little understood as it operates outside the control, or even the visibility, of regulators including our own Fed. The functioning of this enormous so-called shadow banking may, however, become visible upon its dysfunction, as we saw with the huge structural pressures in the global financial crisis of 2008.
The Eurodollar system started modestly enough as US dollars after WWII were simply parked overseas. Those amounts grew as the US consumed and imported more (with payments in dollars) and was further exacerbated by the binge in dollar-based asset purchases that came with globalization. More and more of those US dollar holdings were moved to foreign banks (starting with USSR to London in 1957 and then with China to Paris) seeding this Eurodollar global financial system which then grew in complexity (including the proliferation of cross-currency swap arrangements, repo agreements, “structured” products, and elaborate derivatives) into the behemoth it is today.
Part of the distortion in this largely opaque system, going back to the Triffin paradox, arises out of the fact that Eurodollars cannot be conjured into existence the way US dollars are through our fractional reserve system (i.e. commercial banks “loan” money into existence as a multiple of said Fed reserves) as there is no equivalent overseas fractional-reserve system. As such, the growing demand for Eurodollars to support an expanding growing global monetary system can thereby be “starved”, leading to a so-called short dollar squeeze.
While this shortage may be partially addressed through the sale of other dollar-denominated assets or by means of those complex cross-currency “swap” arrangements, sometimes this shortage is so large that it results in that Eurodollar squeeze as had occured in 2008. With all the above (and other matters) as hypothesis, we will discuss matters which might seem otherwise counter-intuitive:
whether the explosive “expansion” of the Fed’s balance sheet is really a false indicator of major inflation in that the Fed is dealing with reserves (to the commercial banks), not money per se, such that money must first be “loaned” into existence by those commercial banks under the fractional reserve system; as such, low loan demand then translates into low new money supply with consequent low reflation or even outright deflation);
whether this artificial demand for dollars might be the root cause of the otherwise inexplicable strength of the dollar and demand for US government bonds, thereby maintaining elevated long-term bond pricing which, then, translates into those historically-low interest rates (which, in turn, has led to the previously-mentioned massive wealth disparity and the hollowing out of the middle class);
whether the freeze-up of the Eurodollar system operating in the regulatory shadows was a major factor in the 2008 global financial crisis and, if so, whether that system remains vulnerable today;
whether the dislocations introduced by the Triffin paradox with the advent of the opaque Eurodollar system raise a legitimate question about the ongoing suitability of the US dollar to be the global reserve currency (even Keynes had floated the idea of the Bancor) in a globalized, rather than a US-closed, economy -- possibilities sometimes discussed behind the scenes include the IMF special drawing rights (SDRs) and maybe even a form of crypto.
Or, maybe I should get a life :)