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 hostile
US government, as happened to the funds held in
the United States by the People's Republic of
China after the Korean 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 the
financial hegemony of the British Empire after the
fall of Napoleon Bonaparte. 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 to and from London with little cost;
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.
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 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 US dollars, euros, yen and
Swiss francs, the money market operates on "T+2".
This means that settlement, when delivery of funds
takes place, occurs two business days after the
trade date. The settlement date is also known as
the value date. So if on Monday, August 13, 2007,
JPMorgan agrees to lend US dollars to Credit
Suisse First Boston (CSFB) for three months,
JPMorgan would pay this money to CSFB two days
after trading, on August 15, and it would be
returned with interest three months after that, on
November 15, 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, sterling is T+0 and almost all
others are T+2.
There is a standard
definition of the seemingly simple phrase "three
months". For example, when is three months after
November 30, 2009? It can't be February 30, 2010,
because there isn't such a day. And it can't even
be February 28, 2010, because that is a Sunday. As
it is, the official definition from the
International Swap Dealers Association (ISDA) says
that three months after Monday, November 30, 2009,
is Friday, February 26, 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 one day to one 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 in 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 with 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. 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
the 1998 crisis involving Long Term Capital
Management (LTCM), 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 were spread over 240,000 customer
accounts in 14 countries, it became a different
problem. The identities of counterparties for
over-the-counter derivative contracts were unknown
as risks were unbundled and sold off to a variety
of investors with varying appetite for risk.
Dealers such as 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 (CDOs).
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 last October 20 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 US$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 an abyss.
There is 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 a 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's 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
gross domestic product.
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 creditworthy 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
realizing 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
lendable 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 its currency 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 were to demand all that money at once,
their demands could not 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 that 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. Former US Federal Reserve
chairman Alan Greenspan's formula had always been
more liquidity at low interest rates, which pushes
the monetary system into what John Maynard Keynes
called the liquidity trap. This transformed
Greenspan 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 (repurchase
agreement) 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
that 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 that 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 that 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
(consolidated annuities) 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 that 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
creditworthiness of the dollar monetary system
would take decades to restore and would require
much systemic pain.
How banking
evolved Banking was not 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 frequently
trails 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 a finance
company 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
was 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), the 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 US dollar
through over-issuance to maintaining the economy
of a great state, notwithstanding Greenspan's
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 are 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
went on to explain why some countries had more
gold - in proportion to population and wealth -
than others; it was because there was 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." But 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 that
were made to prevent it, became in a great measure
uncertain. To remedy these inconveniences, a bank
was established in 1609 under the guarantee of the
City of Amsterdam. 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 that 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 600 guilders and upward
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 postwar
international trade. Since then, the central bank
of every trading nation has been obliged to keep a
dollar reserve account with the US 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 US
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
United States. 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 US
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 that 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
until 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 that 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 at
what rate of interest 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 United States, when house prices
have generally tripled in less than a decade, it
is evidence that the value of the dollar has
declined 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 joyride 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 be
securities dealers 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 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 stockbrokers
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
two 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 in
essence 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 with the stock market,
where a broker receives a commission to act 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 accounts. These accounts and
funds pool together the assets of hundreds of
thousands of investors 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 nine months, with
maturities of one to two 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
creditworthiness issue commercial paper. Over the
past four 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 Corp was 4.26% on 30-44 days and 4.56% on
266-270 days, while the Fed funds rate target was
4.25% and the discount rate was 5.25%, both
effective since December 13. Through the
commercial-paper market, GE has become the world's
biggest non-bank finance company.
Next:
The commercial paper predicament
Henry
C K Liu is chairman
of a New York-based private investment group.
(Copyright
2006 Asia Times Online Ltd. All rights reserved.
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