Inspecting the interest rate imbroglio – Part II

Daniel Gomes Luis
June 10, 2021
Let us get right down to business and resume where we left off in the first instalment of this two-part series.

Owing to functioning efficiently, the financial firms operating in the eurodollar markets were crushing their rivals in the New York (on-shore) money markets. Following the amplification of Regulation Q, which capped the interest rates payed on time deposits, in 1968, a very large flow of deposits started to move from New York City to London (for the most part) in the form of large-time deposits. This, coupled with the collapse of the London Gold Pool in March 1968, pushed NYC banks to send those deposits off-shore, to their overseas subsidiaries, and then borrowing them back to the head offices in NYC.

In many cases, it was far easier than that. Usually, there would not even need to be any bank customer leaving the bank at all. The transactions could all occur physically in NYC, where, as Milton Friedman affirmed in 1969, the “bookkeeper’s pen” could accomplish the round trip by itself. Unsurprisingly, these developments caught the eye of the Federal Open Market Committee (FOMC), inspiring bewilderment and unease among its members.

Moreover, these innovative funding setups allowed banks to easily circumvent external constraints, including monetary policy and regulations, by using the wholesale techniques exposed in the first part. However, wholesale processes greatly favoured the larger banks that could, apparently, use their influence and superior expertise, both in technical and legal terms, to broker funding markets on- and off-shore to boot. Hence, the liaisons for these wholesale flows (primarily repo, or securities financing transactions, as they are sometimes called now) would be the biggest banks which were very keen on abandoning the traditional banking formats. As a matter of fact, this is what led to the S&L crisis of the 1980’s (which left its mark as I am going to show later on), as many smaller banks and even thrifts sought to emulate what those large commercial banks discovered in the late 1960’s.

Because of this, the new forms of money, fuelled by the eurodollar markets, were confounding the monetary officials in charge of keeping track of the money supply so as to accomplish their mandate of price stability – do not forget, “inflation is always and everywhere a monetary phenomenon”, as Friedman asserted). Using the measurements available at that time, M1 and M2, Fed staffers and economist just could not make sense of them. Curiously, these monetary aggregates could not keep up with the money demand depicted in their statistical models. To be more specific, the estimated demand for liquid deposit balances, for one, would regularly come in six, seven or even eight percentage points greater than the actual growth in money demand for those money forms. Something was amiss.

As a result, this was exactly what led Princeton economist Stephen Goldfeld, in 1976, to make the case for the “mising money”. Notwithstanding, that money was never missing; just operating in the shadows, with the officials at the Fed and at other central banks never really bothering to look for it.

In September 1979, Norman Bowsher of the Federal Reserve bank of St. Louis elaborated a synopsis of this money demand issue, founding that repo was a big part of that “missing money”. According to his estimates, the volume of the repo market at the end of 1970 amounted to roughly $2.8 bn. By 1975, that had turned into more than $15 bn, then reaching in June of 1979 an astonishing $45 bn. Interestingly, these advancements were taking place while prices were skyrocketing across the board (Great Inflation).

Likewise, as the eurodollar markets were revolutionising the realm of banking, as well as finance in general, researchers Günter Dufey and Ian H. Giddy from the University of Michigan and Columbia, respectively, published a paper in February 1981 (right around the climax of the Great Inflation and the apex of the eurodollar system). In here, they detail several of the financial procedures and instruments experimented throughout the two previous decades.

“…the general principle is that the currency of denomination of an asset can be “converted” by contractually selling the future cashflows from that asset for another currency. Similarly, the currency denomination of a liability may be altered by contractually purchasing the foreign currency necessary to liquidate that obligation. The remarkable feature of this use of forward contracts in the Eurocurrency market, for example, is that it enables banks to offer deposits or loans in any currency for which there is a forward exchange market, even if no external money market exists in that currency. The result is that the Eurodollar is the only full-fledged external money in existence; other Eurocurrencies are often simply Eurodollars linked to forward exchange contracts.”

– Dufey, G. & Giddy I. H. Innovation in the International Financial Markets, Journal of International Business Studies, 1981

On account of feeling the urge to document the financial bacchanal, Dufey and Giddy listed all sort of newfangled products; not jusy those who caught on, but also those that failed to do so, like floating-rate notes.

In a nutshell, what they demonstrated was that all of this financial innovation had turned the monetary system into a virtual, reserve-less and cash-less, currency-like system, as is styled by Jeff Snider, which operates on risk calculations to assess balance sheet capacities, as I expounded in the first segment. Besides the US dollar, they noted every other currency, insofar as there were forward exchange markets, was part of this monetary apparatus for being, in fact, “simply Eurodollars linked to forward exhange contracts”.

Thus, the actual monetary system had become even more derivative, although it kept its monetary essence. Essentially, it moved from a system where money in possession was that system’s primary constraint (traditional fractional reserve banking) to one in which the balance sheet factors balancing “future cash flows from that asset” have reigned supreme.

Ergo, real world bank liabilities could be liquidated or cleared based upon external – virtual, as opposed to real (having nothing to do with computers and the internet) – exchange markets of potential future transactions. Needless to say, such transfigurations stupefyed monetary policy-makers and regulators.

Similar to Bowsher’s efforts, Morgan Guaranty Trust, the precursor of the current JP Morgan Chase, used to provide estimates for the size of the whole Eurocurrency marketplace. In the middle of 1980, the eurodollar system mounted up to grossly $1,310 bn. Comparing to the US domestic system, the Fed’s M2 aggregate, which included Eurodollar deposits held by US citizens at Caribbean branches, totalled in the same period $1,587 bn, with the Eurodollar deposits at a mere $2.9 bn. In addition, the M3 aggregate was about $1,850 bn. Remarkably, in 1980, the gross size was already two-thirds of the broadest monetary bundle of domestic money supply.

Since the early 1960’s, the eurodollar system had mushroomed tremendously, with the estimates from Morgan Guaranty numbering approximately a paltry $50 bn at that time. Then, by March 1988, which happended to be, for whatever reason, the last year Morgan Guaranty produced these estimates, the gross size of the eurodollar setup was worth $4,561 bn, while M2 in May 1992 added up to $3,396 bn, with the Eurodollar component being at $17.8 bn. Hence, the gross magnitude of the eurodollar regime was a third, or thereabouts, greater in 1988 than the M2 aggregate would be three years afterwards.

As I mentioned before, the S&L – Savings and Loans institutions – crisis of the late 1980’s was precipitated by these small entities taking a bigger step than their legs (as we say in Portugal) by following the larger banks, in a quest for higher returns. Accordingly, when the 1990’s broke out, the shadow banking system took over, making the risk quantification calculations, such as VaR, pervasive in every major firm.

Furthermore, a big break came in 1995, which interestingly coincided with the rise of excessive speculation and enormous credit creation. In short, a series of bubbles started to emerge. By allowing absolute public access to its thorough database on variances and covariances for a myriad of securities and financial instruments of all types, known as RiskMetrics, JP Morgan (the old Morgan Guaranty) was, inadvertently, the instigator of the heyday of the eurodollar system, where the “proliferation of products” spiraled out of control.

“The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition.”

– Alan Greenspan, FOMC Meeting, June 2000

In spite of sounding odd to some, the regulatory framework contributed immensely to the expansion of this banking modus operandi. The Basel Accords that were enacted in that decade were derived from these kinds of mathematical concepts, joining the “bucket” approach first introduced by the UNCR (see Part I).

Due in large part to this new regulatory format, the quantification of risk became money-like. Therefore, regulatory bodies, both national and international, for being complaisant, emboldened banks to adhere to these practices. Hence, banks kept on expanding credit (the true “printing press”) and, consequently, the money supply, as long as volatility and loss probabilities measurements, chiefly, permitted.

Speaking of “printing press”, contrary to popular belief, monetary policy is not, in the current molds, “money printing”, in view of the fact that bank reserves (which are the byproduct of asset purchase programmes by central banks) do not factor in these calculations.

Seeing that the pigheaded central bankers are guilty of negligence for not grasping the importance of these shadow off-shore markets, it merits a few articles on its own, if not a whole compendium. For that reason, I am not going to dwell on it here. Despite the utter irrelevance of bank reserves, combined with the undeserved faith in central bank mastery (the Greenspan put), these aspects managed to suppress risk perceptions, resulting in colossal balance sheet space. Moreover, this ultimately induced the relentlessly growing of the eurodollar system, up to that fatidic day of August 9, 2007.

From then onwards, as the charts above show (using data only from banks operating in the US as a proxy for the entire eurodollar system), after the GFC, the expansion of money turned substantially tighter. Surely, it seems as if it had not been for the benevolent politicians and bureaucrats (in those graphs represented solely by the US government) credit origination would have practically stopped in its tracks, meaning that economic growth would have been almost inexistent. However, that is far from the truth, though unfortunately I have to defer that discussion for another day.

As the graph above demonstrates, there is a huge variety of interest rates, at various levels, moving in distinct directions and transmitting different informations. Let us not forget, interest rates are simply prices and the price system is nothing more than a mechanism to convey information about the economic landscape and all of its elements. Looking at the chart, notice how the riskiest kinds of credit, like consumer and personal loans, have not kept the pace of descent of, or even diverged completely from, the safest (most liquid) forms, such as corporate and government yields, since the top of the Great Inflation.

Although signaling that money creation is in the doldrums, some assets and sectors, as is exhibited by the next couple of charts, benefit with the low interest rate environment (e.g. bonds, real estate, large-cap and growth stocks, etc) Therefore, this entails that every asset class and industry are not hit by the economic “malaise” (tight money) equally, for some of them, albeit a small group, gain considerably.

To conclude, how do we reconcile and relate the interest rate fallacy and classical/Austrian theory of interest? Evidently, it has to be the case that perceptions on entrepreneurial and inflation risks, besides the time preferences, are not sufficient to explain interest rates. Even if they denoted  the most favourable conditions (i.e., no risk), interest rates could not possibly be zero, not to mention negative, on account of null and negative time preferences are an imposibility given our nature (i.e., human action). Hence, another component is necessary: liquidity risk.

Back in the day, prior to Markowitz unwittingly shifting the monetary and financial paradigm, the liquidity risk, albeit already a factor, was not as relevant as today. In fact, I posit that, in this day and age, the liquidity risk is all that matters. Since zero and negative interest rates (mostly on government bonds of advanced economies) are an outlandish reality, this must mean the liquidity risk completely overpowers the other components.

Undeniably, owing to volatility and liquidity being opposite sides of the same coin, and that volatility is infered from all kinds of risk, it is then clear that liquidity risk encompasses entrepreneurial and inflation risks already. Merely time preference (the pure interest rate) is left as an element constituting interest rates.

By looking at the sovereign bonds, for example, through the perspective of a typical investor, it is normal to reject them, not even touching them with a 10-foot pole, as Jamie Dimon, who is JP Morgan Chase’s CEO, declared. Indeed, he fears high inflation is on the cards and, ergo, demands higher compensation, which should be reflected in a higher pure interest rate. Yet, in the reign of the eurodollar system, time preferences have little to no influence.

During periods of financial distress, like the one encountered on March of last year, while the most liquid assets experience soaring prices, such as USTs with their yields dwindling, the riskiest securities and businesses will be priced accordingly, which will be reflected in their interest rates. This emphatically explains the intransigence of interest rates on those illiquid consumer and personal loans to join the others at the bottom (shown on the FRED chart above).

By the same token, due to banking regulations that are designed to protect depositors, especially small ones, largely the schemes of deposit guarantees, the “retail” deposits have become after all risk-less assets (for the holders of these deposits). Accordingly, they yield the same as those risk-free assets, the sovereign bonds – in the case of Europe, banks refuse to impose negative rates just because their clients would immediately vanish.

In view of the nature of the eurodollar beast, as uncertainty rises, the more liquid a security, the more will be requested in order for banks to maintain their balance sheets at maximum possible capacity. In the end, the conditions in the economy, validly appraised or not, in tandem with expectations of those conditions in the future are determinants of the rates of interest. Undoubtedly, for living in the era of the eurodollars, interest rates have no interest in the mainstream (keynesian) economists’ explanations, whether it is Ben Bernanke’s “global savings glut” or Larry Summers’ “secular stagnation”, rendering them absolutely laughable, if this situation was not so dreadful.

You can read the first part of this article here