I want to offer today an historical perspective on the favorite liquidity injection tool: Currency swaps. These coordinated interventions are not a solution to the crashes, but their cause, within a game of chicken and egg. But I’ve just given you the conclusion. I need to back it now…
To read this article in pdf format, click here: May 5 2013
With equity valuations no longer levitating but in a different, 4th dimension altogether, and credit spreads compressing… Which fiduciary portfolio manager can still afford to hedge? Any price to hedge seems expensive and with no demand, the price of protection falls almost daily. The CDX NA IG20 index (i.e. the investment grade credit default swap index series 20, tracking the credit risk of 125 North American investment grade companies in the credit default swap market) closed the week at 70-71bps. The index was at this level back in the spring of 2005. By the summer of 2007, any credit portfolio manager that would have wanted to cautiously hedge with this index would have seen a further compression of 75% in spreads, completely wiping him/her out.
It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick won’t work. In anticipation to the next and perhaps final attempt, I want to offer today an historical perspective on the favorite liquidity injection tool: Currency swaps. These coordinated interventions are not a solution to the crashes, but their cause, within a game of chicken and egg. But I’ve just given you the conclusion. I need to back it now…
How it all began
Let me clarify: By currency swaps, I refer to a transaction carried out between two central banks. This means that currency swaps cannot be older than the central banks that extend them. On the other hand, foreign exchange swaps between corporations may date back to the late Middle Ages, when trade began to resurface in the Italian cities and the Hansastädte. Having said this, I believe that currency swaps were born in 1922, during the International Monetary Conference that took place in Geneva. This conference marked the beginning of the Gold Exchange Standard, with the goal of stabilizing exchange rates (in terms of gold) back to the pre-World War I.
According to Prof. Giovanni B. Pittaluga (Univ. di Genova), there were two key resolutions from the conference, which opened the door to currency swaps. Resolution No. 9 proposed that central banks “…centralise and coordinate the demand for gold, and so avoid those wide fluctuations in the purchasing power of gold which might otherwise result from the simultaneous and competitive efforts of a number of countries to secure metallic reserves…”
Resolution No. 9 also spelled how the cooperation among central banks would work, which “…should embody some means of economizing the use of gold maintaining reserves in the form of foreign balance, such, for example, as the gold exchange standard or an international clearing system…”
In Resolution No. 11, we learn that: “…The convention will thus be based on a gold exchange standard.” (…) “…A participating country, in addition to any gold reserve held at home, may maintain in any other participating country reserves of approved assets in the form of bank balances, bills, short-term Securities, or other suitable liquid assets…. when progress permits, certain of the participating countries will establish a free market in gold and thus become gold centers”.
Lastly, gold or foreign exchange would back no less than 40% of the monetary base of central banks. With this agreement, the stage was set to manipulate liquidity in a coordinated way to a degree the world had never witnessed before. The reserve multiplier, composed by gold and foreign exchange could be “managed” and through an international clearing system, it could be managed globally.
How adjustments worked under the Gold Standard
Before 1922, adjustments within the Gold Standard involved the free movement of gold. In the figure below, I show what an adjustment would have looked like, as the United States underwent a balance of trade deficit, for instance:
Gold would have left the United States, reducing the asset side of the balance sheet of the Federal Reserve. Matching this movement, the monetary base (i.e. US dollars) would have fallen too. The gold would have eventually entered the balance sheet of the Banque of France, which would have issue a corresponding marginal amount of French Francs.
It is worth noting that the interest rate, in gold, would have increased in the United States, providing a stabilizing/balancing mechanism, to repatriate the gold that originally left, thanks to arbitraging opportunities. As Brendan Brown (Head of Economic Research at Mitsubishi UFJ Securities International) explained (here), with free determination of interest rates and even considerable price fluctuations, agents in this system had the legitimate expectation that key relative prices would return to a “perpetual” level. This expectation provided “…the negative real interest rate which Bernanke so desperately tries to create today with hyped inflation expectations…”
There is an excellent work on the mechanics of this adjustment published by Mary Tone Rodgers and Berry K. Wilson, with regards to the Panic of 1907 (see here). The authors sustain that the gold flows that ensued from Europe into the United States provided the liquidity necessary to mitigate the panic, without the need of intervention. This success in reducing systemic risk was due to the existence of US corporate bonds (mainly from railroads) with coupon and principal payable in gold, in bearer or registered form (at the option of the holder) that facilitated transferability, tradable jointly in the US and European exchanges, and within a payment system operating largely out of reach from banksters outside of the bank clearinghouse systems. The official story is that the system was saved by a $25MM JPM-led pool of liquidity injected to the call loan market.
How adjustments worked under the Gold Exchange Standard
During the 1920s and particularly with the stock imbalances resulting from World War I, the search for sustainable financing of reparation payments began. Complicating things, the beginning of this decade saw the hyper inflationary processes in Germany and Hungary. By 1924, England and the United States rolled out the Dawes Plan and between 1926 and 1928, the so called Poincaré Stabilization Plan in France. The former got Charles G. Dawes the Nobel Prize Peace, in 1925.
As the figure below shows, against a stable stock of gold, fiat currency would be loaned between central banks. In the case of a swap for the Banque de France, US dollars would be available/loaned, which were supposedly backed by gold. The reserve multiplier vs. gold expanded, of course:
With these transactions central banks would now be able to influence monetary (i.e. paper) interest rates. The balancing mechanism provided by gold interest rate differentials had been lost. As we saw under the Gold Standard before, an outflow of US dollars would have caused US dollar rates to rise, impacting on the purchasing power of Americans. Now, the reserve multiplier versus gold expanded and the purchasing power of the nation that provided the financing was left untouched. The US dollar would depreciate (on the margin and ceteris paribus) against the countries benefiting from these swaps. Inflation was exported therefore from the issuing nation (USA) to the receiving nations (Europe). The party lasted until 1931, when the collapse of the KreditAnstalt triggered a unanimous wave of deflation.
How the perspective changed as the US became a debtor nation
Fast forward to 1965, two decades after World War II, and currency swaps are no longer seen as a tool to temporarily “stabilize” the financing of flows, like balance of trade deficits or war reparation payments, but stocks of debt. By 1965, central bankers are already worried with the creation of reserve assets, just like they are today; with the creation of collateral (see this great post by Zerohedge on the latter).
Indeed, 48 years ago, the Group of Ten presented what was called the Ossola Report, after Rinaldo Ossola, chairman of the study group involved in its preparation and also vice-chairman of the Bank of Italy. This report was specifically concerned with the creation of reserve assets. At least back then, gold was still considered to be one of them. In an amazing confession (although the document was initially restricted), the Ossola Group explicitly declared that the problem “…arises from the considered expectation that the future flow of gold into reserves cannot be prudently relied upon to meet all needs for an expansion of reserves associated with a growing volume of world trade and payments and that the contribution of dollar holdings to the growth of reserves seems unlikely to continue as in the past…”
Currency swaps were once again considered part of the solution. Under the so called “currency assets”, the swaps were included by the Ossola Group, as a useful tool for the creation of alternative reserves. Three months, during a Hearing before the Subcommittee on National Security and International Operations, William McChesney Martin, Jr., at that time Chairman of the Board of Governors of the Federal Reserve System, acknowledged a much greater role to currency swaps, in maintaining the role of the US dollar as the global reserve currency.
In McChesney Martin’s words: “…Under the swap agreements, both the System (i.e. Federal Reserve System) and its partners make drawings only for the purpose of counteracting the effects on exchange markets and reserve positions of temporary or transitional fluctuations in payments flows. About half of the drawings ever made by the System, and most of the drawings made by foreign central banks, have been repaid within three months; nearly 90 per cent of the recent drawings made by the System and 100 per cent of the drawings made by foreign central banks have been repaid within six months. In any event, no drawing is permitted to remain outstanding for more than twelve months. This policy ensures that drawings will be made, either by the System or by a foreign central, bank, only for temporary purposes and not for the purpose of financing a persistent payments deficit. In all swap arrangements both parties are fully protected from the danger of exchange-rate fluctuations. If a foreign central bank draws dollars, its obligation to repay dollars would not be altered if in the meantime its currency were devalued. Moreover, the drawings are exchanges of currencies rather than credits. For instance, if, say, the National Bank of Belgium draws dollars, the System receives the equivalent in Belgian francs; and since the National Bank of Belgium has to make repayment in dollars, the System is at all times protected from any possibility of loss. Obviously, the same protection is given to foreign central banks whenever the System draws a foreign currency.
The interest rates for drawings are identical for both parties. Hence, until one party disburses the currency drawn, there is no net interest burden for either party. Amounts drawn and actually disbursed incur an interest cost, needless to say; the interest charge is generally close to the U.S. Treasury bill rate…”
My graph below should help visualize the mechanism:
Essentially, with these currency swaps, foreign central banks that during the war had shifted their gold to the USA, became middlemen of a product that was a first-degree derivative of the US dollar, and a second-degree derivative of gold.
On September 24th 1965, someone called this Ponzi scheme out. In an article published by Le Monde, Jacques Rueff publicly responded to this nonsense, under the hilarious title “Des plans d’irrigation pendant le déluge” (i.e. Irrigation plans during the flood). He minced no words and wrote:
“…C’est un euphénisme inacceptable et une scandaleuse hyprocrisie que de qualifier de création de “liquidités internationales” les multiples operations, tells que (currency) swaps…”“C’est commetre une fraude de meme nature que de présenter comme la consequence d’une insuffiscance générale de liquidités l’insufficance des moyens dont disposent les Etats-Unis et l’Anglaterre pour le réglement de leur déficit exterieur”
My translation: “…It is an unacceptable euphemism and an outrageous hypocrisy to qualify as creation of “international liquidity” multiple transactions, like (currency) swaps…”…“…In the same fashion, it is a fraud to present as the consequence of a general lack of liquidity, the lack of means available to the USA and England to settle their external deficits…”
Comparing the USA and England to underdeveloped countries, Rueff added that these also lack external resources, but those that are needed cannot be provided to them but by credit operations, rather than the superstition of a monetary invention disguised as necessary and in the general interest of the public (i.e. rest of the world).
With impressive prediction, Rueff warned that the problem would present itself in all its greatness, the day these two countries decide to recover their financial independence by reimbursing with their dangerous liabilities (i.e. currencies). That day, said Rueff, international coordination would be necessary and legitimate. But such coordination would not revolve around the creation of alternative instruments of reserve, demanded by a starving-for-liquidity world. That day would be a day of liquidation, where debtors and creditors would be equally interested and would share the common responsibility of the lightness with which they jointly accepted the monetary difficulties that are present….Sadly, Rueff’s call could not sound more familiar to the observer in 2013…
How adjustments work today, without currency swaps
Until the end of the Gold Exchange Standard, even if the reserve multiplier suppressed the value of gold (like today), gold was still the ultimate reserve and had in itself no counterparty risk. After August 15th, 1971, when Nixon issued the Executive Order 11615 (watch announcement here), the ultimate reserve was simply cash (i.e. US dollars) or its counterpart, US Treasuries. And unlike gold, these reserve assets could be created or destroyed ex-nihilo. When they are re-hypothecated, leverage grows unlimited and when their value falls, valuations dive unstoppable. Because (and unlike in 1907) the transmission channel for these reserves today is the banking system, when they become scarce, counterparty risk morphs into systemic risk.
When Rueff discussed currency swaps, he had imbalances in mind. In the 21st century, we no longer have time to worry about these superfluous things. Balance of trade deficits? Current account deficits? Fiscal deficits? In the 21st century, we cannot afford to see the big picture. We can only see the “here and now”. Therefore, when we talk about currency swaps, the only thing we have in mind is counterparty risk within the financial system. The thermometer that measures such risk is the Eurodollar swap basis, shown below (source: Bloomberg). As the US dollar became the carry currency, the cost of accessing to it became the cornerstone of value for the rest of the asset spectrum, widely known as “risk”.
In the chat below, we can see two big gaps in the Eurodollar swap basis. The one in 2008 corresponds to the Lehman event. The one in 2011 corresponds to the banking crisis in the Eurozone that was contained with a reduction in the cost of USDEUR swaps and with the Long-Term Refinancing Operations done by the European Central Bank. In both events, the financial system was in danger and banks were forced to delever. How would the adjustment process have worked, had there not been currency swaps to extend?
In the figure below, I explain the adjustment process, in the absence of a currency swap. As we see in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. We see loan loss reserves increase (bringing the aggregate value of assets and equity down). As these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates their risk profile
Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, the banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. We live in a fiat currency world, and banks simply let their loans amortize; there’s no mark to market. With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. As long as this process is left to the market to work itself out smoothly, borrowers don’t suffer, because ownership of the loans is simply transferred. This is neutral to sovereign risk, but going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.
In the end, an adjustment takes place in (a) the foreign exchange market, (b) the value of the bank capital of Eurozone banks, and (c) the amount of capital being transferred from outside the Eurozone into the Eurozone.
How adjustments work today, with currency swaps
Let’s now proceed to examine the adjustment –or better said, lack thereof- in the presence of currency swaps. The adjustment is delayed. In the figure below, we can see that the Fed intervenes indirectly, lending to Eurozone banks through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30th, of 2011, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk. The Fed becomes a creditor of the Eurozone. If systemic risk deteriorates in the Eurozone, the Fed is forced to first keep reducing the cost of the swaps and later to roll them indefinitely, as long as there is a European Central Bank as a counterparty for the Fed, to avoid an increase in interest rates in the US dollar funding market. But if the Euro zone broke up, there would not be any “safe” counterparty –at least in the short term- for the Fed to lend US dollars to. In the presence of a European central bank, the swaps would be bullish for gold. In the absence of one, the difficulty in establishing swap lines would temporarily be very bearish for gold (and the rest of the asset spectrum).
Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. This occurred in two steps: First at a global level, with the irredeemability of gold: The world could no longer devalue. Second, at a local and inter-temporal level, with zero interest rates: Countries can no longer produce consumption adjustments. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation.
In the past months and right after implementing Quantitative Easing Unlimited Edition, the Fed began surfacing the idea that an exit strategy is at the door. With the latest releases of weak activity data worldwide, the idea was put back in the closet. However, a few analysts have already discussed the implications of the smoothest of all exit strategies: An exit without asset sales; a buy & hold exit. I have no doubt that as soon as allowed, the idea will resurface again.
Underlying all official discussions is the notion that an exit strategy is a “stock”, rather than a flow problem, that the Fed can make decisions independently of the fiscal situation of the US and that international coordination can be ignored. This is logically inconsistent and today’s letter will address these inconsistencies. Let’s see…
Monetary expansions are treated as a flow process
Conventional PhD wisdom on monetary things tells us that government deficits represent net credits to the system via reserves, as well as to non-government deposits at banks.
When it comes to bond purchases by the Fed, such wisdom implies that the US Treasury is assisting markets with liquidity. This is not new. As a student, I once heard that “governments must run deficits, so that markets can have a benchmark rate”. My professor meant that “thanks” to fiscal deficits, bonds are issued and markets can proceed with the price discovering process. Today of course, we don’t even have that luxury, courtesy of Quantitative Easing (Not happy with the lesson, I asked Dr. Julio H. Olivera his thoughts on this statement. He chuckled (although Dr. Olivera never really chuckled) and recalled a similar exchange with John Hicks. According to Dr. Olivera, when Hicks was faced with the same proposition, he replied: “The merchant makes the market”. Unfortunately, I cannot prove this exchange, but thought I would share it with you).
But monetary contractions are treated as a stock problem
Why do I bring this up? Because if deficits are welcome by the PhD standard when it comes to monetary expansions, surpluses should not be ignored, when dealing with monetary exit strategies. It’s only fair…Yet, in the past months there has been a timid incursion into the upcoming debate on exit strategies available to the Fed, but without a single comment on fiscal policies. By now, I have become used to typing CTRL+F “fiscal” (i.e. find “fiscal”), whenever I come across any research note on potential exit strategies. If nothing comes up, it looks suspicious to me.
Once such example was Bank of America’s April 10th note titled “The consequences of a “no sales” Fed exit strategy”, from the Global Economics Rates & FX team. This paper has not a single sentence or thought on the fiscal situation and Treasury issuance forecasts of the United States (the word “fiscal” only shows up once). They are not alone. How can mainstream economics afford to ignore the fiscal side of the problem when facing an exit strategy? They simply treat it as a “stock”, rather than a flow problem.
Terms of the “stock” perspective
As a stock problem, mainstream economists look at a “no sales” exit strategy by the Fed, in these terms:
1.-Not to sell means to hold, while principal and interest payments are reinvested.
2.-The target of a 6.5% unemployment rate is reached and there are signs of a firm recovery underway
3.-Losses on their US Treasuries portfolio are manageable, particularly since the Fed announced its accounting policy change on January 6th 2011, where capital losses may be treated as negative liabilities (Truly, you can’t make this stuff up). Even putting this fiction away, mainstream analysis is comfortable with a negative impact on the asset side of the Fed’s balance sheet. To assess that impact, reference is made in terms of 10-yr equivalent duration exposure held outside of the Fed. Growth of 10-yr equivalents is expected to stabilize. As I mentioned in the last letter on the Bank of Japan, I side with Shuichi Ohsaki and Shogo Fujita, from Bank of America’s Pac Rim Rates Research team, who argue that volatility in the Japanese bond market could be diminished if the BOJ announced a schedule for buying operations, with the amounts that would be purchased in each maturity sector. In other words, the market does not look at the stock of government debt as a block of exposure that is sizable in equivalent duration terms.
4.-Reserves management, via interest on reserves, can be used to send short-term signals to the market.
In the next sections, I will seek to demonstrate that it is a huge mistake to ignore the fiscal side of this dynamic picture, and that a smooth, no sales exit strategy is fiction. Moreover, I will show that this is a flow, rather than a stock problem. Before I proceed, let me offer you this interesting exchange between Stanley Druckenmiller and Kevin Warsh, which took place on March 5th (Druckenmiller’s intervention starts on minute 5:41)
The flow perspective of the “no sales” exit strategy
To simplify the exposition, let’s look at the cash flow situation of the US government. Like any of us, the government has to collect taxes and pay for expenses. For this particular discussion, it will not matter if the same are ordinary, extraordinary, operating, capital expenditures etc. All I want to do here is to separate this collection of taxes net of expenses –which I will call Primary Cash flow- from the cash flow that has to be used to service debt obligations. In other words, like any of us, the US government will have, after collecting taxes and paying expenses, a primary cash flow with which to service debt obligations:
If the Primary Cash flow (PCF) is not enough to service the debt, unlike us, the government can issue more debt (at least the US government; at least for now). Additionally, the government can liquidate assets. Therefore:
Let’s now look at the demand for the gross issuance and simplify it, saying that the same is purchased either by the Fed, by the rest of the central banks in the world, and by the rest of the world (ROW, i.e. anyone else in this planet who is not a central bank, either in the public or private sector). Under these terms:
Let’s assume that the government sells no assets. If the Fed stopped purchasing US sovereign debt but did not sell any holdings and kept reinvesting the interest and principal payments it received, re-arranging the terms, we obtain:
Let’s further call a Net Demand of one of the agents (i.e. central banks, rest of the world) the difference between its purchases and the collected interest and debt repayments. We can then say that under a “no sales” exit strategy of the Fed and without asset sales, the primary cash flow of the US government equals the sum of the net demands of the central banks and the rest of the world. This is valid at one point in time as well as when we consider the comparative statics of the issue (the term “D” below denotes temporal change in a variable, between t and t+1):
Having arrived to the identity above (the above notations are identities, not equations), let’s look at the context under which the “no sales” strategy would take place. It is a context of a firm recovery, as the Fed has told us and we have every grounds to believe that for this reason, interest rates would tend to rise, as capital moves out of fixed income and credit, into equities. This means that the Net Demand of US Treasuries by the Rest of the World will likely be negative (i.e. Drucknemiller’s observation) or zero, at best:
Let’s take the optimistic view that the Net Demand of the Rest of the World is zero (Clearly, Mr. Druckenmiller does not share this view…and he has every reason not to be). This means that if neither the Fed nor the Rest of the World add US Treasuries to their balance sheets, the primary cash flow of the US government has to be addressed by the Net Demand of central banks, exclusively.
We can think of three different scenarios for the primary cash flow of the US government: A scenario of surpluses (PCF >0), deficits (PCF <0) or balance (PCF = 0).
If the primary cash flow is negative
This is the toughest scenario. It implies that the negative primary cash flow of the US government will be financed by the central banks of the rest of the world. The question here is: Why would these central banks keep accumulating US Treasuries when the Fed itself does not? From here, it is very clear to me that in the presence of continuing fiscal deficits, regardless of where the unemployment rate is, the Fed has no alternative but to continue monetizing the deficits.
But let’s examine this case further. Let’s suppose that by some miraculous intervention, the central banks of the rest of the world would in fact resolve to continue purchasing US sovereign debt, even if the Fed itself wouldn’t. How would this process take place?
There are two ways. Either the currency zones these central banks operate in generate balance of trade surpluses or their respective nations incur into fiscal deficits.
In my last letter, I explained how the latter way worked in Japan under Shirakawa. With regards to the former, to expect a sustainable recovery in the United States (which is the a priori condition for an exit) within a context of fiscal deficits, increasing sovereign debt and balance of trade deficits is a contradiction. Yet some mainstream economists see this as something very feasible, whereby the Debt/GDP ratio falls because the denominator rises faster than the numerator. If this is true, then I am completely wrong and I have nothing else to say. If you believe in the sustainability of this context, please accept my apologies for having taken your time. If you don’t, please proceed to the next scenario analysis.
If the primary cash flow is positive
If the primary cash flow was positive, the Net Demand of the rest of the central banks would be negative. This would imply a strong and positive savings rate in the United States. The problem is to figure out how the United States can get to achieve a savings rate strong enough to get to this point, in a context of negative to zero interest rates, where nobody has any incentive to save and where the same Fed wants to boost consumption. I asked about this problem (i.e. how the savings rate will improve) to a very well-known economist who gave a presentation this past Wednesday April 24th, at the Oakville Community Foundation. His answer was that the stronger savings rate would come from the public sector. But this explanation seems to me a tautology (i.e. The US government will be cash flow positive because it will save)
The real question in the face of this problem is “What will push the US government and the US to save, when all its deficits are monetized and interest rates are negative?” This is not a new question. In fact, it occupied the mind of Jacques Rueff for decades. Perhaps the first time M. Rueff made public this concern was during an exchange with no other than the same John Maynard Keynes in 1929, during a conference at the Assembly of the League of Nations, in Geneva. M. Rueff suggested that there was indeed an adjustment mechanism for the balance of trade and Keynes asked how such an adjustment could be brought about.
Rueff explained that inflation is nothing else but the creation of purchasing power in a country without a counterpart increase in production. For that reason, it is only possible to run balance of trade deficitsindefinitely –like the US has done over the 20th and 21st centuries- if there is inflation. The opposite should also be true: In the absence of inflation, there would be a balance of trade surplus, until all debts are paid (as in this scenario, where the Net Demand of the rest of the central banks is negative).
In summary, to effect a negative Net Demand of the rest of the central banks in US Treasuries, the purchasing power of Americans should be decreased. But how will the United States ever achieve such a state of affairs, when the Fed targets a 6.5% unemployment rate precisely by inflating the purchasing power of Americans? If the Fed is successful, the opposite will have occurred and the nominal purchasing power of Americans will have increased. Therefore, a positive primary cash flow is not possible, as long as the Fed continues boosting asset prices.
How did Keynes react to this view? We have only the testimony of Jacques Rueff on this, which I reproduce below:
“…Et Keynes, qui marchait de long en large –c’était sur la scène d’un théâtre- s’est arrêté brusquement et a dit: “Tiens, mais, cela c’est une idée intéressante, il faudra que j’y réflechisse.”
Je dis cela à mon ami Largentaye, parce que c’est très important pour l’historie de la pensée keynesienne. Cela prouve qu’en 1929 la théorie de la dépense global n’était pas encore au point dans son (i.e. Keynes’) esprit et que c’est plus tard, dans l’ouvrage que M. de Largentaye a traduit, qu’elle s’est élaborée, d’abord dans le Traité sur la monnaie et, ensuite, dans la Théorie générale. Et cela indique, d’ailleurs, le caractère mouvant de sa pensée; ce n’est pas une critique que je lui adresse, c’est plutôt un éloge; c’était un des esprits les plus actifs qui fût…” (J. Rueff, Le système monétaire international”, presentation given at the Conseil Economique et Social, May 18th, 1965).
Finally, if the nominal purchasing power of Americans will not be decreased by the Fed, the real purchasing power will have to fall, with the devaluation of the US dollar. This is a logical conclusion. In a context of global monetary easing, this can only be achieved against gold and…. why not, commodities in general.
If the primary cash flow is zero
This is a simple theoretical conjecture, just like the existence of general equilibrium in the fractionary reserve system and shadow banking we live in. To discuss it is an intellectual exercise of dubious utility.
In this discussion, I sought to show that:
-The exit strategy of the Fed is not a stock, but a flow problem.
-Just like expansionary monetary policy must address fiscal policy, contractionary monetary policy cannot ignore fiscal deficits.
-The fiscal issue PRECEDES the monetary issue. Without first addressing fiscal policy, it is irrelevant whether or not a labour market objective is achieved (i.e. unemployment rate of 6.5%).
-Any analysis of a potential exit by the Fed that dismisses fiscal deficits and focuses on the management of the balance sheet of the Fed only is surreal. It is not enough to claim that buy & hold is better than selling.
-In the case of the Fed, international coordination is required for an exit strategy to succeed.
Bonus: Was Mr. Druckenmiller correct?
As you may have noticed, I was optimistic and assumed that the Net Demand of US Treasuries by central banks would increase (i.e. international coordination) and that the Net Demand of the Rest of the World would remain unchanged.
What I believe Mr. Druckenmiller had in mind is a more realistic picture, where the Net Demand of the central banks would remain unchanged, while that of the Rest of the World becomes increasingly negative. In this context, with the US government continuing to run negative primary cash flows and the Fed shifting from quantitative easing to a buy & hold stance, the supply of US Treasuries would increase and interest rates would rise exponentially. Mr. Druckenmiller was correct.
About a month ago, in the third-quarter report of a Canadian global macro fund, its strategist made the interesting observation that “…Four ideas in particular have caught the fancy of economic policy makers and have been successfully sold to the public…” One of these ideas “…that has taken root, at least among the political and intellectual classes, is that one need not fear fiscal deficits and debt provided one has monetary sovereignty…”. This idea is currently growing, particularly after Obama’s re-election. But it was only after writing our last letter, on the revival of the Chicago Plan (as proposed in an IMF’ working paper), that we realized that the idea is morphing into another one among Keynesians: That because there cannot be a gold-to-US dollar arbitrage like in 1933, governments do indeed have the monetary sovereignty.
Is this true? Today’s letter will seek to show why it is not, and in the process, it will also describe the endgame for the current crisis. Without further ado…
After the fall of the KreditAnstalt in 1931, with the world living under the gold-exchange standard, depositors first in central Europe, and later in France and England, began to withdraw their deposits and buy gold, challenging the reserves of their respective central banks. The leverage that linked the balance sheet of each central bank had been provided by currency swaps, a novelty at the time, which had openly been denounced by Jacques Rueff. One by one, central banks were forced to leave the gold standard (i.e. devalue) until in 1933, it was the Fed’s turn. The story is well known and the reason this process was called an “arbitrage” is simply that there can never be one asset with two prices. In this case, gold had an “official”, government guaranteed price and a market price, in terms of fiat money (i.e. schillings, pounds, francs, US dollars). The consolidated balance sheets of the central bank, financial institutions and non-financial sector looked like this before the run:
And like this after the run:
Indeed, those who claim that today is different and make the dangerous case that “…one need not fear fiscal deficits and debt provided one has monetary sovereignty…” refer to this crucial difference in the balance sheet of the central banks then (i.e. in the ‘30s) and now:
And they are right: There cannot be any arbitrage, because there is no real asset to exchange fiat currency against. Only fiat vs. fiat (i.e. currency vs. government debt). But does this mean that the governments have monetary sovereignty? Does this mean there will not be an end game? I don’t think so. We cannot arbitrage fiat money, but we can repudiate the sovereign debt that backs it! And that repudiation will be the defining moment of this crisis. The key to understand how this will occur lies in focusing in the shadow banking system, rather than the banking system. In the universe of shadow banking we do not back fiat currency with real assets, but we provide sovereign debt as collateral to obtain the fiat currency necessary to establish positions in the commodities markets.
Some preliminary details
Our first assumption is therefore that the debt of the sovereign that issues the world’s reserve currency is repudiated. We can think of many events that would trigger that reaction: A monetary policy of the Fed that continues to enable fiscal deficits (something that already Jacques Rueff explained in the ‘30s) or the coming burst of the European Yankee market bubble (i.e. US dollar denominated debt issued by European corporations). Whatever the reason, the repudiation will have an impact in the repo market, which finances positions in the commodities markets.
Consider a trader in the commodities futures market. To finance his trading activity, he pledges collateral in the repo market, and receives cash. The collateral is often US sovereign debt and those supplying the cash in exchange for it are money market funds, under repurchase agreements. This secured financing entails the actual exchange of ownership, title on the collateral, which is “warehoused” in the balance sheet of the “lender”.
With the funds, the trader enters into a futures contract in the commodities market, but facing a central counterparty (clearinghouse). The trader has to post an initial and a maintenance margin. While the futures contract is in place, the trader (and his counterparty, the clearinghouse) will have an unrealized gain or a loss. As long as the contract is on, the trader will have to adjust the margin according to the gains or losses. At maturity of the contract, the trader can settle in cash or by delivery. At a consolidated level, however, there has to be a delivery of the commodity, at an auction, for the market (usually not higher than 1% of contract settlements). In the end, the trader must repurchase the collateral it had given to the money market funds, at a price equivalent to the principal plus accrued interest (i.e. repo rate). Below we show these steps in a chart, with real samples of how a hedge fund would show these transactions in its financial statements:
The End Game
Now that we are familiar with the steps above, think what would happen, if the US sovereign debt began to be repudiated, just like the debt of Italy or Spain. At the beginning, the repo rate (i.e. the interest rate charged by the money market funds) to lend to the commodity markets players would increase, making trading in commodities futures more onerous. Immediately after, however, liquidity would disappear as those investing in money market funds seek only short-term exposure with minimum risk. As well, given that most central banks hold US sovereign debt as reserves, one would expect an increase in global concern and a flight to safety in real assets.
With the rise in the cost of funding (i.e. repo rate) and the rise in commodity prices, it is to be expected that one trader short of a futures contract may suffer substantial losses. The increase in counterparty risk or the increase of a failure by a central counterparty (i.e. clearinghouse) would jump. And I think the jump would be so significant that even the delivery of physical commodities at auctions would be at risk.
The failure of a central counterparty is not new. In 1974, the Caisse de Liquidation failed on margin calls defaults associated with sugar futures contracts. In 1983, the Kuala Lumpur Commodities Clearinghouse crashed on palm oil futures and in 1987, the Hong Kong Futures Exchange clearinghouse failed also due to futures contracts, in equities.
Should a scenario like the above unfold, the Fed would likely be forced to intervene, inter-mediating between the money market funds and the commodities futures market. It could do so by issuing its own debt to money market funds (or any lender in the repo market) and using the proceeds to enter into repurchase agreements with traders in the commodities markets. The chart below illustrates this scenario:
Let’s take a close look at the balance sheet of the Fed, once it enters the repo market. A few observations are relevant:
a) The Fed would now fund positions in the commodities markets
b) Operationally, the Fed would probably mark the repoed Treasuries to model, not to market. Like the European Central Bank does today with Greek or Spanish bonds.
c) The Fed would not “print” money. They would simply raise funds from the shadow banking system by issuing its own debt. Therefore, they would have to pay an interest rate high enough to entice money market funds to buy it.
d) The Fed would not be able to “refuse” US Treasuries repoed. It would have to buy all the US Treasuries offered in repurchase agreements at their “marked-to-model” rate. But the money market funds could refuse to lend to the Fed, if a market rate is not offered.
And here is the catch, because in order to raise US dollars from the shadow banking system, the Fed would have to pay a higher rate than it would charge for its repurchase agreements. Otherwise, there would be no need to intervene the broken repo market, to start with!
And what would traders in the commodities markets do with the “cheap” financing provided by the Fed? Why, buy gold among other real assets!
This would constitute a much worse scenario, than the laughed at arbitrage that Keynesians so proudly say today is not possible, from fiat currency to gold.
Under this scenario, the rest of the world would get their hands on the reserves of central banks (i.e. US Treasuries) to dump them in the Fed’s balance sheet via the repo market and recycle the US dollars it obtains with money market funds, to receive Fed debt! (See chart below). In the process, the rate the Fed would have to pay to raise US dollars from the shadow banking system would have to spiral, sending a wave of bankruptcies across the US dollar zone, including the Yankee market. The Fed would be forced to increase its currency swaps and at the same time continue doing unlimited quantitative easing. The currency swaps would be extended to delay the inevitable defaults in global US dollar denominated bonds and the quantitative easing would be necessary because, given the high interest rates and defaults, even with austerirty, the fiscal deficits would continue, as tax revenues fall driven by the collapse of activity.
And now, the cherry on the top: How would the Fed cover its net interest losses, between its debt and the US Treasuries it would repo? By issuing currency!! This quasi fiscal deficit would lead us to double-digit inflation and if left unaddressed, would end in hyperinflation. The process would end when the US dollar loses its status as a global reserve currency, a status that the Fed would seek to defend at all costs, repoing Treasuries in the commodities futures markets.
For the sake of intellectual honesty, I want to end this exercise laying out the main assumptions:
The first and foremost critical assumption is that there will be a repudiation of US sovereign debt. The second assumption is that this repudiation will break the repo market enhancing counterparty risk in those markets where the funding is sourced from the repo market. I think these two assumptions are reasonable and the spike in the price of gold to $1,900/oz was in my view triggered first by the speculation and later by the confirmation of the downgrade to AA+ of the US credit rating by Standard & Poor’s. It has also seemed very curious to me that since that moment, and in a very strange way, the gold market became more volatile, with violent triggered sales, on no relevant news (But this is pure speculation, only proper to myself, of course).
The third assumption is that the Fed would intervene in the way I suggest. And this, indeed, is more debatable. It is certainly not the only way the Fed could act. There are other “versions”, but this is the more likely in my opinion and others have led to the same results, in other countries at other times (refer for instance, the “Cuenta de Regulación Monetaria” implemented by Argentina in 1978, where the central bank paid a subsidy on interest-bearing deposits and cashed a penalty on chequing accounts). Also, bear in mind that if this scenario unfolded, nobody would want to take the other leg of the long futures contracts on commodities (for instance, by 1981, the central bank of Argentina had to absorb and finance a loss $5.1BN in foreign exchange swaps from failed counterparties, refer Communication “A” 31 (May 6th, 1981). At the end of 1982, this loss was estimated at $10BN), converting the markets into a one-way ticket to high inflation: The link between forward rates, commodity prices and inflation expectations would be lethal!
Finally, the fact that US policymakers have been busy lately trying to regulate money market funds is to me an indication that I am not alone with these concerns. After a failed attempt by SEC Chairman Mary Schapiro to regulate money funds, on November 13th, the Financial Stability Oversight Council put forth new recommendations to regulate the industry. Of course, some of these recommendations (see “minimum balance at risk”, on page 6 of the document) do not apply to Treasury money market funds, because US sovereign debt is not risky, right?
As long as fx swaps (USD backstop) remain in place, we will be long gold. The top for the gold market will be reached the day this backstop is eliminated either voluntarily or forced upon the Fed by the market.
Today, we were supposed to follow up on our last topic (how to shift to a commodity-based standard, with a 100% reserve requirement). However, we will have to leave that for quieter times. Right now, we have to address a few points that we have been making since 2009:
There’s a truly “must-read” book, for anyone who is really interested in understanding how central banks have run the show since the 1920’s: “The monetary sin of the West”, by Jacques Rueff. In his memoirs, M. Rueff makes it clear that the rally that ended in October 1929 was fueled by what we call today currency swaps. Indeed, in 1931 (Robert Triffin was still a student) M. Rueff was writing:
“…There is one innovation which has materially contributed to the difficulties that are besetting the world…(…)… Under this system, central banks are authorized to include in their reserves not only gold and claims denominated in the national currency, but also foreign exchange. The latter, although entered as assets of the central bank which owns it, naturally remains deposited in the country of origin. The use of such a mechanism has the considerable drawback of damping the effects of international capital movements in the financial markets that they affect. For example, funds flowing out of the United States into a country that applies the gold-exchange standard increase by a corresponding amount the money supply in the receiving market, without reducing in any way the money supply in their market of origin. The bank of issue to which they accrue, and which enters them in its reserves, leaves them on deposit in the New York market. There they can, as previously, provide backing for the granting of credit.” Letter to Pierre-Étienne Flandin, October 1st, 1931.
The innovation M. Rueff referred to 81 years ago was what Keynesian economists of the 21st century very mistakenly call “decoupling”; a term that was used precisely to characterize the impact that the reduction in the price (to 50bps) of USD currency swaps had on the funding market, in December of last year. Today, this impact is best reflected in the cost of funding of the world’s carry currency, the US dollar, in terms of Euros. That price is called the Eurodollar swap basis. From the chart below (3-month basis, source: Bloomberg), we see how it has performed since 2008, as a result of interventions. Every time the cost spiraled up (basis down), the Fed intervened with the swaps (i.e. US dollar liquidity lines).
On December 12th, 2011, we explained the mechanics of these swaps, and in January 2012, tired of reading the idiotic claim that policy makers had decoupled the US from the Euro zone, we wrote in a note titled “There is no decoupling” that : “…The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fed’s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse, together with the ECB, without any swaps …”
Why did we say (and still maintain) that “The problems of the Euro zone are now really coupled to the Fed’s balance sheet”? The same economists who view these swaps as decoupling the Euro zone from the USD zone also believe that the swaps effectively removed “tail risk”. As we warned on March 4th, the FX swaps would allow credit Euro zone corporations to raise debt in US dollars, opening the door for the European Central Bank to monetize sovereign debt and crowd out, in Euros, the non-financial private sector. In US dollars, this crowding out was not going to happen (and it did not happen), courtesy of the Fed.
However, if the Euro zone was going to survive, we wrote that: “…eventually, we shall see a wave of EU corporations defaulting: Compared to US corporations, EU companies are exposed to higher taxes, an overvalued currency, institutional uncertainty and the benchmark rate ( i.e. sovereign spreads) is higher than that for US companies (i.e. US Treasuries)….but, if that wave of defaults occurred…who would be bailing out the US institutions that financed the EU corporations? Yes, you guessed right: The Fed! No, Bernanke did not mention QE3 last Wednesday, but we don’t need him printing monetary base to create the next bubble. All we need is a good currency swap, cheap Euro rates, a zombie EU financial system and the commitment to keep USD real rates in negative territory until at least 2014.” We offered the chart below:
Which brings us back to the core of today’s article…What has happened since we wrote about these issues?
First, last week Dennis Gartman, in his homonymous letter said that he was concerned about the fact that the adjusted monetary base has been falling, rather than rising, taking away the bullish case for gold on the topic of “money printing”. One must therefore remind those with this concern that the credit expansion caused by the backstop of the Fed alone is enough to inflate asset prices. This is consistent with the case we made in our last letter, that a commodity based standard is not as relevant as having a 100% reserve requirement. By the same token, if the reserve requirement is below 100%, it is not that relevant to see the expansion of the monetary base! The “printing of money” will eventually come, when EU corporations begin to default and the Fed has to “ensure there is enough US dollar liquidity”. It happened in 1931-33, in spite of the fact that the adjusted monetary base had been contracting since 1929: The US dollar was devalued from approx. $20.65/oz to approx. $34.70oz and gold was confiscated. If you don’t believe this, here’s the video showing the bailout of Germany from USD debt, announced by President Hoover in 1931:
And here’s the announcement of the confiscation of gold:
It can happen in the future, because the same Ponzi scheme is being played out before our eyes.We are not alone with this concern. Congressman Ron Paul has publicly expressed this view, as this video shows:
We will repeat ourselves: AS LONG AS THESE FX SWAPS (USD BACKSTOP) REMAIN IN PLACE, WE WILL BE LONG GOLD. THE TOP FOR THE GOLD MARKET WILL BE REACHED THE DAY THIS BACKSTOP IS ELIMINATED EITHER VOLUNTARILY OR FORCED UPON THE FED BY THE MARKET AND NOT ONE MINUTE EARLIER.
But, how do we know this is a problem? Is it true that EU corporations have already embarked in US dollar borrowing which can have consequences in the future? On October 5th, BNP Paribas’ US Credit team published a review of the state of the Yankee market. Compared to a decade ago, the Yankee market represents now 20% of the US dollar corporate bond market (from 10%), but the strongest growth occurred since 2011/12. The same publication notes that industrials (i.e. non-financial issuers) have grown in importance and now constitute 58% of all Yankees (bonds) (Curiously, the authors of the publication see this positively, because –apparently-, thanks to this growth in US dollar borrowing by non-US issuers, the market (both demand and supply) gains in diversification. I hope someone reminds these people to check what level the cross-asset correlation reaches, when the next liquidity crunch comes. Our bet is that it probably reaches 1!)
Can we see this “coupling” of the Fed’s balance sheet with the rest of the world causing other distortions? The Credit Derivatives team of Morgan Stanley, in its Credit Derivatives Insights publication of October 9th, noticed that less than 5% of the bonds in USD non-financials (in the iBoxx) are trading below par. And in the high-yield space, 70% of the non-financials are above par. What’s even worse, 24% of high-yield non-financials is even above their call prices!
In this context, hedging with credit default swaps is not efficient, because under the respective contracts, protection on default is covered only up to 100% of the price of the bond, and these bonds are trading above 100%. This means that, in some cases, even if one bought a bond and hedged it with a credit default swap, at default, one would suffer a significant loss. In other words, this shows a probability of default that is under priced, underestimated. And guess what…it makes sense!! Yes, with Bernanke at the helm of the Fed, you have to underestimate the probability of default, because he is telling in our faces that he will print dollars as long as US dollar liquidity is needed! But, but….should we really fear defaults? Well, there is always the ongoing concern that the Euro zone may break, sending shock waves everywhere. But also, in corporations, leverage is once again building up, and this time, more because EBITDA is deteriorating than the debt increasing.
This brings us to our final point: Will interest rates increase? We have observed a discrepancy of views in US Treasury rates forecasts this week too. If you read our last letters, you will know by now that we expect, if the ECB engages in its Outright Monetary Transactions, a convergence of short-term sovereign yields within the Euro zone. And, in the end, we expect both the short-term Euro zone yield and the USD yield to converge too, courtesy of the Fed’s coupling via the backstop entailed in the FX swaps. But the path towards that convergence is what has been taking our attention lately. We think that in the beginning, US yields should increase until a maximum tolerable level is achieved, after which, the Fed intervenes via purchases to keep yields within an implicit target. Until we get there, we will have to first see the bailout of Spain and some concrete steps towards an EU banking union. That will surely be the topic of future articles. But right now, obviously, we’re not seeing the materialization of these steps.
Once that level in USD rates is reached, the Fed will have to regularly purchase US Treasuries, to keep yields within their acceptable range. The assumption is that both the US fiscal deficit and the Outright Monetary Transactions continue. This would devalue the USD, making Yankee issuance even more palatable! This will be the bailout of the Fed, to the EU corporate sector and it can only last as long as the appreciation of the Euro does not hurt the Euro zone periphery. But it will…
With yesterday’s fears of a rating’s downgrade on Greece’s sovereign debt and weak US jobs market data, the markets (except in Canada or Mexico) sold off. However, we could not make sense of the simultaneous rise in the price of gold. We’ve seen this pattern before too, but it did not go too far, [...]
With yesterday’s fears of a rating’s downgrade on Greece’s sovereign debt and weak US jobs market data, the markets (except in Canada or Mexico) sold off. However, we could not make sense of the simultaneous rise in the price of gold.
We’ve seen this pattern before too, but it did not go too far, when it happened in 2008. Indeed, one could explain the behaviour by pointing at Mr. Bernanke’s comments yesterday, who made every effort before the Senate’s Banking Committee to be clear on the Fed’s intention to maintain a level of liquidity consistent with that of economic activity (weakness = low rate environment). Or maybe his comments on the possibility of reviewing MBS purchases, if required? But if that was the case, why would stocks not also rise, along with gold and oil? Why would the USD not weaken as well?
Clearly, the above factors cannot explain what happened yesterday. But if gold was bought as a way out of future currency debasements, then we have some comments to add here this morning.
If you have been reading “A View from the Trenches” long enough, you will remember that we turned neutral to bearish on gold (in USD) after the Dubai event, at the end of November 2009. Essentially, we believe the power of monetary policy coordination is a formidable challenge on gold’s prospects as a reserve currency. Therefore, if yesterday’s rally on gold and gold mining stocks was due to the increasingly likely fall of the Euro, as a consequence of the peripherals’ problems, we think gold bugs could later be disappointed.
In the 21st century, there are two global social classes: Politicians and taxpayers (This social stratification truly has global characteristics). If you think politicians will let you taxpayers get away from the inflation tax easily, think it twice. Let’s specifically consider the scenario where the Euro plunges. We think that if this happened, there would be an immediate increase in liquidity preference, expressed as a flight to the USD and the Treasuries markets. In that case, gold and stocks would be sold in favour of liquidity.
To those who disagree with this view, believing this chaotic situation would get off hands, we suggest that the Fed would be able to establish again, as it did in 2008, currency swap lines with other central banks, cushioning the impact of this move. This would be a deflationary event and no central bank would hesitate to provide extra liquidity. In summary, we fail to see a compelling story to be long of gold. And yet we are indeed worried, because the market proved us wrong yesterday and will prove us wrong today too, for gold is already at $1,112/oz.
For an historical perspective on this dynamic, let me quote below part of an interview M. Jacques Rueff gave to The Economist (Jacques Rueff: (http://en.wikipedia.org/wiki/Jacques_Rueff ). The interview was published on June 1965, and titled “The Role and the Rule of Gold.” The entire interview was reprinted in Jacques Rueff’s book “The Monetary Sin of the West”, MacMillan Co., New York, 1971, Part III. Its online version can be found at (www.mises.org/books/monetarysin.pdf ):
The Economist: …one of the countries that saw the biggest constriction imposed by the gold standard was, of course, Britain, which held no foreign exchange in its reserves. And, as we have always recognized, Britain at this time suffered precisely because of the harsh and inflexible disciplines of the gold standard, which you now want to restore.
J.R.: Let me tell you that you touch a point on which I have quite a few personal recollections. In 1930 I was financial attaché in the French Embassy in London, and in that capacity I was responsible for the deposits of the French Treasury with British banks. They were the direct result of eight years of the gold-exchange standard, because we had kept the pounds sterling in London, as my colleagues in New York had kept in the American market the dollars that had been pouring into the French Treasury from 1927 onward. Then, in 1931, the failure of the Austrian Creditanstalt caused successive waves of repatriations; and it was this collapse of the gold-exchange standard that, without any possible doubt, transformed the depression of 1929 into the Great Depression of 1931.
The Economist: While you are on this historical episode, what would your comments be on the very widespread view that it was to a substantial extent French pressure on London at that time, through the withdrawal of sterling balances, that was in part responsible for the general collapse later on?
J.R. Let me tell you that, unhappily for the world, the French pressure did not exist, or was so mild that it had no effect. There is a very interesting document from this period, a letter from Sir Austen Chamberlain, who was then Foreign Secretary in London, to M. Poincaré, who was Prime Minister and Finance Minister in France; it must be of 1928. Sir Austen said, “We know that you are entitled to ask gold for your sterling, but in the frame of the close friendship between Britain and France we ask you, so as to avoid trouble for the City of London, not to do that.” And we were, I must say, weak enough to comply with this request and not ask for gold. The fact that I had such important sterling deposits in London shows that we did not use this right to ask for gold. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 1927, 1928, and 1929. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed. We were too gentle in complying with official appeals not to convert our sterling balances into gold…
The analogy here consists in that France did the same we suspect the US would do in case the Euro plunged: Providing Europe with USD currency swaps is the same as having France in the late 1920′s not withdrawing their gold deposits from London. Think about it. I know it sounds counter intuitive at first sight, but ask yourselves what was backing the sterling pound then, and what would the Euro be exchanged for if it plunged? If the USDs are there for the Euro as gold was for the pound, we will be only delaying a painful adjustment. But politicians only care about the present.
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