The Great Global Dollar Short-----Clearing Some Misconceptions

Every once in a while, you get the sense that the officialdom is starting to come around to the legion of finance as it actually exists rather than the one printed inside the dusty textbooks still crowded within the halls of academia. The “rising dollar” of the past six months has left its mark of bewilderment, as so many economists are rushing to see it as they want to not as it actually makes sense with the world around us. A “strong dollar” is assumed to be testament to the successes of monetarism, especially when the US is breeding GDP where others cannot seem to gain any traction whatsoever.

If the US is the cleanest dirty shirt, then the Fed did something very right, and the “dollar” supposedly recognizes that. So it was interesting to see in Barron’s, of all places, a roundtable discussion about the subject that actually alluded to the “dollar” rather than the dollar.

The dollar was strong against every major currency in the world last year. That hasn’t happened in at least 25 years.

 

Mainstream economists are telling us that the dollar is strong because of growth differentials among countries, and an impending interest-rate hike in the U.S. They don’t understand the true reasons for the strong dollar.

So far so good.

The Federal Reserve, under Alan Greenspan and Ben Bernanke, pursued a monetary policy that kept interest rates too low. It weakened the U.S. currency, which became a funding currency around the world. Corporations issued dollar-denominated debt. According to the Bank of International Settlements, there is $9 trillion of dollar-denominated debt outstanding in the private sector around the world. That is the short position.

So close. That is most decidedly not the “short position.” The global “dollar” short, a synthetic short, comes about not because there was tremendous growth in dollar-denominated assets but that financial entities borrowed “dollars” in which to “buy” it all. What they borrowed were currency liabilities that don’t really exist anywhere except on a bank ledger somewhere, and it so often isn’t very clear exactly where. The problem of such an arrangement is that the system is therefore very susceptible, asymmetrically, to periods where funding, rolling over the synthetic short, becomes less easy and cheap.

If the world simply owned a bunch of dollar-denominated bonds, as suggested by the quoted passage above, funding or liquidity would never much be of a problem as owners would simply hold the securities to maturity. It is this very serious mismatch between funding and “ownership” (who owns collateral in a mass repo relationship? Title remains with the owner but it gets murky, as many found in both the Lehman estate and MF Global’s) that generates the potential for crisis – perpetual at that.

Given that this very significant distinction is so often unknown or misunderstood, it is not surprising that nobody seems to know where all these “dollars” came from.

At the same time, the current account deficit of the U.S., which is the way the U.S. supplies dollars to the rest of the world, has been shrinking in recent years. Therefore, there is a diminishing supply of new dollars.

No, no and no. There is absolutely no need of terrestrial dollars in the eurodollar standard, as so often now and for the whole of its history these “dollars” may never so much as touch American shores or American interests; including American banks. Yet, even those that recognize bank evolution cannot break free from trying to see the “dollar” world solely in cozy, domestic terms. There is simply no need of that, which was the entire attractiveness (to banks) in the first place:

What really happens is that South Korea obtains “dollars” solely by way of Brazil’s borrowing them in eurodollar markets (more specifically still, Brazilian banks borrow them in eurodollar markets to be on offer domestically inside Brazil to companies that wish to engage in global trade; all of this dollar/real financing “governed” by what’s called the cupom cambial whereby the Banco do Brasil attempts to influence the “cheapness” of this short-term dollar borrowing on the part of Brazilian banks in order to create a convoluted sense of economic management). Once those “dollars” appear on a bank balance sheet in Brazil to be “paid” to the South Korean company, they are simply ledgered from that perception to the next.

 

Of course, in reality, the exchange may never actually get to South Korea as the company that is counterparty to the Brazilian trade may never actually repatriate that piece of global finance, instead keeping the dollar balance on offer globally (likely in UST or actually eurodollar repo) as it would probably maintain dollar balances as a measure of prudence. Assuming it does wish to convert to won, the balance simply transfers again to like a South Korean bank or its central bank which does the exact same – offering those “dollars” as what looks like “flow” into US assets.

 

The origin of those “dollars” is not, again, this mysterious “global savings glut”, though it might look that way to Bernanke in his simplified viewpoint, but rather some eurodollar bank (and one that is not all that likely to be even American) expanding its balance sheet to create a new asset, i.e., a debt balance.

The idea of a closed system or a physical origination of a dollar inside the US is false, having been undone in size as far back as the 1960’s. This why banks are paramount in modern “monetary” policy that contains absolutely no reference or need of actual money. Liquidity is not some stack of dollar bills printed at a government agency, but rather the proclivity of one bank trading some kind of liability (and it is not at all clear which kind is “necessary”) with another.

That should offend everyone that has an interest in US law and the severe implications of simple economic life, as we so closely found starting in August 2007. But since it has appeared to “work” and be stable for most of our experience it is just accepted as “how it is” – even though there is great confusion, even and especially amongst policymakers, “how it is” actually happens and stays happening.

Monetary policies so often work as an illusion, a sort of sleight of hand playing upon perceptions. In this case, of the eurodollar standard that replaced the too-soft gold standard of Bretton Woods, the magic trick is almost literal as nobody really much cares to penetrate the current state of financialisms and their “dollars.” Even those that make their way through the looking glass of modern “money” have trouble making sense of it, as it just doesn’t relate well to preconceptions that are based really in financial anachronisms.

This drastic alteration began in earnest around 1985 when eurodollar futures and interest rate swaps first traded in Chicago. That meant funding markets could go not just global, as they were already there from the 1960’s onward, but into nothing more than perception – it was virtual money before anyone had ever heard of virtual reality. In many ways it was a beautiful and elegant transformation, if only it were conducted under strict “rules of the game.” That was the true attractiveness of gold as an international form of money, in that everyone knew what the rules were and there were severe consequences from courting too much instability.

The current setup is the exact opposite, just as Milton Friedman and his acolytes intended. Those ostensibly “good” intentions never saw the practical applications of doing so in the extreme. This is it, and rather than remain a creature of beauty and efficiency these “experts” unleashed a financial monster that dominates everything and anything. Banks must be maintained at all costs because everything, in this framework, starts and ends with a financial balance sheet.

Unfortunately, we are still on Step 1 – getting enough people to even understand what happened decades ago.

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