The theme this week has been one of killing currencies, or monetary genocide, as that seems to be reaching once-believed improbable levels of descent. While not specifically a self-contained series, the prior pieces, which are relevant to this discussion, are here, here and here. My intent so far as this angle is far more speculative, looking ahead at projecting a possible, or many possible, end point(s). This relates to the overriding governing dynamic that I believe defines our time, in both the financial and real economic realms. It is the supercycle; the rise and now fall of the eurodollar standard.

To appreciate the significance is somewhat difficult because we are not talking strictly about money and currencies, though that is the subject matter. The eurodollar standard encompasses the dollar, or “dollar” as I think a more apt notation, but it is really the elevated and central expression of the wholesale model of finance. It spans the globe and forms the central axis by which the entire financial/economic framework is managed. In that sense, currencies aren’t as much currency, and surely not money, but nodes in a network of ordered arrangements.

That would include the euro and yuan, and even the yen if to a lesser extent, as complimentary almost plug-and-play elements surrounding the wholesale model’s eurodollar system. The difficulties in both finance and economy for all those contained within this eurodollar existence I think are clearly traced to the rupture of August 9, 2007 – when imbalances became too difficult to handle and balance, such that they cannot still be handled meaning that the rift was permanent and ultimately fatal. Central banks, identifying none or very little of this, preferring instead their 19th century view of the world, have been busy trying to keep the sinking system afloat if only a little while longer.

I think that is why they have “had” to go further and further in terms of their intrusiveness. Because dominant orthodox theory tells them to “kill the currency”, if only gently and nudging at first, they don’t seem to realize that they may be hastening the end of the wholesale model itself. Rather than acting in tandem with a determined effort to alleviate the transformation, their stubbornness acts as artificial rigidity that may make the ultimate end that much more destructive than it might “need” to be (that is certainly speculative on my part, but I think well-founded by just recent history).

ABOOK April 2015 TIC Net Cumulative

To appreciate that, you only need to revisit the panic in 2008 which was unlike any other in history in one central aspect; there was no panic among the population, it was only panic among banks themselves. Again, that more than suggests a systemic problem rather than something financial or monetary, which should have been more appreciated by those in policy positions. Ideology, however, has prevented any recourse in either theory or action.

The eurodollar standard itself was predicated on one aspect of technological innovation. The textbooks teach that banks hold reserves of cash or account (in the US, prior to the Fed, smaller banks would hold “correspondent” balances with city banks, city banks with central city banks in “money centers” like Chicago and especially NYC). These were idle balances that created a drag on profitability and efficiency (aside: that was only in the case for some correspondent balances, as clearly the larger banks were allowed to “invest” and almost rehypothecated into call money, and thus the great stock bubble of the late 1920’s). By and large, cash in a vault was a necessary disfavor of pre-modern banking.

The eurodollar development in the 1960’s solved that issue because it had no cash to speak of, meaning a true dearth of physical currency. Despite misconceptions that still persist today, the eurodollar market was the first real wholesale expression because it was all ledger balances that could be “better” utilized toward efficiency. Ledger figures are far more fungible when they are connected inside that system.

That answers a great deal about why banks would “rather” hold negative yielding cash balances especially in Europe at the moment. What is being revealed by the ECB’s attempt at killing the euro is this premium for efficiency that is tied back to ledger money in its basic form. What the ECB wishes is that banks would instead of taking that negative yield transform their asset base by shifting out of that ledger cash and into risky assets – the nefarious “portfolio effects.” Banks are clearly reluctant to do so, as I described in the prior efforts on this currency genocide.

What is important here is whether or how much that efficiency premium is durable. The unspoken option is for banks to convert those ledger balances yielding negative numbers into actual, physical cash. Again, they resist doing so because there is a cost to it, not just in terms of figuring out in the physical world how to transport and store billions of euros in actual currency, but in taking that option such “vault cash” is no longer directly connected to the wholesale system; ridiculously, that means that cash liquidity is no longer truly liquid. To this point, they are not willing, apparently, to go that far which suggests that we haven’t reached a point where the artificial, central bank-induced cost of not doing so is high enough – yet.

The ECB seems intent on pushing this, using the efficiency development as if it were permanent capture to club banks with negative rates they cannot escape.  They seem to believe that this divide between wholesale and old-fashioned is an uncrossable boundary when history is clear there are none.

Understanding bank runs is really understanding fractional lending, an admittedly un-insightful but important point. The “run” is really the exchange of forms of liabilities, i.e., convertibility. The modern central banks believe that they have reduced or even eliminated the convertibility “problem” by first destroying gold and then taking more flexible (in the academic words of Ben Bernanke) power. But what 2008 showed was that convertibility was not exiled but rather shifted to places orthodox economists weren’t even aware existed. The liability structure, which is really a tangled, complex maze of traded and chained liabilities that have often very little to do with cash or currency, broke down in many ways just like a bank run – it was a convertibility problem except that nobody really knew (and we still, in some ways, don’t) what was being converted into what.

That fact destroys the entire rationality for ending the gold standard to begin with, as now the eurodollar standard has been revealed to suffer the same problems (which are not markets but intrusiveness and the arbitrary nature of that) but worse; no solution because there is no mechanism contained for correction. The gold standard worked for so long, even accounting for the artificial government means to try to influence it, because at the end of any dislocation there were, axiomatically, the means for un-entangling – convertibility.

What might happen to first the euro system should the ECB get to a point where they have raised the cost of maintaining those ledger balances too far? Instead of paying, say, -50 bps (or -100 bps, -200 bps?) and certainly not lending, might banks opt for convertibility despite the inconvenience and cost of doing so? It wouldn’t be easy, as how would a large-scale global bank quickly turn to storing €20 billion euros in vault cash, but I don’t think you can so readily dismiss that possibility. If one bank did it, then another might and then you have a good, old-fashioned bank run as convertibility of liabilities would be just like it was 1930 or 1893.

How might the ECB respond to that situation? The textbook answer is obvious, as Milton Friedman spells out in his Monetary History when discussing the “Great Contraction” (page 335):

The essential point for our purpose is that the demand for liquidation of security loans involves one of three arrangements: (1) finding someone willing to take over the loans which, as for securities, can be done by a change of price, that is, a rise in interest rates; (2) finding someone willing to acquire assets for money to be used by the borrower to repay his loan, which can be done by lowering the price of the assets; or (3) arranging for more or less roundabout mutual cancellation or creation of debts, which involves changes in the relative prices of the various assets. The pressure on interest rates and on security prices can be eased by any measure that enhances the supply of funds in one of these forms to facilitate the liquidation of loans in one of these ways. [emphasis added]

That is, in one sense, what every central bank around the world has been doing since 2007, to little avail, precisely because they are not doing so to “facilitate the liquidation” but rather to prevent it in the first place. Having already been engaged in trying to “enhance the supply of funds” continuously the pressure of convertibility would be enormous, maybe even unthinkable. In other words, the ECB would literally “have” to print currency.

ABOOK April 2015 Interbank to Loans

This is an utter mess and there is no reason to think that the worst cases are unrealistic – that is orthodox ideology applying improper stringency, as if the likely proffered solutions are, in fact, solutions. In some cases, they might be but the wholesale system of finance has proven rather impervious to these 19th and 20th century remedies because it is an entirely different systemic arrangement – and it is falling apart with or without them.

The point of this exercise is not one of prediction but rather investigation in that “other” direction that economists and central bankers will not concede is even slightly possible. In other words, we want to look at where there are possible choke points and inflections where bad circumstances might become something far worse. There are a range of really bad possibilities that such depredated money markets might lead to, which is the point I am trying to make. Unfortunately, as shown clearly above, the ECB doesn’t look the least deterred in trying to prove it.