I’ve never understood the myth of central bank dollar swaps. They are automatically placed in the category of QE or IOER, perhaps because very few seem to understand what was really happening with them (as well as outside of them). The Fed expands its balance sheet which everyone assumes is the same as expanding either base money or something like it. It’s a false equivalency, and one that is demonstrably so.

They make their first crisis appearance in December 2007; seven, not eight. On December 6 that year, the FOMC gathered telephonically for one of those emergency policy calls that were becoming more frequent, the level of discussion more urgent.

MR. DUDLEY. The upward pressure in term funding markets and the uncertainty about forward LIBOR rates have caused impairment of the foreign exchange swap market—a market used by many European banks to obtain dollar funding. In this market, bid asked spreads have widened, transaction sizes have dropped, and some dealers have stopped making markets.

To address these problems, the FOMC voted in favor of a Term Auction Facility via the Federal Reserve and also dollar swaps to be transacted with each respective central bank. Dr. Nathan Sheets, FOMC senior staff economist, stated on the call the swap line was at the request of the European Central Bank, an important detail.

MR. SHEETS. This temporary arrangement with the ECB is proposed to allow dollar funding problems now faced by European banks, particularly at terms longer than overnight, to be addressed more directly by their home central bank. Improved conditions in European dollar trading would guard against the spillover of volatility in such trading to New York trading and could help reduce term funding pressures in U.S. markets. In addition, these measures may help address the difficulties in the foreign exchange swap market, which Bill [Dudley] has discussed.

Over the next year, however, dollar swaps would only expand in volume as well as capacity. An actually effective program would see the opposite, where dwindling volume would accompany an end to the liquidity issue (international or not).

In that respect, the dollar swaps performed exactly like QE in that the Fed and the other central banks were always seeking more, more, more, not because they worked but because it was clear that they didn’t. Even FRBNY’s historical review of the program shows just how ineffective they were, at least in the early stages.

Despite the resumption of auctions by the European Central Bank and Swiss National Bank, excess demand for dollar funding among European banks was once again evident. While the Fed had sharply increased amounts available under the TAF, the amounts available in the auctions of the European Central Bank and Swiss National Bank were limited by the caps on their swap lines, leading to high bid-to-cover ratios in these auctions and significant unmet demand for dollar funding from European banks (Chart 3).

All throughout the summer of 2008, European firms were bidding way in excess of allotments for dollar funding from the ECB. That’s not evidence for something that is working. It is evidence for what Bill Dudley and Nathan Sheets were worried about in December 2007, except “the spillover of volatility in such trading to New York trading” did happen but in a very different way than Fed officials could grasp.

Many people simply assume that the final blowout in dollar swaps in late autumn did the trick, that such huge volume finally became sufficient so as to address the scope of the disaster. Again, this isn’t true. There was a third and in many ways more devastating global liquidation starting in January 2009 (lasting until March) that occurred with swaps open and then the addition of ZIRP, TARP, etc. The level of drawn swaps indicated, just as official selling of UST’s under the “rising dollar” (or what really replaced dollar swaps for ad hoc “dollar” liquidity in these later years), the level of all that was going wrong, not right.

Not only that, the global economy was in full meltdown for months afterward. Starting in November 2008, the US economy according to the BLS lost more than 600k jobs each and every month for six months straight. In terms of full-time jobs, employers cut more than a million in December 2008, January, February, and March 2009 (shifting only some several hundred thousand to involuntary part-time).

You find similar economic stories from China to Brazil to Europe. The economic costs of the monetary panic were not fully delivered until the middle of 2009. Was that a lagged delay to an effective monetary policy, where eight months after there was still the worst taking place? Or was it the continued response to continued monetary inadequacy including that final liquidation through March 2009?

Citigroup, which was handed the largest government bailout in US history in November 2008, “required” even more by February 2009. In a third bailout deal, the government took an even larger stake in the bank as its capital position continued to erode, cash and liquidity short.

One month earlier, British, European, as well as American banks were still facing prospects of bailouts if not full nationalization. They were writing down assets not because of credit risk or even defaults, but more so because liquidity problems in the wholesale space continued havoc on pricing what was illiquid to begin with. Banks were still in fire-sale mode, which they would not have been had global liquidity turned back more normal (the LIBOR spread was greater in early 2009 with full dollar swaps than in summer 2008 before they were expanded).

That’s all that really needs to be said about the effectiveness of dollar swaps, or anything else of monetary policy. That track record was merely continued over the next decade since August 2007. But we aren’t interested in leaving it at that. You are here because there is more to the story, a lot of which applies to the world of 2017. Part 2 is here.


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