Gold, Eurodollars, and the Black Swan that will devour the US Futures and Derivatives Markets

by Jesse at CaféAméricain
Posted December 3, 2011

THE EURODOLLARS ESTIMATE IN THE CHART BELOW IS BASED ON THE BIS BANKING ESTIMATES from Commercial Banks and may not include official reserves held by Central Banks. As you know the Federal Reserve stopped reporting Eurodollars some years ago, with the consequence that it also stopped reporting M3 money supply. I like to think of Eurodollars and banking system derivatives as the Fed’s off-balance-sheet method of monetization and policy implementation, with plausible deniability.

Swap lines are provided to other Central Banks, and they in turn make the loans to their member banks, and from there to their customers. So this eurodollar creation is made outside the real domestic economy, and therefore has no immediate effect on domestic money supply and prices at the end of the money chain. But the effect is there, and the smart money closer to the financial system sees it coming. I do not know if the Fed’s swap line activity actually shows up immediately in their Balance Sheet and therefore the Adjusted Monetary Base. But I think it is fairly obvious that if swaps are used to create dollars by foreign central banks, who in turn loan those dollars to their own members, the impact of that broader dollar creation will only be felt with a significant lag in the domestic US economy. But it will be felt at some point.

When the Fed was tracking Eurodollars, I believe that they were not counting certain assets, or liabilities from the banks point of view, as money.  What exactly those assets might be and how liquid they are is a open question.  How much of them were held in Agency debt, and how much in Treasury debt?  Is a liquid obligation held by a foreign source part of the broad money supply, or not?  Since it can be quickly converted into dollars, and then into another currency, leaves little question that it is potential money at least.

At least part of the problem being faced by Europe in this crisis is the sharp point of the deleveraging of US assets underlying dollar denominated debt.   And if foreign confidence in the US dollar debt breaks, the losses would be daunting for the holders of that debt, so there will first be a rush into Treasuries and away from Agency debt and CDOs.  This will be like the ocean retracting, causing people to flock to the shore in wonder at the cheapness of the debt.  But eventually the returning tsunami of US dollars may very well swamp the Fed’s Balance Sheet and the domestic US economy and the savings of many. The hyper-inflation of financial paper is happening quietly and  off the books. The growth rate in derivatives held by the Banks is mind boggling. And how this will manifest in the real world economy is not fully known. A good sized chunk of the financial system may simply vaporise.  And I suspect that the policy makers will heavily allocate the damage to the least powerful members of the private sector.

Ownership of the real economy will continue to be concentrated in fewer and fewer hands. Stagflation is the most likely outcome because of this lack of reform and the rise of a self-serving oligarchy. As for the US Dollar, as I have said on numerous occasions, inflation and deflation are at the end of the day a policy decision. Period. Those who see a hyper-deflation or a hyper-inflation as inevitable elude my knowledge of the facts as they are. The Fed owns a printing press, and it uses it selectively.

Speaking of lags, I think the unusually long lag between the growth in Eurodollars and the price of Gold can be attributed to the gold sales programs by the Western Central Banks. Once those programs were suspended, and the Banks turned again into net buyers, the gold price rose dramatically. The most recent Eurodollar operation of the Central Banks in relieving the Dollar short squeeze in euro is not yet in the totals.

It should also be noted that there are other correlations one can use in determining the gold price, most notable ‘real interest rates.’ However, there are linkages amongst all the variables, given a non-organic increase in the money supply and artificially low interest rates for example being among them. So, when will the price of gold stop rising? Most likely when the Central Banks stop printing money, and return to transparently set market based interest rates and a productively reformed financial system. ‘Not on the horizon’ does come to mind.

Who’s Going to Regulate the Regulators?

by Clif Drok
Originally published March 8th, 2011

The single most dominant theme among political commentators is the belief that government should do something – anything – to fix the financial system. Regardless of party affiliation, there is a near universal agreement that government should be charged with the task of regulating the financial realm in order to prevent another catastrophe.

This unquestioned assumption that government knows best is a surprisingly stubborn holdout from the early days of America’s first Great Depression some 80 years ago when Americans of all stripes turned to government for relief. In the intervening period since the Depression government has proven itself incapable of preventing the regular recurrence of financial market crashes and business recessions.

One would think this would be a strong testimony against the ubiquitous belief that government has the answers for saving the U.S. from its economic fate. Alas, few seem to have learned this lesson of history and there’s reason to believe that this failure will result in yet another Great Depression by 2014.

In the aftermath of the credit crisis of 2008 we’ve witnessed a steady stream of books, articles and political speeches which attempt to diagnose the underlying reasons for the credit crisis and how it could have been prevented. The common assumption behind nearly every facet of the debate is that increased regulation could have prevented the crisis. It’s further argued that additional regulation is required to prevent a recurrence of this disaster.

The core belief embraced by nearly all parties in the debate is that the government is capable of knowing best how to recognize excesses in the financial system and to prevent them from metastasizing. The absurdity of this proposition can easily be seen when you look at the government’s own fiscal condition.

If ever the dictum, “Physician, heal thyself” applied, it would apply in this case to the federal government. This naturally elicits the question as to why an entity that has proven itself incapable of managing its own financial affairs should be entrusted with the oversight of the private sector’s finances.

Quite apart from the obvious question of the government’s competence in monetary matters is the issue of trust.  Why should anyone trust the government to regulate the financial market when it has proven so woefully inept in preventing market crashes and financial debacles in even the recent past?  This is also an extension of the agency problem.

Let’s look at just two agencies of the government, namely the Securities & Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFCT). Both agencies have proven to be unequal to the task of regulating even the simplest aspects of financial market speculation. An argument could be made, for instance, that the SEC helped destabilize the financial system heading into the credit crisis by abolishing the uptick rule, thereby making it easier for hedge funds to create more downside momentum during the 2008 stock market crash.

Government economic leaders surprised that Real World isn’t responding to their magic pixie dust

Submitted by George Washington
Posted originally September 02, 2010

Fed chief Ben Bernanke told the financial crisis inquiry commission today: If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved. Too-big-to-fail financial institutions were both a source… of the crisis and among the primary impediments to policymakers’ efforts to contain it…

That’s funny, given that Bernanke has been one of the biggest defenders of the too big to fail banks, arguing strenuously against breaking them up, throwing trillions of dollars their way, and begging the banks to play nice with one hand, while patting them on the back with the other hand and giving them a big wink. And Christina Romer – Obama’s outgoing chief economist and Chair of the Council of Economic Advisers – said in her outgoing speech yesterday, as summarized by Dana Milbank at the Washington Post: “She had no idea how bad the economic collapse would be. She still doesn’t understand exactly why it was so bad. The response to the collapse was inadequate. And she doesn’t have much of an idea about how to fix things.”

Many have tried to explain to the neoclassical economists running the show exactly how bad the economic collapse would be, why it was so bad, and how to mount an adequate response to fix things. But Bernanke, Romer and the rest of the gang ignored them.

Who Knew?
As I pointed out in March, Greenspan’s big defense is that the financial crisis was caused by a “once-in-a-century” event. Forget about the fact that the “once-in-a-century event” couldn’t have happened if Greenspan’s Fed hadn’t:

• Turned its cheek and allowed massive fraud
• Acted as cheerleader in chief for unregulated use of derivatives at least as far back as 1999 (see this and this)
• And for subprime loans
• Allowed the giant banks to grow into mega-banks. For example, Citigroup’s former chief executive says that when Citigroup was formed in 1998 out of the merger of banking and insurance giants, Greenspan told him, “I have nothing against size. It doesn’t bother me at all”
• Argued that economists had conquered the business cycle, and that modern, technologically advanced financial markets are best left to police themselves
• Preached that a new bubble be blown every time the last one bursts
• Kept interest rates too low
• And did alot of other hinky things

More importantly, as Nassim Taleb repeatedly points out, financial experts who don’t plan for rare events are like pilots who don’t know about storms. There are storms out there, Taleb says, and any pilot who doesn’t know how to deal with storms shouldn’t be flying. Similarly, no one should be in a position of financial leadership if they don’t know about – and plan for – the infrequent event:

High Priests Shake their Magic Wands Even Harder
As Australian economist Steve Keen wrote last week, mainstream economists have been acting like religious fundamentalists, rather than scientists:

Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics. In the same way that Christianity is not the only religion in the world, there are other schools of thought in economics. And just as different religions have different beliefs, so too do schools of thought within economics—only economists tend to call their beliefs “assumptions” because this sounds more scientific than “beliefs”.