The year in money
A 2017-end post with this title might be thought to focus on bitcoin, and I will indeed have something to say about that, but in my view the bitcoin bubble is mostly a symptom of deeper trends that need to be uncovered first.
Today money is global, so we can start pulling the string anywhere and eventually get the full picture, just by following the trail from any particular balance sheet, with its own assets and liabilities, to the counterparty balance sheets on both sides, and the counterparties of those counterparties, and so forth. Notwithstanding the reality of financial globalization, politically the globe is still divided into separate nations, as we are reminded by this year’s rise of various nationalisms, all of them at least in part reacting to the reality of global money, so let’s start there.
Yu Yongding, in a remarkable essay for INET, draws our attention to “Imbalances in China’s International Payment System”. Basically China has been borrowing private (FDI) and lending public (US Treasuries), both sides of its consolidated national balance sheet denominated largely in dollars, which is to say in global money. There is nothing new in this per se, as it has been going on for a decade at least. What is new is a recent shift in the lending side from official assets (held by the central bank) to nonofficial assets (held by private citizens or businesses), and subsequently some shift of those nonofficial assets out of China. “To a large extent, [this development] reflects an unwinding of carry trades and capital flight.”
Yu does not say so explicitly, but we might concretely picture what is happening as China shifting from US Treasuries held by the central bank to US real estate held by private citizens. The problem is that, whereas official holdings of US Treasuries can be used to pay off dollar denominated foreign debt, non-official holdings of US real estate cannot. And whereas official holdings of US Treasuries could potentially be used to acquire higher yielding foreign assets as preparation for the demographic challenge facing China as a whole, non-official holdings of US real estate cannot. “Capital account deficits caused by such activities cannot lead to increases in foreign assets and decrease in foreign liabilities.”
Meanwhile, as Zoltan Pozsar points out in a remarkable book of data he calls “Dollar Funding after the Storm”, global money markets have been through a transformation. One dimension of that transformation is a shift from unsecured funding to secured funding; formerly the central rate for global dollar funding was LIBOR in the Eurodollar market, but now increasingly it is the tri-party RP rate. Another dimension of that transformation is a shift in the location of market-making from the balance sheets of global banks to the balance sheets of asset managers and broker-dealers of various sorts. Arbitrage profits in the cross-currency basis swap, especially the dollar/yen swap, were the key incentives driving that institutional change at the global level.
Pozsar does not say so explicitly, but we might concretely picture what is happening as a shift of matched book market-making operations out of the banking system entirely, largely onto central clearing counterparties, coupled with a significant reduction in the balance sheet capacity for speculative book market-making operations. The driving force for all this transformation has been the desire to “protect the taxpayer”, by raising the cost of market-making within the banking system. The desire to avoid public loss exposure has focused attention on solvency more than liquidity, and on the national more than the global footprint of the system. I conclude that the transformation of the system remains a work in progress, probably incomplete. It remains to be seen to what extent we have yet succeeded in reconstructing a private market-making system that is able to absorb periodic shocks without collapsing onto the public dealer-of-last resort backstop.
The important point to hold onto, when reading both Yu and Pozsar, is that the capital market-based credit system that has arisen as the natural form of banking for a financially globalized world is here to stay. Absent a global depression or world war, we are not going back to the national autarky of immediate post-WWII, any more than we are going back to the bank loan-based credit system that proved to be the natural form of banking for that world. Financial globalization is here to stay.
Even more, the massive expansion of credit since the crisis, almost all of it in the emerging market economies and substantially denominated in dollars, suggests that financial globalization is now spreading on the extensive margin into every corner of the world. It’s not just China, it’s everywhere. Private firms are tapping global dollar funding markets, and central banks are accumulating global dollar reserves. The visible face of financial regulation has focused on solvency, while leaving potential liquidity problems to national central banks, and their loose global system of liquidity support through regional reserve pooling and bi-lateral central bank swaps.
Against this background of reality, the bitcoin bubble points our attention to the central challenge of making financial globalization work, which is a political economic challenge more than a technical one. The bitcoin bubble is a symptom of that challenge, insofar as it arises from deep distrust of both states and banks. The crypto dream is of a world without governments or financial intermediaries, a radically decentralized and non-hierarchical world in which each individual interacts with each individual directly, those interactions being facilitated by computers and code. Put simply, trust in bitcoin is a measure of distrust in traditional authority, both public and private.
Can bitcoin replace the dollar? I have already weighed in negatively on that score, and I have not changed my mind. My opinion on that point was almost entirely based on my understanding of how monetary systems work, which is to say the economics of payment systems and the economics of market-making. In both, credit is completely central, a feature not a bug, and hence impossible to eliminate. The inherent instability of credit is therefore also a feature, of the market-based credit system just as much as the loan-based credit system. What is needed is not bitcoin but rather management, both private and public management, and that’s where the problem lies because a prerequisite of management is legitimate authority.
Let us stipulate that we have succeeded in putting in place the foundations of a new global monetary system. The problem of re-establishing the legitimacy of authority remains.