ECON120: Monetary History

DOLLAR IN DISREPAIR

Today, our financial system is broken. It works, but the fractures within make it prone to ruptures. It almost collapsed in 2008 and again in 2020. The Federal Reserve has done its job as lender of last resort in each circumstance and kept the financial system alive, but everybody now understands the Fed is the world's only true source of liquidity, and without its support the system couldn't stand on its own. From a layered-money perspective, there aren't a lot of places in the dollar pyramid that don't have an explicit or implicit guarantee of liquidity backstop from the Federal Reserve today. The dollar pyramid has fractured itself in so many places since 2007, that the Federal Reserve has had no choice but to place bandages across its entire facade. This chapter tells the account of how the Federal Reserve became the world's lender of only resort.

A Bookkeeper's Pen

Without gold, U.S. Treasuries stood alone atop the dollar pyramid as the only first-layer money. Treasuries them- selves are a form of credit, and their creditworthiness comes from the assets of the United States government and the power to collect taxes from its citizens. These government bonds became the highest-quality way to store dollars and still are today. In gold's absence, the Fed's balance sheet used U.S. Treasuries as its dominant asset, and the private sector used them as the omnipotent form of monetary collateral. For banks, ownership of these government bonds wielded the power to create yet another type of dollar called Treasury Repo dollars.

During the second World War, the United States Treasury suspended the Federal Reserve's independence with regard to monetary policy and effectively forced the Fed to finance the war effort. The Fed purchased enormous quantities of U.S. Treasuries at fixed interest rates as a result, and the United States government's quest for geopolitical dominance supplanted the Fed's politically independent monetary policy. A few years after the war ended, the Treasury-Fed Accord restored independence to the Fed, but more importantly, transitioned a vast portfolio of Treasuries into the hands of dealer banks, responsible for the healthy functioning of the Treasury market and dealing of Treasuries. These dealer banks had the power to extract liquidity from their Treasury holdings using a market for collateralized borrowing called the Treasury Repurchase (Repo) market. In a Treasury Repo transaction, a bank that owns a Treasury bond can pledge it as collateral and borrow money against it, just like in a pawn shop. Treasury Repo dollar creation occurred via the same balance sheet mechanism used for Eurodollar creation: the bookkeeper's pen. Banks could use the money they borrowed in the Treasury Repo market in interbank dollar settlement, and thus their Treasury holdings were a brand-new source of money. By 1979, the Federal Reserve concluded in a study that the explosion in Treasury Repo transactions was in fact causing an overall increase in the measurable supply of dollars and admitted not being able to make that measurement with exact precision. By 1982, the Federal Reserve fully gave up on managing the supply of dollars because they had veritably lost the ability to keep track of it; between the explosion in Eurodollars and Treasury Repo dollars, the dollar money supply had unquestionably lost all measurability. Instead, the Fed shifted to a monetary policy regime focused on managing short-term interest rates.

The Dollar's Suite of Reference Rates

Reference rates are pivotal in understanding how the dollar system broke in 2007. A reference rate is the interest rate of a credit instrument considered risk-free within financial academic theory. Financial theory uses the concept of a "risk- free rate" as the reference point for quantifying the risk of an investment. But credit instruments, by definition, have counterparty risk; no such thing can truly be wholly risk-free. Any borrower, no matter how mighty, can theoretically default. In reality, however, an entity like the United States Treasury has never defaulted on its debt obligations and has its own central bank to implicitly back any and all of its issuance. The Fed is the largest holder of Treasuries in the world; it is likely to purchase them ad infinitum because the purchase of Treasuries is how the Fed creates second layer reserves into the system.12 Also remember that in the past, the Fed was legislated into purchasing U.S. Treasuries in order to assist with war finance.

Treasuries are considered the risk-free asset in academia because financial models and valuation formulas require a baseline interest rate to reference. The entire spectrum of financial lending, from corporate debt, to residential mortgage loans, to consumer credit cards uses reference rates to set a baseline. After all, no lender would charge a family a lower interest rate to borrow than it would charge the United States government. From a layered-money perspective, instruments will always look one or two layers higher for their reference rate. Recurrently, this lands on Treasuries as the most creditworthy asset within the dollar spectrum. And in fact, it is. No other corporate, sovereign, or private entity has the track record and the implicit backing of a powerful central bank like the United States government has, landing the risk-free crown atop Treasuries. However, U.S. Treasury interest rates aren't the only reference rates in the dollar universe.

First, let's look at the differentiation between Treasuries themselves. Newly issued Treasury securities range from one month to thirty years in maturity, leading to a range of risk between Treasuries. While short-maturity Treasury Bills (T-Bills) have minimal price variability during their life, long-term Treasury Bonds have a much higher price sensitivity to changes in interest rates. This sensitivity, formally called duration, gives long-dated U.S. Treasuries a unique and markedly different risk profile relative to their monetary cousins, T-Bills. T-Bills don't have any considerable duration and are considered the highest quality, most liquid monetary instrument one can own within the dollar denomination. The interest rate on T-Bills is therefore one of the most cited reference rates in the money market.

The Federal Reserve targets a short-term interest rate as a part of its monetary policy called the Federal Funds Rate (Fed Funds), an interbank lending rate for second-layer reserve deposits held at the Fed. Fed Funds is an essential reference rate because it's the Fed's desired price for short- term lending within the U.S domestic banking system.

In 1986, interest rates on Eurodollar deposits in London were formalized in a rate called LIBOR, which would express the average rate at which banks in London lent Eurodollars to each other. These dollars didn't have any connection to the Fed's second-layer reserves or third-layer dollar deposits insured by the FDIC. Nevertheless, LIBOR mirrored Fed Funds; the investing world didn't prescribe any substantial quantitative difference to the price of interbank money whether in New York or in London.

In 1998, the Fixed Income Clearing Corporation introduced an interest rate called General Collateral Financing to reflect the average collateralized lending interest rates of Treasury Repo. The concept of General Collateral (GC) started because hundreds of different Treasury securities can exist at any time, and therefore measuring the interest rate of Treasury Repo should be done by averaging interbank Treasury Repo transactions.

Interest rates for T-Bills, Fed Funds, LIBOR, and GC all mirrored each other, implying the financial system viewed these four money-types as more or less identical. The four reference rates all harmoniously trudged along in congress until August 9th, 2007, when harmony turned to discord. Before we recount that fateful day, we must start with an overview of Money Market Funds.

Money Market Funds

Most people are instinctually risk-averse. They tend to avoid conflict, or in monetary terms, they crave higher-order monies that won't default. In small amounts, FDIC insured third- layer bank deposits suffice. In large amounts, it gets more complicated. Let's bring back the example of the VOC, its shares, and the creation of the Bank of Amsterdam to illustrate the state of money today, relative to investment. In Amsterdam, shares of the VOC were speculative but rewarding to its earliest investors. When investors wanted to cash out, they required a cash-type superior to gold and silver coins stuff ed into a suitcase. The Bank of Amsterdam provided that cash- type in the form of BoA deposits, which with mandated usage became a remarkably convenient way to swap between investments and cash. It was at this point that cash transitioned into a word used to describe the alternative to investments with risk. Cash now refers to a higher order of money relative to stocks and bonds, not exclusively to paper currency. In reality, no large investor can actually use paper currency with any utility: that type of cash is useless when dealing in large amounts of money. Cash today means monetary instruments that are safe relative to basically all other investments that have risk. That brings us to Money Market Funds.

Let's say you win a billion-dollar lottery. Unfortunately for you, your government exerts a 99.99% lottery tax on all winnings, leaving you with a tax bill of over $999 million dollars. The tax collector won't accept your money for a month. How do you keep the money in cash? The safest way is to purchase a T-Bill that matures on your tax due date. Th at way, your money is tied up in the safest possible asset until your tax bill is due. Second-layer money simply isn't an option for you: no bank has access to or the capability to store that much paper currency, and you as an individual don't have access to Fed reserves. You can keep it on deposit at your bank, but that third-layer money far exceeds the FDIC insured amount, so it carries the risk of default by the bank. If the bank is healthy, this shouldn't be a problem, but are you willing to put all your eggs in one basket and trust one single bank with a billion dollars? There is an option, however, that combines Treasuries, bank deposits, and other monetary instruments into shares of a Money Market Fund (MMF shares): a tidy cash instrument that services the world's unrelenting demand for safe money in a world of risky investments. Your best option to store your lottery winnings is by investing it in a Money Market Fund.

Money Market Funds became popular during the 1970s alongside the boom in Treasury Repo supply. MMF shares were a phenomenally desired investment product: a method to diversify away from concentrated bank risk exposure while simultaneously holding a cash-like monetary instrument. These funds had the most powerful trait possible of money; their shares held a par value relative to other high quality second- and third-layer money-types. This means that a dollar invested in MMF shares could always be redeemed for a dollar. MMFs invested in T-Bills, other U.S. Treasuries, Treasury Repo lending, commercial paper, and an array of bank liabilities.

Money Market Fund shares, depending on the exact composition of monetary instruments, became second- and third-layer money-types in their own right. Demand for MMF shares raged on as they allowed an uncomplicated way of owning a mix of monetary instruments in one security. Excess cash held by investment managers from across the world swept funds every afternoon into MMFs that in turn would purchase monetary instruments. This transformed the world's cash pool into a liquidity lifeline for multinational corporations that began to heavily rely on commercial paper funding of their operations. If, for some reason, cash holders decided to sell MMF shares for higher-layer monetary instruments, banks and corporations relying on the constant demand for their short-term obligations would face a crisis in liquidity. Therefore, the success of Money Market Funds also brought a great fragility to the financial system. Figure 13 shows what the dollar pyramid looked like as we headed for the twenty-first century and how MMF shares became the dominant form of retail money. There are two pyramids, one to represent the U.S. dollar system and another to represent the off shore U.S. dollar system.

Figure 13

Source: Nik Bhatia: Layered Money
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