Fed buy up Euro?

[Gumby]

I would think that private US banks and private European banks would be perfectly capable of making currency trades to cover their positions in different currencies.

You have to imagine a world where everyone is clamoring for dollars. As you know, there aren't enough dollars in the private sector right now — with all of the deleveraging going on. The swaps just makes it easier and cheaper for the banks to exchange Euros for dollars. Otherwise it would be total chaos.

Again, this is just from what I've read on the subject. I'm not an expert by any means.

[cabronjames]

has there been any consideration of intra-Eurozone policy to balance big trade deficits between nations within the Eurozone?  Such as Warren Buffett's "Import Certificates" idea or just regular tarriffs?  Perhaps only applied to the weaker nations that have a combined trade deficit to the other 16 nations in the Eurozone of X% (30%?).

iirc the original theory of Free Trade from Adam Smith assumed a balanced trade.  Eg. Germany exports 500 billion EUR in goods to the other combined 16 Eurozone nations, & imports roughly 50 billion these other 16 EZ nations.  Or at least the sum of exports tod

Adam Smith did not assume a continuing years/decade+ trade deficit, like what presumably Greece has to the other 16 EZ nations, and what the US has to China.

It seems to me unsurprising that a decade+ trade deficit could lead to economic problems.

Maybe the situation is excessively dire for this "balanced trade" policy to work now, but it might've worked if done earlier in the Eurozone's history.

[MediumTex]

I don't think we can expect the Fed to buy up the entire privatized world. The Fed should really only be interacting with banks. Only Congress — via the Treasury — should have the authority to hand out money to people.

As I read that I thought about the Fed becoming a being like "V'Ger" from the first Star Trek film.

[stone]

Cabronjames, I thought, that Keynes argued at Bretton Woods that trade surpluses should be what was penalized. If say Germany ran a surplus with Greece running a deficit, then it would be Germany that had to pay money to Greece. Keynes also came up with an idea for an international commodity linked currency called a Bancor. The Chinese have been murring about trying to resurect some of his Bretton Woods proposals (that were all rejected back then inorder to have the system that only lasted until 1972 before collapsing).

Currently as it stands, the Euro entails Greece paying bond interest to bond holders in the trade surplus countries and that creates the death spiral we now see. At least with China and the USA, the USD China gets as bond interest can not get annuled as tax within China as is the case with Greek bond interest paid to German or French banks.

[Gumby]

Been reading more about the swaps. Even though the swaps aren't "bonds," it seems that Moda was correct in terms of default risk. From an MMT perspective, the US just made a big fiat currency blunder.

From (MMT economist) Warren Mosler:

Just looks like the Fed lowered the rate on its swap lines to keep libor down, which had been moving up to its prior swap line rate.

No big deal, apart from the fact the Fed shouldn’t be allowed to lend on an unsecured basis like this without explicit approval of congress.

Lending unsecured on an unlimited basis has the potential to be highly inflationary.

With the currency a public monopoly, the price level is necessarily a function of prices paid at the point of govt spending and or collateral demanded when govt lends.

Allowing unlimited unsecured lending has the potential to vaporize the currency. And while in this case that kind of abuse isn’t likely, the potential is there.
Source: CB: announcements

Also, according to MMT — which is the only economic framework to describe how a fiat currency might actually work — there are severe inflationary risks if a government owes debt in a foreign currency. On the surface, a currency swap doesn't seem like owing foreign-denominated debt. However, these swaps are technically unsecured loans. If the Eurozone collapses or fundamentally changes, their is the potential the swap agreements won’t be honored.

From Cullen Roche (another MMT researcher):

The swaps expose the US government to potentially substantial foreign denominated debt. From an MMT position, this is an absolute no-no. The loans are essentially unsecured since they’re denominated in a foreign currency so if the Euro vaporized tomorrow the Fed could be on the hook for the losses. This is an entirely irresponsible risk.

...

The Euros are on deposit at the ECB who is the real borrower of the USDs. If they default the ECB would have to transfer the USDs to another account where the Fed would buy them. This would be fiscal policy in essence. So, if Euro banks borrow $580B as they did at the peak in 2008 and then the Euro vaporizes then the Fed has literally printed $580B. It would be like off balance sheet fiscal policy which the Fed could do for instance, by buying USDs on the open market.
Source: http://pragcap.com/swap-lines-not-a-panacea

This is an unlikely scenario, however you can see how this could potentially set the stage for some bad unintended consequences.

[moda0306]

Gumby,

Is this really foreign debt?  I thought we agreed this was Euros, not bonds?  Or does that count as debt because its value could go to zero while what we gave them was worth something??

This is kind of my problem with this... now we're playing on someone elses turf, invested in their assets (which are only valuable as long as the governments of Europe maintain it as a currency... it could be confetti eventually).

[Gumby]

...and if we want to know the plausible answer as to why the Fed extended these swap lines (again), I think Nomi Prins has a pretty interesting theory. This was another US Bank bailout in disguise...

In the wake of chopping its Central Bank swap rates today, the Fed has been called a bunch of names: a hero for slugging the big bailout bat in the ninth inning, and a villain for printing money to help Europe at the expense of the US. Neither depiction is right.

The Fed is merely continuing its unfettered brand of bailout-economics, promoted with heightened intensity recently by President Obama and Treasury Secretary, Tim Geithner in the wake of Germany not playing bailout-ball.  Recall, a couple years ago, it was a uniquely American brand of BIG bailouts that the Fed adopted in creating $7.7 trillion of bank subsidies that ran the gamut from back-door AIG bailouts (some of which went to US / some to European banks that deal with those same US banks), to the purchasing of mortgage-backed–securities, to near zero-rate loans (for banks).

Similarly, today’s move was also about protecting US banks from losses – self inflicted by dangerous derivatives-chain trades, again with each other, and with European banks.

Before getting into the timing of the Fed’s god-father actions, let’s discuss its two kinds of swaps (jargon alert - a swap is a trade between two parties for some time period – you swap me a sweater for a hat because I’m cold, when I’m warmer, we’ll swap back). The Fed had both of these kinds of swaps set up and ready-to-go in the form of : dollar liquidity swap lines and foreign currency liquidity swap lines. Both are administered through Wall Street's staunchest ally, and Tim Geithner's old stomping ground, the New York Fed.

The dollar swap lines give foreign central banks the ability to borrow dollars against their currency, use them for whatever they want - like to shore up bets made by European banks that went wrong, and at a later date, return them. A ‘temporary dollar liquidity swap arrangement”? with 14 foreign central banks was available between December 12, 2007 (several months before Bear Stearn’s collapse and 9 months before the Lehman Brothers’ bankruptcy that scared Goldman Sachs and Morgan Stanley into getting the Fed’s instant permission to become bank holding companies, and thus gain access to any Feds subsidies.)

Those dollar-swap lines ended on February 1, 2010. BUT – three months later, they were back on, but this time the FOMC re-authorized dollar liquidity swap lines with only 5 central banks through January 2011. BUT – on December 21, 2010 – the FOMC extended the lines through August 1, 2011. THEN– on June 29th, 2011, these lines were extended through August 1, 2012.  AND NOW – though already available, they were announced with save-the-day fanfare as if they were just considered.

Then, there are the sneakily-dubbed “foreign currency liquidity swap”? lines, which, as per the Fed's own words, provide "foreign currency-denominated liquidity to US banks.”? (Italics mine.) In other words, let US banks play with foreign bonds.

These were originally used with 4 foreign banks on April, 2009  and expired on February 1, 2010. Until they were resurrected today, November 30, 2011, with foreign currency swap arrangements between the Fed, Bank of Canada, Bank of England, Bank of Japan. Swiss National Bank and the European Central Bank.

They are to remain in place until February 1, 2013, longer than the original time period for which they were available during phase one of the global bank-led meltdown, the US phase. (For those following my work, we are in phase two of four, the European phase.)

That’s a lot  of jargon, but keep these two things in mind: 1) these lines, by the Fed’s own words, are to provide help to US banks. and 2) they are open ended.

There are other reasons that have been thrown up as to why the Fed acted now – like, a European bank was about to fail. But, that rumor was around in the summer and nothing happened. Also, dozens of European banks have been downgraded, and several failed stress tests. Nothing. The Fed didn’t step in when it was just Greece –or Ireland  - or when there were rampant ‘contagion’ fears, and Italian bonds started trading above 7%, rising unabated despite the trick of former Goldman Sachs International advisor Mario Monti replacing former Prime Minister, Silvio Berlusconi’s with his promises of fiscally conservative actions (read: austerity measures) to come.

Perhaps at that point, Goldman thought they had it all under control, but Germany's bailout-resistence was still a thorn, which is why its bonds got hammered in the last auction, proving that big Finance will get what it wants, no matter how dirty it needs to play.  Nothing from the Fed, except a small increase in funding to the IMF.

Rating agency, Moody’s  announced it was looking at possibly downgrading 87 European banks. Still the Fed waited with open lines. And then, S&P downgraded the US banks again, including Goldman ,making their own financing costs more expensive and the funding of their seismic derivatives positions more tenuous. The Fed found the right moment. Bingo.

Now, consider this: the top four US banks (JPM Chase, Citibank, Bank of America and Goldman Sachs) control nearly 95% of the US derivatives market, which has grown by 20% since last year to  $235 trillion. That figure is a third of all global derivatives of $707 trillion (up from $601 trillion in December, 2010 and $583 trillion mid-year 2010. )

Breaking that down:  JPM Chase holds 11% of the world’s derivative exposure, Citibank, Bank of America, and Goldman comprise about 7% each. But, Goldman has something the others don’t – a lot fewer assets beneath its derivatives stockpile. It has 537 times as many (from 440 times last year) derivatives as assets. Think of a 537 story skyscraper on a one story see-saw. Goldman has $88 billon in assets, and $48 trillion in notional derivatives exposure. This is by FAR the highest ratio of derivatives to assets of any so-called bank backed by a government. The next highest ratio belongs to Citibank with $1.2 trillion in assets and $56 trillion in derivative exposure, or 46 to 1. JPM Chase's ratio is 44 to 1. Bank of America’s ratio is 36 to 1.  

Separately Goldman happened to have lost a lot of money in Foreign Exchange derivative positions last quarter. (See Table 7.) Goldman’s loss was about equal to the total gains of the other banks, indicative of some very contrarian trade going on. In addition, Goldman has the most credit risk with respect to the capital  it holds, by a factor of 3 or 4 to 1 relative to the other big banks. So did the Fed's timing have something to do with its star bank? We don't really know for sure.

Sadly, until there’s another FED audit, or FOIA request, we’re not going to know which banks are the beneficiaries of the Fed’s most recent international largesse either, nor will we know what their specific exposures are to each other, or to various European banks, or which trades are going super-badly.

But we do know from the US bailouts in phase one of the global meltdown, that providing ‘liquidity' or ‘greasing the wheels of ‘ banks in times of ‘emergency’ does absolute nothing for the Main Street Economy. Not in the US. And not in Europe. It also doesn’t fix anything, it just funds bad trades with impunity.

Source: http://www.nomiprins.com/thoughts/2011/ ... man-b.html

[Gumby]

Gumby,

Is this really foreign debt?  I thought we agreed this was Euros, not bonds?  Or does that count as debt because its value could go to zero while what we gave them was worth something??

This is kind of my problem with this... now we're playing on someone elses turf, invested in their assets (which are only valuable as long as the governments of Europe maintain it as a currency... it could be confetti eventually).

Well.. let's think of it this way. It's a currency swap, right? No bonds. Seems harmless. At least, I originally thought it was harmless.

But, when we swap a $1 Trillion for $742 Billion Euros, we technically loan the Dollars to Europe and they loan us Euros. In other words, we literally owe Europe $742 Billion Euros. So, that's the foreign-denominated debt right there.

Now, the way the rules are written, the Fed can loan the Euros to US Banks if they need to cover European positions (this was actually a brand new provision added to the old dollar swap lines). If the US Banks default, the Fed is still on the hook for paying back the Euros, and the Fed would literally need to print dollars in order to buy the Euros to pay them back.

Similarly, if the Eurozone vaporizes, the US just printed a whole bunch of inflationary dollars.

Man, this stuff is complex.

[Gumby]

This reminds me of that scene from Ghostbusters:

Dr. Egon Spengler: There's something very important I forgot to tell you.
Dr. Peter Venkman: What?
Dr. Egon Spengler: Don't cross the streams.
Dr. Peter Venkman: Why?
Dr. Egon Spengler: It would be bad.
Dr. Peter Venkman: I'm fuzzy on the whole good/bad thing. What do you mean, "bad"?
Dr. Egon Spengler: Try to imagine all life as you know it stopping instantaneously and every molecule in your body exploding at the speed of light.
Dr. Ray Stantz: Total protonic reversal.
Dr. Peter Venkman: Right. That's bad. Okay. All right. Important safety tip. Thanks, Egon.

Now, if we replace "cross the streams" with "owe foreign-denominated debt" the scene would sounds like:

Dr. Egon Spengler: There's something very important I forgot to tell you.
Dr. Peter Venkman: What?
Dr. Egon Spengler: Don't owe foreign-denominated debt.
Dr. Peter Venkman: Why?
Dr. Egon Spengler: It would be bad.
Dr. Peter Venkman: I'm fuzzy on the whole good/bad thing. What do you mean, "bad"?
Dr. Egon Spengler: Try to imagine inflationary dollars spewing into the open market as every dollar in the civilized world hyperinflates at the speed of light.
Dr. Ray Stantz: Total currency upheaval.
Dr. Peter Venkman: Right. That's bad. Okay. All right. Important safety tip. Thanks, Egon.

The Fed just crossed the streams.

[moda0306]

Gumby,

You made my day with that analogy.

[stone]

Gumby, is it base money with no interest charged or paid though? Might that make all the difference? Perhaps that point doesn't matter if the euro to USD changes in the way that the Yen to USD or CHF to USD did and keeps going?

[moda0306]

Gumby,

Also, if the risk truly is that the Euro collapses, wouldn't it be "easy" for the US to pay for a bunch of worthless Euros?

Further, if it's the fed that's in a position of bargaining with a foreign bank about to collapse, shouldn't we be exercizing that a little bit.  The fed almost always acts strong when banks are in desperation, but never charges "panic FMV" for the liquidity they provide... domestic banks get a pass because they would loan to US businesses (theoretically) and succumb to our regulations... why are we giving Europe a pass on fair interest rates?  "OK... you can have our liquidity, but we're charging 7% to your 0% on the swap, and we want a new Beemer for Bernanke."

Shouldn't we get the Eiffel Tower out of this deal or something?

[Gumby]

Gumby, is it base money with no interest charged or paid though? Might that make all the difference? Perhaps that point doesn't matter if the euro to USD changes in the way that the Yen to USD or CHF to USD did and keeps going?

Again, I'm definitely no expert on this. I barely know what I'm talking about. But, I don't think the interest rate really matters.

The point is that the Fed might need to print dollars into the open market to settle the unsecured swaps (or to buy its dollars back in the event of a Euro collapse).

Basically, all we need to know (in terms of fiat currency) is that the rules of MMT no longer apply once a country owes foreign-denominated debt.

[Gumby]

Also, if the risk truly is that the Euro collapses, wouldn't it be "easy" for the US to pay for a bunch of worthless Euros?

I had the same thought initially. But, the problem isn't so much about the Euro becoming confetti. The problem is that the Fed actually needs its printed Trillions of dollars back (to avoid inflation). If the Eurozone restructures or implodes, they might not be willing to accept the old worthless Euros anymore. Then the dollars wouldn't be swapped back to the Fed.

Basically, the Fed not only needs to repay its Euros, but it also needs to retrieve those dollars back from circulation.

Further, if it's the fed that's in a position of bargaining with a foreign bank about to collapse, shouldn't we be exercizing that a little bit.  The fed almost always acts strong when banks are in desperation, but never charges "panic FMV" for the liquidity they provide... domestic banks get a pass because they would loan to US businesses (theoretically) and succumb to our regulations... why are we giving Europe a pass on fair interest rates?  "OK... you can have our liquidity, but we're charging 7% to your 0% on the swap, and we want a new Beemer for Bernanke."

Shouldn't we get the Eiffel Tower out of this deal or something?

Yes... But, as Warren Mosler points out (in the quote, above), the Fed acted irresponsibly by allowing these loans to be unsecured. That's the problem.

[moda0306]

Again, I'm definitely no expert on this. I barely know what I'm talking about.

Isn't it interesting how we're all muddling through these conversations on macro/currency, almost accidentally happening upon quasi-conclusions by asking each other the right (and wrong) questions and giving each other "our take."  

Do you think many financial advisors are having these conversations right now?

Yes... But, as Warren Mosler points out (in the quote, above), the Fed acted irresponsibly by allowing these loans to be unsecured. That's the problem.

So you literally are saying we should have the Eiffel Tower in custody right now... I was just kidding.

Seriously though, what tends to serve as collateral in these deals?  Gold?  Fine art??!!

[moda0306]

Gumby,

From now on I'm just going to call you Ask Jeeves... I just ask you a question on macroecon and you go get it from MMTmadness.com.

Thanks for all the input.

[Gumby]

Do you think many financial advisors are having these conversations right now?

I do. Though, I suppose many of them are having more general conversations through their own blog posts.

Yes... But, as Warren Mosler points out (in the quote, above), the Fed acted irresponsibly by allowing these loans to be unsecured. That's the problem.

So you literally are saying we should have the Eiffel Tower in custody right now... I was just kidding.

Seriously though, what tends to serve as collateral in these deals?  Gold?  Fine art??!!

Probably Gold, at this point. However, Germany has publicly stated that its Gold is not up for discussion in terms of collateral.

Germany has rejected proposals by France, Britain and the US to have German gold reserves used as collateral for the Eurozone bailout fund.

Germany Economy Minister Philipp Roesler said on Monday that the German people's gold reserves cannot be touched and “must remain off limits."  

"German gold reserves must remain untouchable," said Roesler, who is head of the Free Democrats (FDP), a partner in Chancellor Angela Merkel's coalition.

Roesler added his voice to opposition to an idea proposed at the G20 summit of using reserves including gold as collateral for the euro zone bailout funds.
Source: ZH: Germany to G20: German Gold “Must Remain Off Limits”?; Italian Gold Sale Again Proposed In Germany

If Gold was used as collateral, I suspect it would go through the roof. Also, remember, the Fed wants these swap lines in place so that the dollar and interest rates don't go crazy when a (deflationary) dollar shortage happens. The Fed probably can't demand Gold if the Fed is the one that's really concerned about dollar liquidity.

[MediumTex]

But Gumby, isn't it inflation that the Fed desperately wants?

It sounds like the Fed is just looking for an efficient way to create some inflation.

In Ghostbuster-speak, the Fed is just trying to find the best way to roast the Stay-Puffed Marshmallow Man (i.e., the U.S. dollar).

[Gumby]

But Gumby, isn't it inflation that the Fed desperately wants?

It sounds like the Fed is just looking for an efficient way to create some inflation.

In Ghostbuster-speak, the Fed is just trying to find the best way to roast the Stay-Puffed Marshmallow Man (i.e., the U.S. dollar).

I believe that the problem is that when a country owes foreign-denominated debt, there is a potential risk of "high inflation". The Fed certainly doesn't want high inflation and it probably feels that the risks of high inflation are very remote. And I would agree with that — it is a very remote risk.

The Fed really wants inflation that it can control (via interest rates, POMO, etc). If the Fed didn't continue these swap lines, they would probably risk losing control of interest rates, and exchange rates, as the banks of the world clamor for dollars during an all out deflationary collapse.

If things go very bad over the next 12 months, the swaps could backfire and the loans would effectively turn into real dollars in the open market...and then they might have inflation that they can't control. That would be bad.

[Storm]

Great posts, Gumby.  The inflation potential is scary indeed.

[Gumby]

Great posts, Gumby.  The inflation potential is scary indeed.

Thanks.

But, let me be clear. It's highly unlikely that the worst-case scenario will happen with these swaps. I'm still a deflationist.

I just find it fascinating that the Fed technically broke our ability to have a true fiat currency.

[stone]

Is it foreign denominated debt? Isn't it printing fresh USD and then sequestering some euros away in the fed in exchange? I suppose they think that those freshly printed USD in euro banks don't matter because the need for them has come about because US banks are keeping USD at the Fed instead of lending them to the European banks as they normally would. So European banks actually just have the amount of USD that they used to have

[Gumby]

Is it foreign denominated debt?

It is. The Euros are loaned to the Fed (as part of the swap). It's an MMT red flag. If all goes well, it won't be a problem for the Fed to pay those Euros back to complete the swaps. But, if the Euro restructures or vaporizes, it could be impossible for the swaps to be completed — particularly since the swaps are unsecured.

Isn't it printing fresh USD and then sequestering some euros away in the fed in exchange?

Well, it's still a debt that must be paid back. If those Euros became worthless, or restructured, the Europeans could demand payment in some sort of new Super-Euros in order to send the Fed's printed dollars back.

And, don't forget that the Fed changed the rules this time around, so that it can loan out those Euros to US banks who may need them. In other words, the Euros probably won't be sequestered. And even if they were sequestered, the problem is that the Fed needs a way to get the freshly printed dollars back by completing the swap. If the Eurozone vaporizes, the swap goes bad and they just printed way too much money.

I suppose they think that those freshly printed USD in euro banks don't matter because the need for them has come about because US banks are keeping USD at the Fed instead of lending them to the European banks as they normally would. So European banks actually just have the amount of USD that they used to have

Not exactly. You are correct that the dollars don't matter during a deflationary crunch. The swap lines are actually necessary because they reduce the cost of attaining dollars for everyone during a liquidity crisis. That's important.

However, more importantly, the implications of those dollars do matter after the deflationary crunch. Why? Because those dollars must eventually be destroyed (i.e. returned to the Fed) when the deflationary crunch is over — otherwise they would become highly inflationary. The problem wouldn't be a few billion dollars here or there. The problem is that there is the potential for a Trillion dollars or multi-Trillion dollars getting released into the open market with no way to bring it back to the Fed. That would be bad. It's a very small risk, but theoretically it could happen.

Here's what happened to the CPI when the 2008-2009 swap lines were in play (the swaps are in blue; the CPI is in red):

[align=center][/align]

As you can see, swaps filled the liquidity void nicely during the deflationary crunch. But, if those dollars hadn't been destroyed after the swaps were completed, the moderate rise of inflation would likely have been a large jump as those dollars entered the open market.

In order for the Fed to retrieve its swapped dollars when the deflationary crunch is over, it needs the Euro to still exist so that it can complete the unsecured swap. If the swap can't be completed, those dollars become stuck in the money supply and will need to be destroyed somehow to control inflation.

The Fed could have avoided this dilemma if they had secured the swaps (i.e. demanded German Gold if the dollars were never paid back). But since this is a dollar liquidity crisis (or at least a bailout for US banks, in disguise), the Fed really had no choice but to flood the world with liquidity. You can see the Fed is starting to get backed into a corner.

[FarmerD]

Would we know 10% about macroeconomics as we seem to (here on this board) if it weren't for 2008's crash and the current Euro debacle?

It seems to me I probably would never have seeked out the PP or really gotten interested in currencies, bonds and macroeconomics as much if I hadn't seen the market drop and Euro coming to near-implosion.

Completely agree with you.  I would never have gotten into the PP if not for the current frightening situation. 

While I am somwhat more knowledgeable about macroeconomics since I've read at least a dozen books on investing for crisis/economics (and read this forum) since 2008, I still hold the opinion that most macroeconomics is just gibberish.  Microeconomics is far less fuzzy since you're dealing with only a couple variables, however, in a macro sense you have to juggle literally hundreds of variables. 

[moda0306]

While I am somwhat more knowledgeable about macroeconomics since I've read at least a dozen books on investing for crisis/economics (and read this forum) since 2008, I still hold the opinion that most macroeconomics is just gibberish.  Microeconomics is far less fuzzy since you're dealing with only a couple variables, however, in a macro sense you have to juggle literally hundreds of variables. 

I like macro precisely because it's so difficult... you're never really sure if you're right or not.  It's like particle physics vs Newton physics... it can be counter-intuitive and using Newton assumptions when dealing at a particle or astro level will leave you with the wrong answers.