Rate Watch #1073 - Petrodollars. Dollar as the World's Reserve Currency.

The US $ and the World's Reserve Currency

One of the reasons the U.S. dominates the world's economy is that the U.S. dollar is the world's reserve currency. The U.S. dollar gained status as the world's reserve currency consequent to a meeting of forty-four allied nations at Bretton Woods, New Hampshire in 1944. That meeting had several long term consequences, such as the establishment of stable currency exchange rates and the creation of the International Monetary Fund, but perhaps most importantly, it established the U.S. dollar as the world's reserve currency. Before Bretton Woods most nations were on the gold standard meaning that a holder of their currency could demand gold in exchange for the currency. Bretton Woods changed that so that currencies could be exchanged for U.S. dollars.

The US dollar was a natural replacement for what had been the world's reserve currency - the British Pound. Like most of Europe, Great Britain was damaged and debt-ridden as a result of the war. The U.S. was essentially untouched and in a position to be the world's most stable and pioneering economy. At that time the US dollar was still backed by tangible gold. Nations could tap the U.S. gold reserve by exchanging U.S. dollars for gold.

In the late 1960's the amount of U.S. dollars increased making the ratio of dollars to gold reserves smaller. Gold reserves dropped from 574 million troy ounces at the end of World War II to around 261 million troy ounces in 1971. Nations, perhaps, taking a cue from Goldfinger, started draining the Fort Knox gold reserve. On August 21, 1971 President Nixon suspended the convertibility of U.S. dollars to gold. Nixon blamed this on International speculators and stated that the conversion ban was temporary but those were ruses. In any case, unfettered by the gold tie the Federal Reserve was subsequently able to create as much money as it liked.

This had a serious negative consequence for the US dollar. Once ties were severed between the dollar and gold, nations had less motivation to secure and hold dollars. This could negatively and seriously impact the value of the US dollar. In September 1971, OPEC issued a joint communiqué stating that, from then on, they would price oil in terms of a fixed amount of gold.

Petrodollars

In 1973 OPEC's Arab members decided not to sell oil to the U.S. in retaliation for the U.S. having supported Israel in what is usually known in the U.S. as the Yom Kippur War. Those of us old enough to be drivers at the time remember long gas lines and being only able to buy gas every other day depending of the last number of our license plate.

Nixon responded to this with a rather clever strategy. He chose Saudi Arabia because of its vast oil reserves and rather odd political structure of being essentially a family business with little internal opposition and vast need of external military support. Nixon agreed to support the House of Saud in exchange for using its position as the leading player in OPEC to agree that all OPEC oil had to be purchased in US dollars. This is where the term "petrodollar" came from.

The size of the foreign exchange (FOREX) market is enormous - over $5 trillion per day. About 85% of the Forex transactions involve U.S. dollars on one side. This enormous liquidity machine is a significant part of what the Federal Reserve can increase money supply with little consequence. To sidetrack briefly about the enormous Forex volume - most (about 90%) of it is intraday trading by speculators.

The petrodollar system is one of the most important things which has enabled the US dollar to remain strong even with the enormous increase in money supply after the Great Recession. Zerohedge speculated last week that Saudi support of the petrodollar system may have been the reason Saudi Arabia was not on the Trump immigration ban list despite the fact that 9/11 was essentially an operation by Saudis.

An end to the petrodollar system would be a disaster for the U.S. dollar and the U.S. economy. My belief is that the real problem is that this could come "out of the blue."

The only recent threat to the U.S. dollar's reign has been the Euro but that has been mitigated by concerns about Brexit, Le Pen, and weakness of the economies of Greece, Italy, and Spain. China would like to take over the role but China is cursed by lack of believability of its macroeconomic data and near total lack of transparency in general.

The risk of the end to petrodollars also provides justification for increasing domestic oil production, alternative energy sources, and things such as CAFE (Corporate Average Fuel Economy) so that we seriously reduce the outflow of U.S. dollars used to purchase imported oil from the mid-East.

 

Watch the Dollar

Wednesday showed that words from the FOMC regarding QE will dominate markets. I think that the worst part of this decrease in the rate of expansion of money supply (tapering) is that it could drag on for a year and create a continuous series of doubts as to when QE would end and extend the long-term Treasury bear market for many months. The pain would be lessened if the Fed ended QE rather abruptly. The only positive effect of QE been an equity bubble and the wealth effect created thereby but we all know what happens to bubbles.

 

The fact is this: mortgage rates move in harmony with Treasuries. If the Fed stops buying Treasuries and in China stops buying Treasuries there is no telling where yields will go. For now they remained contained by the absence of inflation but Treasury prices, because of QE, do not represent values we would have in a real market situation. This is a market with price supports.

 

I could imagine a situation in which MBS prices start moving on their own irrespective of Treasuries. I am not saying that will happen. I am thinking that might happen.

 

The key thing to pay attention to may be the Forex value of the UD$. If the US$ starts losing value, inflation will ensue. Underlying domestic economics indicate that we should have little inflation. A loss of US$ value will completely undermine that. The value of the US$ could decrease it the money supply keeps increasing especially is it keeps increasing by $1 trillion a year.

 

The point is that with inflation contained by a domestic economy with low GDP growth and a barely keeping pace with population growth jobs market inflation may be induced by what is eventually judged to be bad monetary policy resulting in the loss of dollar value relative to other currencies.

 

You can now follow my daily posts on the economy on Twitter @dicklepre

 

The US Dollar as the Reserve Currency

Since I cautioned above that one should start be be vigilant regarding the possibility that QE could have the effect of weakening the US$ I think it is time for me to start paying more attention to the value of the dollar and also to remind folks the massive importance that the US$ has as the world's reserve currency.

Let define a few terms:

Fiat currency

Fiat currency is currency created by governments and decreed to be legal tender in the country run by that government. Fiat currency has no intrinsic value. The government does not, for example, guarantee that it can be exchanged for precious metals. The end of convertibility to gold happened in 1971. First West Germany left the Brenton Woods system. Then Richard Nixon ended the convertibility of the U$ dollar into gold. The result was that by 1976 all of the world's major currencies were floating relative to one another.

The result is that the Federal Reserve can create as much money as it wants whenever it wants. The importance of this cannot be underestimated.

Reserve Currency

A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for commodities.

The fact is that the US dollar has long been "the" world's currency." Almost all commodities are traded in US dollars and countries in various parts of the world price their trading in US dollars. Why? Realistically there are only three important currencies in the world: the US $, the Euro and the Chinese Yuan. One of the less obvious advantage of trading in dollars is that there is an enormous set of markets for dollar denominated securities. It is extremely easy and cost effective to hedge exchange risk if the trade is made in US $. Not only are these markets large, they are also liquid. When there is a crisis, liquidity is paramount.

Money Supply - Another View

We assume that the government should have as its primary economic policies: low unemployment, low inflation and a modest expansion of GDP. The classic economic problem is trying to avoid the annoying trade off of high inflation followed by high unemployment. These were what Keynes called business cycles.

Keynesian policy indicates that the government should aggressively regulate the money supply. The concept is that having too much money around causes inflation and having too little money around causes recessions. The concept is intuitive enough. If I have a lot of extra cash in my pocket I am more inclined to buy things. If enough people have extra money demand may exceed supply and prices will rise. Conversely, if no one has any extra money the prices of things will fall.

The government should then be able to prevent unwanted inflation and recession cycles by turning up the money supply when a recession is about to hit and turning it down just in time to avoid unacceptably high inflation. For decades it was believed that regulating the money supply would smooth out the bumps in the business cycles.

The person who first started tearing down this concept was Milton Friedman. Friedman is what would be described at a late 20th century conservative economist. "Conservative" is the sense that he wanted the government to butt out of money policy. Friedman contended that the government moves too slowly to make these policies work. It takes some time to recognize the problem, additional time to implement a solution and then a perhaps very long time for the now-in-place solution to have any effect. The proposition that Friedman made was that the problem would have fixed itself without intervention and, worse yet, the policy would set the inflation-recession cycle into motion in the other direction. Imbued in this is a notion common to conservative values: government is a self-perpetuating thing - it tends to create problems that it then has to fix.

It might be more accurate to say that Friedman expounded the theory that money supply was a "no brainer" it should simply expand along with GDP and that the effectiveness of the Fed would not be in varying from a money supply dictated by GDP but by tweaking interest rates.

Friedman is a clever dude. To better sell this notion he sold a redefined concept of money. (Let's face it - that is a major accomplishment.)

What is Money?

In times gone by money was something that you could exchange for gold. Gold was equal to wealth. Nations fought wars for the opportunity to plunder the gold of the vanquished. Spaniards came to Mexico to "relocate" gold to Spain. These "problems" could be attributed to a very narrow definition of wealth and an unsophisticated concept of money. These folks simply lacked: 1)international telephony and the Internet 2)Fed-Ex and DHL and 3)the Fed funds system to instantly wire transfer gigantic sums of money over long distances. A world in which the IMF can arrange for wire transfers of $500 million to an economically distressed nation is a lot different world than one in which the economically-distressed nation may have seen its only recourse as declaring war on a wealthy neighbor.

The "money" which we currently have in the U.S. is not backed by precious metals and it thus described by the term "fiat money". Fiat money is money because the government says so. To be a bit more practical: it is money because the government says so and can convince people that it is so. The power than was once help by Emperors and armies is now held by the Federal Reserve.

Ultimately, money is simply something that we get for our present goods and services so that we may exchange them for future goods and services. Money has value in as much as it can be relied upon to buy stuff in the future. Inflation erodes the reliance that money will buy an adequate amount of stuff at some later late. Inflation is the enemy of money. Our musings in describing inflation as "The I-Monster" are justified. Perhaps then, the principal charges of the Federal Reserve are: don't screw up the economy and don't screw up the perceived value of money.

But it is not all that simple. Let's get back to the "money supply" thing. If we are going to regulate the supply of "money", what precisely should be counted as money?

Let's go to the Federal Reserve for the answer. These folks say that there are several different "supplies" of money. (Digress for a moment and personalize this. You may regard your "money supply" as: 1) the cash you have on you -a mugger would) 2) the cash you have on you plus your checking account - a mugger whose buddy was a forger would or 3) your cash plus your checking account plus your savings account - a divorce attorney would.)

Every Thursday the Federal Reserve releases a report on the money supply. Until recently there were 3 money supplies published:
M1, M2, and M3. These may be viewed at: http://www.bog.frb.fed.us/releases/H6/Current/ The Fed is dropping regular reporting of M3. If you want to go to the "conspiracy theory" web sites you can probably find that this is due to: 1) a desire to cover up the disastrous state the economy is in 2) a Klingon invasion 3) a right/left wing plot. The fact is this: it has always been M2 which has gotten the attention.

M1 consists of currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; travelers checks of non-bank issuers; and checking accounts. M1 is money ready to be spent. It buys groceries and gas for the car and pays the rent or mortgage

M2 is M1 plus savings deposits (including money market deposit accounts), small-denomination time deposits and balances in retail money market mutual funds. M2 buys groceries and gas for the car and pays the rent or mortgage plus it buys the car and makes a down-payment for the house. It also is a source of capital investment.

M3 consists of M2 plus large-denomination time deposits (in amounts of $100,000 or more), including institutional money funds.

The most commonly watched money supply is M2.

Friedman convinced people that the government should expand M2 at approximately the same rate as GDP expansion - about 4% per year. This policy is called monetarism. This policy was, largely, followed until the stock market crash of 1987 when Greenspan and the other members of the Federal Reserve allowed funds to expand and dropped rates. Some inflation resulted but the economy recovered nicely and saw a a decade of expansion.

Greenspan achieved success either by an extraordinary amount of luck or by being pragmatic: not following any dogma but applying a small dose of the right medicine at just the right time. The medicine had been small changes in the Fed Funds rate. He even showed that he was not "dialed in" to that and dramatically slashed rates in 2001.

Money Supply, M3

Money Supply, M3, Conspiracy Theory

I started to do a piece on the nature of the Internet. What I had in mind is that the Internet is a vast repository of facts, opinions and fiction disguised as fact. In a sense, the problem is that Google does not separate search results by fact, opinion, and fiction. A consequence is that someone can do a search on a topic and be unfamiliar with the sources and reach an erroneous conclusion about what is going on. For example, the Federal Reserve has announced that in March 2006 it will stop reporting M3 (a broad measure of money supply). What does this mean? I will devote this newsletter to discussing money supply and next week (or the week after) will talk about what is wrong with the Internet and the blending of fact, opinion an fiction.

Every Thursday the Federal Reserve releases a report on the money supply. There are 3 money supplies: M1, M2, and M3.

M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) travelers checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. Government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions.

M1 is money ready to be spent. It buys groceries and gas for the car and pays the rent or mortgage.

M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. Seasonally adjusted M2 is constructed by summing savings deposits, small-denomination time deposits, and retail money funds, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.

M2 buys groceries and gas for the car and pays the rent or mortgage plus it buys the car and makes a down-payment for the house. It also is a source of capital investment.

(If you cannot see the graph - I am trying graphics here for the first time-) it may be found at http://research.stlouisfed.org/fred2/data/M2_5yrs.png

M3 consists of M2 plus (1) balances in institutional money market mutual funds; (2) large-denomination time deposits (time deposits in amounts of $100,000 or more); (3) repurchase agreement (RP) liabilities of depository institutions, in denominations of $100,000 or more, on U.S. Government and federal agency securities; and (4) Eurodollars held by U.S. addresses at foreign branches of U.S. banks worldwide and at all banking offices in the United Kingdom and Canada. Large-denomination time deposits, RP's, and Eurodollars exclude those amounts held by depository institutions, the U.S. government, foreign banks and official institutions, and money market mutual funds.

M3 consists of M2 - the money in play in the U.S. economy and two other big ticket items: Eurodollars, which are not in play and RP's which are in play, theoretically, only in the short term. Much of M3 is not "money in play" in the economy. Eurodollars are not and large-denomination time deposits are held by folks with wealth who have no intention to spend those dollars any time soon. RP's are more difficult to get a handle on. These are short-term borrowings but if they keep getting loaned out they are in play. In fact, the entire purpose of RP's is to put dollars in play.

(If you cannot see the graph - I am trying graphics here for the first time-) it may be found at http://research.stlouisfed.org/fred2/data/M3_5yrs.png)

The most commonly watched money supply is M2.

Eurodollars

Eurodollar are dollar denominated assets held at financial institutions outside the United States and, consequently, not under any regulation by the Federal Reserve. Subsequent to World War II the U.S. started pouring money into Europe for rebuilding. That money was in the form of dollars and those dollars stayed in Europe. During the 1960's the Soviet Union became a holder of dollars and feared seizure of those dollars if they were kept in US banks. British banks agreed to hold those dollars for the Soviets and make deposits in U.S. banks in dollars. In essence the Soviets were able to hold dollar based assets satisfied of their safety.

The popularity of such transactions has expanded vastly. The expression "eurodollar" is now used to refer to any currency held outside its native country and banking system.

When the Federal Reserve uses the term "eurodollars" they refer to U.S dollars held outside their control. That could be dollars held in foreign countries including dollars held by U.S banks in branches outside the U.S.

A current topic of discussion is why the Federal Reserve is dropping regular reporting of M3 - a measure of the money supply which includes Eurodollars. Presumably the Fed does not regard those dollars as being "in play" in the U.S. economy. In short, the substantial increase in Eurodollars has not had an inflationary effect (too many dollars chasing too few goods) in the U.S. Those dollars are not really doing any chasing of goods with the exception, perhaps, of real estate of both coasts.

Repurchase Agreements

The following 2 paragraphs are from the web site for the Federal Reserve Bank of New York:

Among the tools used by the Federal Reserve System to achieve its monetary objectives is the temporary purchase and sale of United States Government securities and federal agency obligations in the open market.

In conducting these operations, the System uses "repurchase agreements" ("RP's" or "repos") and "reverse repurchase agreements" transactions which have a short-term, self-reversing effect on bank reserves.

Such repurchase agreements are instigated by the Fed's trading desk for the purpose of controlling money supply. In theory, they are used to offset day-to-day fluctuations in bank reserves. In would seem to me that repos should be included in regarding the money supply and regularly reported. Nevertheless more attention has always been paid to M2 than M3 so dropping the regular reporting of M3 is not exactly drastic. The Fed has not used money supply but rather interest rates to spearhead monetary policy for the past 20 years. The fact that M2 and M3 have increased so dramatically with modest inflation speaks volumes to this disconnect.

Dick Lepre

www.loanmine.com