by Gary Littlejohn for The Saker Blog
Implications of Recent Changes in US Monetary Policy
Ramzin Mazaheri’s excellent article of 16th April attracted some very interesting comments:
This supportive response aims to provide recent relevant evidence that many of the likely changes Mazaheri describes are already happening very quickly. Over the past few months since December, it has become clear that the US Federal Reserve (the Fed, which has actually been privately owned since 1913 but is allowed unconstitutionally to act as the US Government’s central bank) has been grappling with serious problems of liquidity in various US financial markets. This included the ‘repo’ market which handles overnight lending between financial institutions, especially commercial banks, but also other very large financial markets, many of which did not have the funds to pay off debts that were due at the ‘year end’ of their contracts. Depending on the contract, the 2019 ‘year end’ could be at any time between 14 December 2019 and 16 January 2020, but it turned out that the problems did not end in mid-January. All of these problems have been made worse by the COVID-19 pandemic.
This link below times the start of the acute liquidity crisis to September 2019, before I had personally noticed it, and argues that the COVID-19 pandemic only triggered the current crisis, rather than caused it:
The author concludes that monetary policy as we know it is as dead as a doornail and that the Fed is, in effect, a lawless economic government unto itself. This deep crisis has recently led to the development of a new strategy to strengthen the US Dollar by new means that have effectively eliminated any safeguarding constraints on US monetary policy. These new measures are reported to have the implicit backing of the Bank of International Settlements [BIS]. This backing by the BIS is said to include backing for the new Fed policy of buying corporate bonds, which effectively means that the Fed controls which companies survive and which do not, and could probably do this internationally. If this BIS backing is true, then that confirms Ramin Mazaheri’s view that the USA would not be acting alone to retain the global dominance of the US Dollar. I think that time will also confirm Mazaheri’s view that such subaltern countries as the UK and the EU Member States will not oppose these new measures, even though they break the already stretched/broken conventions on monetary policy.
The recent outcome of this has been that a version of Quantitative Easing [QE, or electronic ‘printing’ of money] has been being run by the Fed without the usual requirement to buy US Treasury debts to avoid all that money going straight into the everyday economy and fuelling inflation. Very recently, the Fed started to break its own rules and buy corporate bonds, which are private companies’ debt. This effectively means that the Fed is taking a stake in large private companies. Something very similar has happened with the European Central Bank (ECB, based in Frankfurt) but in the EU the Competition Commissioner has very recently changed the competition rules to allow but also to regulate this crisis-driven behaviour (see The Guardian newspaper recently). That has had the intention (if not the guaranteed effect) of trying to avoid one EU Member State supporting its own companies at the expense of other Member States.
Yet what seems to be happening in the USA is that Steve Mnuchin (US Secretary of the Treasury) has formed an alliance with head of the Fed Jerome Powell to permit the Fed to issue unlimited quantities of money but with no safeguards in corporate bond buying. (Remember that corporate bond buying is itself against the Fed’s own rules.) This seems to allow the development of a possible strategy that discriminates against foreign-owned companies (such as Chinese-owned Huawei) to be starved of Fed funds. Indeed it may well become a lot easier to sanction both companies and countries that the US Government sees as a threat or merely a strong competitor. This approach seems to have influenced what looks like a recent change of attitude towards the IMF by Steve Mnuchin, and he has recently appointed a close ally as the No. 2 in the IMF. IMF policy is now especially important because the present crisis has meant that over half of the world’s countries have asked for IMF support.
This seems to give the USA enormous leverage in placing any company it dislikes in a difficult position, at a time when US Dollars [USD] remain the means of payment for at least 80 per cent of all international trade. I will later refer to a link that shows how much USD is being held by various countries, compared to an estimate of how much they need to carry on trading as normal. The largest EU economies such as France and Germany have only a few per cent of USD in their foreign exchange [FX] reserves, and the same applies to the UK. So Mnuchin is now apparently in a position to inform Trump that he could cause very serious damage to the EU, China and Iran such that the USA could come out of this incipient global depression ahead of its main economic competitors. They may also think the same about Russia but in my view that would be more difficult, because Russia’s economy is inherently more resilient these days. And as indicated above, the USA could also target individual companies. [Incidentally, there is a lot of lobbying going on in Congress right now to gain access to the Fed’s largesse and other emergency funding, and so such preferential treatment could be applied within the USA in a Presidential election year.]
Before providing links to show this situation as it has emerged very recently, it is important to show that the non-financial sectors of the US economy have been in real and accelerating trouble, despite Trump’s claims to the contrary. These illustrative indicators make it clear that the problem is not only financial and so any recovery will probably be very slow because the ‘real’ US economy was heading for a deep recession anyway. Doubtless an awareness of this underlying situation has helped drive the desperate financial measures that we now witness, measures attempting to prop up the US Dollar and ensure that it fully recovers its global dominance.
The following indicators of the contraction of the US economy illustrate a process which started months before the COVID-19 pandemic. There were other earlier indicators – this list is just to give a flavour of the developing trends. The first shows that the Fed has been fully aware of all this:
Now for the evidence of the apparent policy changes described above:
[19 Mar 2020.]
[10 Apr 2020.] Mnuchin says IMF and World Bank are important partners in addressing global issues. So this is before the public change of heart.
Here is a crucial quote from the above link:
“In the U.S., Treasury Secretary Steven Mnuchin has forged a crisis partnership with Federal Reserve Chairman Jerome Powell, giving the central bank a bigger role in fiscal policy.”
Now for the public change of position on the IMF:
Also on the 16th April various reports covered the reasons that Mnuchin gave for not supporting the IMF issuance of Special Drawing Rights [SDRs] to support a whole series of countries: he basically suggested the use of much more limited IMF funds for developing countries on the grounds that 70 per cent of the IMF SDRs would go mostly to stronger economies, and developing countries would only get 3 per cent. But some commentators think that the real reason for this change of approach to the IMF is that SDRs would give China and Iran funding without any strings.
The Latent Demand for US Dollars at a Time of Serious Economic Contraction
The link below by Michael Every of Rabobank estimates the impact of the sudden global economic contraction on the demand by various countries for US Dollars:
It treats the global market for Dollars under a single label, namely Eurodollars, but if one adopts that approach then it tends to downplay the historical significance of the rise of the petrodollar after Nixon took the Dollar off its fixed exchange rate to gold in 1971. Following that major policy change, Saudi Arabia was quietly given permission to raise the price of oil in 1973 in exchange for US guarantees of its military security. What the US got out of this deal was a guaranteed demand for Dollars because Saudi Arabia agreed to insist that oil had to be traded internationally in Dollars. There was a repeat oil price shock in 1979, further strengthening the dominance of the US Dollar.
The article linked above in part uses The Matrix movie to make some of its points, but the argument is still understandable if you have not seen that movie. The BIS is often described as the central bankers’ central bank, but in my view there is a power hierarchy there. The article claims that the origins of the EuroDollar market are mysterious but in fact it was mainly the US Dollars that arrived in Western Europe as funding for the Marshall Plan for post-war reconstruction of Western Europe that created the market. One part of the argument slightly overstates its case, although it is historically true:
“However, there is a cost involved for the US. Running a persistent current-account deficit implies a net outflow of industry, manufacturing and related jobs. The US has obviously experienced this for a generation, and it has led to both structural inequality and, more recently, a backlash of political populism wanting to Make America Great Again.”
Yet while running a persistent current account deficit implies such a net outflow, it does not entail it. A more judicious policy promoting industrial investment and innovation could have fostered a greater resilience of US industry. Despite its reputation for innovation, in fact most post-war US innovation has either come from the military-industrial complex (increasingly feeble at creating new products owing to the political gravy train that reduced incentives to innovate) or was actually imported, mainly from Nazi Germany or the UK.
The important point now is that few countries can manage to trade without access to US Dollars [USD]. China has reduced its USD holdings for over $2 trillion a few years ago to less than $1.8 trillion now, judging by Table 1 in the link above. That Table highlights in red those countries that are most vulnerable to a US Dollar shortage. Yet it seems that China will need about double its current US Dollar reserves to avoid serious trading difficulties, according to the above article. China has been buying US Dollars and US Treasury Bills [T-bills] again recently, as Mazaheri would expect in the present circumstances:
No other country has anything like the absolute amount of US Dollar holdings as China, and few have as good a ratio of holdings to required US Dollar finance demands (0.52. for China, or 52 per cent). Switzerland has 0.48, Russia has 0.36 and Saudi Arabia has 0.69. (Taiwan with 0.51 is too small an economy to have that much global impact.) Russia has far greater resilience in my view than most other countries, because it also holds Euros and Gold, and has swap arrangements with various countries. It is also able to source most of its raw materials within its own borders, can feed its own population and has sufficient reserves to pay off all government and corporate debt immediately on demand – or did until the COVID-19 pandemic and the oil price war with Saudi Arabia and the USA forced it to start selling foreign exchange within the last few weeks. (The amount of such recent sales is not known.) But the currency swap deals will make it easier for it to keep its international trade going better than most countries.
However, such Russian currency swap deals must pale into insignificance in relation to the easy swap deals that the Fed has engaged in, and these have been ramped up in volume and now include additional countries. As Michael Every explains:
“The Fed has, of course, stepped up. It has reduced the cost of accessing existing USD swap lines–where USD are exchanged for other currencies for a period of time–for the Bank of Canada, Bank of England, European Central Bank, and Swiss National Bank; and another nine countries were given access to Fed swap lines with Australia, Brazil, South Korea, Mexico, Singapore, and Sweden all able to tap up to USD60bn, and USD30bn available to Denmark, Norway, and New Zealand. This alleviates some pressure for some markets – but is a drop in the ocean compared to the level of Eurodollar liabilities.”
He goes on later:
“Yet despite all the Fed’s actions so far, USD keeps going up vs. EM FX. Again, this is as clear an example as one could ask for of structural underlying Eurodollar demand.”
He shows this with a graph of the US Dollar holdings within European Markets’ Foreign Exchange holdings [EM FX]:
He then quotes the Bank of International Settlements [BIS] where in a recent report the BIS argued that:
“…today’s crisis differs from the 2008 GFC [Global Financial Crisis], and requires policies that reach beyond the banking sector to final users. These businesses, particularly those enmeshed in global supply chains, are in constant need of working capital, much of it in dollars. Preserving the flow of payments along these chains is essential if we are to avoid further economic meltdown.”
“In other words, the BIS is making clear that somebody (i.e., the Fed) must ensure that Eurodollars are made available on massive scale, not just to foreign central banks, but right down global USD supply chains. As they note, there are many practical issues associated with doing that – and huge downsides if we do not do so. Yet they overlook that there are huge geopolitical problems linked to this step too.”
This clearly implies that the Fed has had a green light from the BIS to lend to companies, as I suggested near the beginning of my commentary on Mazaheri above. I mentioned some of the possible geopolitical problems then. But Michael Every spells out the logical endpoint of such an approach. He had earlier mentioned this as one of three outcomes that were possible in principle, while now pointing out that recent policy changes make this outcome the logical one, even if we have not yet reached it:
“Notably, if the Fed does so then we move rapidly towards logical end-game #2 of the three possible Eurodollar outcomes we have listed previously, where the Fed de facto takes over the global financial system. Yet if the Fed does not do so then we move towards end-game #3, a partial Eurodollar collapse.”
Even a partial Eurodollar collapse would do serious damage to those countries (more than half) which have sought emergency IMF support, and so this new power gives the Fed enormous political leverage over most major economies and over multilateral agencies such as the IMF, the World Bank or even the European Union [EU]. Given that Trump sees the EU as a potential competitor to the USA, and given the low proportion of US Dollars that its major economies have in relation to their trading needs, the EU is very vulnerable to US economic pressure in the present circumstances.
Since the US Dollar is used for about 80 per cent of global trade, then even the fact that the Euro is a fairly substantial international trading currency and forms part of the FX holdings of various non-EU governments such as Russia counts for relatively little. All it could be used for is to buy some time to trade when the global economy slowly pulls out of the COVID-19 recession/depression. A similar argument applies to non-Dollar currency swap arrangements between, for example China and Iran or Russia and Venezuela. All four countries could be potential targets, given that China is seen as the major economic competitor to the USA and the others have important oil and/or gas reserves while the US shale industry is now in deep trouble and will cost billions to keep in business. It should not be surprising that the USA is keeping up the military pressure on Venezuela:
Turning to the EU in more detail, it is clear that the Euro currency itself is under stress as it has led to increased economic inequalities between EU Member States. In addition, political solidarity with the EU has declined partly owing to these growing differences and the austerity policies of the European Commission [EC] and the European Central Bank [ECB]. The ‘bailout’ of Greece was really a bailout of French and Italian banks that had made loans to Greece, and the Greek economy has shrunk enormously since 2008. Now Italy is feeling the pinch as it finds itself constrained by EC/ECB policies in its attempts to kick start economic growth. A recent opinion poll shows that 49 per cent of Italians favour leaving the EU and only 40 per cent want to remain in it. Budgetary problems for the EU will increase after the UK leaves it since the UK is only one of about three net contributors to the EU budget and the tensions over the next EU budget are very visible.
The EU has again very recently failed to agree to ‘debt mutualisation’ whereby the richer economies such as Germany and the Netherlands would also take responsibility for the debts of others, mainly the southern European economies, especially the debts of Italy which is the third largest Eurozone economy. The latest attempt to reach this agreement though the issuance of common EU bonds meant that these proposed EU bonds were relabelled ‘coronabonds’ in the hope that the COVID-19 pandemic would concentrate minds. Despite a public apology from the head of the European commission for the EU’s failure to help Italy after the coronavirus outbreak there, the electorates of the northern EU countries will not accept what amounts to a fiscal union within the EU. No wonder the Italian Prime minister stated that the EU now faces an “existential crisis”. Trump (advised by Mnuchin) may see this as an ideal opportunity to undermine a competitor. It is not at all certain that the EU institutions themselves would survive the collapse of the Euro currency, even though some Member States still have their own currencies.
It may not be well-known worldwide, but it is well understood within the EU that most of the global trading in the Euro currency takes place in London, even though the UK stayed outside of the Eurozone when it was created. Paris, Frankfurt and Amsterdam would love to take over this trading market which amounts to trillions of Euros daily, but for practical reasons (well-established institutional expertise and even sheer amount of office space) this cannot happen in the near future, even though the UK is scheduled to leave the EU at the end of this year. Because of the importance of the Euro trading to the UK economy, the UK government is keeping a very close detailed eye on global financial flows, and is increasing its capacity to do so.
So if the Euro collapses as a currency in the coming depression, apart from causing a further bout of economic contraction in the EU, it would cause serious damage to the UK economy, thereby rendering the UK even more subservient to US interests than it is now. Doubtless the Fed and the Trump administration would take full advantage of this in any trade deal negotiations. [These have already being going on behind the scenes and it does not look good for important sectors of the UK economy including farming.]
So could the EU turn to the Eurasian Economic Union [EAEU] to retain some measure of independence from the USA and keep its economy growing? This would require a major cultural change within the European Commission and in some Member States which harbour hostility to Russia, and which may not see Central Asian markets as having much growth potential. Even China has not invested as much in Central Asia as those countries would like. That might change if economic relations between China and the USA become even worse, and China decides to invest more in countries where the Belt and Road Initiative has already provided infrastructure that is less susceptible to foreign military intervention. Yet the population sizes of the Central Asian countries place a limit on how quickly demand for Chinese and other foreign products can be fostered.
While the standoff between Russia and Saudi Arabia would have sounded the death knell for the US shale oil industry in normal circumstances (and it was dying anyway because US capital markets had effectively stopped lending to this sector) there is now a distinct possibility that it will be kept going by the Fed as part of a strategy to keep up pressure on economic competitors. Whereas I recently saw the declining price of oil as loosening US dominance of the global economy by reducing its means of influencing the price of oil, it now appears that giving the Fed unlimited powers to finance companies as well as financial institutions has so changed the global economic landscape that the USA may well emerge from the incipient global depression in a position whereby it remains dominant, albeit in a much smaller global economy.
In such a scenario, and given the inevitably increased dependence of developing countries on the US via the IMF, then the policy options for the Russia-China ‘helix’ will become more constricted as the BRICS group (Brazil, Russia, India, China and South Africa) becomes weaker owing to the probable increased dependence of India, Brazil and South Africa on USD funding. This inevitably raises the profile of the EAEU as a possible source of continued growth despite the fairly limited consumer power within this bloc at the moment. While Russia has managed more or less to stabilise its population and has reduced inflation, thereby easing pressure on living standards, China has been unable to turn round the effects of its earlier policy of limiting child birth. While China has been moving from an export-oriented growth strategy to one promoting rising living standards within its own borders, the ageing population (which like that of Japan has a high propensity to save) means that this strategy will run into limits if China cannot rely on exports to maintain its growth rates through what was intended to be a transition period to the new growth strategy. This implies that the EAEU becomes much more important to both Russia and China, although it would be prudent for China to use institutions such as the Asia Infrastructure Investment Bank to try to sustain the EU as a source of demand for its exports. It will have to do this at a time when it is possibly going to be under legal attack from the USA for what some in the USA are claiming is China’s legal responsibility for the COVID-19 pandemic.