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11 November 2021

Money from the Shadows


This article was written by Richard Horswill. All views and opinions expressed are strictly his own.


The term ‘shadow money’ suggests criminality and wrongdoing; ‘eurodollar’ sounds much more respectable. Since the advent of computerisation and digitalisation, banks have been able to create borrowing and lending streams away from the regulated end of the dollar system, the "onshore dollar”, to create their own supra-national internalised ledger based parallel reserve dollar system that is self-regulating. The late 1950's and 60's was the point in time when "offshore" dollar development started really to take off. This article attempts to provide an alternative point of view to the mainstream narrative that Central Bankers have the necessary tools, intellectual models, and timing skills positively to steer the global financial system. Instead, it suggests that the market ultimately dictates the course of events with Central Bankers tinkering around the edges of the financial system merely delaying inevitable outcomes.

It's important to note at this point that during the 1960's the dollar as the reserve currency was criticised by Robert Triffin, whose research led to the term Triffin's Dilemma which is the conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies. Triffin pointed out that the country whose currency foreign nations wish to hold as a reserve, must be willing to supply the world with an extra supply of that currency to fulfil global demand for such foreign exchange reserves, leading to a trade deficit. However, the "shedding of the dollar skin" which led to the parallel eurodollar system was certainly not envisaged by Triffin. Under the then global system of Bretton Woods set up after WW2 with the dollar linked to gold, the dollar crises that occurred through the 60's and 70's led to its ultimate breakdown and demise as gold convertibility at $35 per Troy ounce led to thousands of tons of gold leaving the US because of dollar devaluation. The gold window was thus closed unilaterally by the US in August 1971. Shortly after this, the reserve currency was linked to oil. President Richard Nixon and his Secretary of State, Henry Kissinger, feared that the abandonment of the international gold standard under the Bretton Woods arrangement (combined with a growing US trade deficit and the massive debt generated by the ongoing Vietnam War) would cause a decline in global demand for U.S. dollars. In a series of meetings, the United States and the Saudi royal family made an agreement. The United States would offer military protection for Saudi Arabia's oil fields, and in return the Saudis would price their oil sales exclusively in United States dollars.

Thus, the US dollar was able to maintain reserve status, and this allowed the shadow eurodollar to continue to grow unchecked in the global economy. Without the shackles of golds limitations, the shadow dollars were able to expand exponentially. In monetary economics, the money multiplier is one of the closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. This ratio was able to grow in the offshore eurodollar without the control that the Federal Reserve Central Bankers held over the onshore dollar. Of course, the very same Central Bankers knew the shadow system existed but, had no direct control of it and had no way of knowing the size of it. So, as any good Central Banker would do, they decided to ignore it.

This links us to the business cycle, and the virtuous and vicious cycles that account for the peaks and troughs of global trade. The most significant dollar crises have been at the commencement of the new evolving dollar/eurodollar system which saw the great inflation running up to the early 1980's and the current crises which is the exact opposite, the great deflation which started in 2007/8.

The early virtuous growth inflationary cycle built through the 1960's and peaked in the late 1970's with many believing that dollar devaluation was the issue and linked this problem to the closing of the gold window in 1971.  A series of other events also contributed to the sense of devaluation and the gold window closing. Wars in Korea and in particular Vietnam had concerned holders of dollars looking to convert to gold but these were minor compared to the actual global growth that was occurring in the eurodollar shadows. The massive expansion of offshore dollars driven by global growth saw them leaking into the US economy through an ever more complex banking system. Many attempts were made to stem these inflationary forces; however, the big central bank bazooka that Paul Volker, then Federal Reserve chairman, fired in the early 1980's, raising US$ rates in an attempt to kill the inflation off was seen as the hammer blow to the inflation problem. The myth of course is that it worked, providing the Central Bankers with rock star status capable of taming global monetary excesses. This result some 20 years after the initial inflationary cycle started was not in the action of the bazooka but actually in way the eurodollar stabilised and matured of its own accord. Volker merely steered the US economy into two quick recessions in the early 1980's. From that point in the early mid 1980’s, the onshore dollar and offshore eurodollar eco-systems seemed to cohabit nicely. Nevertheless, Central Bankers took the credit for the newfound global dollar stability having provided the seemingly ultimate solution.

This nicely leads us into the current eurodollar crisis which came about in 2007-ish as the vicious cycle took hold and saw global growth going into contraction mode. The inability of the eurodollar to continue to expand allowed deflation to take hold as global debt levels at the prevailing interest rates were unsustainable. The Minsky Moment had arrived. Of course, as with the inflation of the virtuous cycle in the 1960's and 70’s, the Central bankers of the Federal Reserve mobilised again this time to tackle deflation. Agreeing on an emergency course of action to re-inflate the US economy - along with the rest of the world - the blame for the whole monetary mess was placed at the doorstep of subprime mortgage lending. However, Central Bankers were unable to monitor offshore dollars and so were not noticing that global dollar shortages were actually created by the offshore eurodollar contraction. In an attempt to commit to stabilising the global financial system with trillions of newly minted dollars through the button of the digital printing press, many new banking regulations were passed, and the Central Bankers were again lauded as the saviours of the system and the chosen ones to provide the financial alchemy they were historically known for. No one mentioned that they had been asleep at the wheel not noticing the obvious signs of the crash course that the global economy was on!  The destruction of the banking system globally was based purely on the reversal of eurodollar growth into contraction over which Central Bankers had no control. All the Federal Reserve and the incumbent government could do was socialise the debt in the largest bailout in human history and hope that the problem had been solved. Sadly, fourteen years later the vicious cycle is still in progress with no signs of abatement. Global debt levels in both private and sovereign hands continue to allow global depression to persist as there is no allowance for malinvestment to be purged. Central Bankers maintain their same stance of QE to infinity, if only to suppress interest rates long enough for a miracle to occur. Miracles rarely happen; however crises seem to be more and more frequent. 

The coronavirus is something that we can't blame the Central Bankers for. It has certainly created a multitude of knock-on events that look likely to persist well into 2022. Their transitory inflation call based upon the deflationary eurodollar cycle we are in looks good, but the supply chain bottlenecks have put them to the test as temporary inflation, also driven by the fiscal response to the virus that provided unearned spending power to Americans, has driven asset values and inequality to all-time highs. Even so, they are likely to get the transitory expectation right as the stimulus is depleted from savings accounts allowing disinflationary forces take back control. We thus await the next big deflationary shock. This could look very much like another China virus as we see the Chinese real estate bubble starting to burst particularly as a consequence of the CCP turning away from the capitalist model it has pursued for the last 30 years to the socialist one that it has always aspired to. How can one share the wealth if you have none to share? That was the clear failure of the Russian system that the Chinese were certainly not going to follow. As we have seen in recent history one failure leads to another which leads to another crisis.

This is of course not a given; however it is difficult to see where global growth is going to come from to pull the economy from the doldrums. Modern Monetary Theory is one idea conjured up which basically provides for the money printer to keep on turning. The new green deal is another, but it would have to be financed via MMT. The overwhelming problem is and has always been the burden of the debt. With the shadow eurodollar system flatlining and the US government and treasury the only possible source of stimulus, the next phase of the current deflationary spiral looks very much in sight. 

The eurodollar was born out of ingenuity and opportunity to assist in the greasing of the wheels of global commerce. Bitcoin in many ways is cut from the same cloth, a more decentralised ledger-based currency system looking to provide a remedy to the business cycle boom and bust without intervention and manipulation. No one knows how any of this will play out and if a Central Banker tells you they do then they're lying. Their current smoke and mirrors stance is all about expectation management purely to buy more time! 

Typically, in hindsight, the policy makers realise their mistakes but at the time feel duty bound to act by providing solutions that generally prolong the pain. Left well alone, the eurodollar ship would probably right itself allowing the misallocation of capital to wash out of the system. Sadly, that capitalist model died a long time ago in Western developed economies although it's seems that in some part the most unlikely of actors, China, may well look to use the tried and trusted playbook to de-lever its economy. Its actions over the coming months could either sink the global economy into another 2008 moment or they will see the danger signs and bail out the problem with the dollar reserves that they hold kicking the can down the road as we have done in the West. 

The ever-enduring problem with that solution is that it is always temporary providing the next opportunity for the draught from the black swan’s wings to wobble the ever-faltering house of cards. 



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