A few thoughts before a hot weekend

One of my acquaintances, who seems to be very informed in matters pertaining to the Clowngress, told me this morning that a last minute deal will be reached with regard to the debt ceiling stand-off and there are few variants of compromise.

The big problem is that all politicians involved are craving for the media attention generated by this false crisis (it saves some serious campaign money) and the most convenient solution is to do something to extend the life of the circus, since this whole show is very important in deciding the outcome of the next presidential elections. The whole subject is simply to juicy to be ended so soon. Therefore, as I've suspected, a partial extension of the debt ceiling will be approved, in order to allow the false debate to continue. However, I have been told that some of the politicians involved are so pathetic, that a last minute posturing snag is possible, which would trigger a technical default. Even if that happens, Timmy and Ben do have financing contingency plans and US gov should have no problem covering Tsy paper till the end of September.

Probably I won't be able to post any new entry over this weekend and I just want to make a weekend reading recommendation and a couple of points.

Marc Flandreau has a very good piece in VoxEu : From lender of last resort to global currency? Sterling lessons for the US dollar. This is actually a very enlightening backgrounder putting the 2008 crisis, as well as the current debt ceiling circus, in a very interesting light. There is a longer version of this paper about the Overend-Gurney panic of 1866 and, for those who are fascinated by monetary history, this longer version is a must read. Although just by inference, not explicit statements, the paper offers some interesting insights on the birth of money markets, Too Big To Fail investment bank equivalents and other interesting concepts, including the triggering of deflationary episodes by drying up the financial paper fountain. Today's dark pools are nothing than the old mercantile discount houses made less transparent and more exclusive. I highly recommend reading the long version of the paper, if you have time, since it offers a wealth of historical details having interesting resonances with the present day.

I had yesterday a chat with a friend of mine, who made the point that, under Basel II, government debt which is at least AA is granted zero risk on the balance sheet of the banks and, in addition of this obscure stipulation, special provisions can be made for lowering the threshold of zero risk status for domestic government debt issued in the local currency... I think this says it all...T paper counts as domestic debt since it is issued in the local currency... Therefore, there is already a fudged antidote, which is conforming to Basel II, making Tsy paper collateral impervious to a ratings downgrade. The rating houses can eat their downgrade reports. I mean the game of lies and pretending, with respect to the risk of collateral can continue unimpeded till the end of days. The same applies for money markets: under SEC’s Rule 2a-7, government securities are deemed to be first tier securities so long as they are eligible for purchase. No comments needed... If US Tsy paper is downgraded what else will retain first tier status? Money markets will be forced by SEC to believe in rating by regulations and dump more money in treasuries.

Another point I want to make is about the IOER (interest paid on excess reserves) paid by the Fed to the depositary institutions. Currently we are in a very strange situation, which can be described as a monetary singularity point, becasue IOER and the Fed discount window are both equal and close to zero (more precisely they are at 0.25%). In this singularity point the Fed can pump trillions into TBTF banks, which in turn the banks will deposit as excess reserves with the Fed. This is a false expansion of the monetary base, which costs nothing to maintain (since the two rates are equal and close to zero), is creating the illusion of liquidity and capital level adequacy for a few select big banks. The trick is to hide the risk on the balance sheet of the Fed, since Ben is accepting a lot of garbage securities as solid collateral at nearly par level, as I've said before more than a few times.

However, reading Flandreau's paper and seeing the reaction of the bond market to the spectre of default reminded me of a comment made a few years back by Ben Steil, about using IOER as an incentive to foreign central banks to deposit their reserves with the Fed. Considering that in the global financial system Tsy paper is the instrument of holding sovereign and capital reserves, due to their rating, liquidity and because Tsy paper is a from of interest bearing global currency, the Fed now has the ability to replace UST instruments with excess reserves in FRN's deposited with the Fed.

Therefore, instead of having China hoarding dollars in treasuries, the hoarding can take place directly as excess reserves of PBoC with the Fed. This thought may require a long stretch of imagination, but even more surprising things have happened during the last five years.

With respect to liquidity, excess reserves which can be withdrawn on demand would offer a better alternative to UST, which have to go through the bond markets. Storing CB reserves as excess reserves with the Fed has its advantages, plus the uncertainty generated by the evolution of the yield curve is removed.

If Tsy paper takes a hit of confidence simultaneously with other sovereign debt instruments used as global currency (see what is happening now in EU), we may face a general downgrade of sovereign debt bonds. I mean a downgrade of all sovereign debt. As a result, the flight for safety will be from UST's directly into FRN's deposited as excess reserves with the Fed and desperate foreign players will be happy to take a haircut and accept a stealth partial default produced by a diving USD on Fx markets. For that to happen the Fed would need a deflationary regime in Tsy paper, with yields flooring, (which is not hard to imagine considering the Euro crisis), while creating a mild inflationary regime in the domestic economy, favouring a return to cash reserves, which can offer similar yields to treasuries, once the reserves are parked with the Fed (Hello, QE 3! plus capital returning for safety from overseas).
Basically, if the Tsy paper yields are approaching zero (or even go briefly negative) and the curve is severely flattened, while the IOER is raised and becoming competitive, then there is nothing that can stand in the way of this transfer, except the political grand standing of foreign leaders protesting the loss of their monetary sovereignty. Looking at the short term yields for Tsy paper I don't think that Fed needs to raise the IOER too much since excess reserves may be considered almost like demand deposits.

Of course, while the currency reserves of foreign central banks begin to move on the balance sheet of the Fed, neither IOER nor the discount window will have to remain nailed at close to zero levels and there is nothing that prevents the Fed from keeping for ever the discount window at similar levels to IOER. :)

All what is needed is to have a clear spread between the discount window rates offered to a few select TBTF banks and funds, while the rest of the suckers will have to rely on interbank lending, which will be above IOER. By controlling the spread between LIBOR and IOER the Fed will control global interbank lending and by controlling the spread between the discount window rates (probably they will create some new special discount rate for minion banks) the Fed will be able to control the amount of liquidity in the global system. Moreover, for the expansion or contraction of this global, FRN-based liquidity, the Fed will not be strictly tied to normal inflationary or deflationary moves, exactly as it does now domestically with the dollar by fudging the BASE with the fake excess reserves of the TBTF minions.

Just to make things better, for the Fed, imagine a regime where IOER is almost as high as LIBOR, while only a few select bank can launder their garbage securities with the Fed at rates almost equal to IOER. The Fed will be able to choke the global interbank lending, while feeding with zero cost liquidity only a few select number of banks and at the same time laundering all risk from the balance sheet of its minions.

In such a scenario, the Fed would become for the first time independent from the Treasury, in controlling the global financial system. There will be no need any more for expanding US gov debt, in order to expand its global financial influence and control. Such a new global monetary regime will make the Triffin dilemma obsolete.

The Chinese have an interesting curse: "May you live through interesting times!"