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So now I want to tell you
a little bit of a story about what happened in the global financial crisis.
I've told I've, I've given you hints of this before, but I'm going to give you
a little bit, now we have more economics, so we can do a little bit more
One of the things that was going on in the buildup to the crisis
was a
Was the, what was called the Shadow Banking System.
In fact, the shadow bank that I'm going to show here is not, not in fact a shadow
bank, this is not in the, it's off balance
sheets but it's on balance sheets, it's in Europe.
So Union Bank of Switzerland was doing this sort of thing, and
a number of other big European banks were doing this sort of thing.
They were buying residential mortgage backed securities,
US
residential mortgage backed securities.
And they were funding them in
the dollar world, international dollar funding market.
So
they're borrowing short term, and lending long term in dollars.
And picking up this differential.
That's the idea here.
Okay. And the source of this money,
let's say, is a money market mutual fund that is doing
this Funding, and issuing
shares, which are a kind of deposit substitute.
Two non-US residents, often, so these could be central bankers
that are holding those, it could be, foreign countries that don't
want to hold their money in the U.S. because the U.S.
can just take it, if they decide they don't like you.
They'll say, we're going to freeze your accounts, okay.
But if these accounts are offshore, they're out
of reach of the U.S., the U.S. legal system.
What I'm describing here, okay,
is a system of international dollar borrowing
and lending, okay, that's outside the U.S. It's
borrowing, borrowing lending in the dollar, the
actual U.S. currency, but the people who are
doing this are not, are not in fact, in the U.S. and they don't have access
to the U.S. banking system, they don't have access to the U.S. central bank.
And so, when the crisis came,
this system came under stress. It came under stress, and the way it came
under stress, is that these money market mutual funds here Said,
you, you borrowed from me for a month, or
two months, I would now like my money back.
But, this is a European shadow bank.
Okay, it doesn't, it doesn't have any access to alternative dollar funding.
It's in trouble. It goes to it's own central bank.
And the ECB says, "Well, I can lend you euros, but I don't have any dollars.
I'm not the fed."
This is what happened right after the collapse of
Lehman and AIG, basically Money Market Mutual Funds said, "Forget
this."
They had been holding, they had been
lending, there were other people in between here.
They had been holding Lehman commercial paper there And they lost that, they lost
on that, and so, it's like, well, I don't want to hold any risky things anymore.
What I want is treasury bills.
That's what I want.
a many market mutual fund, I don't, I'm worried about being
able to maintain these shares at par, I want to hold treasury bills.
But if everyone wants to hold treasury bills,
where are you going to get treasury bills from?
You know, the people who have them aren't going to sell them.
Everyone wants to hold them.
Well here's what happened. So, we have the Shuttle Bank here.
We have, let's say, the ECB. European central bank here.
We have the Fed, we have the
treasury, of
the U.S., and we have
money market mutual fund.
so this and that are those two over there o.k.
and what happened because this sharer bank could not refund itself
directly with the ecb and it couldn't fund itself in private banking markets Okay.
Here's the operation that that was, that was engineered.
I've shown this to you before, but I'm going to,
going to go through it now, and you'll
understand it probably a little better now.
and then we'll link it to the
[INAUDIBLE]
argument.
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So the shadow bank has these Residential Mortgage Back securities and
it needs to roll it's funding so it needs a dollar loan.
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Okay, and it gets the dollar loan from it's
domestic central bank, here, where does the,
where does the central bank get the dollars?
The central bank gets the dollars from the Fed.
The Fed,
does a, does a swap.
Dollar deposit for a Euro deposit.
Okay? This is a liquidity swap.
The ECB creates Euros and the Fed creates dollars.
And they swap.
Okay.
This deposit can be loan, can then be lent out to the shadow bank.
That's where this money comes from.
This is the liquidity swap.
Here. The two sides of it.
This deposit ultimtaely winds up, as its being
recycled, being deposited by the treasury.
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Which issues additional T bills. This actually happened.
If you remember seeing the expansion of the Feds balance sheet, and on the
liability side there was this enormous deposit
by the, by the Treasury in there Okay.
The treasury because money market mutual funds
cannot have deposit at the fed, okay.
They want treasury bills.
They would have been happy to have a deposit at the fed.
Okay.
But the, their, the treasury acted as
an intermediary okay, in order to facilitate this.
What is, what is going on here.
Is cooperation between central banks of the kind that Mundell says is needed
okay, in these times of in these times of crisis but it's only temporary.
It's temporary.
What happens ultimately is, this is just a holding action to keep these shadow banks.
From selling these residential mortgage securities
and therefore collapsing the market for them.
What happens eventually after this holding action
is that the Fed winds up buying them.
It winds up on the Fed's balance sheet.
So all of these, all of these, this, this thing
here holds things in place while you have time to.
move toward a more, more permanent solution, but the more permanent solution.
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Temporary cooperation
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Then more permanent solution
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Is repatriation. Bringing
these mortgage-backed
securities back to the US so that the, the financial globalization, the
international, the internationalization of finance, Begins to be undone.
The Fed is responsible for making sure that mortgages
on the U.S. are—mortgages on U.S. properties are financed, and if
foreign countries don't want to hold it, they bring them back home.
But this was exactly what's not supposed
to happen in an international financial system.
You're supposed to be, there's supposed to be free market in, in capital assets.
So there's been a significant
home bias.
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In, in return to home bias investment. And why is that?
Because of, the lender of last resorts, reports is national.
So, this contradiction between a global system.
And national macroeconomic management is still sort of with us.
And we don't have a global currency. It's very clear.
The dollar is a national currency. The dollar is the liability
of the fed. And there is no global currency.
This reversal of globalization
'Kay. Is what is I think worrying,
it was certainly worrying me in terms of, because we've seen this game before.
Right?
This game before at the end of the 20s. The reverse, reversal of globalization Is
not good for global growth at all. The boom,
the boom that led to his crisis was about globalization and
the reversal of that is a headwind against which individual.
National policies are not really going to work.
So you, you see this happening, playing out in the
in these debates.
Every country is trying to think, well, what should I have?
I should have, should I, I have
stimulative physical policy or monitory policy or something.
And you try it and then all it winds up doing
is making you more indebted and therefore vulnerable to, to international crises.
So, we're in the same kind of plight that I think this is what
Mondell would, would point out or it's
certainly more consistent with his argument, okay.
This ongoing contradiction between national economic
management and international monetary, international monetary stability.
Maybe we'll make our way out of this.
but meanwhile, what is holding the system together is international
central bank cooperation, okay? And and
and speculative trading.
So, we'll talk about speculative trading next time.
Yes?
I see a hand.
>> if the Fed consistently lent to other central banks though,
couldn't that be seen as, taking on excessive risk for the US?
>> Okay, so the question is, if the Fed is lending to foreign
central banks, could that be taken could that be, That's the Fed taking
on risk.
It looks like the Fed is taking on some exchange risk here, right?
Because they're issuing, they're issuing dollars and they're buying Euros.
This is exactly the question that was asked
of Ben Bernanke in congress when he was testifying.
this, this amount into 600, 600 billion dollars.
The, the, the size of this.
And he was asked, you know, where did you get the authority to do this?
And, he said, This, this is standard central banking.
It's not a loan.
they're all secured. Well, I mean, it is a loan.
it is, it is a loan and it's secured by Euro
deposits which are themselves, so it's a swap between central banks.
He can genuinely claim that there's no risk in the following sense, okay?
That the Fed is booking their booking, doing their
books in dollars, and the Euro, and the ECB is doing their books in Euros, and as
long as their swap is reversed later on, okay, so that the ECB
pays back those dollars, okay, and the, and the FED pays back those Euros.
At the same
amount that you've got, fro, in the beginning, it all just evaporates, okay.
So that even, de, not, regardless of what happens to the exchange rate, right, that
the, if the, the euro-dollar exchange rate can move all over the place, but you've,
you've, you've promised to pay back the same number of euros you got, the same
number of dollars you got, so that you can claim that you didn't make a loss.
Now if you're paying back at a different
exchange rate, if the exchange rate has changed,
one of these parties will have lost.
I mean, if you did this, if commercially, one of these parties would have lost.
You would say geez, I wish I had not
made that agreement to pay back that many dollars
because, you know, I did this originally at this
spot exchange rate and then the exchange rate changed.
And one of these sides will win And one of these sides will lose.
That's, that's where your intuition comes from
and it's perfectly correct, but if one
of these sides is doing their counting in dollars and one of the sides
is doing their counting in Euro's you don't see that.
Nobody books a loss.
Nobody books a loss because you're doing
your, your books in different, in different currencies.
if you were both doing your books in Euro's or
both doing your books in dollars you would see those.
You would see those losses.
So that's one, one part of the answer.
The other part of the answer is in fact, that this is, this is the central bank's.
Acting as lender of last resort internationally in a, in a unified way.
Where the shadow bank could not refinance
itself in, in the private banking system, okay.
You had to rely on these official banking
systems as lenders as, as lenders of last resort.
and cooperation between, between central banks.
So it's not as if the Fed and the
ECB kind of had, had a choice in the matter.
Okay it's not that they're choosing to take
on risk, they're acting as lender of last resort.
They're doing, they're doing they're job okay, in a way.
But try to explain the, try to explain this to Congress
it's not going to, it's not going to work Is, is not going to work.
They haven't had a course like this.
and central banks do cooperate like this and now there are swap lines,
the, there are swap lines between the C5. Okay?
For the last year.
The big, the big central banks which is Japan the ECB
the Swiss s, s, Switzerland, the Bank of England And the Fed.
and they have agreed in all currencies to
do swaps of an unlimited amount with each other.
This is written down, in limited amount.
So they're worried about the international monetary system
holding together and they are prepared to
cooperate, or they're saying they're prepared to cooperate.
We'll see if it actually comes, comes to it.
to keep it from breaking down, they're aware of the stakes.
They're aware of the history.
I don't know if they'd go, would go quite so
far as Mandell to say okay, if we screw up
here we're going to get worldwide depression, Nazi's, you know, all
of that you know, that's what, that's what Mandell says.
Okay,
but, they're, they're prepared for, they're
aware for periods of monetary instability.
Are periods of economic instability, and periods
of economic instability are periods of social instability.
and so the stakes are rather, are rather high.
maybe central bankers overestimate their influence.
I think that there's more they're, they're not able to prevent
social instability that comes from, just by lender of last resort.
I mean that seems a little excessively ambitious.
that if there's, if they, if there's not the
political will, then then there's not the political will.
But worse happened when people can't figure
out, how, what, what to do next.
and that's a sort of how we got World War 1 and how we got World War 2.
Just as nothing, you kind of back into these things.
And in wars it's much easier, finance is
much easier because all the, all bets are off.
The central bank becomes basically the financing agent of the government.
And it's, it's it, it's, it's all over.
I'd rather not go down that road. I hope
we can find another way, another way out of this.