We Found The Missing Money

Banking in the Shadows - Part 2

@CharlieLongren

TLDR: The second part of the Eurodollar system is the wholesale banking system through which banks used accounting tricks in transactions like repurchase agreements to “print” even more dollars at the “stroke of a bookkeeper’s pen.”

In my late 20s, I became enamored with an online multiplayer video game called Uncharted 4. Essentially, I spent hours competing for status in Uncharted’s virtual economy where rank and cosmetics meant everything. When you are playing competitive video games as an adult, you are fairly disadvantaged because most of the people you are competing against have faster reflexes, better hand-eye coordination, and are mentally sharper. One of the few ways I could out compete in Uncharted was to be more strategic. I noticed that your rank in each game was not determined solely by the amount of players you killed, but instead was based on points scored. So I became hyper focused on the points system. Eventually, I figured out how I could maximize the number of points I scored in each game without being a better shooter than the other team was. At the twilight of my Uncharted career there were games where other players had twice the amount of kills that I had, but only half of the points.

When you have inaccurate or incomplete information about how a game is played or about how a system functions, it is difficult to survive in that system. Furthermore, it is near impossible to compete with someone who understands the system. By the 1970s government economists and central bank policy makers finally realized that they did not know how points were being scored in the US monetary system. Before, central bankers believed that they could measure the supply of US dollars using M1, or narrow money. M1 includes cash, notes, and deposits that can be quickly and easily converted to cash. When policy makers attempted to predict future demand for US dollars they found that actual demand was much lower than what their models had predicted. Actual demand was much lower than expected because dollars were being created in a system separate from traditional banking. Princeton economist, Stephen Goldfeld, dubbed this phenomenon “The Case of The Missing Money.” (Snider 17)

Imagine going to the casino to place a bet, but you do not have any cash. You sell your car to a bookie for access to his $5000 credit line at a casino, and you both agree that you will buy the car back from him for the next day for $5500. Hopefully, you win big on your bets and you are able to pay the bookie back, but if not, the bookie will just sell your car.

Upon further investigation policy makers found that the money was not missing at all. It just was not being measured. Much of the “missing money” was found in the bank repo markets. Repo is short for Repurchase Agreement, and it is a system by which banks use their assets as collateral to borrow cash from another bank or large corporation with an agreement to repurchase those same assets within a short period of time, sometimes no longer than 24 hours. More simply put, it is the quick sell and buy-back of a particular asset. The initial seller of the asset gets access to liquidity and cheap financing, while the buyer earns interest on their non-performing cash deposits while still maintaining short term liquidity.

Since these bank repo transactions were considered very low-risk, the borrowing banks became increasingly dependent on them for liquidity, meaning they were increasingly less dependent on customer deposits. On the other hand, the lending banks or corporations would often write checks and make payments from their repo account because they were fairly certain that the cash they lent would be available to use.

i.e. You are placing bets and the bookie is paying bills using the same $5000 credit line with both of you believing that the full value of the credit line is accessible to you. If the casino is not privy to the double spending of the credit, and the transactions are settled before the casino becomes aware, you and the bookie have effectively doubled the credit line and printed money. Through wholesale banking ( banking services, like repo agreements, sold to the largest bank clients ) banks were creating US dollars from thin air using accounting tricks. Wholesale banking is the second half of the Eurodollar system. A system by which “banks create US dollars through creative accounting at the stroke of a bookkeeper’s pen.”

By the 1990’s banks were no longer dependent on deposits, income, or long term financing for liquidity. The repo market had become so large and such an important part of bank and interbank financing, that banks were willing to buy US Treasury Securities for way more than they were worth. Because the treasury securities were considered “pristine collateral” banks could use them as collateral to receive funding in repurchase agreements and pay very low interest rates.

Additionally, securities that were considered to be pristine collateral could be hypothecated and rehypothecated. Hypothecation is the fanciest way possible to mean that an asset is pledged as collateral without the borrower giving up possession of it. When you buy a home using bank financing, it is a form of hypothecation. If pristine collateral is hypothecated, the borrower can use the same piece of collateral in several different repurchase agreements. Rehypothecation is the fanciest word possible to mean that the same asset that is used as collateral by the borrower and again used as collateral by the lender. It is completely legal for banks to use your home as collateral to borrow funds from another entity.

In a world without defaults ( the inability of a borrower to repay their debt ), hypothecation and rehypothecation is a negligible consideration. But through hypothecation in the repo markets, banks created high levels of risk in what was supposed to be a low-risk or riskless market. In the 1990s and early 2000s as the world economy was growing, the system appeared to be working and central bank policy makers appeared to have the keys to the kingdom. Eventually, that changed.

Even throughout the turn of the century, US policy makers were uninformed of the system that was growing in the shadows because they believed that their definition of money was the correct one. But, as I explained in my article ‘What is Money?’, a central authority can not decide what money is or what money should be. Only the market can. There was demand for US dollars in the financial markets worldwide, so banks and large corporations acted according to the system’s incentives and fulfilled that demand. The biggest players in the world economy had created their own shadow system in which they made the rules.

Banking in the Shadows - Part 3 November 7, 2021