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“Thanks to this system it takes only seconds to transmit money – and money trouble – between the U.S. and Europe”.

Milton Friedman in his 1969 whitepaper entitled “The Euro-Dollar Market: Some First Principles

Since 2008 the global monetary system has experienced moments of dislocation induced by severe shortages of U.S. dollars. Emergent over the last 12 years has been a tight correlation between a strong valued U.S. dollar, leading to a shortage of dollars, and global economic challenges.

In 2008, after the failure of Bear Stearns, in 2011, at the onset of the second phase of the financial crisis, again in the second half of 2014, and the beginning of 2018, a higher U.S. dollar signaled a reduction in U.S. dollar liquidity and a corresponding decline in global economic activity. The Trump administration has rightly targeted dollar valuation and the need for its exchange value to fall. In doing so, recognition was given to the idea that, at some level, all countries and economies are connected. If lowering the exchange value of the U.S. dollar helps Europe then it helps the U.S. too. Despite Trump's jawboning and the Fed’s interest rate cuts, the USD continues to maintain a value range of 97 to 99 on the DXY, and bouts of U.S. dollar shortages continue to restrict global economic growth.

The bigger question pertains to why the USD is persistently maintaining such a high exchange rate causing these recurring global dollar shortages, and why can’t we do anything about it? As is usually the case a little history will help with understanding. In this case, the historical context has as much to do with the evolution of the global monetary system as it does with the Fed’s refusal to acknowledge and accept such evolution.

The Emergence of the Eurodollar System

One of my favorite macroeconomists, Jeff Snider, provides straight forward yet compelling case for global dollar shortages driven by higher USD. The case begins with the Fed, for its entire existence, clinging to the traditional monetary theory that states the central bank is central and the center of it is a money-multiplier, deposit-based banking system. The Fed is convinced it rules its domain by occasionally tweaking the dial on fed funds and influencing levels of reserves in the banking system. For the Fed, this is how the liquidity function is provided and how market dislocations are solved. Another stubborn perspective held by the Fed is that it’s only charge of U.S. monetary policy. What other countries do is their business.

Although this traditional paradigm had certain relevance long ago it has little or no application in 2019 and beyond. The global monetary system has evolved since the 1950s and so has the definition of liquidity.

The Eurodollar system emerged out of the post-Bretton Woods period where the dollar/gold standard constricted global trade for countries unable to access sufficient U.S. dollars. The dollar/gold system provided a monetary supply somewhat in-line with the amount of gold on hand at various U.S. banks. With gold pegged at $35/ounce the supply of dollars could not expand fast enough to meet the world's demand for the trade settlement currency.

In response, some very creative and entrepreneurial foreign bankers figured out they could create more dollars by banning together and lending to each other using U.S. dollar-denominated assets – at that time U.S. dollars. As the system grew and the bankers became more creative collateral became financial instruments other than physical dollars – sovereign debt, FX swaps and plenty of other financial derivatives. For the Eurodollar system, liquidity meant currency elasticity or the ease with which someone could create currency and distribute it when it’s needed. And, unlike the gold exchange system, the Eurodollar system could supply what was needed and when it was needed without politics and official interference.

Although Milton Friedman wrote about it in the late 1950s (famously describing the source of Eurodollar creation was the “bookkeepers pen”) and the BIS acknowledged it in the mid-1960s, for the most part, the Eurodollar system flew under everyone’s radar except for those entrepreneurial and creative international bankers benefitting from the system's performance. Acknowledgment of the system didn’t really begin until the mid-1970s when monetary officials began to talk about the obsolescence of the M1 as a measure of money supply and how that was the foundation of ever-growing concerns about inflation. In the ’70s monetary policy was all about projecting the forward-looking demand for money and meeting that projected demand with an equal amount of supply. However, projections were persistently overshooting actual demand demonstrating the monetary authorities no longer had a hold on what was happening in the financial system. In other words, the central banker’s definition of money was failing to keep pace with how the banking system was evolving and doing business. At the center of the Fed’s misunderstanding were the growing and evolving Eurodollar system. The system wasn’t tangible, but it was a system of financing that was accomplishing monetary and financial ends for its participants. It had refined itself into a currency-like system based around banks scattered all throughout the world who participated in it.

By 1995 the Eurodollar system really hit its stride. The proponents of globalization saw the Eurodollar system as a facilitator of international trade, Emerging Market miracles, and worldwide economic growth. By using liquid U.S. liabilities as collateral to create more U.S. dollars not under the control of any monetary authority, including the Fed, the system allowed the global economy to grow unabated. It had become a global shadow money system unrecognized by the U.S. monetary authority and unaccountable to anyone but the other members of the cabal.

By 2007, and after decades of rapid growth in the banking industry, the Eurodollar system had simply overdone it. On August 9th, 2007 the whole system came crashing down, almost without explanation. Subprime mortgages were cited as the cause of the GFC but they were really nothing more than a catalyst for the breakdown in the offshore Eurodollar system, which acted as the primary cause of the GFC. And it wasn’t solely an American failure. It could have been more aptly named the Great Global Monetary Crisis.

Despite all the evolutionary forces within the global monetary system since the 1950s, the Fed continues to hold on to its traditional views. Evidence was given in Bernanke’s 2005 speech misinterpreting the liquidity providing effects of the Eurodollar system as a “global savings glut” distorting the U.S. dollar system. To him, it seemed there was a perpetual bid for U.S. government bonds, U.S. Treasuries and GSE paper that came from the “savings glut”. That these instruments might have been in high demand by international banks wanting to “create” money by possessing them was not part of the Fed’s intellectual framework.

Central Bankers Fatal Mistake

By not recognizing, or not respecting, the Eurodollar system, and its breakdown, central bankers lacked understanding for why a global dollar squeeze had grown out of the GFC and set the stage for several epic blunders going forward. Greenspan’s ignorance of the Eurodollar system became the original sin. Not knowing how it worked – namely how it created liquidity – kept the Fed from being able to plug back into the global money system when it came crashing down in 2007. Soon after the onset of the GFC, the Fed attempted to play lender of last resort with its various emergency liquidity programs that placed traditional reserves into the banking system. None of those programs added liquidity because bank reserves don’t count as liquidity within the framework of the Eurodollar system. In other words, QE wasn’t QE. The Fed thought it was creating massive liquidity by pumping reserves into the banking system, while the global monetary system was starving for it.

Without the necessary liquidity, a severe breakdown in trust among the members of the Eurodollar community occurred. The system froze and a significant reduction in the world’s supply of U.S. dollars ensued. This is the global dollar shortage – a form of money inelasticity. Said differently, this was the banking system demanding currency and not being able to find enough of it. They weren’t looking for bank reserves because they aren’t elastic money.

The Fed did finally make an impact when it initiated rescue packages focused on providing other central bankers with U.S. dollar swaps. During 2008 the Fed’s balance sheet grew as a result of massive amounts of foreign currency swaps, not because of specific bailouts or domestic liquidity auctions. Why did the Fed hand out more than one half-trillion dollars in U.S. dollar funding to overseas entities during the worst part of the banking crisis? And why were banks domiciled outside the U.S. so desperate for U.S. dollar funding? The answer is this offshore U.S. dollar short, or funding gap as the BIS calls it.

Eurodollar System Functioned on U.S. Government Deficits

For decades the Eurodollar system created money by hypothecating highly liquid U.S. liabilities. Growing deficits fed the growth of the system. In 2017 the BIS reviewed the Eurodollar system and found tens of trillions of dollars in FX derivatives that functioned as debt and currency, with mention of them only in financial statement footnotes of the various banks. For several years these footnote derivatives allowed the U.S. government to circumvent balance sheets and borrow more money than otherwise possible. This was facilitated by banking regulation that viewed all sovereign debt as having a zero-risk rating, thereby inducing repo market transactions.

The point to be made here is that FX functions as liquidity and banks use these derivatives to efficiently construct their balance sheets. To acquire liquidity the banks pursued ownership of more sovereign debt and the U.S. government was not been shy about providing. Persistent and growing U.S. government deficits have been supported by the Eurodollar system which used to create liquidity. Another unintended consequence of government regulation.

This all changed, however, in 2016 when U.S. regulators shut down FX hedging books of major U.S. banks. Without efficient FX hedging, yields on hedged U.S. Treasuries went negative causing private foreign investors to pull significant liquidity from the system. This dislocation came on the heels of the official sector no longer sterilizing U.S. deficits (purchasing U.S. Treasuries) in 3Q14. Together these sources of liquidity no longer desiring U.S. Treasuries meant the global regulatory regime was forcing the U.S. to finance its own deficits. However, it was also a crowding out event that led to a global U.S. dollar shortage. The old system worked by the U.S. running deficits so that trade surplus countries to gain possession of U.S. dollars. Now the system is beginning to transition through the dwindling interest of foreigners to continue financing U.S. deficits.

A New Monetary Regime

The GFC was not a one-time event, but instead a systemic break. The system has been in some form of decay ever since as monetary authorities have begun to understand there is nothing in their tool chest to fix the system as its currently construed. Where did the primary dealers go? Where did all of the shadow money go and why didn’t it come back? After all, it was the dealer community that created all of the liquidity and money elasticity, not the Fed. And by providing that liquidity the dealers made a lot of money. Why are they now leaving these profit opportunities on the table?

For Jeff Snider, the answer lies in associated risks. The dealers aren’t providing liquidity anymore due to the new associated risks of doing so. Before 2007 the general perception was that no matter what you did there was no risk and tremendous upside. This asymmetry fed the rapid growth of the private system outside of the Fed’s view in the 1990s. However, with the fall of Bear Stearns bankers learned a powerful and lasting lesson – downside risk. By the dealers forgoing profits they are telling us that asymmetry is now against the market. The shrinking of bank balance sheets over the past 12 years is clear evidence. 2007 convinced bankers that the old private global monetary system really didn’t work the way they thought it did – it was a lot riskier than anyone at the time realized. Once that realization percolated there was no going back.

Before August 9th, 2007 the Eurodollar system grew rapidly, providing necessary currency elasticity to whomever and in whatever amounts were demanded. Afterward, there’s been no growth at all and even signs indicating that the system has been shrinking, as evidenced by episodes of dollar shortages or funding gaps. In this environment, foreign investors are confronted with selling their U.S. dollar assets to gain dollar funding as opposed to other more costly strategies. Since 2016 that’s exactly what we’ve seen as China and Russia turned to net sellers of U.S. Treasuries, leaving the U.S. private investors to fund U.S. government deficits on their own.

Discussions of restructuring the system have included a multipolar reserve currency and pricing commodities and other necessities in non-dollar assets, along with various forms of digital and cryptocurrency. The common thread among the solutions is separating the store of value from the repo collateral, in other words, the reserve asset has to be neutral and float in all currencies. Keynes’ Bancor proposal is the analog.

Its 10 years later and the system has not changed in the ways the PBOC wanted. Out of necessity, China has taken matters into their own hands, as evidenced in the interaction between China and Russia. The world’s largest energy buyer and one of the world’s largest oil exporters are teaming up to force the energy and commodity markets to settle trade in a neutral reserve asset. One that floats at a different price in each currency, and in accordance with that country’s balance of payments. In March 2018 China launched a yuan oil contract that now rivals Brent contract open interest in front and second-month volumes. And in 2019 China and Russia celebrated the opening of a natural gas pipeline spanning most of the width of Russia delivering natural gas into China.

The important takeaway is to understand China’s objective of being able to print yuan to pay for oil, gas and other life-supporting commodities. By doing so China can turn it’s $700 billion trade surplus into dollars thereby ending its dollar shortage concerns. We are beginning to see a change in the monetary system being forced upon us through the commodity and energy markets.

Conclusions and Ramifications for the Commercial Real Estate Industry

After more than 10 years of economic growth, prospects for it to continue become more dubious by the day. The real consideration is the potential magnitude and depth of the next recession, relative to the global central banker’s weak arsenal to counteract the negative consequences. A decade of sovereign debt indulgence and ZIRP and NIRP leave the central bankers with few remaining bullets.

Is a fiscal policy response the only remaining approach? It may be, but that doesn’t mean central bankers won’t try some form of monetary policy approach first. And, without a response from the patient, follow up with massive doses of fiscal policy. Fingers crossed for a soft landing, a gentle correction.

An additional concern is what we’ve just discussed concerning the transitioning nature of the global monetary system. The world is demanding it. It’s no longer a matter of if the system will change because we’re in the middle of the system changing now. Although the old system allowed China to grow into the world power that it is today, that same system no longer benefit them going forward. China’s status as a world power has elevated them to a position of being able to do something about it. Will the transition we’re in hit a road bump somewhere and act as a catalyst for some much larger shock in the global economy?

Commercial real estate development and investment is a capital-intensive endeavor, and therefore one heavily impacted by the flow of capital to the sector. In the shorter term, the most important ramification is a risk-off environment induced by a significant shock in the global credit markets. Global investors will confront a different set of questions, such as where is the safe-haven this time? Not likely USD.

Any restriction on the flow of capital will negatively impact the CRE sector. Eventually, however, over the longer term, I believe the CRE sector will outperform many other asset classes. Hard assets will be more desirable than financial ones in an environment of slower growth (debt burdens) yet higher inflation (fiscal and monetary stimulus). The only certainty is the wild ride ahead.

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