Welcome back to Caribbean Progress with Rasheed Griffith, a podcast of CPSI. In this episode, I am joined by the insightful Joseph Wang, a former senior trader on the open market desk at the Federal Reserve Bank in New York. We discuss the expanding internationalization of the Fed and the steadfast dominance of the USD in global trade and finance across the dollar zone.
Key Points
0:00 Internationalization of the Fed
9:40 Interest Rates in the Dollar Zone
14:13 Fed's Policy and the Eurodollar Market
20:02 US Dollar's Importance in Global Finance
29:53 Fed's Global Influence and Future Expansion
34:38 Transition From LIBOR to SOFR
39:49 Modeling Limitations in Economics
Recommendations
Get Joseph's excellent book Central Banking 101 and follow him on X (formerly Twitter) @FedGuy12. You can also read some of Joseph's detailed analysis on more advanced topics on his blog www.fedguy.com
Subscribe to CPSI Substack
Follow Rasheed on X @rasheedguo
Welcome back to Caribbean Progress with Rasheed Griffith, a podcast of CPSI. In this episode, I am joined by the insightful Joseph Wang, a former senior trader on the open market desk at the Federal Reserve Bank in New York. We discuss the expanding internationalization of the Fed and the steadfast dominance of the USD in global trade and finance across the dollar zone.
Key Points
0:00 Internationalization of the Fed
9:40 Interest Rates in the Dollar Zone
14:13 Fed's Policy and the Eurodollar Market
20:02 US Dollar's Importance in Global Finance
29:53 Fed's Global Influence and Future Expansion
34:38 Transition From LIBOR to SOFR
39:49 Modeling Limitations in Economics
Recommendations
Get Joseph's excellent book Central Banking 101 and follow him on X (formerly Twitter) @FedGuy12. You can also read some of Joseph's detailed analysis on more advanced topics on his blog www.fedguy.com
Subscribe to CPSI Substack
Follow Rasheed on X @rasheedguo
I would dare say that most economists do not really have a deep grasp of financial plumbing. So I'm curious if, from your experience to Fed economists, they already want to actually do have a good grasp of financial plumbing. No, actually, hi everyone, welcome back to Caribbean Progress with me, rashid Griffith. On this episode, I am joined by Joseph Wang, a former senior trader on the open market desk at the Federal Reserve Bank in New York and author of one of my favorite monetary system books, central Banking 101. Our discussion today focused on the internationalization of the Fed and the implications that has on the global dollar zone. It was a great pleasure to chat with Joseph, so let's just dive right in. Joseph, thanks so much for joining me today.
Speaker 2:Thanks for inviting me. It's a pleasure to be here.
Speaker 1:Joseph, I've recommended your book so many times to my friends. I've even recommended it to my personal trainer. It is, I think, the only book I found that I can just hear Say hey, this is how the financial system works in 2023 and not 1823. And that's actually such an important thing, because most books do not really explain the financial plumbing as it is right now, and I've longed for your book for so long, so I'm quite happy that you've actually written it, so thank you for that.
Speaker 2:Thanks so much. I really appreciate your support and I agree, I went about writing this book simply because I was really curious as to how the financial system worked and, like yourself, I came to realize that a lot of the things that I was getting in textbooks were outdated, because the financial system, it's a living organism and it changes over time, and it's definitely changed a lot just since the great financial crisis.
Speaker 1:Throughout this conversation. I want to hone in on a particular theme of your writing, which is what I would guess I would call the Fed internationalization policy and also the idea of this thing I call sometimes the dollar zone. So I'm from Barbados and ostensibly Barbados has its own domestic currency, the Barbados dollar, that is pegged to the USD. But I also know living Panama which is completely dollarized for almost 100 years or over 100 years. So in the royal essence, the entire Caribbean, most of Latin America, especially all the Americas, no matter what clone currency they want to call it, is in this thing called. You know, we can call it the dollar zone and the Fed and the Fed balance sheet. Essentially the balance sheet at the center of the world is the coordinating mechanism for all of these things. So I really want to hone in on that idea a bit more and you presented quite well in your book and on your writings on fedguycom. But before we jump right into that, there is this concept I do want you to discuss.
Speaker 1:It says the idea of the monetary aggregates are supposed to say the benefit of them. So some economists argue that the Fed has stopped looking at proper monetary aggregates. That's one way. Why say, fed policy, broadly conceived, has not been as effective in the last decade post crisis or a pre-crisis. I wonder what's your take on the utility of these M1, m2, or, for example, people at the Center for Financial Stability want to push this idea of Divisio M4. Do you think these M aggregates are particularly still relevant in our version of the financial world?
Speaker 2:I don't think relevant. So that perspective, it's called a monitor's perspective, where you basically look at the supply of money in the world as a significant, having significant influence on inflation and growth. So if you look historically, I think that motive thought was really popular, let's say, in the 1980s, most notably by Milton Friedman, who was a top notch academic who famously, I think, was often quoted as inflation is mostly a monetary phenomenon. But I think what we've learned over the past few decades is that monitor's perspective just isn't true. Back in the day the Fed actually bought in so much into that perspective that one of their targets was focusing on money growth. So they would measure money through M1, m2, and they actually invented a whole bunch of measurements as well and what they figured out was it just wasn't very useful. So they abandoned that and went back to targeting interest rates. And more recently, you can think of what's happening in other countries. If you look at Japan, for example, of course the central bank, they're expanding their balance sheet, tons of money creation, but you don't really see much inflation over the past few decades over there. So the monitor's view I think historically just doesn't hold water. Now more specifically, to your point about why this might not work. I think he described it very well.
Speaker 2:When you're talking about the dollar zone In the US, for example, when we're talking about M2, we're always looking at what's happening onshore in the US banking system. But, as you rightly know, the dollar is special. It's used internationally and so if you're trying to look at simply dollar money supply, looking at the US is never going to give you a complete picture because you have this ginormous offshore dollar system where dollar deposits are everywhere in the world in Europe, in the Caribbean, in China and so forth. So that's just not going to be a good measure at all. And, more broadly speaking, I think it's helpful to describe to the audience what we actually mean when we talk about dollar zone.
Speaker 2:So we all know that the dollar is the world's reserve currency and what that means is that the dollar is like gold in the 100 years ago, under the gold standard. So if you look at global imports and exports, about a half of international trade is invoiced in dollars and most notably in, let's say, in the Caribbean. I think it's largely invoiced in dollars because that falls much closer to the US world. Same for foreign exchange. If you look at foreign exchange, most FX trades are against the dollar and if you look at international loans, most international loans that is to say, loans made across borders or barring of a bar, or barring in a currency that's not his home currency it's often in dollars as well. So the whole world uses dollars and that gives the dollar system significant influence and also a lot more influence to the central bank of the US, which controls dollar interest rates specifically, of course, the Fed.
Speaker 1:Diving into exchange rate policy. So of course we generally know what exchange rate policy is. Some countries will have a peg or fix exchange rate to the dollar, Some might have a flow in exchange rate and there is a delta between the two. But one thing that strikes me as interesting and definitely curious is that in this exchange rate conversation we usually completely avoid probably the most important real exchange rate. I mean real in a grammatical sense of the exchange rate per exchange rate between the onshore US dollar and the offshore US dollar, or the euro dollar exchange rate and the onshore dollar exchange rate. I wonder if you could explain to the audience a bit more about why the offshore US dollar is not as prominently known or even prominently discussed that we discuss financial planning in general.
Speaker 2:When I look at the financial system today and as dollars are traded everywhere, one interesting thing is offshore. A lot of dollars are between foreigners and foreigners. It's not between foreigners and Americans, so it's really just a foreign to foreign currency. I actually think that because the financial markets today are very well connected, it's really easy for dollars to flow from US to abroad back to the US. Now it has always been the case in the past.
Speaker 2:But one other thing that I'll note is that even if you are using a foreign currency, oftentimes a foreign central bank will try to manage the exchange rate so that, vis-à-vis the dollar, it doesn't fluctuate that much. This is because, let's say, your country like Mexico, a lot of your trade is going to be with the US, so you don't really want your exchange rate to fluctuate too much against the dollar. In a sense, even though a lot of countries have their own currency, they're still very much under the dollar zone, which I really liked that phrase you noted earlier and there's been work from the Bank of International Settlements, which is the central bank, studying this and they note that if you look across, let's say in Central South America, even though all these countries have their own currency. It's often managed to be closely moving along with the dollar because of the economic ties those countries have with the US and so that in a sense, they're all this part of this broad dollar zone.
Speaker 1:So, joseph, continuing on this theme of fed internationalization, one of the striking things to me of recent was the fed creation of the FEMA repo. That is, the foreign and international monetary authorities repo facility, and repo is repurchase agreement for those follow along elsewhere and it's a pretty bold move. So what's your perspective on the underlying rationale for, in 2020, the fed to launch the FEMA repo?
Speaker 2:I think the Fed has really taken up the mantle of becoming the world's central bank not just the US's central bank, but the world's central bank. And that's an acknowledgement of the fact that the dollar is the world's reserve currency and if things go badly abroad, it's going to spill over and hurt what happens in the US. So, in order really to carry out their mandate of financial stability, stable inflation, full employment in the US the Fed really has to take into account what happens in other corners of the dollar system, outside its borders. And I'll give you an example In 2008, obviously, we had the great financial crises and everything was falling apart Now at that time. So there was tremendous amounts of investment by Europeans into US assets. So what was happening was that the European banks they were raising a whole bunch of dollars and booking them, let's say, in Paris and Frankfurt, and taking that money and buying a whole bunch of subprime mortgages, and they were in tremendous amounts of stress. All the people that were lending them money no longer wanted to renew their loans. What the banks were doing was they were showing up onshore in the US and bidding up US interest, bidding up dollars, and when they do that, the Fed then loses control of interest rates.
Speaker 2:The Fed controls monetary policy by adjusting short-term interest rates, but since anyone can show up in the US onshore and bid for money, the Fed really, unless it can control offshore dollar conditions, it can't control onshore dollar conditions Because everyone offshore, when they have trouble, they can come back domestically and bid up dollar interest rates and thus cause the Fed to lose control of monetary policy domestically. So the Fed realized that in order for them to control interest rates within the US, they'd also have a way of controlling dollar interest rates outside of the US. So in 2008, they expanded, they brought up something called an FX swap line, which is when the US Federal Reserve lends dollars to other foreign central banks and those foreign central banks then in turn lend to their domestic banks. So indirectly, the Fed became the world central bank willing to act as lender of loss resort not just to banks within the US but banks abroad as well, say in Europe and in Japan and other countries that are friendly to the US. And once the Fed was willing to do this, the Fed regained control of short-term dollar interest rates Because all those guys in Europe who were starving for dollars, they did not have to come onshore and bid up dollars. They could get them through their central bank, which in turn got dollars from the Fed. So this is a way for the Fed to regain control over dollar interest rates.
Speaker 2:Now this all worked really well, but then there's this huge problem, and that is the dollar system is global, it spans borders, but some corners of it are fallen to jurisdictions which are not friendly with the US, for example China, and you could probably talk about some places in the Middle East as well. So these countries have enormous amounts of dollars flowing in them the borrowed dollars, they spend dollars and so forth. Of course, they are highly integrated in the global economy and everyone in the global economy uses dollars. Now what happens if, say, a bank in China suddenly needs dollars, for whatever reason? Then you get into the same problem as we had back in 2008. If, for example, a Chinese bank suddenly needed dollars and couldn't get them at home, they would show up in the US and bid for dollars and push up dollar interest rates, such that the Fed would have trouble implementing monetary policy.
Speaker 2:But of course, because the US and countries like China are not best friends, the Fed can't just turn around and give them an epic swap line. So what does the Fed do to both make sure that nothing blows up in these far corners of the dollar world, but still acknowledge that there are these political constraints? The Fed rolls out with the new FEMA repo facility, which you mentioned, and what that is? That if you have a Treasury security, you can go and borrow dollars against it at the Fed. And if you do that, then even though the Fed can't give you unlimited dollar loans through an FX swap line, they're still able to lend foreign central banks, provided they have Treasury securities. So it's a way for the Fed to continue to act as lender of last resort supporting the global dollar system, but in a way that's, that balances the politics of the situation. Whereas the Fed cannot give, let's say, direct swap lines to China, they're able to lend to them on a secured basis with the FEMA repo facility.
Speaker 1:So even in politically tanked situations, the Fed came out with a system to even manage in those cases also, which is usually one of the arguments you hear about OK, well, what is the situation where you have a non-alloy that needs help? This is there for the answer to that question.
Speaker 2:Yeah, and it's really for the Fed's own interest as well. If something blows up in China, that's not good for financial markets in the US as well. So it's really in everyone's interest that the Fed is able to support the global dollar system.
Speaker 1:There is something subtle you just mentioned in your explanation that I think we should make more explicit. There is this assumption people have that the Fed affects monetary policy by doing some kind of money supply operation in one or the other direction. But in reality the Fed does not just do a money supply operation. There is some more subtle yet complex mechanism running through the interest rate system of the banking sector. So could you give some more detail on how the Fed actually does monetary policy these days?
Speaker 2:So once upon a time in the 1980s, the Fed tried to impact financial conditions and growth and inflation by adjusting the supply of money the monetarism angle that we talked about earlier and that showed to be not a right theory. It just didn't work. And so what the Fed does is, rather than target the quantity of money, they adjust the price of money, that is to say interest rates. And the way that it's done today is through something called the reverse repo facility. The reverse repo facility is a way where market participants can basically lend to the Fed on an overnight basis. Now I'll give you an example. Let's say that the Fed is willing to borrow from the market at 5% interest rate. The reverse repo facility is at 5%. That means that if you are an investor, you're looking around the universe of potential investments what are you going to accept as a return? At the end of the day? You can always lend money to the Fed at 5%, overnight, risk-free, so this is an annual rate. So it's 5% annual rate, but on an overnight basis. You can always lend to the Fed at this risk-free rate. But if you always can get 5% at the Fed, then that means, logically, you will not be willing to lend to someone else at 4%. So by adjusting this overnight risk-free option, the Fed is able to influence a broad range of interest rates.
Speaker 2:You can think of a three-month interest rate or one-year interest rate as the market's expectation of what the path of that overnight risk-free rate the Fed is setting will be in the future. And that's how the Fed influences interest rates today and, through interest rates, implements monetary policy. And now another tool that's very popular, that the Fed has used in the past is something called quantitative easing, and that's where the Fed tries to influence longer-dated interest rates by just going out and buying treasuries. So in the bond market, when you go and buy, when bond prices go higher, bond yields go lower. So the Fed thinks that if I go out and buy a lot of long-dated bonds, say 10-year treasury securities, that puts upward pressure on price, downward pressure on yields and that also lowers interest rates as well. So everything the Fed does is to influence interest rates, the price of money, and not the quantity, and that's what they're thinking when they implement policy these days.
Speaker 1:There's this since the COVID stimulus there's been much more renewed interest in inflation management, essentially across the world, of course, and it reminds me of the recent book by economist John Cochran, the physical theory of the price level, and he also he makes this point similar to the kind of point I think you've made before, that QE is not the thing that pushed inflation. That's been handed for a decade, not inflation. It's when the stimulus happened in the fiscal side of it. Then we saw the inflation. Could you explain why exactly QE mechanically doesn't really cause inflation?
Speaker 2:Yeah. So that was a really big misconception during the great financial crisis. If you rewind back then, when the Fed was doing QE in 2008, 2009, you had an endless amount of people on TV crying for hyperinflation, everyone by gold and that all never happened. So that really misunderstood what the Fed was doing. Now, the way that I find really helpful is to think of it from an investor perspective.
Speaker 2:Let's say you are an investor. You have a million dollars worth of treasury securities in your trading account. You sell that security to the Fed. Okay, the Fed prints money and buys it from you. At the end of the day, instead of having a million dollars in treasury securities, you have a million dollars in deposits in your accounts, because you sold it to the Fed and the Fed printed money and gave it to you. You have more money, but you don't actually have more purchasing power because, instead of having a million dollars in treasuries, you just have the same value, but in dollars, in deposits.
Speaker 2:So QE didn't actually increase the purchasing power of the private sector.
Speaker 2:It simply changes the composition of their assets. Instead of having treasury securities giving me a yield of, let's say, 4%, back then I got a whole bunch of bank deposits that yielded zero and that affected my asset allocation a bit, but it doesn't actually give me any more purchasing power. And that's really what QE is and why QE was not inflationary. But John Cochran's fiscal theory of the price level I find to be very persuasive, because, whereas the Fed really just changes the composition of assets in the financial system so buying bonds from people and giving them deposits, instead, the US Treasury actually goes and buys goods and services and pays for it by printing treasury securities, which we think of as a form of money that pays interest. And so when the US government is going out and buying tremendous amounts of goods and services and paying for it with treasury securities, that's obviously very inflationary and, in my view, is why we have significant inflation over the past few years and while we're likely to continue to see that in the coming decade.
Speaker 1:Why was it that the Eurodollar market became so prominent in international banking?
Speaker 2:The Eurodollar market, I think, really began in earnest, I think in the 1970s, and there's a few reasons for that. One, of course, that in the course of trades we were fighting the Cold War back then and there were some people who were worried that the US who had dollars and did not want to leave them in the US because they were afraid that the US might confiscate them, and so they decided to deposit in European banks like those in London. That's one part of it. Other parts are that the US at the time had these regulations that made it expensive, actually made it that limited the size of the banking sector. So if you were a bank in the US during the 1970s and 80s, you had a limit as to how much interest you can pay your depositors and you also had reserve requirements. That all added up that made it difficult for banks to compete with business and made it more costly to make loans. And one way that US banks could get around that was to simply move their operations offshore, let's say to London, where those regulations did not apply. So there were of course political aspects of foreigners wanting to have dollar deposits abroad, but also domestic regulatory arbitrage. That kind of gave that an impetus, but I think the reason that it continues is that, globally speaking, there's a lot of benefits when you transact in dollars.
Speaker 2:Let's say that today, you are a small developing country.
Speaker 2:If you wanted to borrow money, your home country likely doesn't have very strong developed capital markets. The most deepest and liquid capital markets in the world are the dollar capital markets. So then, of course, you have to go to New York or some other financial center and you borrow in dollars, and again, there's that network effect, like Mastercard and Visa, where dollar markets are very liquid and dollars are accepted globally, and so it just makes sense for many middle income countries to continue to borrow in dollars and to transact in dollars. After all, let's say that you are someone in a middle income country and you want to go and pay for your exports. Are you going to pay in your home country currency? Probably not, because your exporter they don't want it. What they want, though, is dollars, because, for them, they can use those dollars and pay other people as well. You have this huge network effect that I think it's really hard to dethrone, even though there are a lot of efforts to try to move away from that, but I think that's going to take quite a while.
Speaker 1:One of the recent arguments recently it happens all the time, but it's much more recently because of the debt ceiling issue in the US is that US dollar cannot really be relied on because of this potential default factor that it has. But I've heard you argue before that the idea of a US default is quite fantastical, quite fantastical. Could you explain why it's very low risk that the US treasure would default because of debt ceiling issue?
Speaker 2:On the face of it. If you think about the US defaulting, that sounds silly, right? The US can print its own currency. Why would it default? And yet it's been downgraded by S&P and also by Fitch, and the rationale they gave is that, although the US can print its own currency, they could have a self-imposed default, that is to say, they could, for political reasons, end up in a debt ceiling and thus end up defaulting on their debt and thus they have to be downgraded.
Speaker 2:Now, that's all true, but I think that misunderstands some of the other levers that the government has to prevent a default. Now, a very common lever that people talk about and that we found out through confidential documents at the New York Fed was that, in the event that there is some kind of debt ceiling, the Fed will basically step in to prevent a default, and what they would do is they would do something called payment prioritization. So, every day, the US government collects a lot of taxes and it has a lot of expenditures. It has to pay doctors, big government workers and so forth, and, of course, it has to pay interest rate payments. The confidential documents suggest that if, for one of a reason, there's a debt ceiling issue, the US can't borrow anymore to pay its current bills.
Speaker 2:What the government could do is it would prioritize payments to debt holders and instead default on its other obligations. So maybe it makes fewer payments to military contractors, makes fewer payments to government workers and instead takes that money and pays down treasury holders. So that's one thing they could do, and I'm sure there are many others as well. Even though this political dysfunction, I think the scenario of a default, a treasury default, is really unlikely, but I also don't think it has a big impact on the dollar's standing as a global reserve currency. I think a much bigger impact would be just political disagreements. They have, for example, the US most recently confiscating Russian reserves. Now that, I think, would have a much bigger impact on the US's role as global reserve currency than any debt ceiling episode.
Speaker 1:Why would that have a material effect, especially given that a lot of the global dollars does exist, primarily offshore for non-political reasons?
Speaker 2:Because that introduces country risk. Let's think about it from the perspective of Russia. You're the Russian central bank and you have a whole bunch of dollars. Why do you have a whole bunch of dollars? You have a whole bunch of dollars because you need to support your commercial banks. A Russian commercial bank goes and needs dollars, or buys and sells dollars and so forth, and one day it suddenly needs dollars because maybe someone would draw a lot of dollars from them and they're coming up short. At the end of the day, the Russian central bank has these foreign reserves of dollars that they can use to support their own banking system, and the China does the same.
Speaker 2:A foreign central bank keeps its dollar reserves, usually in treasury securities or on deposit at a foreign central bank.
Speaker 2:For example, you could think of a Russian central bank as having a whole bunch of treasury securities or maybe even a deposit at the Fed somewhere.
Speaker 2:Now, during the Russia-Ukrain conflict, the US and the Eurozone froze those dollar reserves and that is to say that money that the central banks thought would be there suddenly is not there, and that's a really big problem, because that means that I might not be able to support my commercial banking system and that would potentially cause a lot of financial stress, and if my money can be confiscated anytime, then I have to diversify a bit and not owe this much dollars or euros, because I could lose access to that at any time. So it's a risk management approach, and I think that's probably going to be a big impetus for countries that are not friendly to the US to try to hold fewer dollars in more in other types of assets. It could be gold, it could be other currencies, but if you money you think is in the bank just might not be there when you need it the most, you obviously have to hold less money in that bank.
Speaker 1:Because I've been thinking a lot about that recently also, For example, the state of Russia case, where Russia has tried to do other currency operations in the Rupee that they got it with that they're really going to wear because they couldn't really use Rupee for anything. Now they're trying to do the UAE Durham, I believe, but the UAE Durham itself is essentially pegged to USD. So I wonder how far could non-friendly countries in the US diversify away from the US, where they still have to get back into the horizon anyway to do most global trade in most products, in most services? I think it's really difficult today.
Speaker 2:Throughout history, reserve currencies are always changing. Now, before the US dollar was reserve currency, it was the British pound and before that you had, let's say, the Dutch currency was also very prominent. So it's something that goes through cycles in history. So the US dollar obviously will not always be the world's reserve currency, but it's something that takes time in a process and, as you rightly note, right now everyone still prefers the whole dollars. Let's say that you sell something to a Russian company. Do you want rubles? What can you do with rubles? Not a whole lot. You would prefer dollars because then I could spend it in a whole bunch of other stuff. So that's still something that is very much in the dollar's favor. But I think it was gradually moving towards a direction where other countries are building out infrastructure to try to have more of a competitor to the dollar, but that's going to take some time.
Speaker 1:Another counter argument to the de-dollarization idea is this argument framed in what can be called the legal theory of finance. That is, the real reason why people trust the US dollar is in this underlying thing. The thing is the English common law perfected in the American legal system. So, essentially, to outcompete the US dollar, one has to outcompete English common law perfected in the US legal system. And one would say that these countries like China, russia, india, that want to compete separately or jointly against the US dollar, cannot really do it, because the real reason why people trust US financial contracts is that they're made in US financial law, which is a very transparent, a very robust body of law from English common law. So, in your view, how much weight should be put on this idea of the legal theory of finance or generally trust when it comes to the dominance of the US dollar globally?
Speaker 2:I think one of the reasons the US dollar is reserved currency is because the US has strong legal systems. You want to deal in dollars and use the US legal system because it's perceived to be a system that is impartial and just and something that people have confidence in. I don't know if that's still the trend, though. From what I see, it seems like more and more people have less confidence in the justice system in the US, and I think that's part of the reason why you could see more of a transition away from the dollar. But again, these things move very slowly and to your point. I think whatever new system that emerges, it would definitely need to be one where people have confidence in, and part of having confidence in a system is that they have a judicial system. That, where people feel that they can trust in or rely on, it's very much confidence. I think that is at the core of a financial system.
Speaker 1:Has you thought much about the idea of dollarization, as in more countries adopting USD as their official currency, going forward similar to Panama, ecuador or Salvador? Some others? Have you given any much thought to it? That's a good idea, still, in your opinion, paging hard currency.
Speaker 2:So if you're a country, you can have different exchange rate regimes. You can have a floating rate regime, like the US, or you can have a hard peg, like Panama, and there are costs and minuses to these different systems. A minus, for example, in a peg system, is that you lose control of monetary policy. Whatever the Fed decides, that's your monetary policy as well, but the Fed's policy is set for the United States and that might not be appropriate for Panama. But on the flip side, by pegging your currency to the dollar, people have more confidence in your economy. I think a big concern that a lot of investors have in developing countries is that maybe the government runs tremendous deficits or maybe they're not well managed, and so you have tremendous inflation and currency depreciation. Committing to peg your currency to the dollar gives investors more confidence and makes them more willing to invest. There's a hard trade-offs in doing that. I think it's going to have to be a country by country basis.
Speaker 1:I'll push back just a bit on that because I don't think the hard trade-offs are hard at all.
Speaker 1:So I usually will say this way For a small economy like all the Caribbean and most of Latin America, when they talk about dollarization you shouldn't think of it as moving from 0% dollarization to 100% dollarization.
Speaker 1:It's more like 80% to 100 or 90% to 100, because all of your invoices at sports imports are priced in USD. There's no real possibility, especially for very small economies, of any kind of import substitution. And obviously when you do an international bond offering everything's USD, so on and so on, because of your invoice dependence on USD for normal global good financial reasons, therefore you import all the inflation. So your domestic inflation rate policy doesn't do anything because you import the inflation. So at best your lowest baseline for inflation would be the Fed rate and above that essentially it would be just some distortions. So dollarization doesn't really give you a hard trade-off because there is no real possibility in a small, open economy of independent monetary policy. The only thing you have with an independent monetary policy, to use that phrase, is the possibility of distortions in the financial market and, essentially, for the government to do bad fiscal policy by aggressive, overdue monetary finance.
Speaker 2:I'm not as familiar with the politics in many of the smaller countries, but yeah, obviously some of the Latin American countries have pegs and it seems to be working well for them, so it seems to be something that makes sense over there.
Speaker 1:I'm curious what do you think has been the most interesting development policy innovation that Fed has done in the last decade?
Speaker 2:I think the most interesting development is what we've been talking about is that Fed is just openly the world's central bank. Actually, I'll take that back. It's not just the world's central bank, it's that they're like the central bank and lender of last resort to everyone. Now buy everyone and not mean everyone. So if you think back, let's say 20, 30 years ago, fed is lender of last resort to the commercial banks, so banks in the US Okay, you fast forward to 2008.
Speaker 2:Fed is lender of last resort to primary dealers, so the dealers are like broker dealers to money market funds and to the foreign banks through the FX soft facility that we discussed earlier.
Speaker 2:So in 2020, fed is last resort to those guys still. But they're also the lender of last resort to corporations the special corporate credit facility, where the Fed basically bought corporate debt and they had a special facility called the mainstream lending facility where they were trying to be the lender of last resort indirectly to companies. So what you're seeing is that almost a slow nationalization of the banking sector by the Fed, where the Fed is really trying to expand their capabilities of being lender of last resort to everyone in the economy. That seems to be the world's safest trend and maybe when we have the next crisis we'll see that come out again. I think it's a tremendous increase in its footprint in the economy and you can see that in other countries they're taking it to the next level, where they're coming out with things like central bank digital currencies, where their central bank cannot just be a lender of last resort, but they're also where mom and pop bank at you can have a deposit at the central bank, just like beforehand you would have a deposit at your local bank.
Speaker 1:So Charles Kindleberger had a very cosmopolitan view of the Fed and Fed policy back in the 60s 70s. Now he had a fairly it's ought to say extreme take, but he had the extreme take where he thinks that the Fed board, for example, should have the Europeans and non Americans additionally on the board in a hope that would have a balance where the Fed would have a more global outlook. Now the Fed definitely has a more global outlook now, probably much more than Kindleberger thought it would. Do you think it's any realistic possible world where the Fed will actually open even further to have this more Kindleberger board structure in any kind of distant future?
Speaker 2:So the Fed is definitely much more global compared to their peers. For example, if you were to go to the Fed board, you would find a surprising number of foreigners that work there, and, that is said, people who are not US citizens, and by that I would not be surprised if, let's say monetary affairs, maybe 20% of the people are not American. Now, in contrast, if you want to work at the ECB, the European Central Bank, you have to be European. I think the Fed is definitely, in that sense, much more international and global.
Speaker 2:The developed market monetary system is actually already pretty cosmopolitan because, although of course, the Fed does not take input, does not answer to foreign central banks, they actually discuss a lot. So the Fed is always talking with what's happening in Europe, what's happening in Japan, in Canada and so forth. So there's a lot of input and discussion that goes through. And I think in the developed markets, all those central bankers they share have similar values, similar education, similar frameworks. So in a sense that they're all very much alike. In a sense, even though they're not formally all big one cosmopolitan family, they are really similar.
Speaker 1:You wrote recently about the switch away from LIBOR into so far. I'm curious if that is a reflection of the diminishing prominence of the offshore dollar relative now to a much more involved Fed in global affairs.
Speaker 2:In the past, the standard reference rate for dollars was LIBOR, which is London Interbank offering rate. That was the interest rate that banks in London would have to pay when they borrowed dollars. That offshore dollar rate is, because of modern technology, arbitrage and all that it's actually been very close to what's on the on-shore rate, so I don't think that there's been that much of a difference there. The dollar markets, I think, are very well integrated and so much as if you actually go to the website of a Chinese bank in China, you'll see that the deposit rates that they offer on their dollar deposits are very much comparable to what you would get in the US.
Speaker 2:I think of the transition as more about the central bank wanting to have more control over interest rates, so LIBOR at times can go really high.
Speaker 2:When there's stress in the markets, no one wants to lend to a bank because they're afraid that maybe the bank would go bust like what happened during the great financial crisis, and so LIBOR interest rates go higher. At the same time, during a crisis, the Fed wants interest rates to be lower because it wants to stimulate the economy. The Fed has control over LIBOR, but not as much control as it would like by switching from LIBOR to SOFR, the Fed changes to a reference rate that it has a lot of control over, so SOFR is more or less set by the Fed. So in the future, let's say you get into a crisis and the Fed wants to cut rates, the Fed will see SOFR go down just exactly the way it wants. In contrast, in the past, when the reference rate was LIBOR, sometimes you would get into a crisis and LIBOR would actually rise because of credit risk, even when the Fed wanted it to go down. So I think of it more as a way to have a better control over dollar interest rates.
Speaker 1:In an article you wrote on your blog, FedGuidecom, you made a very bold conclusion. This is in the Merry Dollars article. You said that concerns over large foreign banks could easily spark a realization that dollars can only be safe within the US. That's a very bold thing to say. That's playing your reasoning behind that.
Speaker 2:Yeah. So that was during the panic with the regional banks in March, and at that time what many investors found out was that when I put dollars in a bank, it's actually not fully insured. It's only insured up to $250,000. Beyond that it's uninsured. And that realization, which it seems like many people in the startup community were not familiar with, led to a massive exodus out of many regional banks and to bigger banks because the Birka banks are too big to fail. So if you keep that in mind that investors are worried that if they have a lot of uninsured deposits, they got to get out of that bank and go to one of these too big to fail US banks like JPMorgan.
Speaker 2:Now you can extrapolate that to the global dollar system, where you have trillions of dollar deposits on deposit in banks outside of the US, let's say in the Caribbean, in Europe, in Japan and so forth.
Speaker 2:Those dollar deposits are not insured by the US government because they're not even in the US.
Speaker 2:If you are someone with a lot of cash worried about your deposits in the US, think about how much more worried someone abroad who has your dollars deposited in a foreign bank should be. Let's say you have $10 million on deposit at a bank in Paris that's not insured by the FDIC, of course. Right, it seems like you should be even more worried there. They might have local insurance, but at the end of the day, these are foreign countries and they can't print dollars, so they're not in a position to fully insure your dollars the way that the US government could. There's much more risk there in those offshore dollar deposits than there is onshore, and if there is ever a time when people offshore begin worried that their offshore dollar deposits are not fully insured the same way that happened in March of this year with the regional bank panic then you can easily see a lot of people move their money onshore, where they know that at the end of the day, the treasury and the Fed, they can print dollars and they can if they want to fully insure their deposits.
Speaker 1:So I have a question about working in the Fed. For some reason, many economists would probably dare say most economists tend to not really understand the moneyness concepts in any kind of detail way. They don't seem to understand plumbing in a structural way either financial plumbing. Has that been, somewhat, as per your experience, you can relate with while working in the Fed, or is it the case that the Fed economists, they understand you plumbing a lot better usually?
Speaker 2:No, actually, one of the most unfortunate things that I've learned in the Fed is that I think there's tremendous decay. There's tremendous decay in our public institutions. At the end of the day, there are basically businesses that can't fail, run by people who can't get fired, and so I think in the junior ranks you get a lot of bright and motivated people joining the organization and then leaving, and at the end of the day, it seems like all the decision making is held by a group of people who were basically spent their entire career there and positions through tenure and politics, so I did not feel like they had very good quality in decision making. But, more broadly, to your point about macroeconomics in general, I don't think that the macroeconomics procession is doing a really good job. Let's just look at the facts.
Speaker 2:Did not see the great financial crisis in 2008. Did not see the resurgence of inflation coming out of the pandemic. In fact, strongly asserted the opposite. So they seem to not be able to understand the world very well and they seem to have missed all the big things of importance over the past several years, and I think the reason for that is that they always try to use math and the tools of physics to explain something that is very much always changing. For example, when you're looking at mortgage rates or something like that, in the past mortgage rates go higher than boom. You get more house prices go lower, you get layoffs in construction sector and the economy slows down. But this time around mortgage rates went higher and you really didn't see all of that because the relationship changed.
Speaker 2:And when you're using statistical methods and you're losing a lot of math, you're always assuming that the future looks like the past. The relationships you have with variables are stable. Now that's true in physics. Say, I drop a bowling ball today, it could falls down at 9.8 minutes per second squared, which is the same acceleration you would see 100 years ago. Or if I drop this in Taiwan, in London, in Tokyo and so forth. It's a universal law, but economics is in part culture, sociology, psychology, so there are really no universal rules. Using math in something that's changing all the time, you're just going to get a bunch of nonsense, and I think that's more of the deeper problem I see in policymaking.
Speaker 1:Okay, final question what do you think is at least one or two of the most important plumbing concepts that especially policymakers, people think about? Financial plumbing should really understand it very deeply.
Speaker 2:Two things actually. So at a high level, money is basically just demand. Right, that's what people are thinking about. If you give me money, you're basically giving me demand for goods and services. Now I think two really important points that I would emphasize is that where does most money come from? Most money is actually created out of thin air by commercial banks. So when you go to a bank and you get a loan, the bank actually creates that out of thin air. It sounds strange, but that's actually what happens, and so focusing on credit creation is a really important way to understand the trends of demand and growth. That's point one.
Speaker 2:Now the second point is that money is a lot more than deposits at a bank or the piece of paper in your wallet.
Speaker 2:Like I mentioned before, I like to think of money as basically demand, and when you think of it in that more abstract way, a treasury security is also a form of money. So the government, let's say, conjures out of thin air a million dollars worth of treasury securities and gives it to you. That's very much like giving you a million dollar bill, and so that leads me to my second point. When the government is doing a lot of deficit spending, it's basically printing money, printing treasury securities, and that also has a tremendous impact on growth and inflation. So bring it back to where we are today. Even though we have bank credit creation slowing, we still have tremendous amounts of deficit spending and that looks to continue for the foreseeable future and that, I think, makes it more very difficult for us to see inflation get back down to normal and I think it suggests that it's going to persist for some time. So those two points of plumbing, I think would be most helpful to a broad range of people.
Speaker 1:Well, this has been a delightful conversation. Thank you so much.
Speaker 2:My pleasure. Thanks for having me.
Speaker 1:Just a quick reminder to definitely get show this book, central Banking 101. And you can also follow him on X, formerly Twitter at FedGuy12. If you have any comments or questions on this episode, you can let me know on X at RashidGor as RashidGuo. Of course, I will add all of these details to the show notes. You can also subscribe to CPSI on our sub-stack CPSImedia for updates on future episodes and for some excellent long form analysis of Caribbean political issues. That's all for now. I'll see you in the next episode.