The Age Of Deficits Has Taken A New Turn

The phenomenal developments in the repurchase markets prompted the Federal Reserve last week to enter those markets. The intermediaries were holding out. If a bank wants cash to cover its short-term settlement needs, ordinarily it stakes “good collateral” (in the Walter Bagehot phrase) and gets a quick loan from an intermediary flush with cash, such as a money-market fund. It settles its transactions in a day or two or a week, and buys back the collateral, returning its portfolio to the initial allocation. A bank dealing with the daily clearing of payments and demand deposits needs surges of ready cash now and then. If a bank lacks cash to meet obligations at the moment, but has plenty of financial assets, the purpose of the repurchase or “repo” market is to swap these things temporarily so that business gets done.

Typically rates are very short, certainly no higher than the interest rates the Federal Reserve advertises. A financial institution is staking good collateral for the short term. There is almost no default risk. Yet there rates were reaching for ten percent. The money markets etc. were holding out. The Fed stepped in to provide repo services at lower rates. 

The question arose: what is going on? Seasonality got the press, as if this were 1873. The end of the quarter and tax deadlines and so forth were approaching. Thanks to the calendar there was a general surge in the bank demand for cash. The homeliness of the explanation was almost unbearable, an affront to the sophistication of New York in particular. The Fed was founded in 1913 in part to avert seasonality issues, those having to do with agriculture. The issue was a phantom one then, and it probably is now. 

Several large developments, rather, appear to be at play. The first is America First. This is the only major nation or region that is growing or has good prospects for growth. Europe is stagnant, China decelerating, formerly major places like Argentina on the precipice of a currency crisis. “Good collateral” increasingly does not include debt instruments from places like these, at least in comparison to American debt. If haircuts could be imminent in the bonds of all sorts of places, on account of entrenching no-growth or slow growth or even nationalization, why take the risk of holding that debt when the haircut happens? The repo bidders would prefer treasuries. If you have the other stuff, then pay 8% where the rate used to be a fifth of that. 

Then there is the matter of banks not having enough cash reserves, an incredible thing after all this quantitative easing. QE, that creature of 2008, ended up being an argument not to put your money in the bank. If the Fed is going to take extraordinary means to prop up the banking system, at some point one of those means might be declaring sovereignty over bank balances, i.e. your deposits. 2008 introduced the idea, however vague, that perhaps large depositors would have to pitch in next time, in the name of saving capitalism and giving back. 

Big depositors therefore, since 2008, have preferred increasingly to hold treasuries as opposed to deposits, because treasuries unlike deposits are not accounted in the banking system. They are agreements people have with the government. Given equal protection, the government could not selectively default on debt as it could—perhaps, via the Fed and Treasury’s banking-supervisor roles—selectively honor deposits. The Fed/government reaction to 2008 introduced this possibility, and it shifted the portfolio preference of deposits over treasuries towards more of the latter. 

Therefore banks have not been able to get their hands on a sufficiency of this best collateral, treasuries, because of the competition for it from other buyers (witness the years-long upward march of treasury prices). This leaves bank portfolios with greater proportions of debt that is not-as-great collateral. In repo crunch time, this switch stands revealed. 

Then there are the international rich. Savers in China will buy the best US financial instrument, treasuries, every time they can get money out of the country. This greatly helps their portfolio allocation, diminishing China notes as much as possible. As for Europe, there are few left who privately think that in, say, fifty years the greater part of it will be characteristic of “Western civilization” (even as we could profit so much from acquainting ourselves with Islamic banking and currency practices). 

The strangeness of this anti-Pirenne-thesis development is too acute for big savers who want to hold their wealth for the long term, to pass it down to heirs, to contemplate. So they buy treasuries. Negative sovereign European Union yields just might reflect a bet on the part of the global market that the U.S. will bail the place out, 2008 again but for the Carolingian realm. 

It all adds up to a lot of holders of good collateral who have nothing to do with asking in the repo market. Those, exclusively, are the banks and such that need ready cash. The repo bidders see this, and say go get treasuries or else pay 8%. The treasury dealers see this and hold onto their inventories. 

What a nice fine situation. Remember when we used to say that the budget deficit came from taxes falling short of receipts? We have said this up till now—those Reagan deficits—but it cannot make sense in the current context. The demand for U.S. debt is so large, so global, so unchallenged by any competitor that to say U.S. debt exists because of the state of the federal books risks mistaking effect for cause. 

It never made sense, given that federal debt became secular at just the time the U.S. took the world off gold early in the 1970s, and then became enormous when the U.S. became a growth dynamo again in the 1980s. Under the old semi-gold standard, a holder of any currency knew from rote practice that it was readily exchangeable for the dollar at any moment. Not anymore, with flexible exchange rates. An inordinate global demand for the best currency materialized out of nowhere when floating happened, and then entrenched itself, just as supply-side economics founder Robert Mundell had predicted. 

The repo fiasco screams in all but words that America is more of a leader than it thinks. It would be best for the United States to comprehend its noblesse oblige and continue to grow, to be the envy and redoubt of the world, as it brings us all back to a proper monetary system. Domestically, a lot of snooty anti-gold-standard worthies in academia, etc. will have to get the picture for the globally necessary reform to have a chance.

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I’m a scholar -- the Richard S. Strong Scholar at the Laffer Center -- who’s interested in our economic history and the theory that went into making it, for good or ill