16. Monetary and Financial System

In order to understand money and finance, one needs to look at the monetary and financial system through a macro lens. But is our monetary system even a system? And what players are truly decisive? What is the dollar shortage and what does the eurodollar standard look like?

16. Monetary and Financial System
Monetary graph
List of contents
A System at all?

A System at all?

As human beings, we strive to categorize and systematize the reality of life around us. Only the systematization of our reference frame allows us to recognize systematics from which recommendations for action can be derived. Proponents and critics therefore both refer to today's monetary or financial system as a system. The former believe they know how to proceed; the latter believe they have recognized what needs to be changed. However, neither the monetary nor the financial system is a clearly separable system. In the end, they are socially complex structures that are the result of human action, but not of human design. Knowing this should encourage humility for the complexity of social structures and ultimately motivate an investor to understand and interpret the "system" rather than to want to plan it.

Commercial Banks

Commercial Banks

Commercial banks are among the main players in the financial world. In addition, there are the insurance companies. The majority of people will probably associate the term "financial system" with these two actors. While banks are responsible for coordinating the flow of financial resources between borrowers and lenders, insurance companies are responsible for diversifying and smoothing risks of financial and economic interaction. It is generally understood that banks still play the leading role in our "financial system". However, there are now a large number of other financial intermediaries (investment institutions, investment companies, shadow banks, and money market funds), whose importance is just as important, but in many cases not well understood.

Central Banks

Central Banks

In recent years, central banks have increasingly become the pivotal element within the "financial system". They are now lenders and dealers of last resort. This is all the more remarkable because central banks are relatively young institutions compared to other financial players. Their origins lie in the fact that they were set up by governments to stabilize commercial banks. In their earliest forms they were put up to help finance wars for kings. As a state authority today, they now issue base money for a national or supranational economic and banking area.

Micro- and Macro-Management

Micro- and Macro-Management

Banks operate an inherently risky business model and are therefore forced to operate microeconomic credit and liquidity management. The decisive factor here is the micro-management of credit creation through the discretion and assessment of credit takers' individual creditworthiness. Central banks, for their part, are responsible for the macro-management of credit creation by assessing the credit creation dynamics of commercial banks and providing the entire system with liquidity. In times of crisis, the central banks stand at gunpoint and support ailing commercial banks with liquidity in order to avoid payment defaults and possible domino effects within the "financial system".

Moral Hazard

Moral Hazard

This safety net that central banks have put in place for times of crisis ultimately has a negative effect on the incentives of commercial banks. Knowing that central banks will always ensure a sufficient dose of liquidity through liquidity macro-management, commercial banks have a negative incentive to neglect their own liquidity micro-management. Their excessive risk appetite makes them more vulnerable to potential liquidity problems at the margin, which in turn makes them dependent on liquidity injections from the central bank.

Shadow Banking

Shadow Banking

In order to limit the commercial banks in their inherently risky business model, complex banking and financial market regulation has been put in place. In fact, banks belong to one of the most heavily regulated industries of all. But even the strongest regulation is never absolute. It cannot be, because every regulation creates new regulatory loopholes. To a certain extent, new players have emerged from these gaps in the course of digitization, the so-called shadow banks. Shadow banks are financial companies that operate financial intermediation outside the regular banking system. As a result of a rampant shadow banking system, a huge debt paper pyramid has grown up in the past decades. Financial analysts currently estimate the extent of this pyramid at USD 1.2 trillion.

Real versus Financial Economy

Real versus Financial Economy

With the rise of shadow banks, the world has undergone impressive financialization. The following reasons should be emphasized here: Banks have become increasingly regulated due to their inherently risky business model. But regulation always means over-regulation. Knowing that the central banks have a safe safety net, banks have started to conduct all kinds of off-balance sheet transactions. This development was facilitated through digitization. The shadow banking system was born. This system was also the source of the savings of ordinary citizens. The latter saw themselves increasingly forced to participate in the financial market since the abandonment of the gold standard. A race to devalue national currencies that began after 1971 not only made it impossible to provide for the long term, but currency fluctuations also made life and business difficult for global, multinational corporations. Shadow banks and other players were able to profit from these trends.

Reserve Currency: US Dollar

Reserve Currency: US Dollar

This international barter economy of national currencies is neither advantageous for financial investments nor for world trade. To counteract this inefficiency on a global level, the US dollar has become the internationally recognized unit of account. As the global reserve and trade currency of central banks, commercial banks and multinational corporations, the US dollar enjoys an undisputed relative strength compared to other national currencies. Due to the dominance of the dollar, multinational corporations and major banks have also globalized over the past decades alongside the Greenback. The numerous players in the shadow banking system have done the same, and have even furthered and accelerated this dollarization of the world.

Eurodollar Standard

Eurodollar Standard

It is all the more surprising that certain observers speak of a eurodollar standard rather than a pure dollar standard. Eurodollars are accounting entries in US dollars that are used to settle cash flows between numerous players outside the banking system supervised by the US Federal Reserve. Because the world has globalized via the US dollar, but in many cases has not had direct access to the US Federal Reserve as the source of dollar liquidity, this dollarization has taken place via the eurodollar shadow banking system. The accounting entries of these shadow banks are called eurodollar because US dollar-denominated accounting deposits outside the US were created exclusively in London. Today, however, eurodollars are spent all over the world and should therefore correctly be called offshore dollar deposits.

US Dollar Shortage

US Dollar Shortage

For reasons of balance sheet optimization, numerous players in the "financial system" worldwide are now indebted in US dollars. The eurodollar balances of the banks and shadow banks are ultimately only booking entries in databases. In a crisis, this quickly becomes the fate of the players. In a liquidity crisis, for example, eurodollar booking entries prove to be no longer money, because the respective counterparty insists on getting actual US dollars. If the demand for dollars rises, the exchange rate of the dollar rises again and only increases the liquidity and refinancing needs of financial market participants who have debts denominated in US dollars. An ever-higher demand for US dollars meets an ever greater shortage of US dollars.

Ultimate Bad Bank

Ultimate Bad Bank

The US dollar shortage hangs like a sword of Damocles over the financial world. The greatest danger today is that systemically important players will lose dollar liquidity. The latter must be maintained at a constant level and in the event of signs of any shortcomings. The US Federal Reserve creates this dollar liquidity mainly by buying up more and more new securities, thus becoming the ultimate bad bank within the "financial system". Losses and distortions are absorbed and absorbed by the US Federal Reserve.

Monetary Socialism

Monetary Socialism

As a consequence, this means that the US government's treasury will take the entire global financial system on its balance sheet via the Federal Reserve System. As a reaction, political upheavals as demanded by Modern Monetary Theory become more probable. This way, the state would create whatever liquidity it needs for itself. Whatever path the monetary and financial system will take in the future, one thing seems certain: Monetary socialism will be to the chagrin of savers, entrepreneurs and ultimately of us all.