Buiter on the potentially parlous state of European FX reserves

Recently, interest in the Bank of England’s US dollar repos has petered out, but at the beginning of the programme, amounts close to the $40 bn limit were taken up. If those US dollars were borrowed by banks like RBS and HBOS, both insolvent except for past, current and anticipated future government financial support, they may well have been lost. These banks (and other UK banks that are still standing more or less on their own two feet) had (and continue to have) very large US dollar exposures on which they made massive losses - well in excess of $40 bn. These banks also have few liquid foreign currency assets.

Assume one or more banks that borrowed US dollars from the Bank of England cannot pay them back. The Bank of England takes the collateral that secured these US dollar loans. Eligible collateral for these loans consists of those securities that are routinely eligible in the Bank’s short-term repo open market operations and Standing Facilities, as published on the Bank’s website, together with conventional US Treasury securities. Assume that little if any of the collateral offered for the US dollar loans from the Bank of England consisted of US Treasury securities. So the Bank gets a mitt full of sterling securities back in lieu of the US dollars it has lost. Nice, but not good enough. When the swap arrangements expires, the Bank of England has to repay the Fed in US dollars, not in sterling securities. So unless the swap arrangement is extended, or extended and expanded, the Bank of England would have to send the Fed an ‘Oops’ note.

If the full swap line was lost ($40 bn), the UK would be completely out of (net) foreign exchange reserves - if we consolidate the foreign exchange assets and liabilities of the government and the US dollar swap exposure of the Bank of England. Not a good place to be. Of course, the beauty of swaps if that they are off-balance sheet items.

I haven’t checked the details about the official foreign exchange reserves of Switzerland and the Euro Area nations, nor do I know much about the foreign exchange losses of Swiss and Eurozone banks, although I expect that these losses are vast. It is possible that the earlier use of the swap lines by the ECB and the SNB has also made a rather large dent in the net foreign exchange reserves of Switzerland and the Eurozone nations.

In any case, the Machiavallian interpretation of the redundant second announcement of the central bank swaps is that it was intended to divert attention from the dire condition of the official foreign exchange reserves of a number of European countries, especially the UK. Extending the duration of the swaps delays the moment that the loss of the US dollars will have to be recognised. If this was indeed the case, it is bound to fail. Markets can be stupid, but not that stupid. This will not reduce the risk that Reijkjavik-on-Thames will have to seek IMF assistance at some point.

J K Galbraith on margin rates

A great river of gold began to converge on Wall Street, all of it to help Americans to hold common stock on margin. Corporations also found these rates attractive. At twelve percent Wall Street might even provide a more profitable use for the working capital of a company than additional production A few firms made this decision. Many companies started lending their surplus funds on Wall Street. By early 1929, loans form these non-banking sources were approximately equal to those from banks. Later they became much greater. 

There were still better ways of making money. In principle, New York banks could borrow money from the Federal Reserve Bank at five per cent and re-lend it in the call market for twelve. In practice they did. This was, possibly, the most profitable arbitrage operation of all time. Only a drastic increase in the Fed's rediscount rate would have made it unprofitable. In fact, higher interest rates would have been distressing to everyone but the speculator.

J K Galbraith on investment trusts

The most notable piece of speculative architecture of the late twenties, and the one by which, more than any other device, the public demand for common stock was satisfied, was the investment trust or company. The investment trust did not promote new enterprises or enlarge old ones. Even in the United States in the twenties, there were limits to the amount of real capital which existing enterprises could use or new ones could be created to employ. The virtue of the investment trust was that it brought about an almost complete divorce of the volume of corporate securities outstanding from the volume of corporate assets in existence. The former could be twice, thrice or any multiple of the latter. The volume of underwriting business ad of securities available for trading on the exchanges all expanded accordingly.

J K Galbraith on margins

In the stock market, the buyer of securities on margin gets full title to his property in an unconditional sale. But he rids himself of the most grievous burden of ownership - that of putting up the purchase price - by leaving his securities with his broker as collateral for the loan that paid for them. The buyer gets the full benefit of any increase in value - the price of the securities goes up - but the loan that bought them does not. 

The machinery by which Wall Street separates the opportunity to speculate from the unwanted returns and burdens of ownership is ingenious, precise and almost beautiful. Banks supply funds to the brokers, brokers to customers, and the collateral goes back to the banks in a smooth and all but automatic flow. Margins - the cash which the speculator must supply in addition to the securities to protect the loan and which he must augment if the value of the collateral securities should fall and so lower the protection they provide - are effortlessly calculated and watched.

Wall Street, however, has never been able to express its pride in these arrangements. They are admirable and wonderful only in relation to the purpose they serve. That purpose is to accommodate the speculator and facilitate speculation. But the purposes cannot be admitted. If Wall Street confessed this purpose, many thousands of moral men and women would have no choice but to condemn it for nurturing an evil thing and call for reform. Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator but that it encourages the extra trading which changes a thin anemic market into a thick and healthy one. At best this is a dull by-product and a dubious one. Wall Street, in these matters, is like a lovely and accomplished woman who must wear black cotton stockings, heavy woollen underwear and parade her knowledge as a cook because, unhappily, her supreme accomplishment is as a harlot.

Buiter on the possibility of sovereign default

Pointing to a non-negligible risk of sovereign default in the US and the UK does not, I fear, qualify me as a madman. The last time things got serious, during the Great Depression of the 1930s, both the US and the UK defaulted de facto, and possibly even de jure, on their sovereign debt.

In the case of the US, the sovereign default took the form of the abrogation of the gold clause when the US went off the gold standard (except for foreign exchange) in 1933. In 1933, Congress passed a joint resolution canceling all gold clauses in public and private contracts (including existing contracts). The Gold Reserve Act of 1934 abrogated the gold clause in government and private contracts and changed the value of the dollar in gold from $20.67 to $35 per ounce. These actions were upheld (by a 5 to 4 majority) by the Supreme Court in 1935.

In the case of the UK, the de facto sovereign default took the form of the conversion in 1932 of Britain’s 5% War Loan Bonds (callable 1929-1947) into new 3½ % bonds (callable from 1952) on terms that were unambiguously unfavourable to the bond holders. Out of a total of £2,086,000,000 outstanding, £1,500,000,000, or something over 70%, was converted voluntarily by the end of 1932, thanks both to the government’s ability to appeal to patriotism and joint burden sharing in the face of economic adversity and to ferocious arm-twisting and ‘moral suasion’.

I believe both defaults were eminently justified. There is no case for letting the interests of the holders of sovereign debt override the interests of the rest of the community, regardless of the financial, economic, social and political costs involved. But to say that these were justifiable sovereign defaults does not mean that they were not sovereign defaults. Similar circumstances could arise again.