US Dollar Hegemony (Part 4):

Bailout Economy

“[The Fed] affirmed today its readiness to serve as a source of liquidity to support the economic and financial system”

-          Alan Greenspan

This is part 4 of the US Dollar Hegemony series.

Part 1 discussed the fall of the British Empire and the rise of the American empire, which began with British World War 1 debts and culminated in its complete submission to the US during World War 2 for the creation of the post war world.

Part 2 discussed how the US went from the world’s largest Creditor to the world’s largest Debtor and in doing so imposed its will on the world through various international bodies such as the World Bank, IMF, and GATT.

Part 3 explored the post “Nixon Shock” world and the US dollar detached from gold. Where the US imposed its will on the world by its massive debt loads with threats of destabilizing the global monetary system.  

In August 1987, Alan Greenspan replaced Paul Volcker as Fed Chairman. Greenspan would head the Federal Reserve for nearly 19 years. After the US dollar rallied more than 100% in the first half of the 80s due to the Volcker regime hiking the Fed Federal Funds rates to over 20%, a G5 intervention was required in the form of the Plaza accord.  The Plaza accord consisted of the United States, France Germany, Japan, and Great Britain which agreed to depreciate the Dollar. Afterwards, the Dollar index reversed its move from the early 80s and collapsed in price. Meanwhile as the currency markets remained volatile, US stocks were in a bull market reaching new heights. But underlying global economic issues persisted as well as the brewing US Savings and Loan Crisis, and the party had to come to an end. 

On October 19, 1987, the US stock market crashed over 22%, which was the largest drop in US stock market history.  The Alan Greenspan Federal Reserve stepped in immediately. The following day after the crash, the Federal Reserve began to act as the lender of last resort to counter the crisis. The Fed then proceeded to provide market liquidity to try and prevent the crisis from expanding to other markets and injected $17 billion into the banking system, which was 7% of the monetary base of the entire nation at the time. The Fed then pushed the Fed Funds rate down 50 bps.  The Fed’s actions stopped the crisis and markets eventually reached new All-Time-Highs within 2 short years.  The “Greenspan Put” was born within the chairman’s first 3 months on the job.  

The Federal Reserve and US Government tackling crises head on with easy monetary and fiscal conditions has become the norm for the next 35 years. Beginning with the ‘Black Monday’ crash, each intervention by the Fed was greater in scope and created a moral hazard amongst American investors. Greater and greater risks could be taken because the Fed would always step in to keep the party going.

The interest rate policies of the Volcker Fed led to crises in different areas that would be dealt with easy monetary policies and Federal bailouts. The first of these would be the S&L Crisis. Savings and Loan associations (S&Ls), or thrifts, had simple business models. They would provide interest on people’s savings and then lend out the money for mortgages, car, and small business loans for slightly higher interest. With interest rates as high as they were, this business model became a losing proposition which eventually led to a Crisis.

The US government stepped in the early 1980s to help the S&L by deregulating the industry. Some of the changes that came from the deregulation to help them “grow” out of their problems were allowing them to offer a wider variety of savings products, including adjustable-rate mortgages (ARMs), expansion of their lending authority, authorization of more lenient accounting rules and less regulatory oversight. The deregulation of S&Ls gave them many of the capabilities of commercial banks without the same regulations as banks nor FDIC oversight.

These new capabilities lent themselves to reckless lending. One of the most notable new capabilities S&Ls had been given was the ability to sell their mortgages and use the cash to seek better returns. This was the birth of the Mortgage Back Securities (MBS) market that would bring the global economy to its knees in 2008.  These less sophisticated S&Ls would often be taken advantage of by Wall Street banks. The S&Ls would sell their mortgage loans to the Wall Street banks often at 10-40% discounts. These mortgages were then bundled together in MBS, effectively turned into government-backed bonds by virtue of Ginnie Mae, Freddie Mac or Fannie Mae guarantees. These bundle products were then often sold back to the S&Ls for substantial fees.

So, a disaster was brewing by conservative institutions becoming more reckless in its lending and risk taking as rising interest rates eroded their profit margins. In 1985, various S&Ls began to fail. Reckless actions with depositors’ money led to bank-runs, bank holidays, and the failure of over 1000 S&Ls from 1986-1995. About 1/3 of all S&Ls. This crisis had spread to commercial banks as well with mor than 1600 banks insured by the FDIC were closed or received FDIC financial assistance.

The US government stepped into bailout the S&Ls by appropriating $105 billion to resolve the crisis. Although the net cost to taxpayers ended up being closer to $130 billion. The height of the disaster came after the markets were still reeling from the ’87 crash, and the Greenspan’s Fed was not about to let the S&L crisis spill over to the financial markets. The Fed stepped in to provide additional liquidity to the markets.  In ’89-90, interest rates were still over 9%, yet by 1994 they were dropped to below 4%. The Greenspan Fed made sure to protect Wall Street.

Another Crisis that was a consequence of the Volcker Fed that Greenspan proceeded to help bail out was the “Tequila Crisis’ or Mexican Peso Crisis. The high interest rates of the early 80s made it extremely difficult for Mexico to access funding from the US as investors bulked at the riskier Latin American investments versus parking assets in high yielding US treasuries. By 1982, Mexico defaulted on its IMF loans, and it was then essentially cut off from international finance markets, alongside the rest of Latin America.

The crisis prompted the then President Miguel de la Madrid to undertake widespread deregulation, privatization and substantially lowered tariffs to open the country to trade. This trend continued with his predecessor Carlos Salinas de Gortari which led to US trade negotiations that created NAFTA and pegged the Peso to the US Dollar. These negotiations were with US Treasury secretary Nicholas Brady, famous for the Brady Bonds. Brady Bonds were debt securities denominated in US dollars issued by developing countries, most notably Latin America countries such as Mexico.  Investments began to flow back into Mexico via the Brady bonds. Although, with the Peso pegged to the US dollar, Mexico’s current account deficit ballooned.

1994 was an election year in Mexico. Strong political pressure was put on the Bank of Mexico to keep interest rates low, which was putting pressure on the Dollar peg. After the opposition party won the election, money fled Mexico in fear of the newly elected government reneging on the reforms.  In December 1994, the new President Ernesto Zedillo devalued the Peso by 15% which sparked the currency crisis.

The US was worried about what was happening to their neighbor to the south. Many banks, mutual funds, and pensions invested in Mexican securities, most notably was the California Public Employees’ Retirement System (CalPERS).  Greenspan, Robert Rubin and Larry Summer met to discuss a bailout to protect American investors. $50 billion was given to Mexico in loan guarantees and the Greenspan Fed reversed its rate hikes. US investors were saved again. The era of irrational exuberance was to begin.

Part V will explore the rise of the bubble economy.

-          The DeFi Fox