Money for Nothing
Who hasn’t dreamed of being able to create money out of thin air? Most of us relinquish this dream by the time we turn 18, convinced that the only way to get money is to earn it, but those few destined to become central bankers cling to the dream. Central banks, including the U.S. Federal Reserve Bank, had always had the power to do this in a pinch. But most chose not to, for reasons we can easily understand. Central bankers are a conservative lot, well aware of the dangers of inflation, which is universally understood to be caused by too much money chasing too few goods and services. There were recessions and occasional financial crises, some fairly severe, like the recession of 1980-1982 and the so-called “Asian Flu of 1997,” but in general the strict frugality of central bankers prevailed over the natural human desire to bend the rules and take advantage of fiat money. For more than 30 years, nothing too terrible happened.
Anything That Can Go Wrong…
But in the early part of the 21st Century, imbalances began to build in the currency reserves of countries like China, India, Japan, and others. Since 1971, remember, there had been no absolute standard of value for currencies. Gold had been the standard prior to 1971, but after 1971 gold was just another commodity with a price set by supply and demand. All currencies therefore fluctuated daily in relation to the dollar, except for those “pegged” to the dollar. They “rode” the dollar, like a small child riding on her parent’s big shoulders.
New York, New York
Since most national currencies were thought to be relatively unstable compared to the dollar, foreign money managers naturally chose to hold their cash in dollars. Dollars could easily be deposited in any big bank in the world, and could easily be invested in New York – turned over to big American corporations like Citicorp, JP Morgan Chase, Bank of America, or investment banks like Merrill Lynch, Morgan Stanley, Lehman Brothers, and Goldman Sachs. The big British and American commercial banks and their investment bank cousins could always find a way to invest the excess cash in the real economy and pay a modest return to those who had deposited the money.
Investors with cash had dozens of options. They could leave their cash in the bank, in what are called “demand deposits” – ordinary cash in the bank – and earn a very low rate of interest, they could put it into money market funds and earn a little more, they could buy certificates of deposit (CDs) and generally earn a tad more, or they could buy many different kinds of debt instruments, called bonds, where they would generally earn the most interest.
Bonds were a brilliant 19th Century invention. Bonds allow debt to be divvied up and sold to many different investors, increasing the range of investors who can afford to buy the debt, and therefore increasing the amount of debt that can be sold. Bonds are highly liquid, bought and sold every business day on the bond exchanges in New York. A bond normally can be sold in a few minutes if necessary. So the global investors who came to New York and London with their wheelbarrows full of cash – figuratively speaking – had a wide range of attractive, usually very safe options.
Prior to 2003, life was good. The investment world was well-ordered, and investing in debt instruments was easy. One thing worth remembering, however, is that the money used to pay interest on debt instruments doesn’t just fall out of the sky. That money has to be earned in the real economy by businesses selling goods and services, generating profits, and paying the interest on their debts. When businesses run into trouble in the “real economy,” it can threaten their ability to pay their debts.