The Mysterious Case of Hamilton’s Monetary Enterprise,
the Financial Instability Hypothesis and Exter’s Inverted Pyramid
ARTICLE
Draft Version: February 15, 2010
Michael “Mack” Frankfurter
Principal, Managing Director
Cervino Capital Management, LLC
mack@cervinocapital.com
Copyright © 2010 Michael “Mack” Frankfurter, Author. All Rights Reserved.
Republication of this document, or any part thereof, is only permitted with the prior and express written permission of Michael
“Mack” Frankfurter and Cervino Capital Management LLC, P.O. Box 2366, Santa Barbara, California 93120-2366.
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The Mysterious Case of Hamilton’s Monetary Enterprise,
the Financial Instability Hypothesis and Exter’s Inverted Pyramid
By Michael “Mack” Frankfurter
Part I – Minsky’s Ponzi Finance Units
“It is my belief, Watson, founded upon my experience, that the lowest and vilest alleys in London
do not present a more dreadful record of sin than does the smiling and beautiful countryside.”
~ Sherlock Holmes in “The Copper Beeches”1
Almost exactly two hundred years before Hyman Minsky published his paper The Financial
Instability Hypothesis in 1992 (the relevance which will become apparent), a blind pool2 known
as the “six percent club” was engaged in the first market corner in the history of the United
States. According to traditional accounts,3 the Panic of 1792 was caused by the scheming and
operations of William Duer, a well-connected businessman and speculator, who had recently
resigned from his brief post as assistant secretary of the treasury of the newly formed country.
It all started when Treasury Secretary Alexander Hamilton put into action a plan to buy at par
value the millions of dollars in promissory notes that the bankrupt Continental Congress and
state governments had issued to soldiers, farmers, and other’s who had supported the Revolution.
Duer, who combined government service with a passion for quick profits, leaked word to his
fellow “grandees” that Hamilton intended to consolidate these debts with federal debt. Recognizing
Hamilton’s plan as a way to make a killing, agents of Duer’s secret circle were soon galloping
across the countryside buying up state paper at a few cents on the dollar.4
As a homily to the present-day bailout of the financial system wherein information asymmetry
has become a recurrent headline about the markets,5 Duer’s anecdote has some interesting parallels
were it to end here. This brief episode, however, set in motion a series of events which ultimately
led Hamilton to invent what in time would be termed Bagehot’s rules6 for how a central bank
should act in a crisis some [eight] decades before Walter Bagehot “rediscovered” them.7
1
Sherlock Holmes in “The Copper Beeches” (Doubleday p. 323); The Adventures of Sherlock Holmes (1892).
2
An investment vehicle that raises capital from the public without telling investors how their funds will be utilized.
3
According to Cowen, Sylla and Wright (2006), “Although specialists in financial history have known of the 1792
panic for decades, at least since Davis (1917) explored it in some detail, it did not make a strong impression on
others.” Further, “The traditional account is not incorrect, but it is incomplete. Other events were unfolding at the
time that are ignored or slighted in the traditional account.”
4
Fleming, Thomas (2009). “Wall Street’s First Collapse,” American Heritage Magazine, Volume 58, Issue 6. See
also: Fraser, Steve (2005). “Every Man a Speculator History of Wall Street in American Life,” HarperCollins.
5
Information asymmetry encompasses “insider trading” (eg, indictment of Galleon Group founder Raj Rajaratnam);
and “front-running” (eg, trading ahead of customer orders, trading ahead of research reports, etc.)
6
“[T]o avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at ‘high
rates.’” Bagehot, Walter (1873). “Lombard street: a description of the money market.” London: Henry S. King.
7
Sylla, Richard; Wright, Robert E.; and Cowen, David J. (2006). “The U.S. Panic of 1792: Financial Crisis
Management and the Lender of Last Resort.” Prepared for NBER DAE Summer Institute, July 2006.
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Copyright © 2010 Michael “Mack” Frankfurter, Author. Cervino Capital Management LLC. All Rights Reserved.
In December 1790, Congress adopted Hamilton’s recommendations.8 Old evidences of debt were
already being exchanged for new federal debt in the form of 6% bonds, 6% deferred bonds and
3% bonds starting in October 1790.9 These bonds were soon trading on America’s first “stock”
exchange under a buttonwood tree at the foot of Wall Street. Hence, it was these very same
events which presaged the origins of the New York Stock Exchange when twenty-four New
York City stockbrokers and merchants signed the Buttonwood Agreement in 1792.
Around this time Hamilton had also called for Congress to incorporate a Bank of the United
States capitalized with 25,000 shares of $400 par value each.9 Noting that speculation was
already brisk in federal 6% notes, Hamilton attempted to check a similar fever in the Bank’s
stock by requiring $100 in specie10 along with $300 in new United States debt securities. However,
“Congress, already demonstrating an eagerness to please as many people as possible,” reduced
the opening payment to $25 for a scrip” 11 which effectively served as a subscription right.
The initial offering took place on July 4, 1791 and was heavily oversubscribed. In five weeks the
value of scrip soared reaching 264 bid-280 ask in New York and more than 300 in Philadelphia
before tumbling. The so-called “U.S. sixes” rose from 90 at the time of the Bank’s offering to 112.50
on August 13th before falling to 100 by August 17th. In response, Hamilton convened a meeting
of the Commissioners of the Sinking Fund which authorized open market purchases of U.S. debt.
Working through various agents, Hamilton restored confidence by supporting the bond market.9
It turns out that the mini-panic of August 1791 served as “a trial run for the crisis-containment
techniques Hamilton was to employ during the more serious price collapse in March-April 1792.” 9
In fact, Hamilton’s actions in 1791 illustrate the mixed blessings of crisis management in that his
response may have encouraged the speculative bubble that followed. Almost two centuries later
Alan Greenspan responded similarly to the stock market crash of 1987 as well as subsequent crisis
during his tenure. As been argued, by coming to the aid of the market and creating the notion of
a “Greenspan put,” the moral-hazard problem may have sowed the seeds of our current crisis.
This is where Minsky enters the picture. A little over a decade ago, the term “Minsky moment”
was coined to describe the Russian debt crisis in 1998 which proceeded the fall of Long Term
Capital Management. Minsky observed “that, from time to time, capitalist economies exhibit
inflations and debt deflations which seem to have the potential to spin out of control.” The Minsky
moment occurs after a long period of prosperity in which debt is increasingly used to finance
investments, in turn causing the value of assets to rise, which reflexively encourages speculation
using borrowed money. At the point when investors’ cash flow no longer supports debt, a major
selloff begins leading to a precipitous collapse in asset prices and market liquidity.
8
Knowledge that the new federal bonds could also be used at par to subscribe for three-fourths of the cost of a share
in the Bank of the United States was officially made public in the Bank Report of December 13, 1790.
9
Sylla, Richard; Wright, Robert E.; and Cowen, David J. (2006). “The U.S. Panic of 1792: Financial Crisis
Management and the Lender of Last Resort.” Prepared for NBER DAE Summer Institute, July 2006.
10
Latin phrase. It is used to indicate that distribution of an asset will be “in its actual form,” rather than cash.
11
Fleming, Thomas (2009). “Wall Street’s First Collapse,” American Heritage Magazine, Volume 58, Issue 6.
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Theoretically, one could link the current financial crisis to a Minsky moment caused by the
failure of two Bear Stearns hedge funds circa June 2007. The irony of the “reverse Minsky
journey”12 is hard not to miss in the following passage of Minsky’s paper:
Three distinct income-debt relations for economic units, which are labeled
as hedge, speculative, and Ponzi finance, can be identified. Hedge financing
units are those which can fulfill all of their contractual payment obligations
by their cash flows: the greater the weight of equity financing in the liability
structure, the greater the likelihood that the unit is a hedge financing unit.
Speculative finance units are units that can meet their payment commitments
on “income account” on their liabilities, even as they cannot repay the
principle out of income cash flows. Such units need to “roll over” their
liabilities… For Ponzi units, the cash flows from operations are not
sufficient to fulfill either the repayment of principle or the interest due
on outstanding debts... Such units can sell assets or borrow. Borrowing to
pay interest or selling assets to pay interest (and even dividends) on
common stock lowers the equity of a unit, even as it increases liabilities and
the prior commitment of future incomes. A unit that Ponzi finances lowers
the margin of safety that it offers the holders of its debts. [Bold added]
As Minsky points out, if authorities attempt to exorcise monetary constraint in “an economy with
a sizeable body of speculative financial units… then speculative units will become Ponzi units
and the net worth of previously Ponzi units will quickly evaporate.” Notwithstanding the obvious
inference to the Madoff affair, the Oracle of Omaha, Warren Buffet, concisely summarized that,
“Only when the tide goes out do you discover who's been swimming naked.”
The common factor distinguishing the difference between Minsky’s hedge, speculative, and
Ponzi finance units is liquidity. Liquidity is conventionally defined as, “the ability of an asset to
be converted into cash quickly and without any price discount”.13 It has been said that the root of
the current liquidity crisis is a lack of confidence—confidence basically disappeared and liquidity
evaporated. But this behavioral observation is both simplistic and obscures turnkey concepts.
The exchange of money involves a valid and legal offer of payment for debts when tendered to a
creditor. A debtor who is unable or unwilling to meet the legal obligations of a debt contract by not
making a scheduled payment is said to have defaulted. In a very narrow sense, legal tender is a
form of payment that, by law, functions in the settlement and discharge of debt. “There is,
however, no Federal statute mandating [a person] must accept currency or coins as for payment
for goods and/or services.”14 A case study in non-payment is the recent default by debtor Tishman
Speyer Properties on the Peter Cooper Village and Stuyvesant Town complex in Manhattan.
12
Term “reverse Minsky journey” is attributable to Paul McCulley of PIMCO, “A Reverse Minsky Journey,”
October 2007. http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2007/GCBF+October+2007.htm
13
“Glossary of Terms”, Federal Reserve Bank of St. Louis, September 2009
14
U.S. Department of Treasury, http://www.ustreas.gov/education/faq/currency/legal-tender.shtml
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Copyright © 2010 Michael “Mack” Frankfurter, Author. Cervino Capital Management LLC. All Rights Reserved.
In 2006, Tishman Speyer headed a venture to acquire the 11,000 unit property for $5.4 billion—
the most ever paid for a residential property in the U.S. Of that price tag, Tishman Speyer only
invested $168 million; however, CalPERS, Church of England, Hartford Financial and even the
Government of Singapore are in danger of having their investments wiped out. The venture’s
acquisition was controversial to begin with as plans were to raise rents in the middle-class haven.
The strategy backfired because of the economy and a court ruling which prevented conversion of
rent-controlled units to market rates. As a result, the property depleted what was left in its reserve
funds.15 Tishman Speyer, having been closed out of the capital markets, essentially faced a liquidity
crisis from a levered deal which could not be supported by the property’s revenues from rentals.
William Duer also faced a liquidity issue in March of 1792. After Hamilton intervened in 1791
by purchasing “U.S. sixes,” confidence was quickly restored. However, rather than learning his
lesson, Duer and other members of his speculative “company” borrowed large amounts of money
and rapidly drove up securities prices during the latter half of 1791. When Duer finally defaulted
in 1792, it caused a contagion of defaults and panic selling. In response, Hamilton began “a series
of lender-of-last resort operations that would last for several weeks as the panic went on”.9
Part II – Exter’s Deflation Prediction
“You know my methods, Watson. There was not one of them which I did not apply to the inquiry.
And it ended by my discovering traces, but very different ones from those which I had expected.”
~ Sherlock Holmes in “The Crooked Man”16
As the saying goes, “cash is king,” especially in a liquidity crisis. However, for cash to function
as a means to discharge debt, then the largely unasked question is: what defines cash as money?
Another unattributed maxim attempts an answer, “Money is a matter of functions four, a medium, a
measure, a standard, a store.” Out of necessity then, it is not surprising that Congress’s first use of its
constitutional power on behalf of the newly formed nation was in passing the Coinage Act of 1792.
The Act, based on a report prepared by Hamilton, adopted a decimal system of account: the dollar,
“tenth part” of the dollar, and “hundredth part” of the dollar. Consistent with bimetallism, Congress
authorized “free coinage” of both gold and silver as [legal?] tender.17 Interestingly, foreign coins
which were circulating at the time maintained their tender status until the Coinage Act of 1857.
The perennial issue facing all monetary standards, however, is that the real value18 of debts may
change due to inflation and deflation, which equates to debasement and devaluation for sovereign
15
Wei, Lingling and Spector, Mike. “Tishman Venture Gives Up Stuyvesant Project,” WSJ (January 25, 2010).
16
Sherlock Holmes in “The Crooked Man” (Doubleday p. 416); The Memoirs of Sherlock Holmes (1893).
17
As opposed to Article I, Section 10 of the Constitution, which states “No state shall… make anything but gold and
silver coin a tender in payment of debts…” James Madison in “The Federalist No. 44, Restrictions on the Authority
of the Several States” (January 25, 1788) cites the term legal tender implying an intent that is still debated today.
18
In economics, nominal value refers to any price or value expressed in current monetary terms, as opposed to real
value, which adjusts monetary measurement for the effect of inflation.
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Copyright © 2010 Michael “Mack” Frankfurter, Author. Cervino Capital Management LLC. All Rights Reserved.
and international debts. But the notion of “real value” goes even deeper than that. Ludwig von
Mises noted that, “The concept of money as a creature of law and the state is clearly untenable. It is
not justified by a single phenomenon of the market. To ascribe to the state the power of dictating
the laws of exchange, is to ignore the fundamental principles of money-using society.”19
Illustrating Mises’ point was the use of “wampum” as currency for trade in colonial America.
Since much trading was done with the Indians, it was easy for the colonists to adopt their system.
The value of wampum was stable, as it took one hour’s labor to produce, and thus production of
wampum did not exceed the production of goods and services, so it served as a stable currency
for over two centuries. According to historical records, tables of value were posted in each
colony, relating currency commodity to wampum and the English shilling. For example, a six-
foot string of white wampum was worth one bullet, and both were worth one shilling.20
In a corollary to 2008 when the commercial paper market stopped functioning and the Federal
Reserve was forced to backstop money market funds, a series of events occurred early in New
York’s history involving Peter Stuyvesant, Dutch Director-General of New Amsterdam (and
namesake to the Stuyvesant Town complex). Here is the story paraphrased from Sharp (1989):
Wampum had been the official currency for trade with the Indians since
1635, and the ratio to beaver stayed fairly stable because there was a limited
supply of each. But by 1650 the shells had started to depreciate and
Stuyvesant was faced with the same dilemma that still occurs today: how to
fix the value of depreciating currency to stop price inflation. At first he tried
to set the price at six white beads to one Dutch stuiver, but by 1659 the
value went to 16 beads to a stuiver. The economic effect was disastrous.
To become wealthy, a person has to have at least one major opportunity in
life, and it must be acted on boldly. Frederick Philipse had two… In 1653,
Stuyvesant replaced an existing barricade with a strong defense from which
Wall Street derives its name. Fortunately for Philipse, he worked on the
project as official carpenter for the Dutch West India Company. Around
the time of the wampum inflation Philipse became involved with a widow
who had a large inheritance from her late husband’s fur trade.
Anticipating a rise in the value of wampum, Philipse bought and buried
(“planted”) large barrels (“hogsheads”) of wampum. By 1663, the price
began to rise because Philipse had cornered the market, and those who had
made contracts to pay in wampum could find none and had to approach
Philipse and take his price. By 1666, the value had gone from 16 beads per
19
Mises, Ludwig von (1912) The Theory of Money and Credit. H. E. Batson, trans. 1981. Library of Economics and
Liberty. Retrieved January 15, 2010: http://www.econlib.org/library/Mises/msT2.html
20
Sharp, R. M. (1989) The Lore and Legends of Wall Street. Homewood, Ill: Dow Jones-Irwin.
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stuiver to 3 per stuiver, and Philipse converted his profits into real estate,
soon owning land from present-day Yonkers to Tarrytown.
The reason for relating this tale is because it serves as a simple allegory to the complex paradigm
which maintains the US dollar as world reserve currency. As noted by McGuire and von Peter (2009)
in their paper, The US dollar shortage in global banking and the international policy response:
The global financial crisis has shown just how unstable banks’ sources of
funding can become. Throughout the crisis, but particularly following the
collapse of Lehman Brothers in September 2008, many banks faced severe
difficulties securing short-term US dollar funding. In response, central
banks around the world adopted extraordinary policy measures, including
international swap arrangements with the US Federal Reserve, to enable
them to provide US dollars to commercial banks in their respective
jurisdictions. What caused this global shortage of US dollars? Which
banking systems have been most affected? How could a shortage develop
so quickly after dollar liquidity had been viewed as plentiful?
It so happens that we’ve been in a similar predicament before. In 1960, a Belgian economist by
the name of Robert Triffin testified before the Congress warning of serious flaws in the Bretton
Woods system. His theory stated that the accumulation of US dollars outside of the United States,
due to its position as a world reserve currency, would result in a tension between national monetary
policy and global monetary policy. Triffin’s solution to the dilemma was for the United States to
reduce the number of dollars in circulation by cutting the deficit and raising interest rates to attract
dollars back into the country. These tactics, however, would continue the legacy of stagnation from
Eisenhower’s presidency, and so President Kennedy opted for looser fiscal policies instead.21
In effect, the host nation of a global reserve currency inevitably runs up a huge current account
deficit that eventually undermines the credibility of its currency. In the aftermath of WWII, the
flow of funds out of the country due to the Marshall Plan, defense spending, as well as Americans
purchasing foreign goods, caused the number of US dollars in circulation to exceed the amount
of gold backing the currency. As implied by McGuire and von Peter (2009), the United States is
forced to run deficits on the balance of payments in order to supply the world with US dollar reserves
and provide liquidity for increased foreign wealth, or risk adversely impacting the global economy.22
The 1970s was a crucial turning point. The costs of the Vietnam War and increased domestic
spending had the effect of accelerating inflation, while US gold stock declined to $10 billion
21
BEA: quarterly GDP figures by sector, 1953-1964. Also see, “Kennedy's Case for a Higher Budget & Lower
Taxes,” Times Magazine, January 25, 1963; http://www.time.com/time/magazine/article/0,9171,940200,00.html
22
According to James Paulsen, chief strategist at Wells Capital Management, the massive U.S. trade deficit that has
built up during the 1990s and 2000s effectively serves as a modern “Marshall Plan” for developing economies. Like
the post-World War II Marshall Plan in Europe, by which the U.S. jump-started the rebuilding of the Continent's
economy, the present day U.S. trade deficit has helped the developing world take on sustained role in supporting
global economic growth. Source: “Economic and Market Perspective” April 2006, Wells Capital Management.
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versus outstanding foreign dollar holdings estimated at $80 billion.23 On August 15, 1971,
President Nixon, a self-proclaimed Republican “conservative,”24 imposed a 90-day wage and
price control program, a temporary tariff surcharge of 10 percent on all imports, and other
various expansionary fiscal policies25 in what became known as the “Nixon Shock”.26 Most
importantly, Nixon closed the gold window to prevent foreign governments that had been holding
dollar-denominated financial assets from demanding gold in exchange for their dollars.
What followed were efforts by the Group of Ten (G-10), under United States leadership, to patch
up the international monetary system. By March 1973, all of the major world currencies were
floating and management was left to the market with central bankers only intervening in
exchange markets in response to extreme fluctuations. As inflation erupted in the United States,
different rates of inflation in other countries made floating exchange rates desirable in order for a
nation to isolate itself from “importing” external inflation. In November 1975, the Group of
Seven (G-7) formed, and in January 1976 final details were hammered out on a framework for a
new monetary system. The agreement called for an end to the role of gold as a monetary standard,
and legitimized the de facto system of fiat currencies and floating exchange rates.25
The long and winding road from Article I, Section 10 of the Constitution, which declares that
“No state shall… make anything but gold and silver coin a tender in payment of debts,” to the
present-day Federal Reserve Note, backed by debt purchased from the United States Treasury by
the Federal Reserve, which generates a financial benefit for the Federal Reserve System known
as seigniorage, is a torturous journey through a series of U.S. Supreme Court cases involving the
constitutionality of the Legal Tender Acts starting with the Act of 1862. Follow the chronology
from 1862 to the Federal Reserve Act of 1913; President Roosevelt’s Executive Order 610227 in 1933;
the Bretton Woods Agreement of 1944; on through to the Nixon Shock in 1971; and it becomes
apparent that paper money (ie, fiat currency) derives its mode from the realm of philosophy.28
In essence, the primacy of fiat currency is the key issue facing investors as they find themselves
buffeted by the current economic crisis. When a monetary or banking crisis erupts, what medium
23
Spero, Joan Edelman, and Hart, Jeffrey A. (2010). The Politics of International Economic Relations. 7th ed.
(originally published 1977). Boston, MA: Wadsworth Cengage Learning
24
Nixon tape conversation No. 607-11.
25
Butkiewicz, James L. and Abrams, Burton A. (2007). The Political Economy of Wage and Price Controls:
Evidence from the Nixon Tapes. Alfred Lerner College of Business & Economics, University of Delaware. Working
Paper No. 2007-10. http://lerner.udel.edu/economics/workingpaper.htm
26
“The Economy: Changing the World's Money” Time Magazine, Oct. 4, 1971. First reference by Time Magazine
of “Nixon Shock”. http://www.time.com/time/magazine/article/0,9171,905418,00.html
27
Text of Executive Order 6102: http://www.presidency.ucsb.edu/ws/index.php?pid=14611&st=&st1=
28
“The loss which America has sustained since the peace, from the pestilent effects of paper money on the necessary
confidence between man and man… constitutes an enormous debt against the States chargeable with this unadvised
measure, which must long remain unsatisfied; or rather an accumulation of guilt, which can be expiated no otherwise
than by a voluntary sacrifice on the altar of justice, of the power which has been the instrument of it.” Source:
Madison, James. The Federalist No. 44, Restrictions on the Authority of the Several States (January 25, 1788).
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of exchange represents the most secure store of value in a global economy? Furthermore, in an era of
universal currency debasement, what standard serves as the best unit of account for valuing assets?
The “goldbugs” argue that the answer lies with Exter’s29 inverted pyramid, which “is delicately
balanced on a tip of pure gold,” with layers “graded according to safety, going from the safest,
gold at the bottom to the least safe, the layer of electronic dollars at the top.” As Antal Fekete
describes in his article, The Shadow Pyramid, “While appearing placid, static, and monolithic,
the pyramid comes alive every once in a while… There is great commotion and agitation
manifested by the scrambling of assets downwards to less prolific layers below, in the wake of
owners trying to take a ‘flight to safety’.” In effect, “the pyramid is deflationary because… it
threatens to collapse to its low-lying layers in consequence of repeated monetary crises.”
Early rendition of Exter’s Pyramid (circa 1987? artist illegible) and updated version (circa 2008 by Trace Mayer).
Orthodoxy is not often kind on free thinkers, yet crisis often reveals itself as the defining moment
which lends credence to views previously held unfashionable.30 In what is one of two more
insightful analyses of our present-day financial situation, the other being The Turner Review
(2009),31 McGuire and von Peter (2009) essentially validated Exter’s cautionary warning.
29
John Exter joined the Board of Governors of the Federal Reserve System as an economist. In 1948, he served as adviser
to the Secretary of Finance of the Philippines, and later as adviser to the Minister of Finance of Ceylon on the establish-
ment of central banks. In 1950 he became first governor of newly organized Central Bank of Ceylon. In 1953 was named
division chief for the Middle East with the International Bank for Reconstruction & Development (World Bank). In
1954 the Federal Reserve Bank of New York appointed him vice president in charge of international banking and gold
and silver operations. Source: Interview with John Exter which appeared in The Moneychanger, June 1991.
30
“John Exter was a free thinker. He never hesitated to raise his voice against what he believed to be imprudent. He
was a severe critic of irresponsible central banking, albeit he was one time a central bank governor.” Source: John
Exter Memorial Oration 2008, authored by W.A. Wijewardena, Deputy Governor, Central Bank of Sri Lanka.
31
“The Turner Review: A regulatory response to the global banking crisis” Lord Turner, Chairman of The Financial
Services Authority, (March 2009). http://www.fsa.gov.uk/pubs/other/turner_review.pdf
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The funding difficulties which arose during the crisis are directly linked to
the remarkable expansion in banks’ global balance sheets… As banks’
balance sheets grew, so did their appetite for foreign currency assets,
notably US dollar-denominated claims on non-bank entities… During the
build-up, the low perceived risk (high ratings) of these instruments
appeared to offer attractive return opportunities; during the crisis they
became the main source of mark to market losses.
Specifically, from 2000 to 2007 the outstanding stock of banks’ foreign claims on US dollars
(vis-à-vis investments denominated in US dollars) grew from $10 trillion to $34 trillion, “a
significant expansion even when scaled by global economic activity”.32 As McGuire and von
Peter (2009) noted, “This acceleration took place during a period of financial innovation, which
included the emergence of structured finance, the spread of ‘universal banking’, which combines
commercial and investment banking and proprietary trading activities, and significant growth in
the hedge fund industry to which banks offer prime brokerage and other services.”
A key finding of McGuire and von Peter’s (2009) paper is that the offices of foreign banks situated
in host countries have massive international operations, which are primarily funded in the world
reserve currency—the US dollar. In fact, “the six countries that make up the core of the Eurozone
all had foreign US dollar denominated claims [at end-2007] which were well over 100% of their
respective GDPs.”33 In other words, “these countries took on an amount of US dollar exposure
that would take on a country’s entire GDP to fund and then some.”33
When the shadow banking system34 met the Mimsky moment in 2007, which began the domino
effect that nearly imploded the global financial system by the fall of 2008, the Federal Reserve
responded by issuing unprecedented liquidity in the form of foreign exchange swaps to foreign
Central Banks. By December 2008, the value peaked at $583 billion from around zero in a move
that responded in correlated fashion with the strengthening of the US dollar at the time.35
Now, recall the circumstances of the colonials, and how Philipse recognized the opportunity of
a lifetime by cornering the supply of wampum. Depreciating wampum effectively increased the
outstanding size of liabilities to Indians in the form of wampum with respect to existing trade and
forward contracts. While Philipse had created the artificial short-squeeze in wampum, the effect then
is the essentially same as what happened in 2008—massive US dollar denominated liabilities on
bank balance sheets due to mismatched maturities36 caused an unprecedented short-squeeze.
32
McGuire, Patrick and von Peter, Götz (2009). “The US dollar shortage in global banking and the international
policy response.” Bank for International Settlements, BIS Working Papers No 291, October 2009.
33
Durden, Tyler. “How the Federal Reserve Bailed Out the World.” http://www.zerohedge.com (October 19, 2009).
34
Term “shadow banking system” is attributed to Paul McCulley of PIMCO, who coined it at the 2007 Jackson Hole
conference defining it as “the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.”
35
McGuire and von Peter (2009), “[T]he amount of US dollars provided globally through international dollar swap
lines surged in October 2008, and peaked at $583 billion in December 2008 (Federal Reserve Statistical Release
H.4.1).” pp. 20-21. Statistical Release H.4.1 is available at: http://www.federalreserve.gov/Releases/H41/20081211/
36
McGuire and von Peter (2009), “This endogenous rise in maturity mismatch… generated the global US dollar shortage.”
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Part III – Hamilton’s Central Bank Legacy
“It is one of those instances where the reasoner can produce an effect which seems remarkable to
his neighbor, because the latter has missed the one little point which is the basis of the deduction.”
~ Sherlock Holmes in “The Crooked Man”37
[This section is in draft form as of 2/15/2010 and will be published at a later date.]
37
Sherlock Holmes in “The Crooked Man” (Doubleday p. 412); The Memoirs of Sherlock Holmes (1893).
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