Over the last several years, most economic crises have been solvable by money. Swap lines. Bailouts. Central bank asset purchases, and so on. But now the world is experiencing a problem that money can't easily solve. When it comes to, for example, avoiding Russian energy, there's no simple solution. Money can't buy an instant energy changeover. This is all part of a new regime that Zoltan Pozsar, Managing Director and head of Global STIR Strategy at Credit Suisse, likens to Bretton Woods III. On this episode, he returns to spell out his framework, and what it means for financial markets, the dollar, and the new world economy overall.
Points of interest in the pod:
Zoltan describes the current monetary system and what’s changing — 04:28
On the four prices of money — 10:26
On commodities funding strains and a Lehman moment — 16:58
On physical money, shipping and commodities — 25:50
Whether the Fed should be tightening and future demand for U.S. debt — 34:47
Will we see new reserve currencies develop? — 40:23
Whether Bitcoin will be a reserve currency — 43:53
How will the U.S. fare in this new environment? — 47:47
Tracy Alloway: (00:00)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:05)
And I'm Joe Weisenthal.
Tracy: (00:07)
Joe you're in Vegas, right?
Joe: (00:10)
I am. I decided to take a little break from life and be in the desert for a couple days and play some poker. It’s pretty nice out here.
Tracy: (00:17)
Communing in the desert?
Joe: (00:18)
If I sound a little weird it's because I'm not in the studio with you.
Tracy: (00:23)
Do you know, this is kind of weird, but whenever I think of poker nowadays and poker chips, I always think -- this is probably just me -- but I always think of Zoltan Pozsar’s analogy of how reserves are kind of like poker chips. Do you remember that?
Joe: (00:38)
Yeah. Oh yeah. I was wondering how… that was a very elegant fold-in. I didn't see that coming, the current situation of our recording with this idea that is very important, which is that we have lots of different kinds of monies in the existing system, and they might even have the same name, like dollars dollars, dollars, but a lot of them are sort of like all pegged to each other one-to-one. Cash, money in your bank account, bank account money held at the Federal Reserve, not that dissimilar from dollar poker chips in a casino.
Tracy: (01:09)
Right. But this is something that's been coming up in various ways on recent episodes of Odd Lots, this idea that you do have different types of money. And at any one point of time, there could be changes in the world thinks of that money or how it uses it. And, you know, for years and years we've had the eurodollar system, basically these synthetic dollars that are sort of sloshing around in the global financial system. We've had reserves courtesy of the central banks and quantitative easing and things like that. And now -- I hesitate to use the term inflection point -- but once again, it feels like as central banks begin to tighten, as we see this big question mark over the role of the dollar given the sanctions against Russia, it feels like this question of ‘What is money? What could a new monetary system actually look like?’ is coming again to the fore.
Joe: (02:03)
Yeah, exactly right. And then the other element that's extremely big right now is, and the Russian sanctions were part of this, but it's clear that like FX reserves aren't enough security. Especially in a world of commodity disruption, supply chain breakdowns, things like that. It's like, it's great to have money. It's great to have foreign currencies, particularly if you're a vulnerable emerging market and so forth. But, as Russia has discovered, you could lose access to your FX reserves, but more importantly…
Tracy:
And Afghanistan.
Joe:
That's right. But more importantly, even if you have ample reserves, you also need food. You also need wheat. You also need natural gas. If you're in Canada, maybe you need a maple syrup stockpile. In the U.S., of course we just saw the announced release of some of the SPR oil. These are also very important. So we're also in a regime in which physical things really matter again big time.
Tracy: (02:58)
Right. And there's not necessarily a guarantee that, you know, the financialized commodities are going to be, I guess, redeemable one for one against the physical commodities. It feels like that's what we're learning right now. Well, whenever we're talking about big money ideas, there is of course, one person who we turn to, and I already mentioned his name, but we are going to be speaking once again, Zoltan Pozsar, he's a strategist at Credit Suisse, a multi-time Odd Lots guest at this point. And he's been writing about these themes, including an earlier note, a few weeks ago, talking about the threat to the dollar’s dominance. And he's back to go into further detail about how he sees a new monetary system actually evolving.
Joe: (03:46)
I feel like after we did that last episode with him a few weeks ago, bam, everyone wanted to be like, okay, the dollar system is in trouble. Yeah. But what's next? Then he published what's next. And now he’s going to talk to us about what's next. But we’re having a fast turnaround because there's so much demand for like the next chapter of this story.
Tracy: (04:02)
It's the natural cycle. Zoltan writes something and then he comes on Odd Lots to talk about it. So Zoltan thank you so much for for coming back on the show.
Zoltan: (04:10)
Very nice to be back.
Tracy: (04:12)
So why don't we start, instead of looking forwards, why don't we begin by looking backwards and why don't you give us your overview of what the existing monetary system actually looks like? Because I think that's gonna help us frame your vision of the future.
Zoltan: (04:28)
Yeah. So before we look at the existing system, let's just, you know, go all the way back to the second world war and you know, the system that grew out of that. And that was the original Bretton Woods system, you know, this was the unipolar world where the U.S. basically shaped the course of things to come. You know, the Eurodollar was not the dominant currency back then immediately after the end of the second world war. But it became the dominant reserve currency and the dominant phenomenon over the 40, 50 years. And so, you know, Bretton Woods was about gold. Everything was linked to gold. And then in 1971, we took the dollar off gold. And then we basically said that we will guarantee price stability. And that's what became the Fed's mantra and everything, in the fiscal and monetary domains, was about making sure that that price stability is there as an anchor to a currency that was only a paper form of money.
And then the system evolved further within this stable prices nominal world that we had once we removed the peg to gold. We had a crisis in 1997 of fixed exchange rates. Southeast Asia then started to accumulate reserves. As a lesson from that in 2000, three years later, China joined the WTO. They started to export and manufacture everything for the rest of the world. They accumulated a huge amount of FX reserves. All of these reserves basically were recycled into U.S. Treasuries. This is, you know, Greenspan’s conundrum, you know, he's hiking rates but the back end of the curve doesn't move. Ben Bernanke called it the global savings glut. Before Ben Bernanke, David Folkerts-Landau at Deutsche Bank and Mike Dooley, they called this Bretton Woods II.
So basically the shift from Bretton Woods to Bretton Woods II is the shift from a gold-backed dollar to a dollar governed by the idea that we guarantee price stability. And because we guarantee price stability, it's okay to accumulate your dollar reserves in Treasury securities. And you know, that system was fine, but again, you have Minsky moments and Paul McCulley and, you know, stability begets instability and shadow banking. So all that system blew up in 2008 and then accumulation of U.S. Treasury securities stopped in certain parts of the world. And then the big central banks, like the Fed and the ECB started to buy the debt of their own governments and that, you know, led to income inequality and soaring stock prices. And some of the things that we are kind of dealing with at the present. And the last time I was on the show, you know, we talked about this piece that I wrote about how we need a new Volker moment and a little bit of volatility and risk assets and wealth destruction to bring people back into the labor force and all that stuff.
And so then, then instead of a Volker moment, we got a Putin moment and we basically have war and out of this war, something will also emerge. And you know, out of this, I think this Bretton Woods III framework that I started to kind of develop and run with is a world where we are, again, going to go back to commodity-backed money where gold, once again, is going to play a big role and not just gold, but I think all forms of commodities. Because, you know, this crisis is about commodities. This is about the largest commodity exporter. This is about metals and grains and energy. And so in a way you’re back to where you started from after the second world war, but it's going to be a little bit more different, and a little bit more complex. It’s not just gold, but it’s commodities more broadly.
And it's not just one currency that's dominant, but there is going to be, you know, as a reflection of a multipolar world, a multitude of currencies. You know, rubles if you want to get Russian oil. RMB, if you want to get stuff out of China. You have the dollar if you trade the U.S., and so it's a fragmented system where commodities play a much bigger role and where price stability is a big issue in certain parts of the growth. So this is a very complex mosaic that we need to navigate here. And, you know, that's what Brenton Woods III is about.
Joe: (09:26)
That was fantastic. I want to, you know, before we even dive further into what this Bretton Woods III looks like, I was reading your latest note and you cite some ideas from your sometimes co-author and one-time co-guest on this podcast, Perry Mehrling, which talks about essentially about the four prices of money. And I don't think many people really think about that. They think, okay, maybe the interest rate or the risk free rate at a given country is sort of a price of money, so to speak, and the Fed adjusts that. But as you point out, money is priced in many different ways. Can you talk a little bit about that? Why is that an important idea to understand? That any given currency has so many different inherent prices?
Zoltan: (10:06)
Yes, yes. Actually I think the next guest you should have after me is Perry. Because from what I understand, he doesn't agree with me. He thinks, the dollar reigns supreme. And, and obviously he's going to have this beautiful new book “Money and Empire: Charles P. Kindleberger and the Dollar System.”
Joe: (10:25)
Oh, well, we'll definitely reach out.
Zoltan: (10:26)
And, you know, that's about why the dollar is the dominant currency and how it became that, and from what I understand, haven't caught up with him in a couple of months, he does not agree with Bretton Woods III, so it will be a wonderful kind of counter thesis. I pretty much owe the structure of my understanding of the world to Perry, his writings and Perry’s teachings. So I think he has done a tremendous service to anyone who's trying to understand monetary frameworks, and money markets and whatnot.
So with that, so the four prices of Perry. So there's four prices, which are par, interest, foreign exchange and the price level. So what does he mean by this? Par basically means that currency and a bank deposit and a bank deposit at JP Morgan and a bank deposit at Citibank, always trade at one. Okay. So money fund shares and banks, all that stuff, right. Par broke in 2008, right? The money funds broke the buck, you know, bank deposits were not certain. So you need to increase deposit insurance, all that stuff.
Interest is about the time value of money, money today versus money tomorrow. You know what it costs for me to part with my liquidity, if I lend it to you for three months to go play in a desert in Vegas.
Joe:
I'm good for it, by the way.
Zoltan:
Yes, yes, yes. And then, so that's the time value, just the basic idea. And then there's obviously different money markets. So there's a repo market, the FX swap market, unsecured money, you know, these all have like different prices and so there is spreads between OIS curves and these other money markets.
Interest. Interest you think about two ways. You either trade it in terms of OIS. You know, how many times the Fed is going to hike? Are we gonna hike? Are we gonna cut rates? Or you trade the basis around OIS, you know, cross-currency basis blows out because it's money fund reform, or it blows out because Covid-19 hits and everybody needs to fund credit lines that corporations are taking down. You know, this is where you think about the bond basis that blew up in early 2020 when the pandemic hit. So, you know, this is about basis between various money market curves and various prices of money.
Foreign exchange is, you know, fixed or floating exchange rates, the price of dollar versus the price of other currencies. You know, foreign exchange is what broke in 1997, for example. When South Korea abandoned fixed FX peg.
And then there's the price level, which is basically the price of commodities in terms of money. And by that, you know, we mean basically energy, grains, metals, and all the goods that get created from these raw materials.
And so once again, the par, interest, foreign exchange, and price level prices of money, as Perry has taught us, is the four prices. And basically this little historical review that I gave you tells you that crises that happen, the big crises that have happened since 1997, which again, Southeast Asia, 2008 and March, 2020, these were all crises of money. Okay. 1997 was about a broken FX peg, 2008 was a crisis of par and March, 2020 when the bond basis blew up, that was a crisis of interest. Okay. Price level type stuff, you know, the price of commodities in terms of money hasn't really been a big deal since 1973. So we were lucky. And we basically had only those types of crises where the central bank has to step into police a nominal gain, right? Because it's a nominal exchange rate and it's a nominal bond basis.
And it's a nominal thing that, you know, the Reserve Primary Fund cannot pay par back. And so it was a dollar problem and a euro problem. And in the case of the sovereign debt crisis and a central bank that deals with a nominal crisis in its own currency, it has it easy because what do you do as a central bank? You provide emergency liquidity to people that have the troubled assets they can't fund, and you also buy the trouble assets, which is either some peripheral sovereign debt or subprime mortgages or Treasury securities in March, 2020. I mean, in 1997, with South Korea was different because it was the IMF that had to step in to provide the dollars, because we didn’t have the swap lines. But the bottom line is these are all crises where someone has to put balance sheet on the line, buy the trouble assets, pump in liquidity and problem solve. Okay. Today it's different because you know, the price level is where real meets nominal. You are talking about the price of real goods in nominal terms and central banks can't do a bloody thing about commodity shortages, you know, the type of environment that we are going through now. And I'm sure you'll ask next, you know, so there's the four pillars of commodity trading, we’ll come to that next, but that's basically the four prices.
Tracy: (16:12)
Can I ask just before we go into the four real pillars or the four pillars of commodities, you know, you've been writing a lot about funding stresses showing up as a result of the volatility that we've seen in commodities recently. So I guess I'm wondering, is there a tension there between saying that commodities as funding collateral can suddenly decline in price and cause a lot of problems for people and also including commodities as part of the sort of monetary framework of the future? Like how do you sort of think about that tension?
Zoltan: (16:50)
Yes. So first of all, you always like to kind of ask me the things I'm wrong about. So, yes.
Tracy: (16:57)
I have to.
Zoltan: (16:58)
But yes, I know this is very interesting because I was very right, but I was very wrong. You know, I was right that the commodity derivative complex and, and the commodity trading world is going to have a liquidity crisis. We are having that liquidity crisis. Where I was wrong is that none of this is gonna show up in traditional measures of funding stress. Hmm. And, you know, you always learn from your mistakes. What I have learned, the commodity trading world completely funds itself through bank credit lines.
They do not tap the FX swap market. They do not issue CP. They don't do anything in the repo market because they don't have the type of financial assets that the repo market would accept as collateral for funding. So you then basically have a world where you have, okay, the two extremes, you know, you have the commodity trading world on left, and then you have one and a half trillion of cash in the reverse repo facility sitting there. And then you have the big banks, again, we always use JP Morgan as the poster child, you have $500 billion that JP Morgan holds at the Federal Reserve Bank of New York. Again, the funding stresses that the commodity world is having are being lessened by more and more and more lending that the big banks provide to commodity traders. But because the big banks are sitting on piles of cash, okay, they can just lend that money to the commodity traders in need, but they don't need to raise that money on the margin.
And so, because they don't have to raise money on the margin, they just don't tap the repo market or the FX swap and they don't have to issue CP. So, you know, the traditional kind of STIR domain of spreads is very calm. However, that doesn't mean that there are no stresses in the commodity trading world. And we know that there are stresses because Peabody Energy had to pay 10% interest when they took their credit line from Goldman Sachs. I think Bloomberg wrote an article about this, right? And we know that Trafigura was in the news about taking credit line from a consortium of four banks, then trying to raise equity from Blackstone. Then, you know, a day later, all the commodity traders were basically writing a letter to central banks that they need emergency liquidity support.
So the strain is there. The strain has a multitude of sources here, again, back to this idea that everything that the commodity traders do is financed by banks. And again, I think, you know, we all live and learn and learn as we go. You know, one thing, for example, I've learned from commodity traders is that when it comes to these credit lines that the traders use to finance themselves is, you know, you get X amount of credit through a credit line from a bank. You draw 705 of it to lease the ship, to fill up the ship with cargo, but you don't use a hundred percent of that credit line because while the goods are in transit, you will have to pay variation margin, right? I mean, the prices go up, prices go down, depending on the physical side of the trade you are on, you will either get paid money or you will have to pay money.
And for that too, you will tap a credit line from a bank. And so when you have a price shock, and when you have all this volatility, you A) need more money to move the same amount of physical goods around, and you also need more credit to be able to pay margin on all this cargo as it is in transit. So this is where the liquidity strains are coming from. And you know, it's a mess because, you know, banks are basically facing credit risk when they are lending into the commodities world. And not only that, but basically you have a shock in terms of the nominal amount of money you need to lend, the nominal amount of balance sheet that you commit to this world. And, you know, I guess one lesson from this, and again, conceptually, and again, in extreme terms, just to concentrate the mind and to spark some thinking, the value of say $500 billion of reserves at the Fed, if you're a large bank, is worth a lot more in a world where inflation is low and stable and commodity prices are low and stable, where the only thing you have to worry about is, you know, where am I gonna lend my next $10, $50, $30 billion to harvest the next cross-currency basis?
So $500 is worth a lot more in a world like that than in a world where basically you need to lend an extra hundred billion dollars to all sorts of commodity traders to move around, to finance all commodities imaginable. So that is happening now, which is another way of saying that this lowest comfortable level of reserves that we like to think about in terms of, you know, how much QT can the Fed do and how much reserves can take out, that LCLOR, again, the minimum level of reserves the banks feel comfortable of running with, is going up as we speak. We don't know how much because it's unobservable, but you know, the Fed does these periodic surveys about LCLOR, I think it's time to do a survey like that now, because these are issues. And I don't think that the issues in a commodity world are going to fade away anytime soon.
They're probably going to get much, much worse. There is liquidity strains. They just don't show up as such. And by the way, the moment some big name can't pay and defaults as a result. And again, you can use your imagination. It doesn't have to be a commodity trader. It can all also be a CCP. The default fund of a CCP, someone can pay margin in a futures exchange. You know, the LME case with nickel is an interesting case in point. But, and again, the other thing that people like to rub in as well, this was not a Lehman 2.0 after all, but give me a break. Lehman took a year to happen. You know, BNP couldn't fund the subprime, couldn't value the subprime exposure in its money funds in August of ‘07. And by the time we got to Lehman, 12 months had passed.
I think the writing is all over the wall, that a lot of things are happening. A lot of things have happened in 30 days. This is like, I think 2008 kind of compressed in time. And again, things can get worse. So I think we need to be approaching this with an open mind. We need to be thinking about a lot of scenarios and we should not assume that just because we haven't had any blow ups to date, there won't be any, but once those blow ups come, the flavor in the markets are going to change because then counterparty risk is going to be something you worry about, which is not something we have to worry about since 2008. So, you know, keep an open mind. And I think we need to be humble. And you know, I'm the first one to recognize that…
Joe: (24:04)
Keep an open mind about the awful things that could be coming in the next year?
Zoltan: (24:09)
Yes. And again, I'm the first person to, you know, admit you can be right but lose a lot of money because you express your views wrongly. So yes, you know, FRA-OIS and cross-currency would not have been the right way to express any of these things, but they are happening nonetheless, and things are not getting better. They're getting worse.
Joe: (24:29)
I've found this already to be incredibly helpful. And just thinking about like, okay, a commodity, a price level shock is very different and fundamentally other types of like financial nominal shocks, it might be politically unpalatable. It might have been politically unpalatable to do Tarp, or maybe for the euro crisis, it might have been politically unpalatable to bail out peripheral spreads, but it could be done and it can kind of be done at the push of a button. And it's kind of trivially simple if you build up the will. And then fundamentally, commodity shocks are just not like that. They are not in a category where there's a button you can press and solve it. And so why don't you talk about that further, because that's sort of the direction of this Bretton Woods III vision, is the challenge that arises in a period of commodity volatility. And you talked a little bit about it just now with what it means to liquidity in the system and funding various margin positions and so forth. Why don't you sort of like build from there about the sort of implications and the differences of a sort of commodity-driven economy.
Zoltan: (25:35)
Yes. So again, maybe we should just start from the four prices of money and then build out the mirror image of all that in the physical world.
Joe: (25:41)
Let's do that. Exactly.
Zoltan: (25:50)
The fourth price is the price level, the price of commodities in money, and then so commodities. So what what's the thing about commodities? Well, commodities, you know, the dirty thing about commodities, the ugly thing about commodities, is that most of it is coming from the developing world. And most of it is being consumed by the developed world, right? I mean, Russia, China, OPEC countries, you know the drill, right? [That’s] First. Second, all these commodities, not only that you can't print them like money, but you need to move them around. You know, you need to ship them. Most of this is seaborne. You know, you don't fly commodities, you ship them, you know, wet cargo, dry cargo, much like in the world of money. You know, when we think about, when then we talked about, you know, the token system and how reserves move around in the money markets, you always need balance sheets for some bank to borrow here and lend there and harvest some funding spread, you know, funding, repo, lending, FX swaps make a spread.
In the world of physical commodities that balance sheet is basically a ship. You load cargo in port A, you bring it to port B, you know, the cargo is not money. The cargo is a commodity, but you encumber capacity, ship capacity, to move stuff around. So there's that. And then of course, you know, there's the par value of money equivalent in the physical world, which is protection. Protection because, you know, as I've learned from Paul McCulley, you know, money is either a purely public or a public-private partnership, which in English means banking doesn't work unless there is a central bank, right? Because nobody can take their money out of a bank all at the same time, you need someone who's gonna do the protection if that happens. Similarly, when you move all these foreign cargos from the developing world to the developed world on ships, which are like balance sheets and are like kind of banks, the real world equivalence of the nominal world of money protection in the case of commodities is about making sure that sea lanes are open.
Straits are open. You know, there's no pirates, no one's blocking the passage of your ships, that type of stuff. And that's also something that the state needs to be involved in because you know, the high seas have to be policed. I mean, it's basic stuff, you know, what the Navy is to shipping lanes, that's exactly the same as the Fed is to the promise of par value. And you know, Bretton Woods II, as a concept was born when China started to accumulate FX reserves, but really it existed much earlier -- ever since, you know, the ’73 oil price shock where, you know, you ship oil, you get dollars. And then you reinvest those dollars into Treasuries. China did the same, but they did it with goods. But that's basically Bretton Woods II, that’s eurodollars, that’s petrodollars, that's all of that.
And, you know, we had a unipolar world where everything flows to the U.S. and everything was paid for in dollars and all those dollars were recycled back into Treasuries. And so now there's a break in history and now we are learning that all the commodities, I mean, not all of them, but a lot of them in the case of Russia come from, you know, Russia is the single largest commodity exporter in the world. Russia and Ukraine, you know, wheat and all that comes from that, is a very important bloc when it comes to the supply of physical commodities and things are getting gummed up. Commodity doesn't come out of that region as easily. If it comes out of that region easily, you know, now they don't accept dollars as a form of payment. They want rubles as a form of payment.
If Europe doesn't take the raw material, you know, crude oil and whatnot that comes out of Russia, Russia will have to reroute the shipment of those to the east – China -- which is going to buy cheap Russian stuff. But if you do that, then you basically have to revamp shipping lanes. You basically end up as I talk about this in my piece yesterday, with a severe shortage of vessels capable of moving oil cargo on long distances. There's a big difference between shuttling Baltic crude from Primorsk to Hamburg than it is to ship it from the same port to somewhere in Shanghai. Okay. So you end up with shipping capacity issues. If China is now buying cheap Russian oil, then they're gonna buy less Middle Eastern oil. And then, you know, all the Middle Eastern oil’s gonna now have to go to Europe because Europe finds it acceptable to buy it from the Middle East, but then all of that goes through the Suez Canal.
You know, do you have the right ship to transport that oil? If it's a VLCC tanker, then that cannot pass through the canal. So, you know, it's going to take more time to ship stuff around. It's going to take more types of specific types of ships to ship stuff around. There will be ship shortages as a direct analog to balance sheet shortages and GSIB shortages in the financial world. You will have issues of Suez, Egypt, wheat, oil. Egypt is a huge importer of wheat from Ukraine, for example, and as any country that doesn't have a lot of wheat stockpiles, you're going to have to pay up for wheat on the of world markets. How do you extract the poundof flesh from somewhere else so that you can pay for your wheat if there's a food shortage? You can hike the transit fees through the Suez Canal. When you think about the enormity and the whole plumbing that underlines the physical movement and trading of commodities, it’s extremely complex.
And in 2008, nobody really understood the plumbing because they didn't have to because it worked fine until it didn't. Okay. And I think we are again, 30 days into this war and we are 30 days into figuring out how basically all these things that we used to do very efficiently are going to be done in the future and how the re-routing of these ships and, you know, boycotting commodities from here and giving it to there, how that's all going to stay with the level of prices. But basically, you know, Bretton Woods III is about that. And not only about that, but also redrawing the terms in which we accept payments. Russia is now selling in rubles. The Saudis are going to sell, consider selling oil to China and invoicing it in RMB.
The big point about that is that when we have the petrodollar and the Eurodollar as the dominant form of international money, you guys know, probably everybody who listens knows, banks make loans and create deposits, right? That's how things get done. When Glencore brings commodities from port A to port B, you know, they go to JP Morgan to borrow money to lease a ship, then another pile of money to fill up the ship. Then another pile of money to pay margin as that cargo is in transit, and you need to post margin on futures. So when everything is priced in dollars, you know, you borrow dollars to move stuff around. The dollar deposits get created. Glencore gives it to the Saudis, the Saudis give it to SAMA and SAMA shows up at a Treasury auction. You have eurodollars that are created through this whole process that will then get recycled into Treasuries. The U.S. didn't really have to think about demand for Treasuries for the past, I don't know, ever since 1973, because this was the game we played.
So now, if all of a sudden, somebody starts to price things in rubles, somebody starts to price things in RMB, the creation of Eurodollars on the margin is going to change. I'm not saying it's going to go down, but the pace of it is definitely going to change. And again, the U.S. Treasury needs to think about this because if you have less creation of eurodollars, you will have to change the way you fund your issuance. If the petrodollar recycler is not gonna show up at auctions, someone will have to. The Fed, right. Otherwise you have a failed auction. So I think these are all things that, you know, this is Bretton Woods III, basically, right? And so this is not immediate, it's inevitable, but it’s started.
Tracy: (34:47)
You just touched on demand for Treasuries there. And you touched on quantitative tightening earlier and the idea that given everything that's happening in the world right now, you know, shipping is more expensive. Commodities are more expensive, there's lower risk appetite. You need to conserve balance sheet, things like that, that there's gonna be higher demand for bank reserves from the banks. Should the Fed be doing quantitative tightening at this moment in time? It seems like timing isn't exactly optimal.
Zoltan: (35:19)
Yes. Well, sure. They should because there is a lot of excess liquidity in the system. And just to be clear, the knee jerk response is yes, we need higher rates. We need the hike, and we need to shrink the balance sheet, which makes sense, because, you know, we blew up the balance sheet for the past decade and a half because inflation was persistently too low. And we tried to reflate, right? So now that inflation is here we need to deflate, right? Fine. And also, you know, before the war, I wrote a lot about so how is this QT gonna play out? There's going to be beautiful QT and ugly QT, active QT versus passive QT. And now you just to do a war and peace edition, you know.
Bretton Woods III messes this up for two reasons. Number one, as we mentioned before, the lowest comfortable level of reserves is going up. So banks need more reserves all else equal, which means that when you think about the marginal buyer of Treasuries as QT progresses I would say that in this ‘new world order’ that we are in, banks will have less appetite to buy Treasuries for their portfolios, trade reserves for Treasuries than before the war, because credit needs from the commodity trading world, you know, and from everybody else ultimately, right, because everybody will have to pay more for goods and trade finance and all that, is going up. So they will buy less than, you know, all this money that's in the reverse repo facility is going to be more important much earlier on in the QT process than before. And so there we have one and a half trillion dollars or so, and so fine. But then again, the other thing about Bretton Woods III is that, you know, we are just talking about the creation of less eurodollars on the margin and who creates money in the system? The central bank and private banks.
And this handoff between, you know, the Fed shrinks the balance sheet takes money out of the system that always needs to be understood in the context of how much lending and money creation is in the system, because the Fed can take out money, but if there's more private deposits and more private money getting created through the banking system, you know, the two things can offset each other. But now we are saying is the Fed is going to take liquidity out, the creation of eurodollars is going to slow on the margin. So the OPEC countries and whoever used to recycle eurodollars and petrodollars is not going to do as much of that. And so that's an issue. Then another issue, this whole idea of, okay, well, you know, you just froze half a trillion dollars of G7 inside money. So maybe it's time to diversify away from our existing holdings of U.S. Treasuries.
So maybe some reserve manager, is not only not gonna buy and recycle less eurodollars, but they're going to trim their exposure to U.S. Treasuries. And so, you know, I say all this because, you know, if the banks don't buy and the Fed doesn't buy, and there's less petrodollar recycling, and there is diversification from existing holdings of FX reserves, it inevitably means that those balances in the overnight reverse repo facility will be soaked up pretty quickly through poor quality demand, but demand nonetheless. The guys that fund in the repo market are basically dealers that are getting bagged up with Treasury inventory and the RV funds, which are in it for a basis. I mean, it's all a levered position – long the bond, short the future, fund in repo, that type of stuff. Not a pretty form of demand, but a form of demand, nonetheless. But again, you know, you go from steady sleepy, reliable buyers in the Middle East and China to fast money stuff that is levered, but it's gonna be fine because we have the standing repo facility. So even if you end up with a repo deficit, you know, thank God the standing repo facility is there. So you can just kind of see this, you know, another legacy of Bretton Woods III will be that all this is going to be less international. It's going to be more domestic. It's going to be some domestic repo-funded entity that's going to fund this, not the rest of the world.
Joe: (39:38)
Let's talk about the other currencies and the roles that they'll play. And so, as you mentioned, okay, Russia is going to be selling its commodity exports and oil and gas, or maybe Saudi Arabia starts selling and invoicing in RMB for sales to China. And so then the question naturally emerges like, well, how significant is this? And there are a lot of arguments against the role of these currencies, I mean, rule of law questions and market depth and the degree to which the Chinese will ever open up its capital accounts and so forth. So where do you see these going? Because these headlines get everyone excited. Like, oh, oil might be sold in RMB, what does it mean? But there are some difficulties for these currencies to overcome to have any more significance.
Zoltan: (40:23)
Sure. People are not born who they become, right? So you're born as a baby and then, you know, you learn to walk and talk and then we all end up doing something with our lives, right? So again, back to back to where we started from. After the second world war, the U.S. dollar was not what it is today. It became that. No currency is born a reserve currency. It becomes it. Sterling was what it was and then the dollar came and then dollars became eurodollars. The RMB is what it is, and then it will become something else. I mean, it's kind of funny and it makes more sense in the present, but you know, we’re all obsessed about, you know, the internationalization of the RMB and all the correspondent banking stuff and all the Hong Kong onshore and the offshore and blah blah.
All that stuff was the baby is born. The baby learning to walk. The baby is walking. That's the plumbing, that's the basic stuff. And then there's a catalyst like the war that we are looking at now, and the whole conversation we are having now, and then things will change, but then you basically have an infrastructure to build on, and then things can go very fast. I also get it that China has a closed capital account, and people like to have open capital accounts, but for Christsakes, what's the difference between an open capital account that ex-poste can be shut in the case of the CBR, versus a closed capital account that you know, that overtime is going to open up. People also tend to forget when China became a part of the World Trade Organization, and, you know, it started to accumulate surpluses.
I mean, the surpluses were first accumulated in bank deposits and then the Chinese started to buy bills. And then they start started to buy two-year, five-year, 10-year Treasuries, and then they bought mortgages. Then they funded CIC. And then they started to do private equity deals, big stake in Blackstone, I think, right, in 2008 they bought. The point is surpluses accumulate. And as more and more accumulate, you change the way you do things. If the dollar became the dollar through lend lease, you know, we lend you money and then you lease stuff from us. You know, maybe the Chinese are now going to go lend you money. And then maybe you buy our corn and wheat reserves or something like that. It doesn't matter. The more trade the rest of the world is invoicing to China in RMB, the rest of the world is to accumulate RMB surpluses.
Those surpluses initially will inevitably accumulate on Chinese banks' balance sheets. And then the Chinese banks get to a point that we just don't wanna have all these surplus on our balance sheet, because it's using too much capacity. State, please take it off our books. The state will start issuing debt to take all that liquidity surplus off the balance sheet of the Chinese banks. And then as the rest of the world accumulates more, you know, and this is gonna start with central bank bills again, you know, held by foreigners and then the foreigners they accumulate more, they will have more and more long-term. And so that's going to be the birth and the development of the debt securities market in China. I mean, all this stuff is a step by step process. Again, just as a child is born and learns to walk and talk and does other things in life. So I think this is going to be a path. This is, I think, inevitable. I think it started already. The infrastructure for it has already been built. And I think this is going to pick up from here going forward
Tracy: (43:53)
On the topic of alternate currencies. This is something that came up in one of your previous research items where you were talking about the possibility of people holding reserves in something other than dollars. And you mentioned Bitcoin, but it had this big caveat around it, which was you put in parentheses “if Bitcoin still exists by then.” What do you see as Bitcoin's utility here, if any?
Zoltan: (44:20)
Joe sparked a kind of bilateral conversation on that too via email, which was interesting. And by the way, Joe my caps lock got stock. So whatever you said in your article is capitalized. It was not intentional.
Joe: (44:33)
Oh, I thought you were very excited.
Zoltan: (44:35)
No, no.
Joe: (44:36)
I was like, Zoltan is extremely excited.
Tracy: (44:39)
It is in caps. It says a “SOVEREIGN HAS TO BE INVOLVED WITH THE QUESTION OF MONEY and Bitcoin is basically short the sovereign (conceptually).”
Zoltan: (44:47)
You know, Bitcoin is short the sovereign, which is precisely why you can't have Bitcoin in China because you can't be short the sovereign in China, there's no outlet for political frustrations. It's one party. Not, not to be facetious or anything here, but I mean, if we are talking about commodity shortages and energy shortages, and if it takes a tremendous amount of energy to mine the marginal Bitcoin, I mean, that just makes no sense.
Tracy: (45:14)
You mean energy is wasted.
Zoltan: (45:16)
I mean, energy is going to be wasted on mining something that, yeah.
Joe: (45:24)
So the question is why would governments who are already facing commodity shortages continue to allow for the energy intensive mining of the thing that’s short the sovereign?
Zoltan: (45:37)
Yes. I mean, if you are releasing record amounts from the strategic petroleum reserve and like, I don't know, see what I mean? So it's like if all the strategic petroleum reserves are empty well, and then, you know, people are using corn to make ethanol and people are hungry and like you're burning ethanol to mine Bitcoin or something, that makes no sense. That's one. And the other thing, the whole central bank digital currency, how does that fit into this? I think Bretton Woods III is not about that because we are talking about rethinking reserve assets. This is FX reserves, which is a nominal pile of wealth versus commodity reserves or real versus nominal. The central bank digital currency is a liability side question for central banks, right. What technology do I use to distribute my liabilities? This is like landlines versus cell phones. Or you stream your movies or you shlep to a video store and get a VHS tape, stick it into a machine to watch it. Bretton Woods III is about how do you invoice stuff? How do you get stuff from a port A to port B? And once you get paid, what do you choose as your optimal reserve? Is it a real asset? Is it a nominal asset? That type of stuff.
Joe: (46:54)
You know, listening to this conversation, it does not necessarily strike me as a negative environment for the U.S. especially vis a vis other rich countries because okay, maybe the dollar doesn't have the same status. On the other hand, unlike other rich countries, [there’s] tremendous ability, at least in theory, to produce oil, tons of natural gas, tons of open space for wheat, corn and soy. Metals. If we want to mine them, we have rare earths here. Some of the more advanced tech, it's sort of a political choice when we're going, and of course our military, and so to the degree that the military is the price of shipping or the price of protection for a lot of shipping lines, obviously the U.S. is far and away is still the strongest military in the world. It seems like even in a new regime, the U.S. has tremendous built-in advantages and stores of wealth.
Zoltan: (47:47)
So yes. When you think about, let's say three regions, you know, U.S., Europe, Asia, China. Eurasia. Again, conceptually very high level. The country that's buying stuff on sale, cheaply, stocking up on stuff, is going to be China, right? Because that's where all the Russian commodities are going to go. You know, big picture. The country that can fill some of the, you know, you can frack your way out of this or grow your wheat out of this. U.S. is fine. I think Europe is in a very delicate position because this is basically, you know, between Russia and Europe and you know, the German reliance on Russian fossil fuels. And, and so yes, you know, I think this is, you know, Bretton Woods III, I think is also a world where the east certainly has some, I don't know, ‘Renaissance’ and it has it better. And inflation is less of a problem there.
The West has ‘some relative decline.’ I’m not gonna say go down the tubes, but you know, this is a multipolar world, which is not meant to be, you know, status of quo, but you know, someone rises someone declines, but still too dominant. Inflation is probably more of a problem in the West. And then I think Europe is very much in the middle. So now when you think about this medium term, what it means for commodities and inflation and who wins, who loses. Some of the themes that come out of this is Larry Fink is right, or rather is probably more informed than all of us on this forum. I do agree that globalization, as we know it, is probably over. So what are some of the things that are coming out of that and some of this conversation? Resource nationalism is a part of Bretton Woods III. More military spending, you know, in Europe, for sure. In the U.S., at least sea lanes, but not as definitely coming out of this. Stockpiling of commodities is definitely coming out of this. Rethinking supply chains is definitely coming out of this.
Bretton Woods II was about a singular supply chain. Foxconn, making everything. And Bretton Woods III, if all that world order is torn up and we have to duplicate production facilities and supply chains and all this, we need to provide a lot of investment and capital into that. So, you know, not to mention all the ESG and cutting, you know, the investments related to that. I think the investment needs for the world that Bretton Woods III reflects is going to need more commodities is going to need more capital. And so, you know, the West, I think has things to worry about because, you know, we are basically talking about upping investment in the West at the expense of consumption, which is exactly the mirror image of the problem China has, which is they have too much investment and too little consumption. Like even kicking it even even higher in the hierarchy, the whole conversation, I think China needs a stronger exchange rate and the U.S. needs a weaker exchange rate, kind of, more consumption, less investment there, more investment, less consumption here. The types of investments that we are talking about are investments that are going to be driven by the state and by corporations as they rethink their existence.
Tracy: (51:10)
Zoltan, I feel like we could talk about this for hours, but we're going have to leave it there. Thanks so much for coming back on.
Joe: (51:16)
That was fantastic.
Tracy: (51:16)
Yeah. That was really good.
Zoltan: (51:18)
Thank you very much, guys!
Tracy: (51:19)
It's always great having Zoltan on the show. And one of the things that came out of that is, I mean, I really think the sort of summary of all of it is that if you are interested in interest rates and the economy, you know, say you're a short-term interest rate strategist or a STIR trader or whatever, you're gonna have to start paying attention to shipping and commodities, and all the micro in order to do the macro.
Joe: (51:41)
You know what I thought that was one of the best conversations ever to think, you know, people always talk about turning points, right? Oh, it's an inflection point. It's a turning point post-dollar. It’s, you know, we've been talking it about for years. I thought that was one of the best conversations I've ever heard that actually put some like meat on the bones, so to speak, of what that looks like and thinking about what are the price equivalents, when it comes to commodities storage protection, the equivalent of maintaining par and then what institutions that have to build up around that to sort of recreate a more commodity-centric world economy is like extremely, extremely interesting.
Tracy: (52:17)
Right. And then just underscoring what a poor position a lot of the central banks are in, in order to do this. Because under Zoltan’s framework, you know, this idea of you have the sort of nominal, monetary stuff, things like price levels and par and interest, or the future value of money, stuff like that. But the problem is emanating from the real, which of course, central banks don't really have any control over.
Joe: (52:43)
Right. We can hope, okay, if we slow things down a little bit, tap the breaks, maybe things are okay if we get to be easing in the price of oil, but everybody knows, I mean, everybody knows that the issues that are arising right now, at least some of them like, particularly on the food and energy side are pretty far from like something that the Fed, the central bank, let alone even the Fed, can handle.
Tracy: (53:05)
Yeah. And I mean, solve. The other point he made is that the last time the Fed really had to fight inflation, which would've been with Volker in the sort of late 70s, early 1980s, that it was such a different world then. And a lot of the problems were sort of emanating from a space where the central bank could have an impact and it was doing it in a sort of maybe not totally unilateral world, but a more cohesive West certainly. And people could sort of follow suit, and now that might not be as possible.
Joe: (53:37)
I just wanna say, I love -- just going back -- I love thinking about like this analogy. So it's like, what is the commodity equivalent of balance sheet space? And you talked about like ship space on ships, shipping. It's so interesting to like try, I find it to be a very useful exercise to think about these different things like interest rates and, you know, obviously curves or what's the equivalent of a yield curve? And obviously like a commodities futures, curve, things that. It's a very useful thought exercise to think about how strains might emerge and how government policies might have to be different in this new world
Tracy: (54:16)
And poker chips as tokens, synthetic dollars.
Joe: (54:19)
And poker chips. Still pegged one to one against the dollar at this point.
Tracy: (54:27)
Excellent. All right. Shall we leave it there?
Joe: (54:29)
Let's leave it there.