AIG wasn't in trouble because they had written a bunch of bad insurance policies?
Uhm, credit default swaps, interest rate swaps, and other such derivatives are essentially unregulated insurance policies that lack any meaningful capital to back them.
Snyder's assessment was admittedly an egregious oversimplification, but it captured the key dynamics of what happened in 2008. Subprime mortgages defaulted, the collateralized debt obligations built on those mortgages went to hell in a handbasket, and AIG (plus a whole lot of other players) found themselves on the losing side of bets none of them every truly understood.
One of the key aspects of the meltdown was the surge in the demand for dollars so that the derivative positions could be unwound and resolved.
It's in meeting that dollar demand that the money supply has broken with its historical patterns. What has emerged since is that derivative markets function so long as there is a reserve of dollars. I do not think it is coincidental that the Fed's easing policies coincided with a decline in money velocity--they were literally creating dollars just so the banks could hold on to them.
Thus the Fed has created trillions of dollars of money that has ultimately not moved through the economy at all--hence the decline in money velocity as the supply of "idle" dollars increased. Because the dollars were "idle", there was no inflationary consequence.
If you subscribe to Freidmanite monetarism, the Fed should have been able to get away with this maneuver because so long as the dollars weren't actually sloshing around the economy there would never be any inflation--and for the decade after 2008 there was no dramatic upsurge in inflation (even Shadowstats does not show an inflationary trend to correlate with the quantitative easing episodes).
Then 2020 happened.
Because of the lockdowns businesses and banks all started screaming "liquidity"--and the Fed stepped up. For most of 2020, they succeeded, insofar as inflation did not take off.
But as things emerged from lockdown and demand returned, supply did not return as fast (and because of Zero COVID in China, won't for some time to come). Then when shipments did start flowing the ports on the West Coast couldn't keep up. Thus lockdown became a continuing exogenous supply shock, and the scarcity of goods sent prices rising.
What has not hit yet is any significant dollar demand that results in a liquidity crisis. Of course, if Powell keeps raising rates to combat inflation, the likelihood of that liquidity crisis increases.
This is the paradox of the current situation. Powell is combating inflation in classical terms, which treats the recent expansions of the M1 and M2 money supply as "excess". Ultimately, he wants to drain away that "excess". Yet when he does, he reveals to everyone the reality that, for the quadrillion+ notional derivatives markets, the trillions in the M1 and M2 money supply metrics still amount to a SHORTAGE of dollars.
I believe it was Warren Buffet who said, "Derivatives are financial weapons of mass destruction". I'm not really a fan of his, but on this point, he was absolutely correct.
The notational value of derivatives should never have been allowed to grow after what happened in 2008. It seems we learned nothing from that experience. At the very least they should be traded on a transparent exchange, one that ensures there is a reasonable amount of capital backing those contracts, just as is done with stocks, bonds, and commodity futures. In fact, doing that would have prevented the notational value from getting so large. Again, the root problem with derivatives is that there's virtually no actual capital backing them.
Yes, the Fed is between a rock and a hard place. I think at this point they've made a choice: Better to let the financial markets suffer (implode?) and thereby maintain the value of the dollar than to let the value of the dollar shrink dramatically.
Derivatives are a dark market. Even the quadrillion dollar estimate is mostly just guesswork.
Yet what is fascinating about the derivatives market is that most of it is actually overseas. 200 Trillion in derivatives are known to the OCC. All the rest is outside the US.
Which means the implosion will do more damage in Frankfurt and Shanghai than in New York.
AIG wasn't in trouble because they had written a bunch of bad insurance policies?
Uhm, credit default swaps, interest rate swaps, and other such derivatives are essentially unregulated insurance policies that lack any meaningful capital to back them.
Snyder's assessment was admittedly an egregious oversimplification, but it captured the key dynamics of what happened in 2008. Subprime mortgages defaulted, the collateralized debt obligations built on those mortgages went to hell in a handbasket, and AIG (plus a whole lot of other players) found themselves on the losing side of bets none of them every truly understood.
One of the key aspects of the meltdown was the surge in the demand for dollars so that the derivative positions could be unwound and resolved.
It's in meeting that dollar demand that the money supply has broken with its historical patterns. What has emerged since is that derivative markets function so long as there is a reserve of dollars. I do not think it is coincidental that the Fed's easing policies coincided with a decline in money velocity--they were literally creating dollars just so the banks could hold on to them.
Thus the Fed has created trillions of dollars of money that has ultimately not moved through the economy at all--hence the decline in money velocity as the supply of "idle" dollars increased. Because the dollars were "idle", there was no inflationary consequence.
If you subscribe to Freidmanite monetarism, the Fed should have been able to get away with this maneuver because so long as the dollars weren't actually sloshing around the economy there would never be any inflation--and for the decade after 2008 there was no dramatic upsurge in inflation (even Shadowstats does not show an inflationary trend to correlate with the quantitative easing episodes).
Then 2020 happened.
Because of the lockdowns businesses and banks all started screaming "liquidity"--and the Fed stepped up. For most of 2020, they succeeded, insofar as inflation did not take off.
But as things emerged from lockdown and demand returned, supply did not return as fast (and because of Zero COVID in China, won't for some time to come). Then when shipments did start flowing the ports on the West Coast couldn't keep up. Thus lockdown became a continuing exogenous supply shock, and the scarcity of goods sent prices rising.
What has not hit yet is any significant dollar demand that results in a liquidity crisis. Of course, if Powell keeps raising rates to combat inflation, the likelihood of that liquidity crisis increases.
This is the paradox of the current situation. Powell is combating inflation in classical terms, which treats the recent expansions of the M1 and M2 money supply as "excess". Ultimately, he wants to drain away that "excess". Yet when he does, he reveals to everyone the reality that, for the quadrillion+ notional derivatives markets, the trillions in the M1 and M2 money supply metrics still amount to a SHORTAGE of dollars.
If Powell address one he makes the other worse.
I believe it was Warren Buffet who said, "Derivatives are financial weapons of mass destruction". I'm not really a fan of his, but on this point, he was absolutely correct.
The notational value of derivatives should never have been allowed to grow after what happened in 2008. It seems we learned nothing from that experience. At the very least they should be traded on a transparent exchange, one that ensures there is a reasonable amount of capital backing those contracts, just as is done with stocks, bonds, and commodity futures. In fact, doing that would have prevented the notational value from getting so large. Again, the root problem with derivatives is that there's virtually no actual capital backing them.
Yes, the Fed is between a rock and a hard place. I think at this point they've made a choice: Better to let the financial markets suffer (implode?) and thereby maintain the value of the dollar than to let the value of the dollar shrink dramatically.
Derivatives are a dark market. Even the quadrillion dollar estimate is mostly just guesswork.
Yet what is fascinating about the derivatives market is that most of it is actually overseas. 200 Trillion in derivatives are known to the OCC. All the rest is outside the US.
Which means the implosion will do more damage in Frankfurt and Shanghai than in New York.
The fun is just getting started!