A Peak Behind the Curtain

Exactly one month ago, the US Federal Reserve issued a simple press release that they will cease reporting M3 as of March 23, 2006. Three whole sentences (read it...). It received zero coverage by the mainstream media. A Fed spokesman said that ''M3 does not appear to convey any additional information about economic activity that is not already embodied in M2."

If M2 and M3 make you think of British motorways or BMWs, read this primer on money supply. I think that this is CRITICAL, because it is the structural backbone to modern geopolitics.

In short, M0 is the value of all US currency that exists in actual bank notes and coins. M1 is M0+checking accounts. M2 is M1+money market accounts and CD's under $100k. M3 is M2+all larger holdings in the dollar (Eurodollar reserves, larger instruments and most non-European nations' reserve holdings). The key point here is that which will be lost when the Fed stops reporting M3, but continues to report M2 and M1: we will lose transparency on the value of reserve holdings in dollars by other nations and major financial institutions.

And, of course, the timing of the discontinuation of M3 data just happens to coincide with the opening of Iran's euro-denominated oil bourse. Funny how that hasn't exactly been reported at all by ABC, CBS, NBC, CNN, Fox or the other "Main Stream Media" sources.

So what will happen when Iran opens its bourse? They won't just sell Iranian oil (although that alone is a sizeable chunk of world production, roughly 4 million barrels per day, or about 5% of global production). Instead, they will create an entirely alternate derivative market to the exclusively dollar-denominated sale of oil derivatives at the International Petroleum Exchange (London) and the New York Mercantile Exchange. The way this works is that NYMEX crude futures are for "West Texas Intermediate" crude, theoretically "deliverable to Cushing, Oklahoma." It will come as no surprise that all the oil is not actually delivered to Cushing, and that oil consumers from around the world still use these NYMEX futures to purchase and hedge on oil. By way of arbitrage, people who need crude oil don't have to actually ship it through Cushing--it doesn't even have to be West Texas Intermediate crude, for example, Nigerian "Bonny Light" or Algerian "Saharan" crudes can all be bought and sold using derivative and arbitrage mechanisms on the NYMEX. So an Brazilian refinery can purchase crude via NYMEX and may actually take delivery from a tanker direct from Nigeria. This is critical because it is exactly the same mechanism by which the new Iranian oil bourse will be a direct competitor to both the IPE and NYMEX. You can count on Venezuela's PDVSA using the Iranian bourse, for example. And naturally, it would only make sense for Euro-zone customers to purchase via Iran using their own currency. This may take some time to build momentum, but it will be a truly monumental shift in the global geopolitics.

The result of this is that countries will no longer need to use the US Dollar as their reserve currency. As reserve currency levels drop, the fundamental impact will be a drop in demand for the US dollar. This will result in a decrease in the value of the dollar, but much more importantly it will mean that there is also a decrease in people wanting to purchase US government debt--the debt that we use to carry huge and consistent budget deficits. Of course, it will still be possible to get other nations to purchase our debt instruments and finance our deficit, but the market will shift the price equilibrium for this debt upward--that is, the interest rate that we are paying on the national debt will increase significantly.

Suddenly the mysterious Fed is much less mysterious: the M3 statistic that they will stop reporting this Spring is exactly the one that would be used to identify just such a shift in the use of the US Dollar as a reserve currency. Was that the motivation for the Fed's move? It's the only one that I am aware of, but it's no more than conjecture.

Just how fast and how strong this shift from the petrodollar to the petroeuro will snowball is difficult to predict. There are plenty of people who think that it will be alternatively minor, catastrophic, or lead to the US nuking Iran in a few months. My goal here (for once) isn't to speculate, but just to shed some light on this murky topic.