As I have been discussing, the current monetary regime is the dollar standard that substituted the gold exchange of the Bretton Woods system. In spite of the US dollar being the global reserve currency, taking the role that gold used to play, the Federal Reserve is for all intents and purposes powerless in managing their own currency. The offshore Eurodollar market has grown to such an extent that it determines where the world economy is headed. The evolution of this market is going to be analysed, and we are going to see how it influences the conditions in the financial markets and the economic growth.
This is part 1 of a three part series. On this one, the development of this system until the Global Financial Crisis is going to be analysed. In addition, we are going to see why and how the 2008 financial debacle happened.
The term “euro” long pre-dates the European common currency in our use here. And in front of the word “dollar” simply conveys the notion of offshore. And there are other markets. There is a eurocurrency market of, for example, offshore yen is called Euroyen. There is even something since the introduction of the European monetary union where there is offshore euro, which is called Euroeuro.
A Eurodollar used to be just an account convertible into physical US dollars that were on deposit outside of the US. As time went by, the Eurodollar turned into a system of interbank liabilities that real economy participants were using, once they connected to it, in order to achieve real-world activities, as the Head of Global Research for Alhambra Investment Partners defines it. Additionally, it is a currency-like system based around the banks, scattered all throughout the world, which participate in it.
Although it was William Clarke of the London Times who coined the term "Eurodollar" in 1960, Paul Einzig, who was known as "dean" of writers of international finance, was the first to write about the Eurodollar system in a widespread fashion. He stumbled across it accidentally in 1959 and he was emphatically told by some bankers not to report on that topic.
At the onset, the Eurodollar market was largely an European affair, where merchant banks were using this market to achieve global trade settlements. Seeing that until the mid-1960's the players of this market were mainly European banks, US officials were not preoccupied by it. The chart below shows that there was little to no mention of the Eurodollar market by the Fed's Federal Open Market Committee (FOMC) in the early 60's, even though a 1964 paper by the Bank for International Settlements (BIS) - colloquially called the central bank of central banks - proposed that this market held "exceptional potential for expansion which may create a special problem for monetary authorities in the future".
The BIS turned out to be right and the Eurodollars managed to increasingly get under the Fed's radar. By the end of that decade, the Eurodollar market was a hot topic on FOMC meetings, because it had worked its way into everything. Moreover, on account of US banks borrowing tremendously from European banks in offshore dollars, distress in currency markets, especially the deutschmark, began to crop up.
Thus, as US banks started to participate in it, the Eurodollar system embarked on replacing several traditional roles of global reserve currencies that had previously been performed by gold alone - the pre-WWI Gold Standard and the Interwar Gold Exchange Standard - and by gold and dollar in tandem - Bretton Woods (BW) system. As a result, the global monetary paradigm shifted, opening the door for different sources of funding through innovations in banking and money itself.
In the late 70's still, the official doctrine written was that the Eurodollars must be treated exclusively as investments. Since, at the time, they were primarily using certificates of deposit, these Eurodollars were mostly functioning as a store of value and not acting as a medium of exchange. The authorities at the Fed and elsewhere had simply made a choice and decided that they were going to view this Eurodollar system as nothing more than an investment option for domestic banks.
Yet, banks and their customers had come to create and utilise different monetary forms to accomplish real-world transactions. These liabilities and wholesale funding techniques did not fall under official definitions of money. So, there is no real Eurodollar. It is not a thing like there is a dollar bill. It is a system of financing and accomplishing monetary and financial ends that was just very different from how it had ever been done in the past.
Monetary evolution that was unleashed during the 50's, 60's, and 70's kept evolving once it was let loose into its own ecosystem offshore. There was as much qualitative expansion as there was quantitative expansion.
Accordingly, when I talk about Eurodollars, I am talking about US dollars, though what I am referring to is a system that operates in the shadows and creates supply of US dollars and creates all kinds of complex transactions in US dollars that the Federal Reserve does not really know about due to being outside of their regulatory purview, and it does not really understand exactly what is going on and how it really works, as well as what these bankers are up to.
(...) the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. (...) a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition."
In its earliest form, this interbank offshore accounting system transformed what used to be deposit liabilities into interbank borrowing. Adding to that the communications technology revolution, you have financial innovations in the form of standardised derivative contracts in the 1980's – things like interest rate swaps and Eurodollar futures – and even the term "interbank borrowing" itself becomes exponentially more complex.
Hence you have this flexible creative vacuum upon which globally connected financial institutions can, all on their own, choose how to participate and how to fill in what is the vitally important role of global reserve currency.
Unlike the gold exchange system under BW, this Eurodollar system could supply what was needed, how it was needed. And it could do so largely without politics and official interference, or even public scrutiny.
For the keynesians, the global exchange system under Bretton Woods lacked both liquidity and adjustment functions to maintain under the kind of demand that the lively swelling financialised world economy begged for. Consequently, it was not only the banks that wanted to do this, the official sector wanted them to do it because they did not want anything to do with figuring out how to replace the Bretton Woods system.
On the one hand, gold was what gave confidence to the dollar in the BW regime, but even that was more and more challenged throughout the 60's on account of the Triffin Paradox, which consisted, at the time, on the depletion of gold reserves at the Fed because of the endless current account and budget deficits.
On the other hand, the Eurodollar offered liquidity and adjustment to demand but, paired in denomination with US dollars, it also gave the confidence that this shadow money would easily supply financing for a globalising world.
Effectively, the US dollar, despite being regulated by the Federal Reserve, it is only regulated by the Fed in the US. And a huge amount of this overall global US dollar system operates in the shadows, outside of anyone’s regulation, and it is all controlled by international bankers.
By the first decade of this century, the Eurodollar system hit its zenith. Inasmuch as this is all shadow money, we have to be careful. Any kind of statistics or estimates that we have, they all come with caveats attached to them. These are, at best, rough estimates simply because, officials decided this Eurodollar system was just an odd investment choice rather than some reserve-less global currency design and, therefore, nobody kept track of what was really going on in these offshore places.
However, in the aftermath of the 2008 GFC, some people were compelled to go back and look at this thing. Maybe we should start to piece some of these things together and match up some quantities for all of these offshore qualities that we’re observing throughout the period.
During the noughties, banks, especially in Europe, had binged on the so-called international assets. From 2000 to the end of 2007, these assets had ballooned from $10 trillion to $34 trillion, according to the BIS estimates.
So, how was all that offshore credit creation funded? Obviously, it was not Alan Greenspan and Ben Bernanke, because the Fed throughout this period had produced little to no bank reserves. The most Alan Greenspan or Ben Bernanke had done was move the Federal Fund target around a quarter point here or there, maybe 50 basis points, every once in a while.
The answer is that the Eurodollar system created its own forms of liquidity, its own forms of reserves that were, again, these long chains of interbank liabilities that stretched all the way around the world and back.
In that BIS study, researchers figured that the world was short of what they called a “funding gap” anywhere between $2 and $6.5 trillion on the eve of the panic. In this case, the dollar short means that there is a material mismatch between several credit dimensions, including maturity and geography as well, whereby some bank in Europe, for example, who has been using its holdings of structured US mortgage obligations or emerging market Eurobonds - bonds denominated in a currency of another country/region - in repurchase agreements (repos), suddenly has very limited monetary recourse when the global repo market suddenly rejects its collateral.
In 2005, what Bernanke would propose was what he called a global savings glut (look at the chart below - US banks' claims on foreigners denominated in dollars, which are used as a proxy for the extent of the Eurodollar system). In other words, from his perspective, he saw that there was something happening in the world and it was distorting the US dollar system, including what seemed to be a perpetual bid for US government bonds, US Treasuries and also government-sponsored enterprises (GSE) agency bonds.
Because of his conviction, Bernanke believed this all had to be global savings with, for instance, foreign baby boomers seemingly getting ready for their retirement by increasing their savings and allocating their savings to US dollar assets for non-specified, unknown reasons. Bernanke and the other technocrats in the US were uncapable of seeing the actual extent of the Eurodollar for their orthodox keynesian convention blinded them. Their view was that since the US dollar is the currency of the United States, the big international capital flows in dollars must all originate in the US because that is where the system is headquartered.
In reality, the bankers have figured out that if they originate major transactions in the US, they are under regulatory scrutiny over there. Instead, they have the ability to create these massive loans, structured products and swaps, and all kinds of elaborate derivatives in the shadows outside of the US banking system, where they are essentially unregulated and can get away with doing whatever they want.
In fact, the Eurodollars expanded rapidly in the 90's till the GFC because what most people saw were only the benefits of globalisation, with growth in the worldwide economy, emerging market economic miracles, and global trade which seemed to be at the center of it, and these economic systems apparently were enhancing as they were becoming more closely tied together by this global monetary arrangement.
Moving on to the 2008 GFC, the conventional explanation for the panic was that a bunch of greedy Wall Street bankers were taking on this allegedly secure instruments in the form of these subprime mortgages, which turned out to be ridiculously dicey. In reality, it was a bit more complicated.
Firstly, even though the subprime mortgage market a threat that could somewhat imperil the financial system, it could not on its own knock down Lehman Brothers or Bear Stearns or AIG or any of the somehow nationalized banks that were scattered all throughout Europe and elsewhere. This panic is called Global Financial Crisis for a reason, it was not just an American failure. Because there were variations in financial systems all across the globe, some of which did not rely on securitisation and, thus, were not heavily exposed to US subprime mortgages at all. More than that, there were large, complex financial institutions that had failed or nearly failed in various countries around the world.
The [majority's financial report] says the crisis was avoidable if only the United States had adopted across-the-board more restrictive regulations, in conjunction with more aggressive regulators and supervisors. This conclusion by the majority largely ignores the global nature of the crisis. For example:
The global nature of the GFC explains the action of engaging in currency swaps taken by the Fed with other central banks. During 2008, the Fed’s balance sheet swelled not due to specific bailouts or domestic liquidity programmes. By far the most that was added was through these US dollar swaps with foreign central banks.
The reason that led the Fed to hand out more than half a trillion dollars to foreign financial institutions (through the central banks), in the midst of the worst financial meltdown since the Great Depression, was because these foreign entities were demanding their central banks to rescue them, begging for funding in US dollar terms, in order to fill the funding gap as the BIS referred to. In more detail, the participants in the Eurodollar system were struggling to get access to US dollar financing owing to the fact that, as I am going to show you, a surge in counterparty risk and a diminishing pool of good collateral were in the making.
Secondly, most people pin the onset of the GFC on September 15, 2008, when Lehman Brothers filled for bankruptcy. While others may consider the Fed bailing out Bear Stearns in March 14 of that year the beginning. Once you look at the graph below, you realise the crisis kicked off on August 9, 2007.
The GFC began to emerge in this day when the 1-month LIBOR - London Interbank Offered Rate is the average interest rate at which leading banks borrow funds of a sizeable amount from other banks in the London market; LIBOR is the most widely used benchmark or reference rate for short-term interest rates - jumped above the 3-month rate and, on the flip side, the Effective Federal Funds (EFF) rate - the EFF is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight; the federal funds rate is the central interest rate in the US financial market - took a tumble. This signaled that the counterparty risk in the Eurodollar system rose and, consequently, the financial institutions were more willing to park their funds at and transact through the US banking system.
In addition, the other parts of the Eurodollar system, this wholesale system, followed the same pattern, much the same way. Asset-Backed Commercial Paper (ABCP) was one of the primary innovations of the Eurodollar system and it was also one of the primary points of contagion as it spread across the globe.
In the wake of August 9, it utterly collapsed. Nothing the Federal Reserve did, which included cutting the Federal Funds rate, there were Term Asset-Backed Securities Loan Facility (TALF) liquidity auctions, collateral swaps, those dollar swaps, and there was even a commercial paper funding program and a money market commercial paper funding program (just like today), would rescue these shadow markets.
Furthermore, the ABCP is a short-term money market security backed by collateral. This collateral may consist of collateralised debt obligations (CDO) and things of that sort, which are comprised of credit card debt, auto loans and student loans. Thus, the commercial paper is backed by the expected cash inflows from those receivables - various types of debt and loans. As the receivables are collected, the originators are expected to pass the funds to the conduit, which is responsible for disbursing the funds generated by the receivables to the ABCP investors, a.k.a. noteholders.
Seeing that these receivables are a function of the general condition of the real economy, one would think that when the economic agents, particularly households, started to exhibit signs of financial constraint, these instruments became less appealing. Although that is a factor, the reality is more complex than that. The uptick in the LIBOR signaled soaring distress in the Eurodollar framework, on account of the collateral losing quality and surging counterparty risk surging.
Likewise, the same thing occurred with the Credit Default Swaps (CDS). These intruments are credit derivative contracts that enable investors to swap credit risk on a company, country, or other entity with another counterparty. For instance, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. The fact that the volume of transacted CDS stopped growing, and even went down slightly, indicates that investors were not very inclined to acquire such instruments, due to the borrowers' perceived probability of default becoming increasingly elevated.
By following the evolution of the yield curve while the GFC was unfolding, you see that each tenor behaved differently. As you can see, the yield curve inversion marked the inception of the panic too. After that, the yields fell until the Bear Stearns debacle, when the Treasury bills (short-term) plummeted while the notes and bonds started to climb. Then, with the Lehman Brothers bankruptcy, the same incident happened again.
What went on during these periods of financial trouble is liquidity became very scarce. Banks turned very wary of lending out their funds. All of a sudden, banks were willing to lend only against the reputed "pristine" collateral. This collateral happens to be Treasury bills. As a result, investors and financial institutions went on a T-bill shopping spree.
Alternatively, market participants could sell their holdings of US dollar-denominated assets so as to quench their thirst for greenback liquidity. The Treasury notes and bonds were included in this sell-off, pushing their yields higher, steepening the yield curve.
In these events of liquidity shortage, the dollar rummage was so intense that even the US Treasuries, which are (foolishly) considered to be the safest of safe-havens, were being liquidated. Like I exposed above, the funding gap of the Eurodollar institutions was colossal. Hence, these foreign entities got rid of any dollar-denominated asset with a bid.
Before the GFC, those institutions were able to use as collateral in the repo market mortgage-backed securities (MBS) and other asset-backed securities (ABS), in addition to CDOs and structured products of that nature.
In times of panic, the banks stopped accepting those less reliable securities as collateral. Therefore, as the next graph demonstrates, the amount of repo fails - which are simply the number of times repurchase agreements come to no avail - shot up during such episodes, resulting in the selling of US dollar-denominated assets.
Since gold is also negotiated in dollars, the precious metal did not manage to escape the liquidation, driving its price lower.
To sum up, the Eurodollar system grew relentlessly up to the summer of 2007. At this time, finacial institutions, mainly banks, became worried with the level of counterparty risk and the quality of the securities that were being used as collateral. From this point on, panic ensued, leadind to a massive sell-off of dollar assets in order to fill the funding gap. That is why the financial crisis occurred and it was so all encompassing, geographically and in securities terms.
On the part 2, I am going to delve into the recovery of the Eurodollar system, or lack of it, until the emergence of the COVID-19 pandemic.