Zoltan Pozsar of Credit Suisse continues to expand on his Bretton Woods III thesis in his latest note out on Wednesday. This time he ties his “end of the ‘Eurodollar era’” theme to wider forces of deglobalisation in the context of perpetual unresolved dollar funding crises related to “breaking par” and/or pegs in general.
What caught my eye specifically was the following section (my emphasis):
In 2019, shadow banking was money market funding of capital market lending yet again, but this time in the most unimaginable way: the “emerging market” was the U.S., which could only fund itself on the margin through the goodwill of relative value (RV) hedge funds harvesting the bond basis. RV hedge funds bought Treasuries, shorted the future, and funded the pair in the repo market – the o/n repo market because that was the only place where balance sheet was unlimited due to the rise of sponsored repo (as an arbitrage around the SLR chapter of Basel III).
The Fed was trying hard to get out of QE and as it conducted QT, it drained all excess reserves from the U.S. banking system, which was the marginal lender to the repo market and hence to RV funds, and through the RV funds to the U.S. government itself. When the money ran out, “par” broke again – the Fed lost control of the o/n interest rate complex, and for a moment, the U.S. government had a little bit of a funding problem…
We say the following for it may be lost on market participants and policymakers…
…since 1997, we’ve been dealing with a series of money market crises that had either the Eurodollar or the U.S. dollar at their epicentre, and where a different price of money broke at each time. Importantly, in each of these crises, the problems got worse and worse, and the crisis was coming closer to home: 1997 was “our currency, your problem”; 2008 was “our currency, our problem” (bank deposits, money fund shares, mortgages, and the American dream); while 2019 was about “our currency, our federal government’s funding problem”, which was the very first time we saw some cracks to the notion of the “exorbitant privilege”. A crisis of U.S. dollar pegs, a crisis of domestic dollars, and a crisis of the bedrock of government finance – the o/n Treasury repo market…a series of worsening crises burning up the hierarchy of the dollar system.
I think this is broadly correct. As a history-minded person (with a penchant for Herodotus) I do tend to see the economic crises of today as intimately connected to the crises before them. An ongoing continuation of a single story.
But not everyone has the benefit of a historical mindset.
Those who do not speak Zoltan might therefore miss the simplicity at the heart of his thesis. Or dismiss his concerns as overly sensationalist. They might also misunderstand what he means when he says: “Commodity traders guarantee price stability, not central banks”.
Key to the whole argument, I would argue, is the role played by America in cultivating and defending a neutral international currency from the Second World War onward.
It’s a funny paradoxical story.
In the first instance, America’s move to help finance the Allied war effort from 1941 demonstrably politicised the dollar by ending the country’s neutrality period. This eventually saw America become a military and nuclear power capable of dictating policy abroad (much of it focused on fighting off communism).
In the second instance, however, it also helped to cultivate an economic environment that allowed for the depoliticisation of the dollar on a truly global scale through the birth of the Eurodollar system. This eventually saw the rise of a truly neutral dollar from the 1960s onwards, increasingly detached from all political influence.
It was this dollar neutrality that inadvertently helped to bolster Pax Americana from the side lines.
The paradox of an overtly political state birthing a truly neutral currency was squared by the recognition that it made perfect sense for a country which championed free market capitalism to be both politically active against countries that defied its doctrine (even blockading foreign investment), and open to the use of its own currency in their territories.
It wasn’t long, therefore, before commodity traders – the quintessential stateless privateers of the modern era – would adopt the neutral system for their own purposes. It was simply the most practical thing to do. However, in doing so, the market would also strike its own informal 20th century concord with the central banking system. This amounted to the market allowing the Fed (considered at the time to be an independent arbiter of a neutral dollar system) to steer commodity markets on price stability.
The Fed, like the conductor of an orchestra otherwise composed of independent entities, did this by controlling the cost at which onshore dollars could be raised and thus the rate at which offshore dollars could be converted back into onshore dollars back in the US. What happened offshore, however, was generally out of its purview. And that was just how commodity traders (and others) liked it.
As this 1963 staff paper from the IMF noted about the paradox:
Euro-dollars have provided a number of central banks with a powerful and flexible monetary instrument which can be used to control domestic liquidity and the import or export of short-term capital. At the same time, the increasing “oneness” of money markets has facilitated the movement of private capital in response to interest rate differentials.
What’s notable is that since 2008 we have been witnessing exactly the opposite of this 1960s depoliticisation trend.
Rather than defending dollar neutrality, a series of ever-escalating financial crises (somewhat understandably) has led the US government to re-politicise the dollar by bringing politically motivated intervention back to money markets accompanied by attempts to control the dollar’s usage outside of its jurisdiction as well as within it. The appointment of former Fed chairs as Treasury officials, meanwhile, has led some to question the notion of central bank independence altogether.
With the benefit of hindsight, it seems obvious this repoliticisation of the dollar was always going to lead to trade-wars between global economic powers, likely culminating in outright belligerence towards each other. The mother of all capital control policies in the form of Russian sanctions in that sense was probably predictable.
But for commodity traders who depend on a neutral and stable settlement unit it was also obvious that this politicisation would amount to a break of trust in the informal concord held between the market with the Fed on price stability. From their perspective, it only really makes sense to take direction from the Fed on commodity flows for as long as the central bank remains more concerned with maintaining price stability than it does in promoting an increasingly anti-free market US political agenda.
But if the Fed can no longer be depended upon to guarantee price stability because of politicisation, the rationale of being bound by a constrained dollar system that won’t allow it the funding it needs to support price stability through the supply of commodities is massively reduced.
Lacking an alternative purveyor of a dependably neutral settlement unit, the incentive for commodity traders is not to sit back and suffer a reduction of trade and opportunity, but rather to re-establish neutrality by proxy. This can either be done through more complicated workarounds involving multilateral funding sources from those who ultimately control the flow and availability of commodities (institutions like OPEC etc.) or via market-led initiatives to set up alternative neutral clearing systems from scratch.
What Happened the Last Time the Dollar was Politicised?
Many like to link the beginning of the dollar system to the Marshall Plan. But in my view, it all goes back to programmes like lend-lease which saw America provide essential resources to Britain and other allies on a “pay later” basis. This was the moment the dollar not only became politicised in the modern age, but the moment it inherited control over the high seas of international finance from Britain. (Even though, naturally, some British imperialists had hoped this would only be a temporary custodial relationship).
Up until the Lend-Lease Act was put through by FDR in 1941, American neutrality had meant forcing Britain to pay on a “cash and carry” basis in gold for all supplies from the US. However, this was ruining Britain by forcing it to liquidate prime assets, which it needed to sustain the war effort.
Rather than fire-sell into the hands of the enemy, Churchill became convinced it would be better to cut a deal with the Americans wherein payment could be sorted out once the war was over. This, he thought, would help maintain the stability of the British empire and secure access to its resources throughout the warring period.
On December 7, 1940, Churchill wrote to FDR with a plea for financial assistance. He later called the letter “one of the most important I ever wrote”. Within it he noted:
The moment approaches when we shall no longer be able to pay cash for shipping and other supplies…
…Moreover, I do not believe the government and people of the United States would find it in accordance with the principles which guide them, to confine the help which they have so generously promised only to munitions of war and commodities as could be immediately paid for.
On December 17, 1940, FDR gave a strong signal he would come to Britain’s rescue (and also that of other allies). He remarked at a press conference how wrong bankers had been to think WW1 would be limited in duration due to a lack of financing, noting:
There was the best economic opinion in the world that the continuance of war was absolutely dependent on money in the bank. Well, you know what happened.”
FDR wanted to financially innovate his way around the limitations of America’s Neutrality act in a similar way:
It is possible – I will put it that way – for the United States to take over British orders, and, because they are essentially the same kind of munitions that we use ourselves, turn them into American orders. We have enough money to do it. And thereupon, as to such portion of them as the military events of the future determine to be right and proper for us to allow to go to the other side, either lease or sell the materials, subject to mortgage, to the people on the other side. That would be on the general theory that it may still prove true that the best defense of Great Britain is the best defense of the United States, and therefore that these materials would be more useful to the defense of the United States if they were used in Great Britain, than if they were kept in storage here.
Now, what I am trying to do is to eliminate the dollar sign. That is something brand new in the thoughts of practically everybody in this room, I think – get rid of the silly, foolish old dollar sign.
He went on:
I can’t go into details; and there is no use asking legal questions about how you would do it, because that is the thing that is now under study; but the thought is that we would take over not all, but a very large number of, future British orders; and when they came off the line, whether they were planes or guns or something else, we would enter into some kind of arrangement for their use by the British on the ground that it was the best thing for American defense, with the understanding that when the show was over, we would get repaid sometime in kind, thereby leaving out the dollar mark in the form of a dollar debt and substituting for it a gentleman’s obligation to repay in kind. I think you all get it.
With lend-lease enacted in 1941, Britain and other European and allies around the world were finally able to receive much needed food, oil, and defence related supplies without imposing on their cash reserves.
As Wiki notes:
In general, the aid was free, although some hardware (such as ships) was returned after the war. In return, the U.S. was given leases on army and naval bases in Allied territory during the war. Canada operated a similar smaller program called Mutual Aid.
From the modern perspective, one could argue this “gentleman’s obligation to repay in kind” was one of the first and most significant “matched book” exposures of the new Eurodollar empire. That it would take until 2006 to be paid off mattered not one iota because what really had been traded in was power and influence over Britain’s remaining empire.
Another way to understand things is that the debt incurred became the basis for the new dollar standard, itself underpinned by the relative values to gold established under Bretton Woods (an anchor that was needed to establish international trustworthiness in the new dollar system). This is because all future revenues and national accounts would have to be squared against it from then on. With the Marshall Plan, which allowed American pockets to derive long-standing cash flows from opportunities arising from the ongoing rehabilitation and reconstruction of Europe, the standard became even more entrenched.
After much of Europe’s reconstruction had been completed, the increasingly favourable market environment cultivated by the Plan in European markets – alongside attractive boomer demographics – created fertile ground for further American investment flows.
The result was a large inflow of dollar-denominated investment into Europe, Britain, and the world beyond.
The Rise of the Eurodollar System
A really great primer on the matter is this 2014 essay by Stephen A. Fowler entitled: The Monetary Fifth Column: The Eurodollar Threat to Financial Stability and Economic Sovereignty.
As it notes, it was this post-war flow of US dollar denominated investments into Europe that provided the balances that later became the seed funds of the Eurodollar market.
In a somewhat wicked twist of fate, it was also the emerging neutrality of European banks – especially London banks – over the course of the original Cold War that helped to expand the market rapidly from then on.
From the Fowler piece (my emphasis):
Shortly after the start of the Cold War, Communist Bloc banks became hesitant to store their dollar balances in the United States for fear that the U.S. government might freeze their assets. Instead, these banks looked to Western European financial institutions as both a place to store dollar-denominated assets and as a source of credit.
As tensions with the United States heightened, Eastern Bloc central banks moved dollar balances from New York to London, and these balances became the seed funds of the Eurodollar market. Once established, the market for Eurodollars grew quickly because of certain advantages it enjoyed over the traditional sources of dollar financing.
First, European banks were willing and able to operate on narrower margins than American banks, meaning that depositors enjoyed higher returns and borrowers benefitted from lower interest rates.
Second, because the European banks were not subject to certain Federal Reserve regulations, they were able to offer interest on a broader range of deposits. Finally, regulations of the British Pound in 1957 forbade British banks from lending the pound sterling to overseas customers; London banks found they could avoid losing business by offering dollar-denominated financing.
What we come to understand is that it was the post-war financing that America provided to the European sector which in part spawned and lubricated the rise of the borderless and stateless Eurodollar market (later further enriched by dollar flows from the Vietnam War and oil-rich Middle Eastern states).
These Eurodollars represented the ultimate no-questions-asked funding – regulated only by the terms and conditions agreed to by “consenting” market participants on mostly bilateral terms.
Key to the arrangement was that the US government and the Fed could not control the lending terms of these dollars and dollar loans. They were, in a sense, without governance, even while they remained anchored to the US dollar via an informal market-controlled peg. I’ve described them before as the original stablecoins.
But the good old days of limitless borderless financing were not to last.
The Herstatt Bank fiasco of 1974, which brought about the creation of the Committee on Banking Regulations and Supervisory Practices in 1974, was the first to reveal the Eurodollar system’s fragility and susceptibility to crisis. The bank’s failure became a key factor leading to the worldwide implementation of real-time gross settlement systems in an attempt to anchor the international waters of high finance with the rules of the land.
And yet, this anchoring wasn’t enough to stop dollar neutrality from attracting ever more trade and risk or from stopping dollars circulating in “unfriendly” countries like the USSR or among illicit trading rings.
Indeed, despite formal sanctions and trade blockades during the cold war, Eurodollars continued to lubricate the black markets of the USSR, demonstrating the worth of a neutral currency to what was then a highly politicised communist monetary system.
Rather than empowering the communist system, however, the growing dependence on neutral dollars eventually sowed free-market seeds in an otherwise closed system, eventually giving way to the liberalising market reforms of Perestroika. These in turn opened the door to an international parley with Gorbachev, marking the way to a largely bloodless coup and subsequent collapse of the USSR. In other words, it was the neutrality of the dollar and its capacity to infiltrate the USSR as a medium of exchange that proved a vital mediation tool between Moscow and Washington in the last days of communism.
Illiberalism for Liberalism’s Sake
This is in stark contrast to today, where Western policy – increasingly hostile to the concept of a neutral dollar – seems actively focused on diminishing the use of the dollar in “unfriendly” states or illicit markets instead. In that sense, it no longer seems confident that market neutrality alone, or unconstrained free-market policy, are enough to sell democracy and liberalisation to those it considers illiberal.
Consequently, it has decided that it can no longer influence these areas softly from the inside. In a way, the renewed politicisation of the dollar becomes the dollar system’s own Brexit moment. A moment when it makes more sense to quit the international system it itself created to lead by example on its own terms and according to its own values outside of it – even if that means intermittently self-sabotaging on trade, globalisation, and market access. It is a moment of illiberalism for liberalism’s sake (which, as it turns out, has to be underpinned by core social values, not just unfettered free-market access to work).
This is understandable in the context of the many financial crises that the neutral dollar market – ultimately backstopped by the US taxpayer – has sown over the decades.
In hindsight it seems clear that it was the 2008 global financial crisis that changed everything. It was at this point that the US offshore dollar became so spectacularly broken from its onshore dollar peg, that it once again fell on the US taxpayer to come to the rescue of the European and ROW financial system. (This rescue was predominantly channelled through central bank liquidity FX swap lines – in a type of financial equivalent of lend-lease).
Once again, it proved in America’s interests to keep Europe afloat.
But the bailout came on the condition that the international dollar system would be reined in. America was no longer prepared to underwrite risky dollar financing on terms they themselves did not agree with. But the regulatory environment that followed, while prudent, also amounted to a de-lubrication of borderless financing and a shutdown of flows to markets not aligned with Western political ideology. It marked therefore the unwitting end of the era of neutral money that had until then been underwritten by American supremacy.
The question at this point, however, is whether allegiance to a repoliticised dollar is capable of maintaining the prosperity of systems that became empowered by neutral money.
While America can support Europe’s “wartime” efforts with discounted or at cost LNG deliveries to a degree, this is no longer the America of WW2 with which we are dealing.
America’s own dependence on China – a would-be Russian ally – complicates the story multifold.
What’s more, it is China that is now well positioned to be the purveyor of “lend-lease” programmes to Russia. And, regardless of what anyone says about how fit or unfit China is for doing business, or how shoddy its legal systems are or are not, this marks the possibility that the yuan provides the seed funding to create a euro-yuan market of its own.
Of course, for it to really take off, China would have to depoliticise the yuan internationally too. That, for now, is unlikely to happen.
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