De-dollarization is all the rage right now, with lots of talk about whether the US currency will be able to maintain its dominant status in the global financial system. But regardless of what happens in the future, it's worth asking how we got to this point originally. How is it that the dollar came to dominate not just global trade flows but also become the currency of choice for things like buying oil? And why are there large pools of eurodollars sitting outside the United States? In this episode, we speak with Josh Younger, formerly of JPMorgan Chase & Co. and now a senior adviser at the Federal Reserve Bank of New York, about the surprising policy decisions that went into creating eurodollars and petrodollars, and why they matter now. This transcript has been lightly edited for clarity.
Key insights from the pod:
The spectrum of dollars — 04:09
The communist origins of eurodollars — 06:20
London's liberalization of foreign exchange — 9:32
Why the US tolerates eurodollars — 12:03
Foreign currency risks in banks — 15:39
The role of dollar swap lines — 17:13
Eurodollars, money supply and inflation — 19:50
Currency volatility and hot money flows — 22:59
The emergence of petrodollars — 28:39
Herstatt risk and the need for eurodollars — 32:37
Saudi Arabia buying Treasury bonds — 38:36
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Tracy Alloway: (00:00)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:04)
And I'm Joe Weisenthal.
Tracy: (00:06)
Joe, de-dollarization. There's a lot of annoying stuff in there.
Joe: (00:09)
Yeah, we're still talking about that. No, it's interesting because I sort of associate it with cranks and stuff, but if you actually take the subject seriously about why the dollar is what it is and where it is, there's many illuminating sub-conversations to be had.
Tracy: (00:28)
Yes. So, it is a theme that tends to be dominated by a certain type of person. But setting that aside, one thing that's good about it is it actually gives us a peg to go back and look in depth at the financial system and ask, well, why is it designed this way? Why is it built this way? Why did dollars become popular as FX reserves in the first place?
And beyond that, why do we seem to have all these different types of dollars. So, we have eurodollars, which hopefully everyone has heard of before. We have petrodollars. There are all these different flavors of dollars floating around the financial system.
Joe: (01:06)
Right. And, I mean, there's two interesting points you made. One, this conversation allows us to like go back and look at things like, well, why are things the way they are, which is helpful. And you know, a recent episode we did with Karthik Sankaran was good on that. And then to your point though, there is no single thing, “the dollar.”
And maybe if someone thinks “the dollar,” the first thing they think about is a dollar in their digital bank account or a dollar bill, but there is no single thing that's “the dollar.” There's a bunch of things that are basically pegged against each other and are usually roughly stable against each other.
Tracy: (01:38)
That's absolutely right. It's also one of the reasons I tend not to like talking about currencies that much, because everything ends up being relative. But setting that aside, I do enjoy talking about the history of the financial system and the decisions that made it the way it is today. And so, I'm very pleased to say that we have one of our favorite Odd Lots guests back with us. Someone who is going to be taking us down the historical path of how we ended up with things like eurodollars and petrodollars.
Joe: (02:06)
I am very excited about this episode is well. I like history lessons as well, and all of these things tend to have surprising origins. They emerge organically, which is part of what makes them hard, when eventually things change. Maybe one day there will be a different currency regime in the world. But again, it's helpful to know the origins of these things to sort of anticipate what that might look like.
Tracy: (02:30)
Right. And I think actually there is often an assumption that they do emerge organically when actually there was a very conscious decision that went into making them what they are today. And then they sort of evolved from there. But without further ado, I am very happy to say that we are going to be speaking with Josh Younger, formerly at JPMorgan, now a senior advisor at the New York Fed. Josh, welcome back to the show.
Josh Younger: (02:53)
Well, thanks. It's great to be back.
Tracy: (02:57)
So, I believe given your new employer, you have to start with a disclaimer?
Josh: (02:58)
Well, I have to, I guess. This is literally something I've always wanted to say which is that these views are my own and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve system.
Joe: (03:08)
This is why, actually, it's always been fun to speak with you because in addition to your various employment over time, you're also just a very curious person who discovers new things.
Josh: (03:18)
I try to, yeah, it's fun to dig down. So I hope this isn't too much of a rabbit hole, but it is a very easy…
Tracy: (03:24)
I like the rabbit hole.
Joe: (03:25)
Yeah, we like rabbit holes.
Tracy: (03:26)
Alright, well, why don't we start at the beginning. You know, I sort of alluded to these different flavors of dollars and I think we're going to be focusing on two of them. They are eurodollars, so US dollar-denominated deposits at foreign banks. People sometimes look at them as like a liquidity measure: how many eurodollars are sloshing around in the system and what does that actually mean for risk appetite and things like that. And petrodollars, which are just dollars earned from the export of oil which tends to be denominated in dollars still, despite a lot of noises to the contrary.
But where do we begin with this? Because I think eurodollars nowadays, I kind of think, well, you know, they've been around for a long time, but they must have come from somewhere.
Josh: (04:09)
Yeah. Well, there's a spectrum of dollars, so a dollar is a liability. The dollar, paper dollars in your pocket are a liability of the Federal Reserve system. The dollars that your bank issues are liability of that bank. And a eurodollar is a dollar-denominated liability of a non-US bank. So, something overseas, and that's been around for a while. There were dollar-denominated deposits in Berlin and Vienna back in the twenties. They're fairly common in correspondent banking since then.
Correspondent banking is, if somebody needs to use dollars versus, say, Deutsche Marks in the seventies or the fifties or the forties, they will have a bank account locally that has a bank account in the US. Their bank has a bank account, and it's just really a daisy chain back to the US. A eurodollar is unique in the sense that it is a dollar-denominated deposit that has an asset side, an asset in which it's deployed that is also offshore, so it's all disconnected. It's not fully reserved, or in other words, it's deployed outside the context of the US financial system as well. And in that sense, it's a complimentary but distinct financial system from the US.
Tracy: (05:12)
Like free-range US currency.
Josh: (05:14)
Yeah. It kind of reminds me of the beginning of the internet, so there's two versions of the internet. There's the internet and the SIPRNet. Everyone talks about how the internet was originally a Defense Department project and there was for a long time — I'm not sure if there still is — a separate internet that's an air gap with the actual internet, which is the SIPRNet, which is the secret internet.
Joe: (05:30)
I want to go on the secret internet now!
Josh: (05:33)
Yeah. So eurodollars are not secret, but they are separated from the US financial system in some sort of air gap type of way.
Joe: (05:40)
It always seemed like… One thing that I have a hard time wrapping my head around is, okay, banks in the US. They have a relationship with the Federal Reserve and if they run into liquidity troubles or other kinds of troubles, you know, there's this lender of last resort. And then when I think of, okay, here's this other bank, maybe somewhere in Europe, issuing dollar-denominated liabilities, are there risks associated that, or when these were born, how does that, how did this sort of, I don't know, I'm struggling to think of the question, but this is always hard to wrap my head around. What kind of risks did these banks issuing dollar-denominated deposits in Europe face by being outside of the US banking system?
Josh: (06:20)
It's like what gives? How can you do this? You can't just write a dollar on a piece of paper, say it's worth a dollar.
Joe: (06:21)
Right, and then expect it to be worth a dollar if they don’t have that relationship.
Josh: (06:23)
And initially that was basically what was done. So, the definition of a eurodollar being deployed offshore is fairly specific. And the question is, when did that start? And we don't really know. We know roughly in the late forties, [from] some declassified CIA documents, after the war ended, the Russians were moving money around because they were worried about a subsequent land war in Europe and they didn't want their funds to be frozen, never mind the weirdness of a Soviet invasion where they need dollars. I'm not sure why that would be necessary, but they were uncomfortable leaving money in New York. And so there were a handful…
Tracy: (06:57)
The title of this episode should be the Communist origins of eurodollars.
Josh: (07:01)
There we go. Yeah. And so, they were worried about sanctions which connects somewhat to today. And they moved their money from New York banks to a handful of banks to, specifically in France, London and Belgium, because the local regulations allowed those banks to issue non-local currency deposits.
Your local regulator has to allow this in the first instance, and in Paris in particular, there was a bank, called basically the commercial bank of Northern Europe. I'm not going to try to pronounce it in French, but it was called BCEN. BCEN was run by a notorious communist sympathizer who had relationships in Moscow, and so they were comfortable with that particular bank and they grew its assets from $7 million to $200 million over a few years.
The first recorded use of those eurodollars was possibly, although it's hard to say, replacing the salaries of striking French coal miners in 1948. So, there's some evidence of that. But that's not really a eurodollar in the definition that I just described. Because it doesn't really have a use because I didn't say anything about the asset side of the equation.
Tracy: (07:58)
So where did the asset side come from? This is just going to be one of those episodes where we ask you like, “How did this happen? And then what?”
Josh: (08:05)
So, it was tied basically to trade, because trade was denominated in dollars. But when it's all communist dollars it has to be East-West trade. So trade crossing the Iron Curtain, which was small because both the Russians and the Americans were not terribly comfortable with a large volume of trade. And the Russians in particular had a policy of self-reliance. So they said “we don't want to need imports from the West to run our economy or our society.”
We don't know how big that was. It was actually as of 1947, illegal to talk about economic data in the Soviet Union. There was a law passed that said this is punishable by some extreme measure.
Tracy: (08:40)
Oh wow.
Josh: (08:41)
So we don't actually know the volume of this trade, but there's some evidence that it was there, that it was funded in part by, like trade finance was facilitated by BCEN to some extent. It's unclear when it started, but it's a very small market. The reason why there's no other applications is because at this time there's really not a foreign exchange market. All foreign exchange rates are pegged and controlled because in the wake of the Second World War, there was no tolerance for volatility.
Tracy: (09:05)
Of course.
Josh: (09:06)
So the pound, for example, was like a controlled exchange rate which meant if you were to issue dollar deposits, you just had dollar liabilities and some non-dollar asset. You're warehousing this risk that at some point the peg goes away.
Joe: (09:18)
Okay. To Tracy's point, what next? What creates this system in which, or is it the sort of introduction or the tolerance of currency flexibility that starts to create the sort of asset side of it?
Josh: (09:32)
Yeah. In London specifically, they start to get comfortable with liberalizing, the foreign exchange regime.
Joe: (09:37)
And, just, sorry, for our listeners, what years are we talking about?
Josh: (09:39)
It's like 1951 or so. It's a gradual process. There are key moments where regulations change, and that's kind of to the initial point that Tracy was raising, which is like, it evolves organically, but there are key decision points that affect the outcome in very important ways.
And so the first decision point is the London foreign exchange market is reopened, I think it was December 1951, but it was roughly around 1951, and they kept the spot rate control, but they allowed FX forwards, which are an agreement to exchange currency at some point in the future. That market was allowed to float.
So, you could start exchanging dollars for sterling on a forward basis. That's effectively a loan where you collateralize a dollar loan with sterling. We have FX swaps today. And that enabled banks in London to accept dollar deposits. And on the asset side, they would buy sterling assets, but they would hedge the FX risk.
And in that environment the pricing of those forwards was such that, that was an arbitrage opportunity. It was free money to do this. It was related to the current account deficit. It was related to the inefficiencies of starting a market after world war. You would imagine there were lots of frictions there, and you don't have computers.
It was like, Joe, you were talking in an earlier episode about what did you do without computers? And so, for a time, it was essentially free money for these banks to attract dollar deposits, issue the liability, buy something in sterling, and then hedge the foreign exchange risk. Starting in 1954, The Economist starts occasionally talking about “foreign money” in London. It sounds kind of nefarious but it was…
Joe: (11:08)
When you say The Economist, the magazine?
Josh: (11:18)
The magazine, yeah. Not the one economist.
Tracy: (11:12)
So that was the first mention, or one of the earlier mentions of currency trading as an industry in London?
Josh: (11:18)
It’s specifically these dollar deposits. So “foreign money” in this context meant a dollar deposit in a London bank and not the US branch, not the London branch of a US bank, right. But a London-based city bank. Midland Bank is the most popular at the time. It's one of the largest. The Bank of England starts to get a little worried, because in 1955 this market is doubling every three months.
Tracy: (11:38)
So how does the US feel about that? Because just going back to the start of the conversation or one of the points that Joe brought up, it does feel a little bit weird instinctively when you start to have, you know, one country's currency sort of being controlled by a foreign entity, or them building up like a sizeable bucket of it?
Josh: (12:03)
Yeah, so their view evolves over time. They're initially a little intrigued, so in 1959 is when they kind of get wind of this. It was not obviously known to the broader world that this was happening. And so in 1959 the New York Fed sends a delegation, Alan Holmes and Fred Klopstock representing what was then kind of the markets division and the research division to basically do a fact-finding mission. And they go to London and continental Europe. So it's like the most phenomenal business trip. It's like a month in continental Europe and you can't go anywhere for a day, right? You have to go for a while.
And so they come back and they say “there's this continental dollar market,” is what they call it because that's the non-London eurodollar market. And it's growing and they find it intriguing is a way to make the dollar useful offshore, and that's a way to get people offshore to hold dollars. To get the dollar proceeds of their trade, and then to keep those dollars in financial instruments.
Tracy: (12:55)
Is that desirable though? Why do they want that?
Josh: (12:56)
It becomes really increasingly desirable because the old Bretton Wood system that had been put in place after the war, I said a dollar is a claim on the Fed or a claim on a commercial bank, but in Bretton Woods, it's also a claim on gold.
So foreign official institutions, not anybody, but foreign official institutions can exchange their dollars for gold at $35 an ounce. It's a specified par-rate on the dollar, but there's other need for gold other than just monetary reserves, right? The economy's growing. People need gold for other purposes, and so gold is trading in London at a little more than $35.
So there's an incentive to sell goods to the US, get dollars in exchange for those goods, use those dollars to get gold for $35 an ounce, and then sell that gold for more than $35 in London. That's an arbitrage profit for foreign central banks. It's also a drain on the gold reserves of the United States, right?
Tracy: (13:45)
Right. So if you get everyone to keep in dollars rather than flipping into gold, then that helps preserve your own gold reserves?
Josh: (13:53)
Yeah, so now there's a place to park your dollars and if it pays a high enough interest rate and eurodollar issuers were not constrained by regulations that made it more expensive and harder to pay high interest rates on deposits in the US. They're unconstrained by regulatory limits on what they can pay. That's Reg Q, that was reserve requirements, that was insurance premiums, FDIC insurance premiums. All these things that made it hard for US banks to pay a higher rate of interest. In London, they're completely unconstrained by it, and so they can attract those dollars.
That means that gold is more likely to stay in the US and that keeps the whole system functioning. It isn't entirely effective in the beginning. When the Kennedy administration comes in, one of his senior advisors is, I think he said “scared to death” in his memoirs. He was very worried about this gold drain because he likened it to a run on a bank.
Basically, you're going back to the bank and asking for the hard currency out of the bank. In this case, the bank is the United States government and the hard currency is the gold. And when you run out of gold, the system doesn't work anymore. You have monetary collapse. And people will later recognize that as one of the precipitating factors with a Great Depression. So there's this very strong and acute concern that collapse of the global monetary system could trigger like a Great Depression type outcome.
Joe: (15:07)
Real quickly, I mean, Tracy asked you about the concerns from the US and you expressed one of them there, but you mentioned briefly the concerns of the Bank of England that this industry that was doubling every three months or the size of this market that is doubling every three months.
How did these foreign regulators or foreign central banks feel about their domestic banks accumulating liabilities in a currency they don't control? And, you know, you imagine you could have a run on those banks and they’re like “we can't help you because we can't.”
Tracy: (15:37)
Right, there's no Fed backstop or anything like that.
Josh: (15:39)
No, and that's the interesting thing is that they can pay a high rate of interest, but they should because there's no liquidity backstop. So if I go to a Eurobank, they were called, and I say “I want dollars.” They might have a bank account in the US where they can fund withdrawals from, but it's not going to be fully reserved. Which means I might not get my dollars and then there's nowhere to go.
And so, the Bank of England and other central banks are initially a little skeptical. They like it because it brings business to London. They don't like it because it devalues the pound in international finance in London specifically, and also is hard to control and part of this is just usual fact finding. This is something all central banks do to this day, is just try to figure out what's going on because it's really important to have good intelligence.
So they're concerned only in that they didn't see it coming and they don't have detail. Other than that, the record's a little sketchy. But ultimately, England is pretty supportive because it makes London a very important financial center. And that's very important to them in the sort of post-sterling world.
Joe: (16:35)
I find that interesting, Tracy, this idea that what's good for London was not necessarily good for the internationalization of the pound and, so at the same time, here's London booming at the cost of the sterling being the global currency. But it's interesting how there is not some sort of one-to-one relationship between the importance of the pound and the importance of the City of London.
Tracy: (16:56)
No, absolutely. Well, okay, so just on this note, I mean we are all aware that nowadays you have these things called dollar swap lines. Were those effectively the backstop for this? Or did someone try to address this question of the riskiness of these dollars outside the US financial system?
Josh: (17:13)
So somewhat indirectly, I guess I would say. The first, so the swap lines started in, I think it's 1962, it might be 1963, but Charlie Coombs, who's the special manager for foreign exchange at the Federal Reserve Bank of New York is tasked with setting up arrangements with foreign central banks.
At the time, the focus was defending the dollar if the dollar comes under attack. Everyone's worried about “speculative attack.” That's kind of like the original bond vigilantes, right? It's the foreign exchange vigilantes. And they're worried that speculative attack on the dollar would lead to a greater run on this sort of like international banking arrangement that the US was functioning as.
And so he goes to England and France and Italy and the Bank for International Settlements in Basel and the Swiss National Bank. And he slowly but surely negotiates a bunch of swap lines which are designed to be able to, for the US at the time, to pull in foreign currency and then buy the dollar with those foreign currencies. So it's kind of the opposite of how they were used in more recent years to lend dollars to the world.
Tracy: (18:11)
Oh, interesting. I didn't realize that.
Josh: (18:13)
Yeah, and so that's the initial logic. But Bob McCauley and Catherine Shenk uncovered this second swap line with the BIS, set up in 1964, which was not for Swiss franc, but was for any other European currency. And it was made with the explicit arrangement that the BIS would act as a channel to the eurodollar market if it needed liquidity. So there's evidence that the BIS didn't love this swap line, but they say “oh, the Fed called us and asked us draw on it, so we'll draw on it.”
It was sort of acting as agent for the Fed on behalf of the whole system, and it was used primarily at the end of the year when there were liquidity pressures due to seasonal effects or the usual variations in demand for liquidity were smoothed over with the swap line, but it was also there and got gradually bigger as a backstop to the eurodollar market more generally.
But it was ultimately not a lender of last resort because it required coordination. But it was like a line, a lifeline for the eurodollar market in its early days, and that allows it to grow a lot. So, you know, we were talking about 1960, it's a roughly $2 billion market. By 1964, it's a roughly $10 billion market. By the late sixties it's, you know, a $60-70 billion market. So it keeps growing exponentially much faster than the money supply.
Joe: (19:24)
So I mean, you sort of anticipated my next question, but I think back then and for a long time, and many people still take very sort of quantitative ideas about monetary policy or M2 and these various measures of money supply are really important policy tools or things that we should target, etc. How do monetary policy makers feel about something offshore? Something that is growing the supply of existing dollars in the world…
Josh: (19:50)
It's a trade-off. So in the mid-sixties, this gold drain is accelerating. So the US is forced — I don’t know if you call that monetary policy, it has to do with the currency — but to maintain the stability of the international financial system and close the current account deficit, which was large, to basically stop the flow of dollars out of the country and bring balance to the global monetary system, they had to impose capital controls.
So that starts with what's called the interest equalization tax, which was basically penalizing the issuance of dollar-denominated foreign bonds in New York. So, you apply a surtax to that, to equalize the interest rates. They eventually have voluntary credit restraint, specifically with extensions of credit abroad. So like New York banks should not loan to foreign entities. The whole point being to keep the dollars in the US.
The only way that works without throwing a massive monkey wrench into the global monetary and economic system is if there's an offshore sort of, I hate to say “shadow,” like an equivalent or an air gap, a segregated dollar financial market that can fill the gap as New York pulls back. And so they identified pretty quickly eurodollars as the eurodollar market, meaning the eurobond market is the issuance of dollar-based bonds in Europe, the eurodollar market is the issuance of dollar-based liabilities. There's also a loan market, and so there's basically a mirror image financial system optimized or an international activity that's gotten large enough to carry the load, especially with this liquidity backstop.
So they see this as kind of the outlet valve for all of that activity that would otherwise drain dollars from the US that helps them try to stabilize this outflow. So that's the sort of financial stability argument. The cost of that is like your money or your life, right? So the other version of that is losing monetary sovereignty. There's dollars that are being issued by non-US entities, not regulated by the Federal Reserve or the OCC. With only sort of intermediated access to liquidity. They don't have a direct access to the discount window. They have to go to their central bank, which goes to the BIS, which goes to the Fed.
So it's a coordination requirement there. And so the question is like, which of these two things is more important? In the sixties through the early seventies, the prevailing view was closing the balance of payments gap and stabilizing the global monetary system, was the more important thing. And so these swap line allocations keep growing. They keep growing the max size of that facility to make sure that if needed, they can stabilize the dollar and provide liquidity to the offshore dollar market.
Tracy: (22:22)
I still like the organic free range dollars analogy. So, you know, you set them out into the world, but you take a risk in doing so. You know, the dollar could get scooped up by a hawk or eaten by a weasel. I don't know.
Josh: (22:35)
It's like an outdoor cat, basically.
Tracy: (22:36)
Yeah, yeah. I'm taking this too far. Okay, wait. But Josh, you mentioned the 1970s. And when I think about dollars and currencies and big financial events in the 1970s, I think about Nixon de-pegging the dollar. And I take the point that eurodollars, to some extent, were solving this gold problem that you described, but that must have had some sort of impact on the market?
Josh: (22:59)
It did. So the seventies are where this all starts to get a little more worrisome, basically. Lots of things got more worrisome in the seventies. Eurodollars start to fall out of favor in the late sixties and early seventies for two reasons. One is there's these speculative attacks on various currencies that are blamed on the eurodollar market as the vehicle through which the speculative funds are flowing around. They called them hot money. So the pound crisis of 1967, various crises in subsequent years are kind of blamed on the eurodollar market.
That's the first thing. The second is it's growing rapidly, and that's for a couple of reasons. One is Libor is invented, so now you can manage the interest rate risk in a eurodollar bank. So Libor is created for the purposes of eurodollar lending and floating rate loans. And so now you don't have this maturity mismatch that would otherwise be hard to risk manage. There's a lot of analogies to the present day.
Joe: (23:48)
It’s so funny how these terms that we consider to be so crucial — eurodollars, London Interbank Overnight Rate — it’s like we just don't even question that. We have all these European names for these crucial things.
Josh: (23:59)
Yeah. Well, I should have mentioned at the beginning when we were talking about the Soviet Union, the eurodollar does not refer to Europe. It refers to the telex address of BCEN, so BCEN’s telex address was Eurobank-BCEN.
Joe: (24:12)
Oh, so it's not even..
Tracy: (24:13)
Oh, this makes so more sense
Josh: (24:15)
Yeah. So eurodollars meant dollars for BCEN. For Eurobank. That was like a shorthand for payment processing agents and things like that.
Joe: (24:24)
This was a totally new one that I had no idea
Tracy: (24:27)
Yeah, this is like a revelation because everyone thinks Eurodollars have something to do with the euro or Europe. But actually, okay.
Josh: (24:33)
Communist-owned bank in Paris. Yeah.
Tracy: (24:35)
Yeah, no one thinks that. Okay, so 1970s, this thing is growing. There's some concern about it potentially getting out of control. What do people do about it?
Josh: (24:44)
So, they start to call meetings and commission studies, basically.
Tracy: (24:49)
As one does.
Josh: (24:50)
So, the problem is the US is maintaining a low interest rate policy, so it's attracting dollars overseas. And so the eurodollar market is absorbing outflows from the US where interest rates are low relative to eurodollar rates and European rates. And so it's a monetary policy dynamic. And that's causing some consternation because at the same time, Milton Friedman is becoming very popular. The monetarist movement is growing, and so lack of control over the money supply is much more concerning when you're focused on the money supply for monetary policy purposes.
And so, in 1971, the BIS calls the standing committee on the eurocurrency market, a very august sounding body. And they meet and they decide to have a standstill agreement where central banks will no longer deposit their own funds in the eurodollar market because there was some concern that when the Bank of Italy puts dollars into the eurodollars, then those get relent and redeposited and relent and redeposited.
And so you have two problems associated with that. One is just multiplier effects. And the other is this sort of official moniker of like “oh, central banks are using this market, that means I can use this market.” And so they all agree to stop putting new money into the eurodollar market. The problem is there's not much else to do with your money. And so after three months, they kind of abandoned that agreement. So it literally lasts until the first renewal date, and then they all kind of go their separate ways.
Tracy: (26:05)
Wait, so there's a three-month standstill on the eurodollar market in the 1970s?
Josh: (26:10)
On central bank placements into the eurodollar market. So the governors of the major central banks get together — the G-10 — and they say, we're not going to put any more money into this market.
Joe: (26:19)
I know this is one of the things, every time we have these conversations, it's like nothing new under the sun. You think about some of the lessons here in terms of people are always going to chase the higher rate, right? So people, you create a new money that offers a higher rate and the money gets stuck there. The lack of alternatives to existing market, I mean, so many conversations about alternatives to Treasuries, etc. It's like often there's just not another thing that you could put it in.
Josh: (26:42)
Yeah, no, I mean it's sort of like more money for the same perceived risk. Now we can debate whether or not it's the same risk, but from the cash investors perspective, “I can get 3% here, 5% here, and looks the same. I'll take 5%.” Hopefully it was a little more nuanced than that but I think that is kind of the logic. And so there's a lot of like hand wringing at the BIS in these regular meetings at the FOMC minutes, they start getting a regular rundown of like, what happened at Basel this month?
And it's kind of a new development because that's the point where it becomes really important and so Governor Daane and sometimes Charlie Coombs or the various people who attend these meetings going back and forth to Europe in 1971. Seems like a pretty aggressive thing to do every month, but I guess the planes were nicer and they had served better meals, but they get a rundown and basically the message is, “we're going to commission a really thorough study and we're really going to think about this. And we have agreed that this is an important problem that's worthy of attention, but there's very little actually done.”
In the financial press, people kind of get to the point where they believe the screws are getting tightened. The hammer's coming down. Like there's an article in The Economist called “Who Killed the Eurodollar Market.” I think that was 1972. There's this sense that it’s getting to the point where someone has got to do something. At some point in this process, there's a company that starts selling eurodollar branded chewing gum. So that's when, you know, a trend has like [emerged]...
Joe: (28:08)
Now we pull up eBay…
Tracy: (28:10)
I must have this chewing gum, but honestly that's amazing.
Josh: (28:13)
So it's kind of got like a pop thing going on. And so, the view is at some point, this is going to get contained. And by 1973, there's like a relatively broad consensus that this is sort of necessary. And then, in September, there’s the Yom Kippur war and the oil embargo. And everything changes.
Tracy: (28:32)
So this is our cue for Act Two of the Josh Younger rabbit hole or the second rabbit hole, which is petrodollars.
Josh: (28:39)
Yeah. So petrodollars are sort of broad term for the dollar-based revenue from the sale of oil. Petrodollars have been around for a while. Actually, the oil-producing countries were involved in the eurodollar market since the sixties. The thing that happens in 1973, is as a consequence of US involvement or support for the Israelis in the Yom Kippur War, there's an embargo of oil shipments to the US. The price quadruples and oil revenues go from 1% or 2% of global GDP to 5% of GDP. So we're talking about a hundred billion dollars a year in 1973.
Tracy: (29:10)
Right. So this huge sudden influx of wealth, presumably going mostly to the oil-producing nations in the Middle East.
Josh: (29:16)
Yeah, and it's kind of come from nowhere, right? It's just the price of this commodity has gone up. It's not like people issued one hundred billion new dollars with which to buy it. And so, they have to figure out a way to issue one hundred billion new dollars a year to facilitate this flow. So most people are focused on the oil revenues needing a place to go, but you also need dollar loans to the oil importers to buy that oil in the first instance.
So you need both sides of the equation and the eurodollar market — for all the reasons we talked about — was reasonably well-developed at the time. So in their search for a distribution mechanism, which is again to take the oil, Saudi Arabia sells a hundred dollars’ worth of oil. They take that money, they put it into something, that has to somehow get to the next country that has to buy a hundred dollars’ worth of oil. And it goes back to Saudi and it kind of goes around in a circle. That's why it's called petrodollar recycling, right?
And so those petrodollars need an intermediary that has elasticity. Elasticity means they can grow substantially to meet this massive increase in demand. And eurodollars, the US in particular, Bill Simon, who's the Treasury Secretary in 1974 for Nixon, he is very focused on using that channel, specifically private market intermediation, not going through the IMF, not going through the BIS, but specifically private market intermediaries serving as that distribution system.
Joe: (30:36)
So, sorry. You know, because again, I think as you said, people use the word petrodollars and they sort of mean all different kinds of things. But to use it in a way that’s actually useful, what we're talking about is the system of private banks that issued dollar-denominated liabilities that handled the flow of oil revenue.
Josh: (30:55)
Yeah. And they issued assets, right? So they had loans to oil importing countries and liabilities to deposits from oil exporting countries. They're the bridge. Because the financial system doesn't track oil imports.
Joe: (31:10)
Who are these banks? Are there specific banks that played a prominent role early on?
Josh: (31:14)
It's just like all the usual massive banks. They were all involved in this. There’s old pamphlets. When I was at JP Morgan, I went down to the archives, they had these old pamphlets. They're like “the eurodollar market, a great opportunity for this, that, or the other thing!” And so it's just seen as like a very lucrative very high growth business area. The concern is that these loans are relatively long dated and these deposits are relatively hot and flighty.
And so, you know, there's a lot of analogies to today, right? So you issue a short-dated deposit, you're not sure how long it's going to stick around. You think it's going to stick around for a long time, but if the Saudis decide that they don't like this bank, they like that bank, they'll move their money, or they're paying an incrementally higher rate or that sort of thing.
So how sticky eurodollar deposits are is an open question, but the loans are long-dated because countries have an ongoing need to import oil. So, the eurodollar market grows exponentially, but it incurs a much larger liquidity mismatch or maturity mismatch. It's doing more and more liquidity transformation — long-term loans, short-term liabilities — and there's this increasing concern by the spring of 1974 that the system is creaking under the weight of this demand and something might break.
Tracy: (32:30)
Does something break? I’m going to take the bait. And also since we're talking about, you know, historical analogies to today, I have to ask, did something break?
Josh: (32:37)
Yeah. So something breaks, not what you'd expect. I think they're the 34th largest bank in Germany, but there's the Bankhaus Herstatt. And people talk about Herstatt risk now, but Bankhaus Herstatt is very involved in speculating currencies. And I didn't talk about the Nixon shock and the de-pegging of the dollar, that's a whole story in of itself. But what it does is it generates a lot of volatility in foreign exchange rates, which had previously been very sticky. And so some people see this as a risk. Some people see this as an opportunity. And Ivan Herstatt runs Bankhaus Herstatt. It's a private bank, privately-owned bank.
And he's like, I think he called it his “big hour,” right? “This is my moment to make my mark.” They take a massive long dollar position. It goes bad. And they fail. The bank fails, right? Herstatt never takes responsibility for this, by the way. He writes an autobiography later, called “How My Life Savings Was Stolen From Me,” or “My Life’s Work Was Stolen From Me,” in German so I’ll check with somebody on translating that.
Tracy: (33:32)
Commitment to the narrative, I guess.
Josh: (33:34)
Yeah. But the bank fails. It's seized by German regulators in the German afternoon, which makes sense. The problem is they had a bunch of outstanding dollar transactions in New York, slated for New York afternoon. So the European transactions, the European payments go through on these foreign exchange transactions: I give you Deutsche Marks; you give me dollars, right? Or you give me Deutsche Marks; I give you dollars, in this case. And so they got their Deutsche Marks, but they never sent out the dollars.
Tracy: (34:00)
So this is classic settlement risk. I mean, Herstatt risk became basically a synonym for this type of risk.
Josh: (34:06)
So not only a synonym, it's the reason we have Basel bank regulations in the first instance. So the Basel Committee is convened to address this issue and it ultimately evolves into a much more elaborate international standard and standardsetting mechanism. But the idea of having international coordination of bank regulations comes out of this episode. So that's also, I guess, another episode...
Tracy: (34:29)
We just need to get the Josh Younger lecture series going, I think.
Josh: (34:32)
Yeah. So in New York, the payments don't go through. It's a significant amount of money. There's a lot of banks holding the bag. And the payment system essentially breaks down. No one is willing to do cross-border payments because they're not sure if this is going to happen again. Like, who's next? What's the next shoe to drop?
Joe: (34:50)
Always the same.
Josh: (34:52)
Yeah. And so, the Clearing House Association starts allowing for claw-backs of payments until the next day afternoon to try to facilitate this. And it kind of works for the spot market, but doesn't really work for the foreign exchange derivatives market. And so you get a tiering of intermediaries, of counterparties where the largest, best-capitalized, most well-known banks can trade freely, but the small and medium-sized banks are essentially shut out of the market.
Tracy: (35:11)
Sounds a little bit familiar.
Josh: (35:12)
So now your eurodollar issuers can't hedge, they can't hedge their foreign exchange risk. Now they're short dollars from their deposits and they don't have any hedge for the other side. So unless they have a match with the assets, which they didn't always have, they have a problem.
Joe: (35:29)
So how did they solve this inability to hedge?
Josh: (35:32)
So then the question is, what do you do if there's another run? How do you backstop the eurodollar market in a more concrete way? Who is the lender of last resort to the eurodollar market?
Joe: (35:42)
Which was kind of like my first question I had at the very beginning.
Josh: (35:44)
So, 20 years later, they start really contemplating this in detail, because the first instance is 1954. Then in 1974 they go, “you know, we really need a plan for this.” And so they start convening meetings and the usual things. In July of 1974, there's like a tacit agreement to do something, but it's not concrete. It's unclear how it's going to be executed and basically the market goes “do better.”
And you have this massive shift where on the one hand the eurodollar market goes from out of favor to very much in favor. This is an important mechanism we need to maintain the flow of oil. To facilitate economic growth, we need a stable eurodollar market.
So the regulatory impulse reverses completely. And in September, the G-10 central bank governors go so far as to put out a public communique where they say, “we are going to do what is necessary.” This is “whatever it takes” the first time. So this is just like what happened in Europe around the sovereign debt crisis, but it's in 1974 with relation to the eurodollar market.
And they say, we're going to do whatever it takes — I don't remember the exact words — to facilitate liquidity in the eurodollar market and make sure it's stable.
Joe: (36:47)
Sorry, real quickly, who said this?
Josh: (36:49)
The G-10. The central bank governors of the G-10. But a communique. So it's a collective agreement. They leave out some details, like what do you literally mean? But because they put it into communique, this is all about central bank communication, right? So like we're putting it on paper, we're putting it in the newspaper. They send it to the Wall Street Journal. Because that's what you had to do back then, right? There are no computers. And so you say, “please print this.” And so they print it.
Tracy: (37:09)
Fax it to the Wall Street Journal. Wait, were there faxes in the seventies?
Josh: (37:12)
Maybe it was telex. I don't know. That's a good question. But they put out a public communication that this is the case, the goal being to stop the contagion. So to specifically to facilitate the acquitted in the eurodollar market, and the implication is we need this thing to avoid a global monetary contraction. There's a lot of hand wringing in the press, like if they don't do something we could have global monetary-based destruction through the collapse of the eurodollar system. That's what happened in 1929 to 1933. It could happen again. We're looking at another Great Depression. Somebody do something.
Tracy: (37:45)
So they don't announce the exact mechanism, but they just announced that they will do whatever it takes. Those sorts of words.
Josh: (37:51)
Yeah. They're very clear about their commitment in a public forum, as opposed to having a behind the scenes conversation that gets leaked out.
Joe: (37:58)
Apparently, the fax machine was invented in the early 1800s. But the actual modern fax, 1964. So who knows, maybe it was a fax.
Josh: (38:07)
I'm sure the eurodollar banks had it. I'm not sure the central banks had it yet at that point.
Joe: (38:11)
So just on petrodollars, you know this word, even more than eurodollars conjures up all kinds of conspiracy theories about, “oh, we've forced the oil exporters to use our currency and this is really crucial.” Is there an element of truth to that story? Where the US made a concerted effort to sort of figure out how the oil exporting nations in the Middle East were going to, the currency that they were going to sell their oil in?
Josh: (38:36)
So it wasn't always petrodollars. It was originally 75% dollars, 25% sterling. So it was a mix. I don't know where that ratio came from, but that was sort of like the agreed upon rough breakout of oil revenues in like 1973. And the question is why was it all dollars after then? And I wouldn't say conspiracy theory, but there was a policy decision at the Treasury, that we do want them using dollars and we specifically want them buying Treasuries. Which makes sense. So other than the eurodollar market, you can have governments provide this redistribution mechanism as opposed to intermediating the extension of credit, it can go through government spending. And the US is looking at a widening budget deficit.
Tracy: (39:13)
Wait, so the idea there was just, well, if we're going to spend enormous amounts on oil, we might as well get something back?
Josh: (39:20)
I guess I can't validate that specifically, but that seems plausible? All we know is that they decided that this was a good way to sell Treasury bonds. Which makes sense, there's a lot of excess dollar-based savings abroad.
But that requires 1) that the oil exporting countries be comfortable buying Treasuries, which has got a bunch of things around that. And 2) that it stays in dollars. Those two things are connected. So, in the spring of 1974, Kissinger convenes this like council, with Saudi Arabia specifically, to think about US-Saudi economic coordination.
We don't have a lot of records from that, that at least I have easy access to but David Spiro wrote a book about this a while ago. And his view was that those meetings in-part revolved around trying to convince him to use only dollars for their oil revenues. So that was one line of debate at these council meetings.
The other is the Treasury side of it, and so Bill Simon's idea is eurodollars are the primary recycling mechanism, but while we're at it, maybe we'll get some revenue for the government. And so he flies to Riyadh in July. He actually gets scooped by Fannie Mae who wants to sell to ventures to fund mortgage bonds.
Tracy: (40:26)
Ah, oh. They get there first and they're like “buy mortgage bonds!”
Josh: (40:28)
They get their first, and there's like this whole back and forth in the State Department about like, “who approved this? And why is this guy here first? No one told me.” But there's a little bit of a gold rush dynamic. But he shows up and he says, “okay, here's what we can offer. You buy Treasury bonds. After the auction, you can look at the price and decide if you want more, we'll do them as on an add-on basis, which means you're not an active participant in the auction. You get a second look and you can decide if you want them at that price. Your name will not appear on the ticket.”
So like the Federal Reserve of New York is going to be the custodian. And so they're going to transact on your behalf. You get confidentiality. And the implication is in exchange — this was a pitch to the Saudis in July — and it's reasonably well-received and they start dabbling in the Treasury market in September.
The problem is that the governor who did this deal dies in October. Suddenly. He has a heart attack in DC while he is in a set of meetings. And so, it takes him a little while to find a successor, but the whole thing gets put on ice for a little while. And then when they find a successor, he's not on anyone's list.
There's a bunch of state department cables who are basically, who is this guy? Because nobody thought he would be one of them, but he's a technocrat. He was educated in the US. He's viewed as quote “very pro-American,” was the evaluation the State Department had. And he's viewed as like the harbinger of a technocratic administration that's going to be much more US-friendly.
So it's a big signal from the Saudi government that, or at least taken to be that, you know, we're willing to sort of work with you guys on stuff when he's appointed. Literally his first meeting is with the Treasury to restart deal negotiations on Treasury bond purchases. And that's his first three days. Before he takes office, he goes “I want that to be my first meeting.”
So they have the meeting. I think it was November. And in December, there's a surprise announcement from the Saudi oil-producing companies that they will no longer accept sterling in exchange for oil, so all oil revenue in dollars. Very awkward, because the British Chancellor of the Exchequer is in Saudi Arabia when this leaks out, so, and when, asked for comment…
Tracy: (42:32)
And the British had really close ties with Saudi Aramco from what I remember.
Josh: (42:36)
Yeah. And basically the response of the administration, Saudi Arabia is like, “no comment,” to the State Department. They said “it's very unfortunate that this happened.” So I don't know what you take from that, other than maybe this was like an unintended release of information. It happens on the 13th of December. On the 14th of December, there's an agreement on the Treasury deal, so there's a lot of alignment between these two decisions. There's no evidence that they were coordinated in any respect, but they certainly go like the same direction.
And some people speculate that there was like a quid-pro-quo there. There's no direct evidence of that in the record, but you know, people put two and two together.
Tracy: (43:13)
So can I just ask, the Saudis agree to all of this to petrodollars sort of as a concept, because they get to buy US treasuries in a semi-advantaged way?
Josh: (43:23)
It's not clear that's the only reason, but those two things are connected in time. And some people have put together that story. There’s later comments from Treasury officials that are like, “The Saudis are holding the line on the dollar, even though people want them to use other things.” And so, like that's where the record's a little sketchy. But the timing and the nature of these agreements, has led some people to speculate that they were connected.
Joe: (43:36)
But also, to your point, if you have a surplus of dollars, that's a problem you have to solve regardless, right? So maybe you don't necessarily go directly into the Treasury market because of some advantage. But at some level, you got to put them somewhere. And so there was some effort made to like, “Here's an easy way to solve your problem.”
Josh: (44:03)
Yeah. And it's not like they're getting a better price. They're just getting somewhat better treatment in the sense that they can go through, they can look at the auction, decide if they like how it went. If they liked the price, they can buy more.
Tracy: (44:13)
Yeah. Imagine if SoftBank had got there first and all the Saudis would put their money in SoftBank stock. So this is it! This is the moment when petrodollars become a thing and eurodollars have already become a thing and the dollar is sort of firmly embedded in the tissue of global financial markets?
Josh: (44:28)
Yeah. And so, it doesn't happen all at once. Like Saudi is not all oil supply. But something like, Bank of England put out an estimate a few years later by ‘75, dollars are like 80% of oil revenue, and then by ‘76 they’re like 94% of oil revenue. So it happens pretty quickly. But at that point, the dollar is already the medium of global trade, for the most part, it's already the primary reserve currency, but because oil revenues are the primary thing happening in global finance and the global monetary system, this cements in some sense that status.
So all of this building up of the eurodollar market is put to work, in a sense, through the oil shock of 1973 and the rise of the petrodollar system. It's important to say that petrodollars don't create the eurodollar market. It has to be in place, elastic and flexible, and already the has the network effects that allow it to function as a distribution mechanism.
Joe: (45:22)
Right. That's the thing I like really never realized before that there is sort of like, it almost sounds like petrodollars are like another skin of the eurodollar market. Then it's like a slice of it.
Josh: (45:33)
Yeah. And they're the thing that makes it grow the most. But all of the basics have to be in place for that to actually work.
Tracy: (45:41)
So is the implication that, you know, we do have dollar dominance nowadays in the global financial system, but in order to get there, the US had to give up a little bit of monetary sovereignty?
Josh: (46:01)
I think the lesson is, at least just the experience of the US in that period, and the US in some sense, when dollar dominance is coming into place, you have the disruption of the Second World War. So you have a massive disruption of the global monetary system. The US is essentially the only economy left standing.
And so the fundamental arguments around global reserve currencies very much applied to that period. Even so, there were lots of policy decisions that had to get made. This was not a foregone conclusion. There were key decision points where certain key policies were put in place, or backstops provided or, you know, agreements offered.
And so the story of global dollar dominance is an interesting one, I guess, is kind of the conclusion. It's an interesting one with characters and actors and decisions and near misses and we usually think of it as just kind of like a boulder rolling down a hill and it's kind of unstoppable. And that may yet have been so, but the real story is a very rich one.
Joe: (46:55)
Well, as Tracy pointed out in the beginning, I was like, it’s sort of emergent. And Tracy was like, well, actually, maybe the story is not. And I think that to your point, like, no, things happen. Meetings happen, flights happen, trips to Europe happened. All these things.
Josh: (47:06)
Yeah, I don't think there's a movie in it. But there's a book in it. ou know, that kind of thing.
Tracy: (47:09)
Someone makes eurodollar gum, that’s the turning point.
Joe: (47:11)
There's a TV series in it for sure.
Tracy: (47:13)
Well Josh, we're going to have to leave it there, but it was wonderful having you on the show. And you know, as much as some of the de-dollarization discourse annoys me, I am very grateful that it gives us a chance to revisit financial history with you. So thank you so much.
Josh: (47:28)
No, it's great to be back. Thanks for having me.
Tracy: (48:03)
So Joe, I don't know if anyone listening heard me frantically typing at the eurodollar gum mention, but I haven't..
Joe : (48:09)
I did the same thing, we both like pulled up eBay and stuff. Like I need to find this out.
Tracy: (48:13)
I haven’t been able to find an image but there’s a 1974 article from The New York Times, it’s called, the headline is “The Eurodollar Bubble,” and it has a description where it talks about how the inflow of eurodollars takes the form of bubble gum packaged in gold foil to resemble coins. Isn't that amazing?
There's so much to pick out of there. So many things I hadn't realized, including where the “euro” in eurodollar actually came from. But I guess two things stand out. So, one, the theme that Josh hit on at the very end, this idea that we think of the dollar dominance theme as largely a sort of network organic effect that emerged over time when actually there were some conscious decisions that might have gone into at least making it more probable.
And then secondly, the asset liability point, that's something that Karthik mentioned in his episode as well, where he was talking about, well, you're not gonna get a lot of Chinese renminbi dominance until you actually see liabilities denominated in this. And that's kind of what happened with eurodollars, right?
Joe: (49:18)
Yeah, no, so much I learned from that and, you know, to the point — not to make everything like a “what does it mean for today?” — but then it sort of gives you a further appreciation of how much work another currency would have to do to ever even like entertain the idea of like a replacement for this. It’s not just going to be emergent, it's going to be the result of diplomacy and back and forth and all these other things. You know, I was thinking about, we recently recorded an episode with Jim Grant and he made that point. He's like, you know, in technology they build on the shoulders of giants. In finance, you just sort of repeat the same stories over and over again in different topics.
Tracy: (49:51)
You build on the communiques of Basel?
Joe: (49:52)
Yeah. And again, it's like every time we talk to Josh it's like, man, nothing really changes. It's just the risk is slightly different. There's a new name for it, but it’s the same sort of puzzles in different time periods.
Tracy: (50:03)
Yeah. No new risk under the sun. Well on that note, Shall we leave it there?
Josh: (50:06)
Let's leave it there.