It’s been nearly four years since COVID-19 burst onto the global stage. We’ve returned to normal, but “normal” just doesn’t mean what it used to.
Domestically, Americans are feeling worn out. Social tensions are high and have been for a couple of decades. Conservatives and the right wing waste no time in blaming it on the commander-in-chief. Meanwhile, the left repeatedly insists not enough is being done by the government, pointing to healthcare, education, and housing as some of the issues where further intervention is needed.
However, both parties largely fail to grasp the full scope of the issue, including its root cause: money, and specifically, global money.
We’ve looked at money and interest rates, and examined the banking system and the ways in which it multiplies or fails to multiply money. Let’s consider monetary history to see if we can avail ourselves of some deeper insights into exactly what’s ailing the American economy.
The Last Update
Like many other facets of society, the contemporary history of money starts with the conclusion of World War II. In the summer of 1944, the Allies were increasingly confident in their eventual victory and held a conference for the purpose of determining how a global monetary system would be organized in a postwar world.
For three weeks in July, 730 delegates from 44 countries deliberated in the New Hampshire town of Bretton Woods. The conference would come to be known by this name. These delegates considered the monetary turmoils of the previous two decades in their design of this new system.
In the throes of the Great Depression, many nations, including the great powers of the United Kingdom, the United States, and France, came to break their fidelity to gold. They did this to make their own currencies cheaper, with the hopes of incentivizing spending and thereby spurring growth. Currency devaluation has the added benefit of effectively making a nation’s own exports cheaper, which gives it a competitive edge in international trade.
When nations devalue their currencies in response to one another, it’s called competitive devaluation. It was a recurring cause of aggravations throughout the 1930s.
The delegates also knew that gold standard money would be too difficult. If every nation used a gold standard for their money, there would be no global currency for trade. This means that if Mexico wanted to trade copper to Norway in exchange for salmon, Mexico would inconveniently need to maintain a reserve of Norwegian kroner, and the Norwegians would need to do the same with Mexican pesos.
And these countries would have to do that for every nation they wanted to trade with. Either that, or they’d have to exchange currencies directly in gold, which is expensive, hazardous, and slow.
So what was the middle ground between a stable-value currency system and an efficient currency system? Legendary British Treasury economist John Maynard Keynes proposed a currency system he called Bancor. Bancor would function as a neutral currency overseen by an international central bank, with nations settling their Bancor balances periodically at a fixed exchange rate. Occasionally, a nation’s exchange rate could be adjusted to reflect changes over time in the value of a nation’s currency.
Bancor is what’s referred to as a “balance of payments” currency system—one in which the value of a nation’s currency changes in value in accordance with its trade balance. More exports mean the currency appreciates. More imports mean the currency depreciates.
But the American delegation rejected the Bancor system. What was decided on instead was the adoption of the U.S. dollar as the global reserve currency.
The arrangement was that individual nations would maintain an exchange rate with the U.S. dollar, and the United States would maintain a gold standard by pledging to redeem U.S. dollars from foreign governments for gold at $35/ounce. This would seem to have solved the currency reserves problem while still featuring a strong store of value through the inclusion of gold—a seemingly elegant system.
The Exorbitant Privilege
With the U.S. dollar established as the global reserve currency, the United States found itself in an interesting economic position. The Bretton Woods system meant that global nations, banks, and businesses would always be in need of more dollars as their economies grew larger. This need would cause foreign exports to be cheaper in dollar terms.
The dollars were naturally flowing from where they were plentiful to where they were scarce, in the same way gas flows from a high-pressure to a low-pressure environment. And all this was in exchange for foreign goods and services.
This tailwind to the American consumer’s purchasing power would be termed the “exorbitant privilege”: the benefit of foreign producers, all competing to sell their goods for the currency that Americans had in relative abundance. But there was a flaw.
An Incipient Problem
The Bretton Woods system suffered from a problem that would come to be known as the Triffin dilemma. Named after Robert Triffin, the economist who would present the issue to the U.S. Congress in 1959, the Triffin dilemma described the tension experienced by the U.S. dollar as the global reserve currency.
Triffin explained that being the global reserve currency meant that the U.S. dollar had to supply enough of itself to meet the currency demands of global commerce. The global need for dollars meant that U.S. manufacturers would be exposed to foreign competition. The Bretton Woods system was having the effect of urging the U.S. to consume more than it produced, and even to borrow money to finance more consumption. Essentially, the U.S. consumer was “forced” to purchase exports instead of domestically produced goods—all to move dollars around the world to the places where commerce needed them.
Money in the Shadows
As foreign economies grew larger, they wanted to hold more U.S. dollars. Naturally, some foreigners wanted to lend their saved dollars in their own country, where dollar demand was high. Others wanted a way to source dollars without direct transactions with the U.S.
If this sounds familiar, it’s because I’m describing banking, but with one important detail: It all took place outside the United States, with dollar deposits held in foreign countries outside the U.S. banking system.
Dollars held in this manner are called Eurodollars. The term doesn’t have anything to do with the euro currency used today. The “Euro-” prefix in the term simply means offshore, or abroad.
Its first usage was describing U.S. dollar deposits held in Europe, but the term can apply to any location. Euroyen are Japanese yen held outside Japan, Eurosterling are British pounds sterling held outside the U.K., and I am happy to share with you that, yes, Euroeuros are European euros held outside the Eurozone.
As all of this Eurodollar finance took place, Triffin observed a burgeoning supply of U.S. dollars held abroad. The Federal Reserve, responsible for keeping track of the size of the global money supply, became increasingly aware of its inability to account for this “shadow money” being lent, spent, and multiplied overseas.
This presented the United States with another problem: The Treasury was still obligated to redeem dollars for gold at a rate of $35/ounce. However, its gold reserves were dwarfed by the U.S. dollars created by this offshore banking system. As more and more foreign governments came for gold, the U.S. gold reserves were depleted.
A Doomed Alliance
One attempt to answer this problem was the London Gold Pool. It was an agreement formed in 1961 between the U.S. and a group of European nations to contribute to a central supply of gold that would be used to help stabilize the price of gold in the London market. The U.S. was the senior partner in this arrangement, contributing 50% of the pool’s supply. It was essentially an effort on the part of the U.S. and other nations in the global monetary “core” to put more gold behind the global money supply.
But it wasn’t enough. The participants had originally intended to implement an apparatus through which they could impart stability to the monetary system. But as the global monetary system continued to grow larger, the effects went in reverse.
The apparatus designed to impart stability to the global monetary system began to imperil the actors working to stabilize it. Instead of transmitting stability from the participants through to the global money supply, it was transmitting instability from the global money supply through to the participants.
France, aware of the direction things were going, withdrew from the agreement and repatriated much of its gold in the summer of 1967. In the fall, the British pound sterling was swiftly devalued in an episode of speculative attack. The pool collapsed that following March. Its members had neither the will nor the means to continue supporting it.
The Final Nail
Most people know what happened next: On Aug. 15, 1971, President Richard Nixon announced that the United States would no longer honor its promise to exchange gold for dollars. It was a decision that shocked the world. In the years immediately following, the price of gold increased in value by a factor of almost five.
Most people don’t understand that this decision wasn’t made so that the U.S. could become a profligate, irresponsible spender. As the proliferation of Eurodollars helps us understand, the dollar-gold peg wasn’t simply broken in a day. It was a system that was placed under increasing strain over a long period of time until, finally, it was no longer manageable. In all sensibility, it was unrealistic to expect the U.S. to continue to supply its gold to the international community at the relatively low price of $35/ounce.
1971 was the year that the U.S. publicly shirked the full responsibility of global money. Little did anybody know that it was ceding control of the global money supply to the invisible hand of the Eurodollar system.
New Money
It didn’t stop with the delinking from gold. Over the decades that followed, the Eurodollar system continued to grow in accordance with global commerce. This was especially in support of the emergent computer and software industry and the foreign mining operations that supplied it.
U.S. foreign policy in the 1980s brought the Arab world deeper into the international banking community. And the development of East Asia, especially Japan and later China, offered new opportunities for Eurodollar expansion as well.
Importantly, the Eurodollar system did not just grow in terms of its nominal size or its prevalence throughout the world. It also grew qualitatively. Whereas earlier-generation Eurodollars may have been certificates of deposit or other more rudimentary assets, the Eurodollar system in the 1980s started making creative use of more sophisticated instruments, such as interest rate swaps, repurchase agreements, mortgage bonds, and forward contracts; instruments less known to the public. These instruments were all used to perform monetary functions without being recognized as money.
The end effect was that banks could become bigger, make more loans into the real economy and support more productivity. Money creation on a tremendous scale enabled by this web of interbank finance.
And how did the Federal Reserve handle this expansion of money? They had some awareness of it. In 1996, sitting Federal Reserve Chairman Alan Greenspan gave his famous “irrational exuberance” speech, in which he insinuated that stock market strength may have partially been attributable to more than just fundamental factors.
He elaborated on this concern in June 2000 with his mention of the “proliferation of products.”
The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that 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. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition.
Alan Greenspan
Here, Greenspan all but admits to the public that not only can the Federal Reserve not control money, but also that they’re not even able to confidently measure it. To the astute observer, this should’ve been quite worrying.
Don’t Look Down
So what did this mean for the financial system going into the 21st century? It meant that it had organized itself using these Eurodollar instruments to enable money to be moved more quickly to where it could be put to productive use, and that commercial banks used this decentralized matrix of assets to facilitate more lending.
This profusion of credit continued until it finally reached its crescendo in 2007. It was the year when the Eurodollar system started to falter. It then did something it hadn’t done since its creation: It assessed its risk.
And when it assessed its risk, it decided that, not only couldn’t it continue its growth, but also it had grown too big. It wanted to go in reverse. The instruments that had been transmitting liquidity through the system started to transmit risk exposure instead. As efficiently as it used to create money, the Eurodollar system started to create hazards.
We all know this reversal event and its fallout as the Global Financial Crisis. And Eurodollars explain what made it global. It was because American mortgages funded multiple layers of Eurodollar finance—so much so that when they became just a little bit risky, the entire system attached to it began to seize.
It’s not as well known, but the first bank to run into trouble at the time was not Bear Stearns in 2008, but a French bank by the name of BNP Paribas in the summer of 2007. And not in U.S. mortgages or mortgage bonds, but in one of its money market funds, of all things.
The Eurodollar system had gone as far as it dared. Instead of writing new loans, it began calling old loans. Instead of creating monetary assets, it began to hoard them.
A Monetary Phenomenon
Fifteen years later, the global economy limps along from crisis to crisis. Interest rates remain low, reflecting a lack of opportunity in the real economy. Banks are awash with reserves and nobody to lend them to, even as interest rates have been at historic lows.
For 15 years, no government has had a good answer. Central banks have gone full bore on stimulus, but just can’t seem to spur growth. They try the same policies, and we hear the same stories.
But in 2024, nobody thinks to ask: “What if the Federal Reserve doesn’t really control money?” What if the Eurodollar system had already created all the money the global economy needed? And what if it’s just been in a slow, painful contraction since 2007? What if we got it wrong?
What do you think? I welcome your comments below.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
