What is the Eurodollar System? This is something that maybe people heard about. Obviously, those who follow my work are familiar with the concept. However, we never really delved into it.
That will change with this article. We will give a quick run through some of the highlights and how it is affecting our world today. By the end of the article, we will also see how the supply of money, since the Great Financial Crisis, was reduced.
So let us dive right in.
This is a term that gets confused, especially since the introduction of the EURO. We have to make clear, the Eurodollar has nothing to do with the European currency. Instead, when we say Euro, we mean outside the country.
So a Eurodollar is a US dollar that is outside the US banking system. In other words, it is dollars that reside in foreign banks. This was the situation after World War 2. Due to the Marshall Plan and other projects (like with Japan), tens of billions was funneled into those areas to rebuild (this is US policy it seems: bomb a place to hell and then give it money to rebuild).
As a result, European and Japan banks had a lot of dollars as vault cash. Of course, banks being what they are, they had to do something with them.
This was the start of the Eurodollar System. It was a design by the international banking system that was based upon the vault cash.
Today, the idea of cash in this system is long gone. Like most of our monetary and financial systems, there is no currency involved. It is all numbers on a screen. Nevertheless, there is an entire system of operations built upon the foreign dollars of long ago.
What resulted, starting in the 1950s was a system of lendings, borrowing, collateralization, remittance, and cross-border payments. As we can guess, this progressed rather rapidly to the point where the currency was gone. So what did they use for money?
Here is where the system took off. The banks, due to, as Alan Greenspan said, "the proliferation of products" created financial instruments that they uses in this manner. Long before the digital world, they understood that money was anything that has liquidity and could be traded. Hence, anything that has the ability to act as collateral was part of the system.
This meant that bank balance sheets were crucial. As long as they could keep expanding them, the ability to generate money was in plact. Of course, banks also being banks, they went to excess which is what really caused the Great Inflation of the 1970s. The money created by the international system was in excess of what the economy could handle.
After that point, however, as balance sheets naturally contracted (without the Fed easing or doing any Quantitative Tightening), the situation resolved itself. It took a while for all that money to run off but eventually it did.
Ben Bernake was right; the subprime mortgage market was contrained. In fact, what many attribute to the collapse of 2008 had nothing to do with subprime lending. This was not big enough to take down the global economy.
What happens was a bank run. This is evident by the fact that everyone ended up at the door of AIG. This was the insurer behind all the collateral, specifically the other side of the mortgage backed securities. What happens when the insurer is insolvent? A system has problems.
The banks quickly realized the MBS were not high quality collateral like US Treasuries. It was a major con job of the rating agencies. In reality, the MBS were mostly junk. One the Eurodollar System realized that, all hell broke loose. Bear Stearns was put under by JP Morgan, the custodian of the Repo market, when it received a collateral call for $5 billion. JP Morgan knew Bear didn't have it but the custodian wasn't about to be on the hook for it.
Exiting the Great Financial Crisis, the Eurodollar System was left without private collateral. It did, however, have sovereign debt. This was at least something to keep things afloat.
Alas, the genius of Larry Summers next sprung up and bit everyone. He was the one who proposed the idea of negative interest rates and how they would kickstart an economy. Since the Europeans were in the toilet, the ECB took this suggestion. Much of the rest of the developed world soon followed. The saving grace was the Fed, who refused to break ZIRP.
As soon as the central banks went negative, it was like nuking the bond markets. Suddenly, the Eurodollar System lost a great deal of money. The overnight lending market was without a major component. This caused balance sheets to tighten, something that is the reverse of what is needed. With collateral lacking, the system started to sputter.
Before going any further, we have to point out that more than 90% of global trade is financed hrough the short-term lending markets. These overnight collateralized loans (Repo) are crucial for the economic productivity of the world. As we are seeing, with massively slowing growth rates, this is costing tens of trillions in lost economic output.
In other words, the total global GDP would be $30 trillion higher if we just kept at the growth rate that was in place from the end of WW2 through the GFC. Sadly, we fell of that trend, an event that was replicated with the COVID lockdowns.
Simply put, with the introduction of massive globalization, which took place post-WW2, the central bank system was too limited. Central banks can really only operate within their own borders. Even the Fed is limited although it does have greater reach since the US dollar is the reserve currency.
For many decades, it worked. The design is to get money where it is needed, at the time it is needed, without regard to the circumstances. Due to the ledger nature of the system along with being outside the reach of any government (or central bank), we can see how this worked.
Unfortunately, since GFC, it is a trainwreck. We are in deflationary money since there is not enough to fund a $95 trillion economy. Growth rates all over the world have been slowing for more than a decade, a sign there is not enough money in the system. While many point to the reserves of central banks, the reality is that does nothing. Those are limited in scope and how can have them.
The Eurodollar System, on the other hand, was the primary monetary vehicle for at least the last half century. Now we are at the point it is running its course. We can expect economic headwinds until a replacement is found.
At the core of this is collateral and the world is in desperate need of high quality collateral.
We will have to see what steps up. Perhaps cryptocurrency could provide some answers.
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