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 became 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 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.
Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway and I'm Jill Wisenthal Joe dedollarization. There's a lot of annoying stuff in there.
Yeah, we're still talking about that.
No, it is.
It's interesting because, yes, it's like this sort of I don't know, I associated 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 sort of illuminating sub conversations to be had.
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 euro dollars, which hopefully everyone has heard of before, we have petro dollars. There are all these different flavors of dollars floating around the financial system.
Right, there's two interesting points you made. One is like this conversation allows us to 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 Sound Ground was good on that. And then to your point, though, like, there is no single thing the dollar, right, 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 dollars. A bunch of things that are basically pegged against each other and like are usually roughly stable against each other.
That's absolutely right. It's also one of the reasons I tend not to like talking about currencies that much, as 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 All Thoughts guests back with us, someone who is going to be taking us down the historical path of how we ended up with things like euro dollars and petro dollars.
I'm very excited about this episode as well. I like history lessons as well. And you know, all of these things and have surprising origins, and they emerge organically, which is part of what makes them hard to you know, when eventually things change. Maybe one day there'll be a you know, 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 what that might look.
Like, right, And I think actually there is often an assumption that they do emerge organically when actually there is a very conscious decision, right that went into making them what they are today, and then they sort of evolved from there. But without further ado, I'm very happy to say that we are going to be speaking with Josh Younger, formerly at JP Morgan, now a senior advice at the New York Fed. Josh, welcome back to the show.
Thanks, it's great to beat back.
So I believe, given your new employer, you have to start with a disclaimer, right, 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.
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.
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 we.
Like rabbit holes. Yeah, all right, Well, why don't we start at the beginning. You know, I sort of alluded to these different flavor of dollars, and I think we're going to be focusing on two of them. They are euro dollars, so US dollar denominated deposits at foreign banks. People sometimes look at them as like a liquidity measure. How many euro dollars are slashing around in the system and what does that actually mean for risk appetite and things like that. And petro dollars, 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 euro dollars nowadays I kind of think like, well, you know, they've been around for a long time, but they must have come from somewhere.
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 your liability of that bank. And a euro dollar is a dollar denominated liability of a non US bank, so something overseas, and that's been around for a while. So there were dollar denominated deposits in Berlin and Vienna back in the twenties. They're fairly common in correspondent banking since then. So correspondent banking is if somebody needs to use dollars versus Sey Deutsche Bark's in the seventies or the fifties and 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 euro dollar is unique in the sense that it is a dollar denominated deposit that has an asset side and 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 complementary but distinct financial system from the US.
It's like free range US currency.
Yeah.
It kind of reminds me of the beginning of the Internet. So the Internet, there's two versions of the Internet. There's the Internet and the Cypronet. 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 Cyparnet, which is the secret Internet.
And so I'm going to go on the secret Internet.
Yeah, so like UR dollars are not secret, but they are separated from the US financial system and in some sort of air gap type of way.
It always seemed like one thing that I have a hard time wrapping my head around is, Okay, like banks in the US, you know, they have a relationship with the Federal Reserve, and if they run into liquidity trouble or other kinds of troubles, you know, there's this lender of last resort. And then when I think of like, okay, here's this other bank maybe somewhere in Europe issuing dollar denominated liabilities like other risks associated or when these were born? Like how does that? How did this sort of like I don't know, I'm struggling to think of the answer, but this is like the question, but there's always like wrapped from my head around is like what kind of risks did these banks issuing dollar denominated deposits in Europe face by being outside of the US bankings?
It's like, what gives how can you do this? Yes, you can't just write a dollar.
Yeah okay, yes, right and expected to be worth it.
They don't have the relationship, and initially that was basically what was done. So the first the definition of the ear a dollar 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' declassified CII 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 like a Soviet and Vais 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.
Title of this episode should be the Communist origins of euro dollars area.
Yeah, and so there were a 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 regular 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 BISON. BSM 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 seven million dollars to two hundred million dollars over a few years. The first recorded use of those euro dollars was possibly, although it's hard to say, replacing the salaries of striking French coal miners forty eight. So there's some evidence of that, but that's not really a euro dollar. 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.
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?
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 trades. 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 a society. We don't know how big that was. It was actually, as of nineteen forty seven illegal to talk about economic data in the Soviet Union. It was a law passed that said this is like punishable by some extreme measure. 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 b sent 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. Of course, 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, okag goes away.
So Okay, to Tracey, what or what next? What creates this system in which or I guess, is it the sort of introduction or the tolerance of currency flexibility that starts to create the sort of asset side of it.
Yeah, in London specifically, they start to get comfortable with liberalizing the foreign exchange using what years are we talking about, like nineteen fifty one or so. It's like it's a gradual product. 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 fifty one, but it was roughly around nineteen fifty one, and they kept the spot rate control, but they allowed FX forwards, which you are in 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, was free money to do this. It was related to the current account deficit. It was related to just the inefficiencies of starting a market after World War You would imagine they would be there are lots of frictions there, and we don't have computers. It was like Joe, you were talking in an earlier episode, you know, what did you do without computers? And so for a time it was this actually 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 nineteen fifty four, the economist starts occasionally talking about foreign money in London. It sounds kind of nefarious.
But it was when you say the economy the magazine, the magazine, not the one economist.
So that was the first mention or one of the earlier mentions, of like currency trading as an industry in London.
And 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, r a London based city bank. Midland Bank is the most popular at the time, it's one of the largest. The bank Evlands starts get a little worried. But because in nineteen fifty five this market is doubling every three months, WHOA.
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, like it does feel a little bit weird instinctively when you start to have, you know, one country's currency sort of in control or being controlled by a foreign entity, or them building up like a sizeable bucket of it.
Yeah, so they have sort of their view of bolves over time. They're initially a little intrigued. So in nineteen fifty nine 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 nineteen fifty nine, the New York Fed sends a delegation Allen Holmes and Fred Klopstock representing what was then kind of the Market's division and the research division, to basically do a fact finding mission, and they go to London and Continental Europe. It's like the most phenomenal business trip. It's like a month and 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 euro dollar market, and it's growing, and they find it intriguing as a way to make the dollar useful off shore, and that's the way to get people off shore to hold dollars to get the dollar proceeds of their trade and then to keep those dollars in financial instruments.
Is that desirable though? Why do they want that?
It becomes really increasingly desirable because the old Bretonwood system that had been put in place after the war, it's at a dollar, I set a dollars a claim on the FED or a claim on a commercial bank, but in breton Woods it's also claim on gold. So foreign official institutions, not anybody, but foreign official institutions can exchange their dollars for gold at thirty five dollars ounce. It's a specified par rate on the dollar. But there's other need for gold other than just monetary reserves, like the economies growing. People need gold for other purposes, and so gold is trading in London at a little more than thirty five dollars, 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 thirty five dollars ounce, and then sell that gold for more than thirty five dollars in London. That's an arbitrage profit for foreign central banks. It's also a drain on the gold reserves. You know.
So if you get everyone to keep in dollars rather than flipping into gold, then that helps preserve your own gold reserve.
Yeah.
So now there's a place to park your dollars and if it pays a high enough interest rate and your dollar issuers were not constrained by regulations that made it more expensive and harder to pay high interest rates on deposits in the US, So they're unconstrained by regulatory limits on what they can pay. That's red 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 the 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 precipitate in 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 out come.
Tracy asked you about the concerns from the US, and you expressed one of them there, But like, what about you mentioned briefly the concerns of the Bank of England that this mar that industry that was doubling every three months, or the size of this market that is doubling every three months. How do 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, like we can't help you because we can't.
Right, there's no fed backstop or anything like that.
No, And that's 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, like 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 it's 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 figureut what's going on, because it's really important to have good intelligence. So you know, 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 these sort of post sterling world.
I find that interesting Tracy, this idea that what's good for London was not necessarily good for the internationalization of the pound, and that like is at the same time, here's London booming at the cost of the sterling being the global currency. But it's interesting how like there is not some like sort of one to one relationship between the importance of the pound and the importance of the city of London.
No.
Absolutely, well, okay, so just on this note, I mean, I 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 like the riskiness of these dollars outside the US financial system, so.
Like somewhat indirectly, I guess I would say, like the first so the swap lines started, I think it's sixty two, it might be sixty three. But Charlie Coombs, who's the special manager for Foreign Exchange at the Federals their Bank of New York, is tasked with setting up arrangements with foreign central banks. At the time, the focus was defending the dollar. So if the dollar comes into attack, everyone's worried about speculative attack. That's kind of like the original bond vigilant, right, 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 the National 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 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.
Oh interesting, I didn't realize that.
Yeah, And so that's the initial logic. But Bob mccallay and Catherine Schenk uncovered this second swap line with the BIS set up in nineteen sixty four, 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 Euro dollar market if it would needed liquidity. So there's evidence that the BIS didn't love this swap line. But they say, oh, the FED call this and as to draw 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 sort of variations in demand for liquidity were smoothed over with this swap line. But it was also there and got gradually bigger as a backstop to the euro dollar market more generally. But it was ultimately not a lender of last resort because it required coordination, but it was it was a line. It was like a lifeline for the euro dollar market in its early days, and that allows it to grow a lot. So, you know, we were talking about nineteen sixty it's a roughly two billion dollar market. By nineteen sixty four, it's roughly ten billion dollar market. By the late sixties, it's you know, sixty seventy billion dollar market. So it keeps growing exponentially, much faster than the money supply.
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 like quantitative ideas about monetary policy that m two 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 or something that is growing the supply of existing dollars in the world.
It's a trade off. So in the mid sixties, this goal drain is accelerating, so the US is forced for sort of I don't know if you call that monetary policy has to do with the currency, but to maintain the stability 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 it a cert tax to that to equalize the exchanger that equalize the interest rates. They eventually a voluntary credit restraint, specifically with extensions of credit abroad, so like New York banks should not loan to foreign entities. The whole point being the dollars in the US The only way that works without throwing a massive monkey wrench into the global monetary and the economic system is if there's an offshore he'd 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 euro dollars as the euro dollar market, meaning the eurobond market is the issuance of dollar based bonds in Europe. The euro dollar market is the issuance of dollar based liabilities. There is also a loan market, and so there's basically a mirror image financial system optimized throughout 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 money terry 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 VIS 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 current account deficit and not the current account deficits are 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.
I still like the organic free range dollars analogy. So you know, you've set them out into the world, but you take a risk in doing so, Like you know, the dollars could get scooped up by a hawk or eaten by a weasel.
It's like an outdoor cat.
Yeah, yeah, I'm taking this too far. Okay, wait, but Josh, you mentioned the nineteen seventies, and when I think about dollars in currencies and big financial events in the nineteen seventies. I think about Nixon deepegging the dollar, and I take the point that euro dollars to some extent were solving this gold problem that you described, but that must have had some sort of impact on the market.
It did, so the seventies are where this all starts to get a little more worrisome. Basically, lots of things got more worries in the seventies. Year dollars start to fall out of favor in the late sixties and early seventies, and for two reasons. One is there's these speculative attacks on various currencies that are blamed on the euro dollar market as the vehicle through which the speculative funds are flowing around. They call them hot money. So the pound crisis of nineteen sixty seven, varying crises and subsequent years are kind of blamed on the euro dollar market. That's the first thing. The second is it's growing rapidly, and that's for a couple of reasons. One is live is invented, so now you can manage the interest rate risk in a year dollar bank. So liveboard's creative for the purposes of year dollar 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.
Actually, it's so funny, how like these terms that we considered to be so crude euro dollars, London interbank overnight rate, are offered rate. It's like we just we just don't even question that we have all these European names for these crucial things.
Well, I should have mentioned at the beginning when we were talking about, yeah, the Soviet Union, the euro dollar does not refer to Europe, refers to the telex address of b sent So tec telex address was eurobank dash bsen.
Oh it's not even this makes so much more sense now, Yeah, so year dollars meant dollars for bcent for Eurobank.
That was like a like a shorthand for payment processing agents and things like that.
This was a this is a totally new one.
This is like a revelation because everyone thinks euro dollars have something to do with the euro or Europe, but actually 's own bank in Paris. No one thinks that. Okay, So nineteen seventies, this thing is growing, there's some concern about it potentially getting out of control. What do people do about it?
So they start to call meetings and commission studies.
As one does.
Yeah, So, like the problem is the US is maintaining a low interest rate policy. It's attracting dollars overseas, and so the eur dollar market is absorbing outflows in the US where interest rates are low relative to euro dollar rates in European rates. And so it's a monetary policy dynamic and that's causing some consternation because at the same time, Milton Freedom it is becoming very popular, the monitorist 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 nineteen seventy one, the BIS calls the Standing Committee on the Euro Currency Market.
It's a very ugust 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 euro dollar mark because there was some concern that when the Bank of Italy puts dollars into the euro dollars 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 the 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 abandon that agreement. So it literally lasts until the first renewal date and then they all kind of go their separate ways.
Wait, so there's a three month standstill on the eurodollar market in the nineteen seventy.
On central bank placements into the euro dollar market. So the governors of the major central banks get together the G ten, and they say, we're not going to put any more money into this market.
I know, this is like 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, So you create a new money that offers a higher rate, and the money gets sucked there. The lack of alternatives to existing market. I mean, so many conversations about alternatives to treasuries, et cetera. It's like often there's just not another thing that you can put it in.
Yeah, No, I mean it's it's sort of like more money for the same perceived risk. Now that we can debate whether or not it's the same risk. But from the investor cash and vexer's perspective, I can get three percent here, five percent here and looks the same. I'll take five. 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 ringing at the BIS in these regular meetings, at the FMC minutes Federal Open Market Committee Meeting minutes, they start getting a regular rundown of like what happened at Basil this month, And it's kind of a new development because it's no that's the point where it becomes really important. And so Governor Dane and some hit Charlie Combs or the various people who attend these meetings going back and forth to Europe in nineteen seventy one seems like a pretty like aggressive thing to do every month. But I guess the planes were nicer and they serve better meals, but they get a run down. And basically the message is we're going to commission a really like 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 coming, the crew is going to get stuck in and tightened, the hammer's coming down. Like there's an article in the Economost called who killed the euro dollar Market? I think that was seventy two, So there's this sense that it's kind of like getting to the point where someone's got to do something. At some point in this process, there's a company that starts selling euro dollar branded chewing gum. So that's when you know a trend has like pressed now we pull up eBay, Oh.
Yeah, I must have this chewing gum. Honestly, that's amazing.
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 constract contained, and by nineteen seventy three there's like a relatively broad consensus that this is sort of necessary. And then in September there's the Young k Poor War and the oil embargo.
Everything changes.
So this is this is our que for at two of the Josh Younger rabbit hole, or the second rabbit hole, which is petro dollars.
Yeah, so petro dollars are sort of broad term for the dollar based revenue from the sale of oil. Petro dollars have been around for a while. Actually, the oil producing countries were involved in the euro dollar market since the sixties. The thing that happens in nineteen seventy three is as a consequence of US involvement or support for the Israelis in the Yunkapor War, there's an embargo of oil shipments to the US. The price quadruples, and oil revenues go from one or two percent of global GDP to five percent of GDP. So we're talking about one hundred billion dollars a year in nineteen.
Seventy right, So this huge sudden influx of wealth, presumably going mostly to the oil producing nations in the Middle East.
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 in a sense 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 year dollar 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 like take the oil Saudi Arabia sells one hundred dollars worth of oil, they take those that money, they put it into something that has to somehow get to the next country that has to buy one 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 petro dollar recycling. And so those petro dollars need an intermediary that has elasticity. Elasticity means they can grow substantially to meet this like massive increase in demand and euro dollars, the US in particular Bill Simon, who's the Treasury secretary in nineteen seventy four for Nixon, he like 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.
So sorry, you know, because again I think, as you said, people use the word petro dollars and they sort of mean all different kinds of things, but this is bait like 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.
Yeah, and they shooed assets, right, So they had loans to oil importing countries and liabilities to deposits from oil exporting countries, and so they're the bridge because the financial system doesn't track oil imports.
Who are these like there specific banks that played a prominent role or.
It's just like all the usual massive banks, like they were all involved in this. There's old pamphlets. When I was JPM Warrion went down to the archives, they had these old like pamphlets like like the eur dollar market a great opportunity for this, that or the other thing, and so it's like it's just seen as like a very lucrative, very like 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 data 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 incrementally higher rate or that sort of thing. So how sticky ero dollar deposits are is an open question. But the loans are long dated because countries have ongoing need to import oil. So the eur dollar market grows like exponentially, but it incurs a much larger liquidity mismatch or maturity missmat just doing more and more and more and more liquidity transformation, long term loans, short term liabilities, and there's this increasing concern by the spring of nineteen seventy four that the system is creaking under the weight of this demand and like something might break does something break.
I'm going to take that. I'm going to take the bait. And also, since we're talking about you know, like historical analogies to today, I have to ask, did something break?
Yes, it's something breaks, not what you'd expect. I think they're the thirty fourth largest bank in Germany. But this bankos Hrschtot, and people talk about Hrschtot risk now, but Bankoushrschtott is very involved in speculating in currencies. And I didn't talk about the Nixon shock and the deepegging 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 Ivanhrschtott runs bankoffs Hrschtott. It's a private bank, privately owned bank, and he's like, this is my I think he called it his big hour, right, this is my moment to make my mark. They take a ass of long dollar position, goes bad and they fail, like the bank fails. Hirstott never takes responsibility for this. By the way, he writes an autobiography later called how My life Savings was Stolen for Me or My life's work was stolen for me? In Germans, I'll check with with somebody. Yeah, but but 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 transaction, the European payments go through on these. For an exchange transaction, 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 dollar.
So this is classic settlement risk. I mean, so Hairstott risk became basically a synonym for this type of risk.
Only a synonym. It's the reason we have Basil bank regulations in the first instance. So the Basil Committee is convened to like address this issue, and it ultimately evolves into a much more elaborate international standard and standard setting mechanism. But like the idea of having international coordination of bank regulations comes out of this episode. So that's also I guess another episode, but from a we.
Just need to get the Josh Younger lecture, I think.
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, Like no one's 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 draw? Right? Always the same, Yeah, And so the Clearinghouse Association starts allowing for clawbacks of payments until the next day afternoon to try to facilitate this, and like 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.
Sounds a little bit familiar.
So now you're eur dollar issuers can't hedge, they can't hedge their foreign exchange risks, and now they're long dollars or 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.
So how did they solve this inability to hedge?
It's so then the question is what do you do if there's another run, Like how do you backstop the ear dollar market in a more concrete way, who is the lender of last resort to the euro dollar market?
Which is kind of like my first like the first question I had, like at the very beginning.
Finally, twenty years later they start really contemplating this in detail, and because the first instance is fifty four, then in nineteen seventy four they go, you know what, we really need a plan for this, and so they start convening meetings and the usual things. In July of seventy four, there's like a tacit agreement to do something, but it's not concrete. It's unclear how it's going to be like executed. And basically the market goes do better and you have this like massive shift where on the one hand, the euro dollar market was 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.
Urin dollar market.
Oh.
Interesting, the regulatory impulse reverses completely, and it's in September. The G ten central bank governors go so far as to put it a public communicate where they say we're going to do it is necessary, this is whatever it takes the first time. So this is just like what happened in Europe around the sovereign deck crisis. But it's in seventy four with relation to the euro dollar market and they say we're going to do whatever it takes. I don't remember the exact words, to facilitate liquidity in the euro dollar market and make sure it's stable.
Sorry, real quick, at who said this or who is in the.
G ten central bank governor to put out a communicate, So it's a collective agreement, collective They leave out some details like what do you literally mean? But because they put it in a communicay, this is all about central bank communication. Yeah, 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's there's no computers and so like you please print this, and so they print it fat.
To the Wall Street fast facts is in the seventies.
Maybe it's a tele accident question. But they put out a public communication that this is the case. The goal being to like stop the contagion, so to specifically to facilitate the quid in the eur dollar market. And the implication is we need this thing to avoid a global monetary contraction. There's a lot of like handwringing in the press, like if they don't do something, we could have global monetary based destruction through the collapse of the eurillar system. That's what happened in nineteen twenty nine to nineteen thirty three. It could happen again. We're looking at another great depression. Somebody do something.
So they don't announce the exact mechanism, but they just announce that they will do whatever it takes.
Yeah, so very clear about their commitment in a public form as opposed to having you behind the scenes conversation that gets leaked out.
Apparently the facts machine was invented in the early eighteen hundreds, but the actual modern facts in nineteen sixty four. It's just amazing. Yeah, so maybe it was a fact.
I'm sure the year dollar had it. I'm not sure the central banks had it.
Yet, just on petro dollars. You know, this word like even more than euro dollars, like conjures up all kinds of conspiracy theories about how we forced, you know, the force the oil exporters to use our currency. And this is really crucial, like is there an element like of truth to that story where like the US made a concerted effort to figure out how the oil exporting nations in the Middle East were going to you know, the currency that they were going to sell their oil in.
Yeah, so it wasn't always petro dollars. It was originally seventy five percent dollars twenty five percent Stirling, 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 nineteen seventy three. And the question is like, 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 like other than the euro dollar 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.
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.
I guess I can't validate that specifically, but like that seems plausible. All we know is that they decided that this was a good way to sell treasury bum which makes sense. There's a lot of excess dollar based savings abroad. But that requires one that the oil importing the oil exporting countries be comfortable buying treasuries, which is like, got a bunch of things around that, and two that it's stay in dollars. Those two things are connected. So in the spring of seventy four, Kissinger convenes this like council that Saudi Araba 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 those meetings in part revolved around trying to convince them to use only dollars for their oil revenues. So like 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 yere dollars of the primary recycling mechanism. But like, while we're at it, maybe we'll get some revenue for the government. And so he flies to Riod in July. He actually gets scooped by Fannie May, who wants to sell more deventures to fund mortgage.
Oh, they get their first and they're like and there's like.
This hole back and forth in the State department about like who approved this, and like 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. They will be after the auction. You can look at the price and decide if you want more. We will do him on an add on basis, which means you're not an active participant in the auction, you get like 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 Federals are from New York, is going to be the custodian, and so they're going to transact on your behalf. You have confidentiality and the implication is in espicially saudis in July and it's like 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 rand it like suddenly he has a heart attack in DC while he's on a set of meetings, and so takes them 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 identified. He's not on anyone's list. There's a bunch of State Department cables for 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 of 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 like a big signal from the Saudi government that at least taken to be that we're willing to sort of work with you guys on stuff. When he's appointed, literally his first meeting is with Treasury to restart deal negotiations on Treasury by IT purchases and that's his first meet, like three 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 cut from the Saudi oil producing companies that they will no longer except Stirling in exchange for whale so all rolaive revenue in dollars. Very awkward because the British Chancellor of the Exchequer is in Saudi Arabia, yes, leaks out. So and when esper.
Conon the British had really close ties with Saudi Aramco from what I remember.
Yeah, And basically the response of the administration Satura Abia is like no comment to the State Department. So 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. But like it happens on the thirteenth of December. On the fourteenth of December that 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 in the record, but you know, people put two and two together.
So can I just ask the Saudis agree to all of this to petro dollars sort of as a concept because they get to buy US treasuries in a semi advantaged way.
It's not clear that's the only reason, but like those two things are connected in time to understand some people have put together that story. There's later comments and 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 records a little sketchy. But the timing and the nature of these agreements has led some people to speculate that they were connected.
But also but to your point, like, if you have a surplus of dollars and that's like a problem you have to solve regardless, Right, So maybe you don't necessarily go directly to the treasury market because of some advantage, but at some level, like you got to put them somewhere, and so there was some effort made to like, here's an easy way to solve your problem.
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 them.
Yeah.
Imagine if SoftBank had got their first and all the Saudis would put their money in soft Bank stock. So this is it. This is the moment when pet your dollars become a thing, and euro dollars have already become a thing, and the dollar is sort of firmly embedded in the tissue of global financial markets.
Yeah, and so it doesn't happen all at once, like Saudi is not all oil supply, but something like Bank eventualy put out an estimate a few years later, by seventy five, dollars are like eighty percent of oil revenue, and then by seventy six or like ninety four percent of oil revenue. So like it happens pretty quickly. But you know, at that point, the dollars 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 global monetary system, like this cements in some sense that status. So all of this building up of the eurodollar market is kind of like put to work in a sense through the oil shock of nineteen seventy three in the rise of the petro dollar system. It's important to say that petro dollars don't create the ear dollar market has to be in place, elastic and flexible and already that has the network effects that allow it to function as a distribution mechanism.
Right.
That's the thing I like really never realized before that there's sort of like it almost sounds like petro dollars are like another skin of the eurodollar market. Then it's like a slice.
Of it, 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.
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.
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 like the fundamental arguments about global reserve currencies like very much apply to that period. Even so, there were lots of policy decisions that had to get made. This was not a foregun conclusion. There were key decision points where certain key policies were put in place, or backstops provided, or you know, agreements offered, and so like, the story of global dollar dominance like is an interesting one. I guess it's kind of the conclusion. Like, it's an interesting one with characters and actors and like decisions and near misses, and we usually think of it as just kind of like a boulder rolling down a hill and it's like kind of unstoppable, and that may yet have been so. But the real story is a very like rich one.
Well as Tracy point it. You know, in the beginning, I was like a sort of emergent in Tracy's like, well, actually maybe the story is not And I think that to your point, Like, no, like things happened, meetings happened, flights happened, troops to Europe happened, like all these things.
Yeah, Like I don't think if there's a movie in it, but like there's a book in it, you know, that kind of thing.
Someone makes euro dollar gum, there's a TV series, there's a TV series for sure. Well, Josh, we're gonna have to leave it there. But it was wonderful having you on the show. And you know, as much as some of the dedollarization discourse annoys me, I'm very grateful that it gives us a chance to revisit financial history with you. So thank you so much.
No, it's great to be back. Thanks for having me.
So, Joe. I don't know if anyone listening heard me frantically typing at the euro dollar gum mentioned, but I haven't.
We both pulled up emay and stuff like I need to find this.
I haven't been able to find an image, but there's a nineteen seventy four article from the New York Times. The headline is the euro dollar bubble, and it has a description where it talks about the inflow of euro dollars takes the form of bubble gum package in gold foil to resemble coins.
We gotta find that gum.
Isn't that amazing? There's so much pick out of there, like so many things I hadn't realized, including where the euro in euro dollar 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, yes, 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 like, well, you're not going to get a lot of un Chinese renman b dominance until you actually see liabilities denominated in this and that's kind of what happened with euro dollars, right.
Yeah, no, so much I learned from that, and you know, to the point not to make everything like 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, like not just 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 sort of like build on the shoulders of giants. In finance, you just sort of repeat the same stories over and over again.
And do you build on the communicats of Basil?
Yeah, and you just sort of do it and again. It's like every time we talk to Josh, it's like, man, nothing really changes. 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.
Yeah, no new risk under the sun. Well, on that note, shall we leave it there.
Let's leave it there.
This has been another episode of the Audlots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and.
I'm Joe Wisenthal. You can follow me on Twitter at the Stalwart. Follow our producers on Twitter Carmen Rodriguez at Carman Arman and Dashel Bennett at dashbot. And check out all of the Bloomberg podcasts under the handle at podcasts and for more oddlogs content, go to Bloomberg dot com slash odd lots, where we have transcripts a blog newsletter comes out of your Friday. And check out the discord where you can chat and hang out with listeners twenty four to seven discord dot gg slash odd lives really fun place to go.
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Thanks for listening.