Course Textbook


For both Eurodollars and liabilities of U.S. banks[,] . . . their major source is a bookkeeper's pen. - Milton Friedman, Nobel Prize in Economics winner, 1976

It only took half a century after the end of World War I for the United States to abandon its gold standard. The retirement of gold from our formal monetary system can be traced to a series of events starting with the great Wall Street crash of 1929. The 1920s, commonly referred to as the roaring twenties, was a decade defined by the first tracesf of consumerism: spending money as a way of life. Credit became widely available to the average American, but instead of measuring the quantity of its growth, it's more interesting to look at what type of credit was being issued. Department stores started offering credit cards to wealthy customers for the first time, oil companies began credit card loyalty programs, and banks fueled speculation in the stock market by lending up to 90% of the capital required to purchase shares. New York had become the center of international finance. Shares of companies listed on the New York Stock Exchange were flooded with demand, and capital poured into the United States. This greatly strengthened the global demand for dollars and bolstered the American currency to the world reserve currency echelon. The swarm of money creation that occurred during the roaring twenties was antagonistic toward gold's disciplinary constraint on money elasticity and conclusively revealed a societal need for the dollar's decoupling from gold. Categorically, there wasn't enough gold held by the United States government to furnish the elastic currency it had promised in its enactment. The proof of this came in the aftermath of a historic stock market crash.

When stock prices found gravity in October 1929, the Fed had to respond to a major financial crisis in earnest for the first time. With a fixed amount of gold reserves and a legally binding 35% gold-coverage ratio, the Federal Reserve was unable to create the necessary amount of second-layer money to stave off an economic depression. Several thou- sand banks failed in the early 1930s, wiping out billions of dollars of the American public's bank deposits. The economic depression coincided with the extremely harsh reality that third-layer money could disappear in an instant. No safety net or insurance mechanism existed to remedy such loss. The Fed did attempt to "furnish an elastic currency" and be a lender of last resort to the best of its ability, but it wasn't enough to overcome the effects of third-layer money contraction that resulted from the public's desire to flee risky deposits. The Federal Reserve was bound by a legislated minimum gold-coverage which limited the amount of credit the Fed made available to the system. Gold's disciplinary constraint received an outcry of blame for the economy's inability to recover and led to dramatic and sweeping changes to the dollar pyramid during the 1930s. These events should be seen as the major catalyst that kickstarted gold's departure from the world's monetary landscape.

No Gold for You

President Franklin Roosevelt issued Executive Order 6102 on April 5, 1933 which instructed all "gold coin, gold bullion, and certificates to be delivered to the government". The order was effectively a forced sale of gold in exchange for Federal Reserve notes (cash) by all United States citizens and out- rightly eliminated the people's access to first-layer money. This brazen declaration made the possession of and trafficking in first-layer money illegal and punishable by up to ten years in prison, reminiscent of the Bank of Amsterdam's mandate for all cashiers to surrender precious metal coins in exchange for BoA deposits upon its creation in 1609.

The following year, the United States passed the Gold Reserve Act of 1934, which devalued the dollar against gold by increasing the gold price from $20.67 to $35 per ounce. This immense devaluation was a surgical strike in an ongoing worldwide currency war wherein countries attempted to cheapen their currencies as much as possible relative to their trade partners. Their goal was to attract foreign demand by having the cheapest prices. The United States was merely copying what every other country was doing: giving anybody with gold more buying power to purchase American goods and services. Unfortunately for the American public, the gold price increase came after the seizure, meaning the American people didn't benefit from it. The Act also legally transferred the ownership of all Federal Reserve gold to the United States Treasury and preceded the physical movement of gold bullion from New York to the United States Army's installation at Fort Knox in Kentucky.

Deposit Insurance

The Banking Act of 1935 permanently established the Federal Deposit Insurance Corporation (FDIC), institutionalizing bank deposit insurance for the average American family. In the context of layered money, FDIC insurance is a federally guaranteed insurance policy on all third-layer bank deposits. The FDIC guarantee alleviated the public's fear of third-layer money vaporizing as it did during the 4,000 bank closures in 1933 alone. In numbers, the impact of the FDIC's creation was tiny: the insured amount for each depositor was only $5,000. But from a psychological standpoint, the impact was enormous. People wouldn't flee third-layer deposits in favor of second-layer cash if they knew their deposits were insured by the federal government. Without gold as an available savings vehicle, federal deposit insurance was the government's attempt to assure citizens that their dollar savings would be protected even if housed by private sector banks with counter- party risk. Around the same time, the Federal Reserve finally secured its official monopoly over note issuance after the U.S. Treasury paid off the last bonds eligible as backing for private notes. The once ambiguous dollar pyramid suddenly started to come into focus: the monetary system existed between the second and third layers of money, and gold's constraint on lower layers had been weakened by the government's actions between 1933 and 1935. Thus, began the journey for the U.S. dollar to stand alone, independent of gold.

King Dollar

Amidst the global currency war, the dollar emerged as the cleanest dirty shirt in the laundry of global currencies. Even though the dollar devalued against gold, other countries were doing so in an even bigger way. Pound sterling abandoned a gold standard in 1931 and officially ended its reign as world reserve currency. The void was filled by the currency of the world's newest superpower: United States of America.

In 1944, world leaders gathered at a hotel in Bretton Woods, New Hampshire and formalized that all currencies besides the dollar were forms of third-layer money within the dollar pyramid. The Bretton Woods agreement would come to be known as the dollar's world reserve currency coronation. The agreement didn't impact the relationship between the first and second layers of money in any way: Federal Reserve notes still promised the bearer gold coins on demand at $35 per ounce. It did pertain, however, to the relationship between the dollar and other currencies. Currencies would have fixed exchange rates with the dollar and wouldn't them- selves be redeemable for gold. Only the dollar kept a link between itself and gold. The dollar had become the axis of the world's various denominations. Governments and central banks across the world were forced to shift the denomination of their reserves, securities, and balance sheets to U.S. dollars (USD).

The agreement brought about an important distinction in the relationship between layers of money. Foreign currencies were on the third layer of money, this time not because of the balance sheet from which they came to exist, but rather because of their price relationship to dollars. In Figure 11, we show USD on a layer above other currencies such as GBP (British pound sterling) and CHF (Swiss franc). The pound and franc are below the dollar in the layers of money because their price is measured in dollars. This means that going forward, there are two possible relationships between monetary instruments within the layered framework: balance sheet hierarchy and price hierarchy.

Figure 11

Destined to Fail

Unfortunately for the international monetary system, the Bretton Woods agreement was doomed. The most prescient thinker on the burden of world reserve currencies during this era was Robert Triffin, a Belgian-born economist who conducted research at the Federal Reserve and International Monetary Fund in its early years. Triffin correctly predicted the end of the Bretton Woods agreement over a decade before it collapsed. While United States citizens were banned from owning gold, foreign nations were still allowed to convert their accumulated dollar reserves to metal. Triffin predicted that these nations would eventually deplete the United States gold stock, making a fixed price of $35 per ounce of gold impossible to maintain. He warned that gold convertibility would not survive without an adjustment to the framework held in place by the Bretton Woods agreement. Most importantly, he identified that being the world reserve currency was a burden, not a blessing. Foreign countries would accumulate dollars because of its reserve status. This would strengthen the dollar and cause trade imbalances that otherwise would not exist without this extra source of world reserve currency demand. Triffin's proposed solution to the problem of one country's currency serving as the denomination of the inter- national monetary system was political cooperation between major economic powers. In a testimony to U.S. Congress in 1959, he admitted his solution remained elusive, a dilemma that drove the demand for gold as the world's only neutral money, no matter how absurd the idea of it might be:

The logical solution of the problem . . . would have been achieved long ago if it were not for the enormous difficulties involved in . . . reaching agreement with several countries on the multiple facets of a rational system of international money and credit creation. This is, of course, the only explanation for the survival of gold itself. Nobody could have ever conceived of a more absurd waste of human resources than to dig gold in distant corners of the Earth for the sole purpose of transporting it and reburying it immediately afterward in other deep holes, especially excavated to receive it and heavily guarded to protect it. The history of human intuitions, however, has a logic of its own.

Off shore Dollars

The story of the Eurodollar is wildly under-told. It's crucial to understanding how the entire dollar denomination was thrown into disarray during the financial crisis of 2007–2009, why the international monetary system has remained in a state of disrepair ever since, and most importantly why the world is starving for a monetary reset.

It all began in the wake of World War II after the United States dollar had unequivocally become the fulcrum of inter- national capital and while Europe was rebuilding, financed in USD. During the Bretton Woods era, the dollar started to dominate the denomination of international commerce. Firms from around the world gravitated toward dollar denominated balance sheets. They financed their operations in dollars instead of local currency because of the dollar's deeper capital market. Demand for dollars outside of the United States skyrocketed, and banks in London, Paris, and Zurich were there to service that demand. These European banks were able to off er more attractive deposit rates than their U.S. counterparts because of regulatory differences. This steered people into European-domiciled dollar deposits. These offshore dollar deposits issued by banks of European origin came to be called Eurodollars (the word Eurodollar has no relation whatsoever to the euro currency, which didn't exist until 2001). International banks had discovered a way, without asking anybody's permission, to create dollars away from the purview of the Federal Reserve. These international banks (off shore banks) were outside the jurisdiction of the United States and therefore didn't have to adhere to any of the gold-coverage and reserve ratios set forth by the Fed and U.S. government.

Another idiosyncratic demand existed for Eurodollars: financial privacy from the United States. The 1950s were defined by the beginnings of a Cold War between capitalism and communism. Despite the political divide, the Soviets were unable to entirely avoid the almighty dollar denomination because they needed dollars to pay for all imported mate- rials and goods required to expand their empire. The supply of dollars was both constrained and surveilled by the Federal Reserve System, so instead of relying on New York banks to hold their dollars, Soviet dollar holdings were deposited at London banks instead. By doing this, their money avoided the jurisdiction of the Federal Reserve System and United States government. The Soviet Union communist government had a strong impetus to avoid financial surveillance and subjugation to its capitalist counterpart. The Soviets chose European bank deposits over American bank deposits even though their deposits were denominated in United States dollars.

By 1957, these new off shore dollar deposits started to trade alongside other European money market instruments in the City of London, marking the emergence of the Eurodollar market. The Eurodollar would prove not to be just another dollar-type, but rather a paradox of the international monetary system and a catalyst for its evolution. Former Federal Reserve board member and prolific author on monetary economics Charles Kindleberger described Eurodollars as a product of the natural demand for the free fl ow of capital around the world. In 1970, he observed that Eurodollars evolved out of necessity because the Federal Reserve System and U.S. private sector banks did not create enough second- or third-layer dollars for international users:

The evolution of the Eurodollar market into a world capital center, detached from the dollar in space and from Europe in currency . . . is a product not of planning by economists but of evolutionary practice. This suggests that the forces of integration in the world, of good's markets, or markets for people, and of the markets for capital are stronger than political boundaries which divide countries.

Dollars were needed outside of the United States in order to participate in an increasingly dollarized global economy. Somebody had to provide them where they were needed, even if the dollars provided only mimicked ones issued by the Federal Reserve and American banking system. By issuing Eurodollars, European banks were responding to the emergent international demand for dollars.

Figure 12

The dollar had become deeply entrenched as the world economy's denomination: barrels of oil were priced in dollars, trade agreements were struck in dollars, and international bank balances settled in dollars. Due to the advent of the Eurodollar, the dollar money pyramid changed. With the Fed unable to properly recognize, diagnose, or regulate the world of international banks and Eurodollars, it became unclear on which layer of money Eurodollars existed. Were they a form of third-layer money underneath Federal Reserve notes? Were they a second-layer money underneath whatever government bonds and various credit instruments the issuer owned? Or were they a new pyramid, untied to the existing dollar one? These questions wouldn't fully be answered until the great financial crisis of 2007–2009. In Figure 12, we show the Eurodollar system with a question mark at the top of the pyramid to illustrate the monetary ambiguity of international banks issuing USD.

Golden Retirement

In 1961, the first warning signs fl ashed that the convertibility of the dollar to gold was in grave danger. As Robert Triffin's cautions echoed louder in policymakers' ears, the United States, United Kingdom, and others came together to form the Gold Pool, whereby central banks sold precious metal into the market to keep a lid on its price at $35 per ounce. Foreign nations accumulated dollars due to its world reserve currency status and eventually began converting these dollars into gold. Redemption requests were beginning to build pressure on gold's fixed dollar price. The Gold Pool col- lapsed seven years later when the price officially exceeded $35 in European markets. Over the next few years, gold grace- fully removed itself from the first layer of the dollar pyramid, losing its official monetary status. In 1971, the United States suspended gold convertibility for the dollar; the suspension initially was supposed to be temporary, but the dollar never returned to any linkage with the commodity. Two years later, the modern era of free-floating currencies began, officially ending the Bretton Woods agreement. Gold transitioned to the informal role of neutral money, still held today by governments and central banks around the world as first-layer, counterparty-free money.