ECON120: Monetary History

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:

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.

Source: Nik Bhatia: Layered Money
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.