Lots More with Lev Menand on the Eurodollar Market Now

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the US dollar system takes place offshore, not onshore. And when we were talking about the development of this in the fifties and sixties and seventies, the onshore domestically regulated dollar deposit system was a much bigger percentage of the overall hull. And now we're in a world that looks quite a bit different in terms of the relative importance.

And we've been in that world for about twenty five or thirty years now, and the two thousand and eight crisis was a crisis of that world, and twenty twenty was in part a crisis of that world. And so we're now in a financial system where instability in the Euro dollar market that's the main with the addition of the repo market. That's the main area of instability and

concern for our whole system. You know, in the twentieth century, we still had a sort of like you know, your grandparents banking system, and now it's not.

that's their liability. It's a money instrument that people can hold who have cash, have demand for cash and cash equivalents in large quantities, and they are competing with domestic US banks that have a really nice product, the deposit that is up to two hundred and fifty thousand dollars per account ensured by the FDIC explicitly, and a whole bunch of other money like products created by other shadow banks. Money market mutual funds create various products, and the swap lines.

The existence of the swap lines is what gives people confidence that, you know, this is a pretty robust money type instrument that has backing from the sort of central bank which is the creator of dollars that makes these money like liabilities money good. And so in order to get such a huge thirteen trillion dollars, such a huge market, you need the swap lines there in the first place to give people confidence to hold large quantities of these

that they will in fact me money good. But the problem you have is that the extent to which the US government stands behind this thirteen trillion dollar dollar money supply, it's ambiguous, it's not explicit. It is like uninsured depodsits

in the domestic system. It's worse, though, but it's similar to it, and so it's highly run a ball and unstable insofar as people aren't the extent to which the system will be supported by the Central Bank of the United States when it gets into trouble in various bad states of the world. So in good times it's fine, but in bad times people decide, you know what, that competing money instrument created in the domestic US banking system, or those t bills are just a much better place

for us to be. We want out, and I have a historical analogy since we've been doing so much history on this. Think about the US system in the nineteen twenties, going to the nineteen thirties, we created the Federal Reserve and the discount window at the Federal Reserve for domestic US banks. It's like a swap line for the banks directly. It's doing what the swap lines are doing. With the addition of the foreign Central Bank. And people thought, oh,

we're going to fix bank runs. We've got this infrastructure setup, we created the central Bank, it's going to accesup all these deposits. And we had the worst bank run ever in the thirty two to thirty three period. What happened. What happened was the FED didn't support all the banks

when push came to shove. The FED allowed a bank called the Bank of the United States, a Jewish run bank based in New York, to fail, and created a lot of uncertainty about the extent of its support for state chartered banks that were not members of the Federal Reserve system, and runs just went throughout the system, and over a third of the banking system ultimately collapsed. Even though we had this support system, and what you saw

in two thousand and eight is a similar problem. People just don't know how much the FED will be there and to what extent, and that can cause systemic catastrophe. And the reason why we got deposit insurance in part in nineteen thirty three as the government saying, you know what, we just have to be explicit about the fact that we're backing these money instruments. We can't have this implicit insurance program that is through FED lending. We got to just be explicit, and that.

checking account in terms of interest. And so the euro dollar market all developed, you know, fifties and sixties London banks offering more interest on balances than National City Bank in New York and drawing depositors to their own banks. They could have a deposit account in dollars in London that just paid more interest. And that's the same story you see with the RepA market and money market funds. These are ways to get a little bit more yield

on your cash instruments. They're competing on price, and the main customers historically where the corporate treasurers who had huge cash balances, and there are lots of different customers now who have cash they want a little bit more yield on. The thing that goes wrong in these markets is they are sacrificing MONEINSS, you know, safety, They're sacrificing the extent to which it's really a liability of the United States

government for some more yield. And when we get to a bad state of the world, that trade off starts to look a little bit different, and that's what creates the run dynamic. Suddenly we're in a bad state of the world. Think August two thousand and eight, and you're a reboke counter party of Leman Brothers. You're parking your extra cash and Linen Brothers for a little extra yield, and you think, you know what, I'm just going to

move my balance to a regular bank account. I'm going to go to JP Morgan and just have a big balance there. Yeah, I'm going to be earning a little less yield on my cash, but I know that it's money good and it's going to be available, and you know what, I just don't need to be a rebooke counterparty to Liam Brothers anymore, and that was what brought down Liam Brothers. It was just an old fashioned bank run on its rebo book.

over the finish line. And the reason I bring this up is you might think when the banking system is making record profits, and the economy is humming along nicely. Would be a great time to strengthen the regulatory regime. And the Biden administration and its bank regulators have tried to strengthen the domestic you know onshore deposit you know, regulatory regime of domestic deposits, and they've been completely stymied. And so plainly, when things are good, that's not actually

a good time because nobody wants to nobody. Everybody's just work. It's everyone's like, everything is fine. We don't need to make any changes right now, and so the inertia prevents changes, and so actually practically it is during crisis. It happened to be the case that the seventy four crisis that we talked about, they felt like things were too too fragile to do anything. Similarly, in the aftermath of two

thousand and eight there was a similar mindset. You might recall there were more significant reforms discussed and at least mooted privately, including with respect to repo and euro dollar liabilities. And the thought was, we're in a bad recession right now. We should try to get out of that recession, and let's not upset the apple Cart and so clearly a

certain type of crisis is not enough either. If you just look to history, one thing you do see is if the crisis is really bad, not like seventy four or oh heait, but like nineteen thirty three, then you get fundamental structural reform. And so if the euro dollar market were to lead to economic fallout on that, I feel very comfortable predicting that it would be fundamentally reformed.

in their own currency. And so if you're a London based bank regulated by UK financial regulators, you cannot issue a dollar demand deposit type liability unless it's fully reserved on the asset side of the bank with a dollar instrument, either a dollar at a US bank like a correspondent bank, and that's going to actually tie into the second question, or like a T bill of a very short maturity. And so you know, you could still have lots of

dollar based banking globally. You wouldn't be getting rid of global dollar. You would be stabilizing the global dollar by going to full reserve banking for the global dollar. There would be no money creation outside of the US. The expansion of the dollar money supply would happen by US domestic banks, but dollars could be held by say, Japanese banks, as long as it was on a one to one basis. And I think that would be the optimal answer, and we could talk about why, but you don't have to

go all the way to that. You could allow some dollar money creation outside of the US, but subjected to some type of US based oversight and regulation to have congruence between the domestic dollar money creation regulatory scheme and the overseas dollar money creation regulatory scheme. What makes the current system so unstable and difficult to govern is there is no congruence, and in fact there can be racis to the bottom dynamics and even worse right now, there's

so much opacity. You know, I said thirteen trillion dollars, but we don't really know the figure because there's no systematized reporting in the US. All of the banks file reports quarterly with their balance sheet information, and we can track the amount of dollar deposits. We actually cannot track the amount of deposit like liabilities being created offshore because there is there is no international agreement by which that information is reported to US authorities, and that would seem

to me to be like low hanging fruit. You don't have to get rid of the ability of banks in Japan and Europe to create dollars. Why don't we just make them tell us how many they're creating, and just some information about the assets on the other side of those balance sheets.

impinge on US monetary sovereignty. I mean it does, but at the same time, the existence of euro dollars combined with the dollar swaps, which you know, basically make them, as you were saying, a more attractive product to people to use, has solidified the dollar's role in the global financial system, like it has helped the dollar achieve and maintain reserve status. So, oh, you're shaking your head.

the role of the dollar as a reserve currency. This is really quite distinct from euro dollars, which are the creation of US dollar money offshore by offshore financial situtions. We're going to connect it back a little bit, but the dollar's roles of reserve currency. What that's directly about is the fact that foreign central banks hold treasury securities as their reserve assets. It's not about using the dollar to transact or to finance trade, although those are also related.

It's about the fact that the Chinese, for example, have huge reserves and they have to invest those reserves, and they have chosen to invest a very large percentage of them in treasuries. So dollar as reserve currency means foreign central banks hold reserves in treasuries, and they have chosen treasuries for lots of reasons, having very little to do with certainly whether they're their domestic financial institutions have the ability to create dollar deposit liabilities versus have to hold

one to one balances with US banks. But also even that has little to do with whether dollars are being used to finance trade or settle international transactions. If you are a central bank and you have a very very large amount of reserves, let's say a couple trillion dollars, what assets are you going to put it in? And the choice to invest in treasuries has a lot more to do with US economic hegemony and the sheer, enormous quantity of US treasureies, then it has to do with

what currency is being used to globally trade. So China, for example, has you know, historically held lots of US treasuries. It's really hard to think that it has anything to do with the euro dollar market, which is really not something that is benefiting in any meaningful sense the Chinese.

What does relate to this sort of dollar as a you know, reserve currency for foreign central banks is the liquidity of treasury markets, of course, and one reason why you know, Saudi's or the Chinese would want to hold their reserves in treasuries is that they can bind sell very very easily with very low cost. That is a shadow banking story in part about the creation of the repo market and treasury repo which is a way to subsidize liquidity and treasury markets. But that's not a euro

dollar shadow banking story. That the repo shadow banking story. Okay, So the first point is if you change the rules on how banks in Japan and London hold dollar balances and you make them fully reserved. Is China going to decide they want to hold euros instead of treasuries. That's I find really really sort of hard to substantially. It just doesn't really connect. So does that mean it has nothing to do with it? No, So the global dollar is more than just a reserve currency. It's also a

currency of international trade and international finance. And so there's lots of trade between third countries that doesn't involve the United States where they use dollars to transact. That's the means of exchange. And because that's the means of exchange, it's also the lending currency associated with financing that exchange. And so we have this dollar financial system that's quite

a bit distinct from dollars reserve currency. You know, Chinese Central Bank wants to hold treasuries, has a bunch of reasons for that, totally different calculus for why Indian conglomerate wants to sell its products to South American country in dollars.

Different calculus. And with that second calculus, the euro dollars fit in a bit more, a bit more, because what's going on there is the Indian company has a bank, and the South American company has a bank, and in all likelihood their primary banks are not US based, and those banks would like to be able to create dollars, lend them in dollars, and not have to look to US banks for that liquidity. And so what the urinal system is really doing is cutting foreign financial institutions into

the profits of dollars seniorage. They're giving them a piece of the action, and they're giving them a reason to

want to be in the dollar business. And the way the whole thing got going initially was a lot of London banks wanted to get into the dollar business and we let them in basically, and that makes them evangelists for dollar based finance, as opposed to constantly trying to say to their clients, you know what, let's do this deal in pounds, because we create pounds, and if we had to do this deal in dollars, then we're gonna have to go borrow from City Group the dollars that

we need because we can't just create them ourselves. And there's not this whole euro dollar market for us. We got to go to the domestic US dollar market, and so we would have all these foreign financial institutions trying to suggest other currencies for international trade and financing and not being as gung ho about the dollar, which is not to say that they would necessarily succeed in convincing

the vast majority of their clients to change currencies. There's a lot of reasons why you would just you know, open up a bank account with a US based bank shift your business there. At the same time, the US has gotten very far in embedding and entrenching the dollar by building this coalition of global financial institutions that all are able to profit and benefit off of being in the dollar, as opposed to trying to keep all of those benefits onshore for US based banks.

swap lines are facilitating dollar money creation. The Chinese swap lines are basically a central bank lending program for indebted foreign governments, and so it's like World Bank or IMF loans, and so like a major borrower is Pakistan. Pakistan has had a swapline with the People's Bank of China.

like the World Bank. So it's it's much harder for international observers to keep track of how much Pakistan and Mongolia and these various recipients of PBOC swap line lending, how much they are actually occurring. It's less reported than maybe if the Chinese did it in a more official channel. But it's nothing like what the FED swap lines are. There's over thirty billion dollars right now of PBOC swap line outstanding. There's like basically zero of the FED swap lines.

It's you know, the PBOC is like an ongoing lending program.

to South American buyers or vice versa using tether. That's a Euro dollar system is tied to the real economy and real economic activity, and up until this point, the cryptocurrency space is very much looking at itself, and so tethers are used primarily to buy cryptocurrency, not to facilitate real economic activity, or they're used to conduct illicit transactions that are difficult to conduct in the FIAT regulated system. I did air quotes, but that doesn't come across in

this media. That said, tether has gotten huge and it is exploiting the same sort of regulatory loophole if the year dollar system is exploiting. The tether balances have a very similar economic status to the Euro dollar balances. And one could imagine, insofar as tether is legitimated in some sense and it takes on greater scale, that it could expand its role and sort of jump over. You get out of just the crypto ecosystem and get into the real economic activity and be a real competitor with other

dollar money forms. It certainly is a dollar money form, and it could be a it could be a competitor in certain transactions for certain purposes.

getting talked about. The whole swap line based euro dollar system is very much a product of a particular geopolitical diplomatic arrangement between the United States and a variety of allies and partners that involves a certain orientation to those allies and partners, where the US is basically making an ongoing commitment over a long period of time that it will be there to provide in essence, discount window like backing to the extent that the US is incapable of

making those types of long term commitments or everything is going to be hashed out on a case by case basis.

And that's the new sort of international multilateral paradigm that's deeply destabilizing for the year dollar market, and to the extent questions would be raised about whether certain countries would be able to actually draw on their swap lines that could lead to runs and panics, just in the way that in nineteen thirty two and nineteen thirty three there were runs and panics throughout the US banking system, in part because he wasn't clear the extent to which the

Federal Reserve was actually going to be there with discount window lending to backstop those entities.