The Eurodollar is the world's reserve currency.
Most people think the US dollar serves that role, and that's not entirely wrong. But it is misleading.
So just what is a Eurodollar? A Eurodollar is created when a US dollar is deposited in a foreign bank account, e.g., in Switzerland. Many foreign banks will let you open up dollar accounts where you can deposit dollars and keep them as dollars without having to convert them to the local currency. Historically those dollar accounts were typically in Europe--Switzerland, London, Frankfurt, etc.--hence the misleading prefix Euro-. Today dollar accounts exist in banks around the world: Toronto, Tokyo, Bermuda, Hong Kong, etc. These are collectively known as off-shore banks, and Eurodollars can be found in nearly every country on earth--not just Europe.
The advantage of a Eurodollar account is that foreign banks are not regulated by the US Federal Reserve Bank (Fed). For example, there is no reserve requirement. Domestic banks need to place reserve money at the Fed to protect citizen depositors from a bank run--the amount is equal to 10% of total deposits. Off-shore banks don't need to do that.
In addition domestic banks can borrow or lend money to the Fed, which gives the Fed power to determine short-term interest rates (and indirectly long-term interest rates). Off-shore banks are under no such constraints, and in fact interest on Eurodollar accounts is typically higher than at domestic banks. Further, off-shore banks pay no taxes to the US government. And finally, off-shore banks are exempt from all the myriad rules and regulations (such as the very complex Dodd-Frank rules) that constrain domestic banks.
The Eurodollar system evolved by accident--it wasn't designed by anybody. Likewise, it exists more or less independently of any central authority. Accordingly, it's difficult to determine how many Eurodollars are in circulation, though a 2016 estimate cites nearly $14 trillion. It is precisely this unregulated free market that has pushed the Eurodollar to the fore as the exchange medium for foreign trade.
The Bretton Woods agreement, signed in 1944, envisioned a structure where most currencies would be pegged to the US dollar, and the dollar would in turn be pegged to gold at $35/oz. In 1960 Robert Triffin realized that this was impossible--gold production was not sufficient to maintain the price at $35/oz, and soon the US Treasury's gold reserves would be completely drained. A variety of kludges were invented to keep the system operational, by which the dollar was effectively pegged to fictional gold. It is out of this confusion that the Eurodollar evolved--the term was first used in the early 60s. In 1971 President Nixon called it quits on the gold standard and formally ended the Bretton Woods system.
Eurodollars, while exempt from US regulations, are governed by the rules where the off-shore bank is located. So, for example, a Eurodollar in a Shanghai bank is governed by Chinese rules, and is in some sense is "owned" by China. Thus, even though a Eurodollar is a US dollar, the national sovereignty of China is preserved. This is what makes Eurodollars so valuable to foreigners compared to US dollars in a US bank.
So how are Eurodollars created? A small number arise from retired Americans living abroad, e.g., in Costa Rica. They deposit their social security checks in a dollar account at a Costa Rican bank--and pronto, Eurodollars are born. They remain Eurodollars until they're repatriated back into the US banking system.
The much more important source of Eurodollars is the US trade deficit. The US exports some products to foreign countries, and imports other products from foreigners. When the dollar value of imports exceeds that of exports, then a trade deficit occurs and net dollars are being paid to foreign countries. Those dollars get deposited in foreign banks, thereby becoming Eurodollars.
The US has run a trade deficit every year since 1974 (pdf). That's all money deposited in foreign banks, growing the total stock of Eurodollars. Indeed, the sum of all those annual deficits since 1974 results in about $13 trillion, comparable to the estimate above. In short, the overwhelming bulk of Eurodollars in circulation comes from the US trade deficit.
So now the bottom line: what makes Eurodollars so useful? They are the currency of foreign trade. Suppose a company in Thailand wants to buy goods made in Uganda. Ugandans have no great need for Thai Baht, nor do the Thais have excess reserves of Ugandan Shillings. So without a common and trusted currency by which to finance the trade, it wouldn't happen.
In the old days such trade might have been mediated using gold or silver. That doesn't work very well today--the transaction costs are too high. So instead Eurodollars are used. Because Thailand has a trade surplus with the US, it has a supply of Eurodollars which it can use to buy Ugandan products. Uganda, meanwhile, may not have a positive trade balance with the US, but instead sells products to other countries, e.g., Thailand, and acquires Eurodollars that way.
In order to engage in foreign trade, every country on Earth needs Eurodollars. Otherwise they're essentially reduced to barter with a few of the nearest neighbors. They have no globally accepted money.
Peter Zeihan suggests that the US trade deficits were purposeful, with the intent of buying allies against the Soviet Union. By allowing any country to sell into the US market, America financed the postwar trade boom, massively increasing globalization and raising living standards around the world, most notably in China. For much of the postwar era the Eurodollar system benefited the United States, but of course it had some costs. Today the costs begin to outweigh the benefits.
An obvious cost is the hit American workers have taken as manufacturing has moved off-shore. We imported cars first from Europe, then Japan, and now Korea. We can't run a trade deficit if we don't import manufactured products, and as a result the wages of US factory workers are depressed. Donald Trump won the election in 2016 in part because of this problem. He initiated tariffs on China and Europe--which persist to this day.
Then, in relative terms, the US economy has shrunk compared to the global economy. In 1960 we made up 40% of global GDP. Today we're merely 22%. It's important to emphasize the word relative. In absolute terms the US economy is much richer today than in 1960, but the rest of the world has grown even faster. Given our smaller relative size, it becomes increasingly expensive for us to finance global trade. Hence there are recurring Eurodollar shortages.
Ludwig von Mises (The Theory of Money and Credit) distinguishes between two types of money (among other distinctions): fiat and commodity money. Commodity money begins with the direct exchange of a monetary commodity, e.g., gold coins of known weight and fineness. This evolves into paper certificates that can be exchanged for the equivalent amount of gold, and in the meantime used as money. Often there isn't enough gold to redeem all the certificates (as happened with the dollar under Bretton Woods) in which case the commodity fix is partly imaginary.
The opposite of commodity money is fiat money, or reliance on currency printed up by the government, no longer redeemable for gold even in theory. The US transitioned to a pure fiat regime in 1971 when President Nixon finally dropped the gold peg. The problem with fiat money is the government's continuing temptation to print ever more paper dollars and thereby devalue the currency through inflation.
While the US dollar is pure fiat money, the Eurodollar is not. The Fed can print as many US dollars as it wants, but the Fed cannot print Eurodollars. Eurodollars are created only when American consumers buy products from other countries. The limitation on the creation of Eurodollars depends on the ability and willingness of American consumers to pay for imports, not on how many US dollars the Fed prints.
Indeed, the Eurodollar is much closer to being commodity money than fiat money. It doesn't depend on gold or silver, but instead on the economic wherewithal of the American consumer. This is a real economic datum--a hard number if you will--and not just an imaginary notation in the Fed's accounts. For the reasons described above--protectionism to benefit American workers and the smaller relative size of the US economy--the ability of American consumers to buy from foreigners is marginally smaller than it has been historically. Accordingly, since 2008 (and I don't know why specifically that year), there have been recurring Eurodollar shortages.
Jeffrey Snider, in a long series of videos, has documented this effect. He records four or five Eurodollar shortages since 2008. The first one began in 2008, with the great recession. Subsequent shortages began in 2012, 2014 and 2018. The fifth, possibly now underway, perhaps began in November, 2020. During these shortages the number of Eurodollars in global circulation stopped growing and/or shrank. Data presented in the slide deck here illustrate the point, though note there is no direct measure of Eurodollars in circulation.
So how can there be a Eurodollar shortage? Two ways: supply and/or demand. The supply of Eurodollars depends on the whims of American consumers, and clearly during recessions they tend to hold back. The demand for Eurodollars depends on the volume of global foreign trade (not just with the US). If that grows faster than the US trade deficit, then a Eurodollar shortage will ensue. Today, for example, China needs to buy oil from the Persian Gulf, and because of bad weather they currently need to import food. Both of these purchases require Eurodollars, and given the Covid recession in the US, those may not be readily available. Hence the current shortage (if that's what it turns out to be).
For Americans a Eurodollar shortage is deflationary. As Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Deflation is the opposite: if the quantity of money is shrinking, then prices have to go down. Since Eurodollars constitute the money supply for global trade, a Eurodollar shortage makes imports into the US cheaper.
Mr. Snider seems to think (I'm not sure) that the Eurodollar is effectively the "real money" that drives the US economy, and therefore US domestic inflation is determined not so much by US dollars, but instead by Eurodollars. I'm not sure I accept that, for according to the World Bank, the "United States exports of goods and services as percentage of GDP is 11.73% and imports of goods and services as percentage of GDP is 14.58%." Wikipedia has a list of countries by trade-to-gdp ratio which shows that the US depends less on foreign trade (as percent of GDP) than almost any country in the world. Further, we're the only country in the world that doesn't need Eurodollars--we can import products using our very own US dollars (which then become Eurodollars).
Nevertheless, Mr. Snider does show that since 2008 there is a close relationship between US recessions and Eurodollar shortages. But correlation is not causation, and what the cause-effect interaction is is anybody's guess.
One last point: Some countries, notably Germany, Japan, South Korea and until recently China, have run large trade surpluses with the United States, hence collecting a large horde of Eurodollars. There is no point in letting all this money sit idly in their domestic banks, so instead they use them to buy US Treasury bills and bonds, and sometimes US equities. The dollars thus flow back into the US banking system, but the foreigners hold a claim on US debt. Since Treasurys are very liquid, they can easily sell the Treasurys and reclaim the dollars as Eurodollars. So effectively US debt held by foreigners is part of the world's Eurodollar supply.
Foreigners will tend to cash in their Treasurys--and/or not buy more of them--when there is a Eurodollar shortage. As that may be happening now, it may be the cause of the very recent rise in interest rates.
Further Reading:
No comments:
Post a Comment