Odd Lots - Josh Younger on the Surprising Origins of Eurodollars and Petrodollars

Episode Date: June 19, 2023

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.See omnystudio.com/listener for privacy information.

and welcome to another episode of the Oddlots podcast. I'm Tracy Alloway. And I'm Joe Wisenthall. Joe, de-dollarization. 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 sort of associate it with cranks and stuff. But if you actually like take this 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 like 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 Carthic Sankhran 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

dollar is 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 because 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 all of these things then 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 will be a, you know, a different currency regime in the world. again, it's helpful to know the origins of these things to sort of anticipate what that might look like. Right. And I think actually there is often an assumption that they do emerge organically when actually there was a very conscious decision that went into making them what they are today. And then they sort of evolved from there.

But without further ado, I am very happy to say that we are going to be speaking with Josh younger formerly at JPMorgan, now a senior advisor at the New York Fed. Josh, welcome back to the show. Thanks. It's great to be 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 interesting. I like the rabbit. 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 U.S. dollar denominated deposits at foreign banks. People sometimes look at them as like a liquidity measure. How many Euro dollars are sloshing around in the system and what does that actually mean for risk appetite and things like that? And Petra 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 20s. They're fairly common in correspondent banking since then. So correspondent banking is somebody needs to use dollars versus, say, Deutsche marks in the 70s or the 50s or the 40s.

They will have a bank account locally that has a bank account in the U.S. Their bank has a bank account. And it's just really a daisy chain back to the U.S. A euro dollar is unique in the sense that it is a dollar-design. denominated deposit that has an asset side, an 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 U.S. financial system as well. And in that sense, it's a complementary but distinct financial system from the U.S. Like free-range U.S. 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 Sipronet. 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 separate internet, which is the secret internet. I'm going to go on the secret internet now. Yeah, so like, euro dollars are not secret, but they are separated from the U.S. financial system 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 U.S., you know, they have a relationship with the Federal Reserve,

and if they run into liquidity troubles 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, are there risks associated that 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, or the question, but this always like wraps my head around. It's like, what kind of risks did these banks issuing dollar denominated deposits in Europe face by being outside of the U.S. banking? It's like, what gives? How can you do this?

Yes. You can't just write a dollar in it. paper and is worth a dollar. Right, and expected to be worth a dollar. They don't have that relationship. And initially, that was basically what was done. So the first, the definition of Eurodollar 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 40s, it's declassified CIA 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 invasion 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... The title of this episode should be the communist origins of Euro dollars. There you go. Yeah.

And so they were worried about sanctions, which connects somewhat to today. And they moved their money from New York banks to a handful of banks, specifically in France, London, and Belgium, because the local regulations allowed those banks to issue non-local currency deposits. Your local regulator 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 Bisen. Bsen 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 $7 million to $200 million 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 in 1948. So there's some evidence of that. But that's not really a euro dollar. And 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? What's next? What's next? 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 trade. 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. They said, we don't want to need imports from the West to run our economy or society. We don't know how big that was. It was actually, as of 1947, 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. Oh, wow. 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-SEN to some extent. It's a lot. It's a lot of,

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 the peg goes away. So, okay, to trade 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 Ford Exchange regime.

What years are we talking about? It's like 1951 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 way. And so the first decision point is the London foreign exchange market has reopened, I think it was December 51, but it was roughly around 1951. And they kept the spot rate control, but they allowed FX forwards, which are an 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. It 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 there would be, there were 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 essentially 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 1954, 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, yeah.

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 deposit. So foreign money in this context meant a dollar deposit in a London bank. And not the U.S. branch, not the London branch of a U.S. bank, but a London-based city bank. Midland Bank is the most popular at the time. It's one of the largest. The Bank of England starts to get a little worried, but because in 1955, this market is doubling every three months. Whoa. So how does the U.S. 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. It does. us 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 sizable bucket of it. Yeah. So they have sort of their view evolves over time. They're initially a little intrigued. So in 1959 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 1959, the New York

Fed sends a delegation. and Ellen Holmes and Fred Klopstock representing what was then kind of the markets 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 offshore.

and that's a way to get people offshore to hold dollars, to get the dollar proceeds of their trade, and to keep those dollars in financial instruments. Is that desirable, though? Why do they want that? It becomes really increasingly desirable because the old Brettonwood system that had been put in place after the war

I said a dollar is a claim on the Fed or a claim on a commercial bank, but in Breton Woods it's also a claim on gold. So foreign official institutions, not anybody, but foreign official institutions can exchange their dollars for gold at $35 an ounce. It's a specified par rate on the dollar,

but there's other need for gold other than just monetary reserves. I think economy's growing. People need gold for other purposes. And so gold is trading in London at a little more than $35. So there's an incentive to sell goods to the U.S., get dollars in exchange for those goods,

use those dollars to get gold for $35 an ounce, and then sell that gold for more than $35 in London. That's an arbitrage profit for foreign central banks. It's also a drain on the gold reserve. Right. So if you get everyone to keep in dollars rather than flipping into gold, then that helps preserve your own gold reserves. Yeah. So now there's a place to park your dollars. And if they 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 U.S. So they're unconstrained

by regulatory limits on what they can pay. That's reg Q. That was reserve requirements. That was insurance premiums, FDIC insurance premiums, all these things that made it hard for U.S. banks to pay a high 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 U.S. 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 precipitating factors with the 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 outcome. Tracy asked you about the concerns from the U.S. and I expressed one of them there. What about you mentioned briefly the concerns of the Bank of England that this 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 imagine you could have a run on those banks and we can't help you because we can't.

Right. There's no Fed backstop or anything like that. No. And 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 Euro bank, they were called, and I say, I want dollars, like they might have a bank account in the U.S.

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 devalies the pound

in international finance, in London specifically, and also it's, like, 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 figure out 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 dollar? outside the U.S. financial system. So like somewhat indirectly, I guess I would say. Like the first, so the swap lines started, I think it's 62. It might be 63.

But Charlie Coombs, who's the special manager for foreign exchange at the Federal Reserve 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 under attack, everyone's worried about speculative attack. That's kind of like the original bond vigilantees, right? It's 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 U.S. was functioning as. And so he goes to England and France and Italy and the Bank for International 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 to, for the U.S. at the time, to pull in foreign currency and then buy the dollar with those foreign currency. 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. And so that's the initial logic, but Bob McCauley and Catherine Schenk uncovered the second swap line with the BIS, set up in 1964, 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 Eurodollar market if it needed liquidity. So there's evidence that the BIS didn't love this swap line, but they say, oh, the Fed called us and asked this to draw on 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 the 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 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 1960.

It's a roughly $2 billion market. By 1964, it's roughly $10 billion market. By the late 60s, it's, you know, $60 billion 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 M2 and these various measures of money supply are really important policy tools or things that we should target, et cetera. How do monetary policy makers feel about something offshore, something that is growing the supply of existing dollars in the world?

It's a trade-off. So in the mid-60s, this gold drain is accelerating. So the U.S. is forced for sort of, I don't know if you call that monetary policy, it has to do with the currency, but to maintain the stability of 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 a surtax to that to equalize the interest rates.

They eventually have voluntary credit restraint, specifically with extensions of credit abroad. So like New York banks should not loan to foreign entities. The whole point. be to keep the dollars in the U.S. 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 sort of shadow, I'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 Eurodollar market, meaning the Eurobond

market is the issuance of dollar-based bonds in Europe, the Eurodollar market is the issuance of dollar-based liabilities. There's also a loan market. And so there's basically a mirror image financial system optimized around 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 U.S. 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. using monetary sovereignty. There's dollars that are being issued by non-U.S. 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 BIS, 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 60s, through the early 70s, the prevailing view was closing the current account deficit. and not the current account deficits, or 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. I don't know. It's like an outdoor cat. Yeah. Yeah. I'm taking this too far. Okay, wait.

But Josh, you mentioned the 1970s. And when I think about dollars and currencies and big financial events in the 1970s, I think about Nixon, deep pegging 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 seven. these are where this all starts to get a little more worrisome, basically. Lots of things got more worrisome in the 70s. Eurodollar start to fall out of favor in the late 60s and early 70s.

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 1967, varying crises in 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 LIBOR is invented. So now you can manage the interest rate risk in a euro dollar bank. So LIBOR is created for the purposes of your 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 consider to be so crude, Eurodollar, London, Interbank Overnight, or Offered Rate. It's like 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 the Soviet Union, the Eurodollar does not refer to Europe. It refers to the telex address of B-SEN. So B-SEN's telex address was Eurobank-B-SEN. Oh.

It's not even, oh. Oh, this makes so much more sense now. Yeah, so Eurodollar meant dollars for B-Sin, for Eurobank. That was like a shorthand for payment processing agents and things like that. This is a totally new one. Yeah, this is like a revelation because everyone thinks Euro dollars have something to do with the Euro or Europe, but actually. Communist own bank in Paris, yeah. No one thinks that.

Okay, so 1970s 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 in commission studies basically. Yes, as one does. Yeah. So the problem is the U.S. is maintaining a low interest rate policy. It's attracting dollars overseas.

And so the euro dollar market is absorbing outflows in the U.S. where interest rates are low relative to Eurodollar rates and European rates. And so it's a monetary policy dynamic. And that's causing some consternation because at the same time, Milton Friedman is becoming very popular. The monetarist 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 1971, the BIS calls the standing committee on the euro currency market. It's like very august-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 market. Because there was some concern that when the Bank of Italy puts dollars into the Eurodollar 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. Right. 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 abandoned 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 euro-dollar market in the 1970s? On central bank placements into the Eurodollar market.

Got it. So the governors of the major central banks get together, the G-10, 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, you know, some of the lessons here in terms of people are always going to chase the higher rate, right? So people, you create a new money that offers a higher rate and the money gets sucked there. The lack of alternatives to an 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 could put it in. Yeah. No, I mean, it's, it's sort of like more money for the same perceived risk. Now, we can debate whether or not it's the same risk, but from the investor cash and extra perspective, I can get 3% here or 5% here and looks the same. I'll take 5. 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-wringing at the BIS in these regular meetings at the FOMC minutes, Federal Open Market Committee meeting minutes, they start getting a regular rundown of like what happened at Basel 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 sometimes Charlie Coombs or the various people who attend these meetings. Going back and forth to Europe in 1971 seems like a pretty, like, aggressive thing to do every month. But I guess the planes were nicer and they had served better meals. But they get a rundown. 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 screw's going to get stark and tighten the hammer's coming down.

Like there's an article in the economist called Who Killed the Eurodollar Market? I think that was 72. 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 Eurodollar branded chewing gum. So that's when you know a trend is like. Oh, no. And now we pull up eBay. Oh, yeah.

No, 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 contained. And by 1973, there's like a relatively broad consensus that this is sort of necessary. And then in September, there's the Yonkipur War and the oil embargo. And everything changes. So this is our cue for at two of the Josh Younger rabbit hole or the second rabbit hole, which is Petrodollars. Yeah. So Petra dollars are sort of broad term for the dollar-based

revenue from the sale of oil. Petrodos have been around for a while. Actually, the oil producing countries were involved in the Eurodollar market since the 60s. The thing that happens in 1973 is as a consequence of U.S. involvement or support for the Israelis in the Yonkapur war, there's an embargo of oil shipments to the U.S., the price quadruples, and oil revenues go from one or two percent of GDP to five percent of GDP. So we're talking about $100 billion a year in 1973. 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? Just the price of this commodity has gone up. It's not like people

issued 100 billion new dollars with which to buy it. And so they have to figure out a way, in a sense, to issue 100 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 euro 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 take the oil, Saudi Arabia sells $100 with oil. They take that money, they put it into something. That has to somehow get to the next country that has to buy $100 worth of oil. And it goes back to Saudi,

and it kind of goes around a circle. That's why it's called petrodollary. And so those petrodollars need an intermediary that has elasticity. Elasticity means they can grow substantially to meet this massive increase in demand. And Euro dollars, the U.S., in particular, Bill Simon, who's the Treasury Secretary in 1974 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 petrodollars, and they sort of mean all different kinds of things. But this is, 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 issued assets, right? So they had loans to oil importing countries and liabilities to deposits from oil exporting countries. And so they're the bridge. Got it. Because the financial system doesn't track oil imports. Who are these, like, are there specific banks that played a prominent? role early on? It's just like all the usual massive banks. Like they were all involved in this. There's old pamphlets. When I was at JP morning, went down to the archives. They had these old

like pamphlets. They're like the Eurodollar 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, it's a lot of analogies to today, right? you issue a short-dated 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 Eurodollar deposits are is an open question. But the loans are long dated because countries have ongoing need to import oil. So the Eurodollar market grows exponentially, but it incurs a much larger liquidity mismatch or, maturity mismatch. It's doing more and more and more liquidity transformation, long-term loans, short-term liabilities. And there's this increasing concern by the spring of 1974 that the system

is creaking under the weight of this demand and like something might break. Does something break? 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, something breaks. Not what you'd expect. I think they're the 34th largest bank in Germany, but there's Bankhouse-Herschstadt, and people talk about Hirschstadt risk now, but Bankhouse-Hurstadt is very involved in speculating on currencies. And I didn't talk about the Nixon shock and the depegging 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 Ivan Hirschstadt runs Bankos-Hurstadt as a privately owned bank. And he's like, this is my, I think he called it this big hour, right? This is my moment to make my mark. They take a massive long dollar position, goes bad, and they fail. Like, the bank fails. Hersch dot 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 German, so I'll check with somebody on

Translidman. Commitment to the narrative, I guess. Yeah, 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 money. of outstanding dollar transactions in New York, slated for New York afternoon. So the European transactions, the European payments go through on these foreign 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 Deutsch marks, but they never sent out the dollars. So this is classic settlement risk. I mean, so Herrstadt risk became basically a synonym for this type of risk. Not only a synonym. It's the reason we have Basel Bank Regulations in the first instance. So the Basel 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 series. Yeah. So the 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. 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 drop? Right. Always the same. Yeah. And so the Clearing House Association starts allowing for clawbacks of payments until the next day afternoon to try to facilitate this. And it kind of works for the spot market, but it 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. This sounds a little bit familiar.

So now your dollar issuers can't hedge. They can't hedge their foreign exchange risks. 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? So then the question is, what do you do if there's another run? How do you backstop the euro dollar market in a more concrete way? Who is the lender of last resort to the euro dollar market?

Which is kind of like the first question I had like at the very beginning. So finally, 20 years later, they start really contemplating this in detail. And because the first instance is 54, then in 1974, they go, you know, we really need a plan for this. And so they start convening meetings and the usual things. In July of 74, 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 comes 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 euro dollar market. Oh, interesting. So the regulatory impulse reverses completely. And in September, the G10 central bank governors go so far as to put out a public communicate where they say, we are going to do what is necessary. This is whatever it takes the first time. So this is just like what happened in Europe around the sovereign debt crisis, but it's in 74 with relation to the Eurodollar market. And they say, we're going to do whatever it takes, I don't remember the exact words, to facilitate liquidity in the Eurodollar market and make sure it's stable.

Sorry, real quickly, who said this? Or who is in position? The G10 central bank governor is put out a communique. So it's a collective agreement. A collective. Okay. They leave out some details, like what do you literally mean? But because they put it in a communique, this is all about central bank communication.

Yeah, 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 no computers. And so like, you say, please print this. And so they print it. Fax it to the Wall Street Journal.

Wait, were there faxes in the 70s? Maybe it's a telex. There we go. It's a good question. But they put out of public communication that this is the case. The goal being to like stop the contagion. So specifically to facilitate the quitted in the euro dollar market. And the implication is we need this thing to avoid a global monetary contraction.

There's a lot of like hand-wringing in the press. Like if they don't do something, we could have global monetary-based destruction through the collapse of the euro dollar system. That's what happened in 1929 to 1933. 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.

They're very clear about their like commitment in a public forum as opposed to having you behind-the-scenes conversation that gets leaked out. Apparently the fax machine was an. invented in the early 1800s by someone, but the actual modern facts in 1964. Just in time. Yeah. So maybe it was a fact. I'm sure the Eurodollar banks 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, oh, we forced, you know, the forced 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 U.S. 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 75% dollars, 25% sterling.

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 1973. 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 Eurodollar 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 U.S. 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 bonds, which makes sense is a lot of excess dollar-based savings abroad. But that requires, one, that the oil exporting countries be comfortable buying treasuries, which is like got a bunch of things around that. And two, that it stay in dollars. Those two things are connected. So in the spring of 74, Kissinger convenes this like council with Saudi Arabia specifically to think about U.S. 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, Euro-Dollars are the primary recycling mechanism, but, like, well, we're at it.

Maybe we'll get some revenue for the government. And so he flies to Riyadh in July. He actually gets scooped by Fannie Mae, who wants to sell adventures to fund mortgage. Oh, they get their first and they're like, buy the mortgage bonds. And there's like this whole 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'll do them 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 Federal Reserve from New York is going to be the custodian. And so they're going to transact on your behalf. You get confidentiality. And the implication is in exchange. And this is a pitch to the 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. Suddenly, he has a heart attack in D.C. while he's on a set of meetings. So it 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 in anyone's list.

There's a bunch of State Department cables where basically who is this guy, because nobody thought he would be one of them. But he's a technocrat. He was educated in the U.S. He's viewed as, quote, very pro-American was the evaluation the State Department had. And he's viewed as like the harbinger of a technocratic administration that's going to be much more U.S. 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 purchases. And that's his first, like three days 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, from the Saudi oil producing companies that they will no longer accept sterling in exchange for oil. So all our revenue in dollars. Very awkward because the British Chancellor of the Exchequer is in Saudi Arabia when this

leaks out. So and when asked for comment. The British had really close ties with Saudi Aramcoe from what I remember. Yeah. And basically the response of the administration in Saudi Arabia is like no comment to the State Department. So like 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 13th of December, on the 14th 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 U.S. treasuries in a semi-advantaged way? It's not clear that's the only reason, but like those two things are connected in time. Understood. Some people have put together that story. There's later comments from 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 record is 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 you, 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 like the price, they can buy more.

Imagine if SoftBank had got there first and all the Saudis would put their money. in soft bank stock. So this is it. This is the moment when Petro 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 of Inland put out an estimate a few years later by $75 or like 80% of oil revenue and then by 76 to like 94% of oil revenue. So like it happens pretty quickly. But at that point, The dollar's 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 euro dollar market is kind of like put to work in a sense through the oil shock of 1973 in the rise of the petrodollars system. It's important to say that petrodollars don't create the euro dollar market. It has to be in place. elastic and flexible and already has the network effects that allow it to function as a distribution mechanism. Right. That's the thing I really never realized before that there is sort of like,

it almost sounds like petrodollars are like another skin of the euro dollar market. And 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 U.S. had to give up a little bit of monetary sovereignty. I think the lesson is at least just the experience of the U.S. in that period is, and the U.S. 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 U.S. is essentially the only economy left standing. And so like

the fundamental arguments about global reserve currency is like very much applied to that. period. Even so, there were lots of policy decisions that had to get made. This was not a foregone conclusion. There were key decision points where certain key policies were put in place or backstops provided or agreements offered. And so like the story of global dollar dominance, like is an interesting one, I guess is 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 the rolling down a hill and kind of unstoppable. And that may yet have been so, but the real story is a very, like, rich one.

Well, as Tracy pointed, you know, in the beginning, I was like a sort of emergent and Tracy's like, well, actually, maybe the story is not. And I think that, to your point, like, no, like things happen, meetings happen, flights happened, trips to Europe happened, like all these things. Yeah, like, I don't think there's a movie in it, but like there's a book in it, you know, that kind of thing. Someone makes Eurodollar gum. There's a TV series.

There's a TV series. For sure. Well, Josh, we're going to have to leave it there, but it was wonderful. you on the show. And, you know, as much as some of the de-dollarization discourse annoys me, and 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 it. So, Joe, I don't know if anyone listening heard me frantically typing at the Eurodollar gum mentioned, but I haven't. I did this. We both pulled up eBay and stuff like, I need to find

this. I haven't been able to find an image, but there's an 1974 article from the New York Times. The headline is the Eurodollar bubble, and it has a description where it talks about the inflow of Eurodollars takes the form of bubble gum packaged in gold foil to resemble coins. We got to find that gum. Isn't that amazing? There's so much to pick out of there. So many things I hadn't realized, including where the Euro in Eurodollar 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 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 Carthick mentioned in his episode as well, where he was talking about like, well, you're not going to get a lot of UN Chinese renminbi 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 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 stuff. over and over again in different conduct. You build on the communiques of Basel. 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. It's 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 Odd Thoughts 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 Carmen Armin and Dashel Bennett at Dashbot, and check out all of the Bloomberg podcasts under the handle at Podcasts. And for more OddLodds content, go to Bloomberg.com slash Oddlots, where we have transcripts, a blog, and the newsletter comes out every Friday.

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