The Hidden History of Eurodollars, Part 1: Cold War Origins

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1:15Bloomberg Audio Studios. Podcasts. Radio. News.

1:23Joe. Joe, what's that noise? Where's this going, Tracy? I'm setting the scene. What was that? All right, let's just start. I'm Joe Weisenthal. And I'm Tracy Alloway, and this is a very special edition of the Odd Thoughts podcast. Tracy, so one thing I've been really fascinated by, and I've mentioned it on some episodes lately, I've been really getting into Cold War history, actually. And I guess, I don't know, probably because I'm a middle-aged man, and that's a middle-aged man hobby. You start reading about 20th century history, but particularly Soviet and Chinese history. And one thing I've learned, And this did actually come up on an old episode.

2:01There's some interesting financial linkages in the past that people might not have expected at all. And I feel like more people should be talking about this. I agree. And also, if you like Cold War history, Joe, you are going to love what we are about to do, because there is a big connection between the history of the Cold War and the development of the modern financial system. And that connection is euro dollars. And of course, just to be clear, this is not the euro dollar exchange rate. I will fully admit that it took me 10 years, like 10 years, maybe less, maybe five. No, it probably was closer to 10.

2:38The euro dollar did not mean the euro, the EUR USD exchange rate. It can be admittedly confusing. So why don't we just define it right away? So euro dollars are dollar denominated bank deposits held at foreign banks or overseas branches of U.S. banks. And you can think of them as basically offshore dollars that sit outside the U.S. banking system and kind of away from the Federal Reserve. They're basically a very special form of money. You could call them shadow money. And it's totally gigantic. So it's almost 10 trillion dollars. And I just find it so interesting, right? Because when I think of dollars, they're either coming from, you know, the government spends dollars into existence or U.S.

3:23bank credit, U.S. banks licensed to de facto create dollars or deposits at will. And yet euro dollars are kind of this weird thing, I guess, because they're not that. Yeah, they're not either of those. And euro dollars didn't just spring up fully formed out of thin air. They were the result of a series of decisions all aimed at solving particular problems. And that's what we're going to hear about today. So the origins of the euro dollar market. And this story has a lot in it. There's political intrigue, rivalry between the East and West, big existential questions about the role of the U.S. dollar itself in the global financial system.

4:05Just a lot of fascinating history to satisfy your new middle-aged man face. Thank you. And we literally, literally have the perfect guests to tell this story. While we're trapped in this bunker or vault. Yeah, you might recognize our storytellers. we're going to be speaking once again with Lev Menand and Josh Younger. I'm Lev Menand. I'm a law professor at Columbia Law School, where I study money and banking and the history of central banking. I'm Josh Younger. I'm a policy advisor at the Federal Reserve Bank of New York. And the views I am going to express are my own and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.

4:42They have been digging deep into archives and are ready to tell us the story of the hidden history of euro dollars in this very special series. There's going to be three episodes with Lev and Josh. And because it's so good, they tell the story so well, Joe and I aren't going to say anything at all. We're just going to listen in. I love this. We should do all of our episodes like that where we just get to listen. Yeah, just cut ourselves out. All right, let's do it.

5:40So euro dollars are among the most important financial instruments in the world. They're really the backbone of the global dollar system. But they come from a very humble beginnings, very idiosyncratic start. and really it all started in Yugoslavia. And I mean that quite literally. This is kind of like the original sin that leads to the development of Eurodollars. And it starts especially when Marshall Tito takes over in Yugoslavia. So in 1945 in November, there's a communist revolution and the US is miffed in a bunch of ways, but one of them is that the old government owes them money. And so the question is, how are they going to get it?

6:14And a few months later, Tito asked for his gold back because the Yugoslav government had$70 million worth of gold in New York. And the Secretary of State, George Marshall of the Marshall Plan, he realizes he's got a bargaining chip, which is the gold. It's in New York. And they don't get it back until they settle their claims. Now, even people within the State Department were kind of skeptical of this. The Yugoslavian government is obviously furious. And so the Russians, who at this point, Tito and Stalin have a falling out eventually a few years later, but at this point, they're quite closely aligned.

6:44And so the Russians are furious. The Yugoslavian government is furious. The State Department internally has some turmoil over this. And they take it to the UN, which has just been constituted. And the UN says, pass. They won't consider the claim. And so the Russians get the sense that the US is willing to use gold as a bargaining ship. They'd previously actually been building up dollar balances in New York. This is kind of a misnomer about the post-war period. There's this sense that the Russians are extracting all their resources from the US, but they're actually building up reserves of dollars because the thought is, we're probably going to need to trade with these people.

7:17We have a trading company based in the US and they need resources. And so they're building up foreign currency deposits and gold. But in 1947, they realize it's not going to go well, potentially. And they pull all the gold out. They actually just called banks in New York and they say, we want our gold back. A massive reversal of the policy. And the question is, where's it going to go? And so they need dollars because the US dollar is the currency of foreign exchange. If they want to trade with the West, they have to trade in dollars. They need gold because gold is the basis for the monetary system.

7:48And so the question is, where can they put gold and dollars in a safe place that's still on the right side of what was then already known as the Iron Curtain? And so it turns out Paris is the ticket. They've actually been secretly stockpiling cash and gold in Paris. They put it in briefcases. They would fly people to Paris and put it in the consular offices. They would just build up piles of cash and gold. And in particular, there's a bank, B-CEN. I won't try to do it in French. And B-CEN is owned by or run by a notorious communist sympathizer who has a very good relationship with Apollo Burrow.

8:21And so this is a friendly bank. And so they take on deposit the Soviet money. And B-CEN's moniker in the telex system they used to communicate was Eurobank. And so Euro dollars were initially in the late 40s, just deposits issued by Euro bank, B-Sen, generally for the Soviets, although also for the Chinese. And slowly this starts to percolate. There's another communist owned bank in London. There's one in Brussels, which the CIA just describes as run by someone with few scruples, I think was the way they put it. And so there's some friendlies across Europe who are willing to take their money. And the Euro dollar market begins this way, which is preemptive sanctions evasion.

8:59Basically, we might be sanctioned. It happened to Tito, it might happen to us. And so we need a safe place to go. And the European regulations allowed for this and they need dollars again, because they trade with the West. And so the first use of Euro dollars is for that. And also to replace the salaries of striking French coal miners was another potential place to do it. The record's not super clear. I think it's worth pausing here for a second to ask, Why wouldn't the Soviets have just been in France all along? Why were they in New York initially? Why hadn't other people thought of this? And I think the answer is the dollar liabilities of a communist sympathizing French bank are not the same thing as the dollar liabilities of a bank headquartered in New York.

9:47And I think it's helpful to think about why we even hold the dollar liabilities of a bank headquartered in New York. Like even today, when you log on to your bank account and you see a balance,$5 ,000,$10 ,000, the bank doesn't hold U.S. government dollars to back that. And yet we are very comfortable treating those as equivalent. We aren't concerned that those dollars are not the same thing. And why is that? There's a number of factors that go into it. Of course, since the 1930s, we've had deposit insurance up to a$250 ,000 balance. Of course, businesses routinely hold larger balances, and they are comfortable treating them as equivalent.

10:31Well, there's the implicit backing of the United States that comes from the fact that your bank was actually chartered by the U.S. government. It's supervised by the U.S. government. There's a sense that it's backed by the U.S. government. And then there's the actual institutional apparatus of the Federal Reserve, which has a facility, the discount window. And if you do go to your bank and say, I actually want to turn this balance into government cash, the bank can go to the Federal Reserve and get that cash. The Fed can print it for the bank and hand it over. And so there's this whole apparatus that facilitates you treating your balance at a U.S.

11:08bank as equivalent to government cash. Those are trading at par. This bank over in France that's now issuing these dollar liabilities that the Soviets are holding, why should we think that that should maintain par equivalence to U.S. government dollars? That bank's not FDIC insured. That bank's not chartered by the U.S. government. That bank's not supervised by the U.S. government. And that bank can't call up the Fed when the Soviets are drawing down their balance and the Fed won't print money and hand it over. And so this move by the Soviets, they're taking on a lot of risk to get out of the U.S.

11:40And they're doing it because they're worried about the risk on the other side, the Yugoslavia risk, the risk that the U.S. will actually freeze their balances. And so they have much higher risk tolerance and they are willing to go out and try something different, which is hold dollar balances offshore. And it's a risk for the bank taking it as well, because the question for B-Cent and others is, what are you going to do with this money? So there's actually an antecedent to the euro dollar market from the 20s when the dollar was actually the global reserve currency in the 20s. And then it lost that status in the 30s.

12:12But at that time, dollar acceptances, which is a form of trade finance, were larger than ones drawn on London. And the dollar was the currency of international trade. And in particular, the reserve currency of the world, it was the largest, much bigger than sterling, at least for a few years. And as a consequence of that, some of the Austrian banks in particular started issuing dollar deposits. There's one in particular in Austria that did a pretty brisk business in this. And they were doing interbank deposits. They were doing private deposits, like non-bank deposits. It looked a lot like the euro dollar market.

12:42The difference is they were basically holding it in cash on the other side. So it was more of a correspondent custody type arrangement. And so the question for a bank taking deposits is not, are you comfortable issuing deposits? Of course, they're comfortable issuing deposits. What are you going to do with the money? And so what can a communist owned bank in Paris in 1948 do with the money? And at the time, there was still some trade between the East and the West, cross Iron Curtain. Now, the Soviets don't like this in general because they have this policy of self-reliance. For obvious reasons, they don't want to rely on the West for anything.

13:14And we actually don't know how much of their trade this was because you'd be sent to the Gulag for talking about economic data. So no talking about payrolls, Joe, in Soviet Russia in the 40s, at least starting in the 40s. But the key was there was enough to make a business out of it, and it was in dollars. So using these dollar deposits to finance East-West cross-iron curtain trade was profitable in two respects. One is you just make more money on loans than you make on cash. The other is you don't have to hedge it because you have a dollar asset, a dollar loan to facilitate trade, and a dollar liability, a dollar deposit.

13:44So you're not taking foreign exchange risk. And so that turns out to be an okay business. There's not enough of that to make for a large market, but it grows. It's$100,$200 million in the early 50s. And so this is the seed that's planted. And it basically sets a precedent, which is banks are willing to do this. But the question is, how do you make this a bigger business? What are the business opportunities to do it? And that's where the early 50s are a critical period because after the war, most foreign exchange markets are just straight up closed. The British in particular are heavily controlling their currency.

14:17London's the obvious place to do this kind of business. It's still a Center for International Trade, but they can't hedge. So if they issue dollar deposits, they're just holding dollars. And unless they have a dollar loan to make, on the other hand, which they didn't necessarily have at the time, you're just warehousing the risk that the dollar depreciates or appreciates relative to sterling, which is ultimately what you pay your employees in. That's your sterling funder, meaning you are a British business. You care mostly about sterling. Then in 1952, as things are starting to improve, the Marshall Plan is mostly done.

14:46The dollar gap has been mostly filled. We'll talk about that a little bit. And things are normalizing. So the British feel comfortable partially liberalizing their foreign exchange markets. Now, not all at once. The spot, meaning today you want to exchange sterling for dollars, the rate at which you can do that is still heavily controlled by the Bank of England. It's in a range that's widened, but it's still pretty narrow. But in particular, they've liberalized the foreign exchange futures market or forward market. So what is a foreign exchange forward? A foreign exchange forward is, I'm going to give you dollars per sterling, not today, maybe tomorrow, maybe in a month, maybe in a year.

15:18This is a very, very large market today. It's a critical piece of hedging equipment for a bank because you can use those forwards. If you've borrowed dollars and lent them out for, say, a year, you don't want to hedge your dollar risk today. You want to hedge it for the return of those dollars in a year. You want to coverage for the full term of the loan. So the forwards market is critical to this. And so the Bank of England says, now you can trade forwards on dollar sterling and other major currencies, but in particular dollar sterling, and we won't control that rate. So now there's a hedging instrument.

15:50And now banks in London can look around and say, what can I do with this? Because there's clearly interest, there's a precedent for dollar deposits. And then the question is, what can I do with it? And so they figure out, something that still happens today, which is there's a shortage of dollars in the UK. That means if they were to borrow dollars and functionally lend them out through the FX markets, they can construct arbitrage type arrangements. And by arbitrage, I mean, I borrow a dollar, I hedge that dollar, I use the sterling proceeds of the hedge to buy an onshore sterling asset, and I collapse the whole thing when everything matures.

16:23So this is just cross-border interest rate arbitrage. Today, we'd call it a cross-currency basis, but it is not perfectly efficient. Meaning if there's more demand for dollars or more demand for sterling, the pricing can get out of whack relative to the relative interest rates on those two instruments. And so the banks in London, in particular Midland Bank, realizes that if they issue euro dollars, use the dollars they borrow through euro dollar issuance to buy sterling assets and hedge that package, they can make arbitrage profits.

17:25Thank you.

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18:14And so the first use case of Eurodollars is sanctions evasion. The second use is to facilitate cross-iron curtain trade, although that's a pretty small business. And so the third and much larger business is cross-border interest rate arbitrage. And that sounds really technical. But what it's really doing is using foreign exchange markets and derivative markets to source dollars that the UK in particular needs in this post-war environment. So imagine a euro-dollar bank, a euro bank, takes in a euro-dollar deposit, which means it gets a dollar in cash. Let's think of a physical bill. That's an asset.

18:47It issues a euro-dollar liability. And then what is it going to do next? because it needs to do some sort of investing. And what it does is it exchanges that dollar asset for a sterling cash and it invests that sterling cash in some short-term sterling investment. That's short bills or something like that. And after it does that, it says, I want to hedge my foreign exchange risk because now I have a dollar liability and a sterling asset. So I'm going to use the foreign exchange forward market to agree to sell that sterling back for dollars at some point in the future at a fixed price that we agree on today.

19:22So that's the bank's position. Who's on the other side of that trade? Let's say a corporation, a manufacturing entity, they make radios. And that radio production process requires inputs. Those inputs are imported. And so that radio production company needs dollars with which to buy the raw materials that it uses to make the radio that it then sells for dollars in foreign markets. And so they get those dollars from the Eurobank in exchange for the sterling they have on hand. They go buy all the parts, but they want to make sure that they know how much they're going to receive in local currency at the end of the production process.

19:59When they sell that radio abroad, they don't want the value of the dollar to go down. So they sell those dollars forward in exchange for sterling. And so they've entered into a derivative agreement, which is the opposite of the one that the Eurobank has or the Eurobanking system. And so then they put together the radio, they sell it abroad, they receive dollar proceeds, they turn those into sterling, which is what they pay their employees in. That's what they pay for their land and equipment in. And that exchange rate was the one they agreed upon in advance through the foreign exchange forward contract.

20:29And so basically what's happening is the euro banks are pulling in dollars from abroad, distributing them through the foreign exchange market that's trading on shore to those that need dollars today. And then providing hedges to those that will receive dollars in the future. And in the case of the euro bank, the dollars they'll owe in the future potentially to the euro dollar deposit holder. Think about this from the perspective of the city of London coming out of the war and those bankers and the world that they grew up in, which is a world that we've completely forgotten, but was the world of sterling dominance before the First World War and the role that the empire played in financing global trade.

21:12What we're looking at in the 50s is a group of London-based financial institutions trying to figure out a way to continue their dominance in a global economy that runs on dollars now and not on sterling. And so the euro dollars are sort of worth the risk to the city of London and to some extent to UK financial regulators like the Bank of England because they need to fix their business model for a dollar world. And they want to get in on the dollar world. Dealing in dollars is going to be a necessary part of that. And so the UK is adapting here by turning to dollars and embracing dollar liabilities for its own institutions.

22:01And in the UK, this was a particular problem because they imported so much of what they used to produce products that were manufactured to sell finished goods abroad. And so there's a great newsreel from the late 40s for the British population saying, you have to go without today for high quality locally manufactured goods so that we can export as much as possible and source the dollars. But another way to do it is to get euro dollars. The Smith household is very dissatisfied. Dad wants a new wireless. mother wants a sewing machine and Betty wants glamorous beauty preparations. But these are needed for export because we must build up overseas markets.

22:39We sell these goods overseas for foreign currency to buy the food and raw materials we need to live and work. These things would soon vanish if we couldn't pay for them. We must sell the things we'd like to buy the things we need. And so this cross-border interest rate arbitrage is really just a way markets distribute the currency according to who needs it and provide the hedges that facilitate the functioning of British corporations as well. It's what we'd call now like a use case, right? This is like a real underlying use case that doesn't involve the Soviet Union for dollar deposits issued by non-US banks, which you can't emphasize enough how fundamentally strange that is.

23:27Because if I tried to make dollars by writing another piece of paper, I don't think I'd get very far. But at the time, that's essentially what these banks are doing. And in particular, London is a more, let's say, reputable locale, particularly banks that are not known to be communist sympathizers. There's a little bit of a funny thing about being a communist bank, but we won't get into that specifically. But these are blue chip banks in London, issuing dollar deposits. And that means you can use them for things and you can feel more comfortable along the lines of what Lev was talking about. You can feel much more comfortable with Midland Bank, which was among the largest in the city, than BSEN, which is a tiny little place on the continent.