Odd Lots: The Hidden History of Eurodollars, Part 3 - Spinning Out of Control

Bloomberg's Joe Weisenthal and Tracy Alloway continue their in-depth exploration of the Eurodollar system in the final installment of their three-part series. Joined by experts Lev Menand, a law professor at Columbia Law School, and Josh Younger, a policy advisor at the Federal Reserve Bank of New York, this episode delves into the tumultuous events of the early 1970s that shaped the modern Eurodollar market.

1. Introduction

The episode kicks off with Joe Weisenthal referencing a pressing contemporary issue—AI prioritization among business leaders—but quickly transitions to the main narrative. Tracy Alloway sets the stage by highlighting the significance of the Eurodollar market, noting its growth to over $10 trillion and its role as the largest form of shadow banking today.

Tracy Alloway [01:17]: "It's the final installment of our three-part Eurodollar series... this is the moment when the Eurodollar market really takes shape and starts to look like it does today."

2. The Growth of the Eurodollar Market

Lev Menand and Josh Younger provide historical context, tracing the Eurodollar market's expansion from the post-World War II era through the Cold War. By the late 1960s, the market had swelled to approximately $70 billion, serving as a crucial pressure valve for the Bretton Woods system.

Josh Younger [02:47]: "Eurodollars have become a pressure valve basically to the Bretton Woods system and they're helping it to stay alive."

3. The Nixon Shock: Abandoning the Gold Standard

The market's rapid growth coincided with mounting pressures on the Bretton Woods system. In response, President Richard Nixon made the landmark decision to suspend the dollar's convertibility into gold, a move famously known as the "Nixon Shock."

Josh Younger [05:22]: "In recent weeks, the speculators have been waging an all-out war on the American dollar... we're not going to be giving you gold for your dollars anymore."

This unilateral action marked a seismic shift, signaling the transition to a floating exchange rate system and diminishing the need for the Eurodollar market as a support mechanism.

John Connolly [05:53]: "We want to settle this thing and we've offered more to settle it than any other nation in the world offered water."
Timestamps [05:53 - 06:40]

4. The 1973 Oil Crisis and Petrodollar Recycling

The episode highlights how geopolitical tensions, particularly the Middle East conflict, led to the 1973 oil embargo. This crisis not only skyrocketed oil prices but also underscored the interconnectedness of oil markets and the Eurodollar system.

Josh Younger [12:35]: "Oil has something to do with everything... if oil prices double or quadruple, that's going to be felt across everything that you buy."
Timestamps [12:35 - 13:00]

The concept of petrodollar recycling emerges as a critical mechanism, where oil-producing countries reinvest their earnings into Western economies, primarily through the Eurodollar market. This cycle became essential for maintaining global trade and financial stability.

5. The Collapse of the Eurodollar Market in 1974

By mid-1974, the Eurodollar market reached a tipping point. The collapse of Bankhouse Herstadt in Germany introduced what Lev Menand describes as "Hirstadt risk"—timing mismatches in international transactions that can lead to systemic failures.

Lev Menand [26:12]: "Has a little dick fold Lehman Brothers to it."
Timestamps [26:12 - 26:15]

The failure triggered a domino effect, leading to runs on banks like Franklin National Bank in the United States. This crisis mirrored the events of the 2008 financial meltdown, highlighting the fragility of interconnected financial systems.

Lev Menand [28:08]: "They were an early promoter of credit cards... but they have deposits, but they also have these deposit alternatives that are highly runnable, that are not FDIC insured."
Timestamps [28:08 - 28:14]

6. The BIS "Whatever It Takes" Response

In response to the escalating crisis, the Bank for International Settlements (BIS) convened the Group of 10 central bank governors. Their public statement, often referred to as the original "whatever it takes" moment, affirmed a commitment to backstop the Eurodollar market, effectively acting as a lender of last resort.

Lev Menand [31:28]: "The Federal Reserve essentially committing to support the banking systems of European countries... And that puts out this fire."
Timestamps [31:28 - 33:24]

This decisive action restored confidence, preventing further collapses and underscoring the critical role of central banks in maintaining financial stability.

7. Long-term Impact and Legacy

The Eurodollar market not only survived the 1974 crisis but continued to expand, eventually surpassing the onshore dollar markets. By the mid-1980s, Eurodollars accounted for more than the total amount of physical dollars in circulation, solidifying their role in global finance.

Lev Menand [33:57]: "This is why everybody uses Libor as a measure of interest rates. The London Interbank Offer Rate is the Eurodollar market interest rate."
Timestamps [33:57 - 34:44]

The episode draws parallels between the 1974 crisis and the 2008 financial crisis, emphasizing the enduring significance of the Eurodollar system in facilitating global trade, investment, and liquidity.

8. Conclusion

As the series wraps up, Weisenthal and Alloway reflect on the profound influence of historical decisions on today's financial landscape. They underscore the importance of understanding the origins and evolution of the Eurodollar market to navigate future economic challenges.

Tracy Alloway [37:13]: "We definitely need to talk more about the future of the Eurodollar market and by extension, the future of the dollar system."
Timestamps [37:13 - 38:31]

The hosts tease upcoming discussions on the future trajectory of the Eurodollar market, promising continued exploration of its role within the global financial system.

Josh Younger [37:37]: "We're recording this on the 50th anniversary... It's a really compelling story... how financial systems evolve in unexpected ways."
Timestamps [37:37 - 38:06]

Key Takeaways:

• The Eurodollar market emerged as a significant force in global finance during the Cold War, initially serving to support the Bretton Woods system.
• President Nixon's decision to suspend gold convertibility in 1971 marked a pivotal moment, transitioning the world to floating exchange rates and reshaping the role of Eurodollars.
• The 1973 oil crisis highlighted the intricate link between oil markets and the Eurodollar system, introducing mechanisms like petrodollar recycling.
• The collapse of Bankhouse Herstadt in 1974 exposed vulnerabilities within the Eurodollar market, prompting decisive action from international central banks.
• The resiliency and adaptability of the Eurodollar system have cemented its place as the backbone of global financial operations, influencing interest rates and facilitating international trade.

Notable Quotes:

• Josh Younger [05:22]: "In recent weeks, the speculators have been waging an all-out war on the American dollar... we're not going to be giving you gold for your dollars anymore."

• Lev Menand [26:12]: "Has a little dick fold Lehman Brothers to it."

• Lev Menand [33:57]: "This is why everybody uses Libor as a measure of interest rates. The London Interbank Offer Rate is the Eurodollar market interest rate."

For those interested in the intricate dance between global finance, politics, and economics, "Odd Lots" provides a nuanced and comprehensive examination of the Eurodollar system's hidden history.