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The "What is Money?" Show
Emergence of the Eurodollar System | The Snider Series | Episode 2 (WiM088)
01:02:49
Jeff Snider joins me for a multi-episode conversation exploring the evolution of money and central banking throughout the 20th and 21st centuries.
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- [00:00]
Robert Breedlove
Foreign hey everyone, welcome back to the what Is Money? Show. Sitting down again today with Mr. Jeff Snyder. And we're going to keep working our way through really the history of money, central banking, and working our way into the Eurodollar system today. And this really gets into the murky edges of modern money, I think where not many people understand what it is. And even those that do understand what it is, we don't understand necessarily how big or significant it is. So I think we left off getting into the emergence of the Eurodollar system in the 50s and 60s. So where do we start? I know this was maybe not something that was even understood until it was understood in hindsight. Really it kind of emerged in the darkness in a way.
- [01:13]
Jeff Snyder
Yeah. I think a good place to start was the fact, I think we talked about this last time where a guy by the name of Paul Einsig, who was an economist and a well known financial commentator, said he stumbled upon this global dollar market, basically centered in the City of London a couple years after it had started. And all the bankers who were operating in it begged him, don't write about it, don't say anything, we're making money here, we got nobody on our backs, there's no regulation, there's nothing, just shut up about it and let us do it.
- [01:43]
Robert Breedlove
What year was that?
- [01:44]
Jeff Snyder
That was around 1960.
- [01:46]
Robert Breedlove
1960.
- [01:47]
Jeff Snyder
So Paul Isaac somewhere in the 1950s there arose this market for US dollars outside the United States. Some of that was the Marshall Plan. There are any number of origin stories about this Eurodollar system. And there was rumors and whispers about a continental dollar throughout the 50s. And so we don't really know where it came from, how it started. It's likely a combination of things. But there arose this robust dollar market outside the United States sometime in the 50s and what you just said, Robert, it wasn't until the middle 1960s that authorities in the United States and even elsewhere really started to take this thing seriously. The first major study, for example, was conducted by the BIS for I believe it was its 36th or 37th annual report in 1964. That's probably a decade after this thing had gotten going. And by 1964 it was already creating all sorts of problems. If you read FOMC transcripts, which unfortunately I do, in the early 1960s, you start out in 1961, they don't mention Eurodollar at all.
- [02:51]
Robert Breedlove
Yeah.
- [02:51]
Jeff Snyder
And then 1962 there's a couple references, and then 1963 there's a couple more. And by the time you get to 65 and 66, you know, they're talking about euro dollar all the time, right? So, you know, it was sort of, hey, let's not. It starts off in secret, we don't really know what it is, and then authorities don't come looking at the thing until it becomes absolutely huge and enormous much, much, much later.
- [03:15]
Robert Breedlove
Interesting. So, and again, just to revisit briefly the definition, this is effectively a derivative dollar system on top of the dollar system, which itself at the time, ostensibly at least, was a derivative of gold. Not to jump ahead of our story here, but I would like to maybe explore this. Seems like there might be some commonality between stablecoins today and this type of system where we have this derivative system living in a digital universe that's derivative to the dollar itself. Is it similar to that?
- [03:55]
Jeff Snyder
I don't know. I kind of look at stablecoins as sort of like money market funds, except money market funds who sell equity shares. Stablecoins issue digital currency. I mean, I don't know how much of a currency it actually is, but that's sort of the point. But I think there are a fair amount of parallels that we can draw, at least so far as purpose and intent are concerned, because that's really what the Eurodollar was for. Again, we talked about Triffin's Paradox or Triffin's Dilemma last time at some length, for good reason, because the money was starving for a reserve currency that the gold exchange system just could not provide. I know a lot of sound money advocates say, well, that's the point. You're supposed to have limited currency so the prices don't get out of control. But the economy wants what the economy wants, so to speak. So it created these workarounds, which, as you alluded to, were sort of virtual currency before anybody even thought about virtual currency. Right, because it's not physical currency. We're not talking about paper Federal Reserve notes, printed Federal Reserve notes that are being traded back and forth. That was certainly part of how this thing got started. In fact, that's what the term Eurodollar really referred to in its initial incarnation was cash deposits outside the United States. But once there were these cash deposits outside the United States, what would stop, say, the Swiss national bank for swapping dollars for francs, which meant no currency moved anywhere. But now we have bank transactions between a central bank and a bank and a private bank in the Eurodollar system that creates some kind of monetary transaction or some kind of monetary outcome that doesn't involve the exchange of currency. That's really what The Eurodollar system was this virtual ledger system that allowed this tremendous flexibility combined with this regulatory black space where banks could simply transact in dollars without ever having to use dollars. So it's essentially a reserveless virtual currency system based on simply ledger transactions back and forth.
- [06:03]
Robert Breedlove
Interesting. Okay, so a couple of questions here. The market starving for global reserve currency, is that specifically the market seeking a common unit of account, or is this looking for a neutral medium of exchange? Is it looking for price stability, all three combination? What is that?
- [06:27]
Jeff Snyder
Well, I think price stability that was sort of inherited by the Eurodollar system from the Bretton woods system. It was a fixed exchange value. So the dollar denomination itself was already stable due to its linkage to gold, or what was left of it, eroding links to gold. So there was a stable unit of account there, and it really was a medium of exchange. And again, I think we also talked about some length of what a global reserve currency is and what it's supposed to be. Remember what it is and what it's supposed to be. It's supposed to be a medium of global exchange where it allows two very different systems, two very different currencies that don't normally transact with one another. Suddenly they're able to do so because they have this common medium through which to transact. But in order for that to work, you have to have this currency insufficient supply and insufficient redistribution potential everywhere around the world. And that simply wasn't the case with the Bretton woods system. And we talked about gold being hoarded essentially by the United States and France, not really much of the rest of the world. So there was these places, Iran and all these other places around the world that were like, we would really like to have some dollars. And these bankers in London were like, we can give them to you. We don't need dollars. We'll just create these bank liabilities and transactions. We'll create the marketplace for them and we'll be able to mediate all of these var. National currency systems, national economies, and tie them all together into this highly efficient global trade centered, worldwide network.
- [08:10]
Robert Breedlove
Yes, a network of interbank liabilities, as you call it. So this is just interconnected ledger entries, essentially. Clearly, this is a very complex domain. But is it that simple that these banks take in reserves of whatever currency and then they just redenominate it in doll for their counterparties. Is that how they created these dollar derivatives?
- [08:35]
Jeff Snyder
Yeah, it's all about their own balance sheet factors. What is it that governs a bank's balance sheet? And it's a lot of different things. I mean there are some regulation even in the offshore world because banks are domiciled somewhere, their headquarters are somewhere. So they do have to pay attention to some sort of regulation. Though it's not nearly as much as it would be if they were onshore. Well, at the same time it's really, you know, what, what makes a bank do what the bank does. And sometimes it's, you know, risk, risk budgets, sometimes it's internal constraints that are imposed upon various activities, various new markets. It's trying to get into credit. Whether it's credit, whether it's derivatives, whether it's short term rates, whether it's, you know, repo, all of these various money dealing activities that a bank can undertake. They're governed by some internal rules that are decided by the bank. The bank decides how it's going to construct its balance sheet and that's really the monetary constraint here. So so long as the bank, the bank's internal rules are favorable to expansion, you're going to see monetary expansion. And that's really kind of what happened, especially in the earliest days where the marketplace was so fertile for this kind of thing. So real. There's so much demand for, you know, this monetary medium, this international monetary medium that, you know, as I said, the bankers were making so much money expanding so fast that they didn't even want anybody to know about it, which is kind of interesting in its own way.
- [09:56]
Robert Breedlove
Yeah, they were making money by actually making new money.
- [10:00]
Jeff Snyder
Yeah, okay, I know.
- [10:02]
Robert Breedlove
And it, so it is just that. And it's just redenomination effectively.
- [10:09]
Jeff Snyder
The easy way to think about it is you look, you're a bank in the Cayman Islands and you don't, I mean, you have, you've gone through all the paperwork, which little paperwork there is to make yourself a bank in the Cayman Islands. You've created your own balance sheet. But I mean that doesn't mean you can just start transacting Euro dollars to say I'm going to create dollars out of nothing. Right? Because everybody else is going to look at you like you don't have dollars. I'm not going to take your transactions. However, you set up a quote unquote bank in the Cayman Islands with a letter of credit from Goldman Sachs or Deutsche Bank. All of a sudden you have dollars, right? Because now you're part of the club. You've been given access to this Eurodollar market, this Eurodollar world, and as soon as you establish your reputation, you don't need the Goldman Sachs letter of credit. Anymore because you're part of the club, you've been transacting, you've been behaving according to these internal interbank rules. And everybody says, okay, your balance sheet is as good as anybody else's. So once you surpass that level of pedigree, then you're in. And then you can start doing all this balance sheet fun. Which is where we're making money by making money. It's a banker's dream.
- [11:19]
Robert Breedlove
That's so interesting. Okay, so it almost. We already had the system of deferred settlement built on top of gold. That's really what currency originally was. But then this is a system of deferred settlement on top of the system of deferred settlement where we're moving away from gold being the store value toward reputation being the store value, effectively. Right. Once they submit their reputation in these interbank markets, that becomes the collateral by which they're making money. By making money, essentially.
- [11:52]
Jeff Snyder
Yeah. And then it's become self feeding. Right. Because if you're good at making money by making money, you'll be able to make more money.
- [11:59]
Robert Breedlove
Right.
- [11:59]
Jeff Snyder
The more money you're able to make by making money, the more accepted you are by everybody else in the system. And of course, the more people want to be you too. But you know, barriers to entry are not really that, that large outside the United States or in this offshore world. So it's sort of like it kind of ends up being like the Wild west, which in some sense that sounds good. I mean that's sort of the free market approach to what was a public hybrid problem. But sometimes naked aggression and free markets, as the Austrians say, quintillion effects, where if you're afforded the privilege of making money first, you're going to benefit from it first regardless of whether or not it's a good idea in the rest of the economy. So sometimes money creation kind of loses sight of itself. We talked about before, money's supposed to be a tool for commerce, but yet after a while these banks said we're just going to create money to create money because it's making us money. And then it's sort of, instead of acting as a tool for global commerce, it sort of becomes an object in and of itself. And that's really where it starts to go astray. Which in the Eurodollar world, it didn't take very long for that to happen.
- [13:08]
Robert Breedlove
Right, right, right. Yeah. It's an interesting way to look at it because it becomes a bit Darwinian. Right. Where you do have these, I guess you could say there's kind of a predator and prey dynamic where if you're in that seat of power and you have the reputation or you have the letter of credit, you've done whatever, you've passed the barriers to entry, let's say, whatever they may be, you're now in a position to kind of prey on the property of others in a way by expanding. Well, but it's not that clean cut, I suppose, because it's your reputation. If you're too aggressive, you could destroy your reputation.
- [13:49]
Jeff Snyder
Right. And I would argue that people, especially in its earliest days, there was legitimate use to all of this. We needed the expansion. The globalized economy needed the expansion. This was a good way to meet the monetary needs of expanding economy. Like a lot of things, you know, human beings are not infallible and they lost sight of its purpose and eventually went way off the rails, got kind of back on the rails and it way, way, way off the rails again. Which is, you know, the dynamic of humans and money and finance from time immemorial.
- [14:19]
Robert Breedlove
Yeah, no, so that's a great point. Then this is, this is a slight tangent, but it just comes to mind, you know. Do you follow Jordan Peterson at all?
- [14:30]
Jeff Snyder
Yes.
- [14:31]
Robert Breedlove
Okay. Some big fan of his. And he argues that the original store value for humans was reputation. Like if we're all out hunting a woolly mammoth and one guy brings it down, clearly you can't eat a whole woolly mammoth. So if you share the food with others, then that creates a reputation for you that the next time they bring down a woolly mammoth, they're likely to share food with you. So this sounds like that, in a way, this is getting us. We became more sophisticated and gold became a store of value. But then as we started to scale gold, we got back to this reputation as a store of value in this Eurodollar opaque marketplace.
- [15:10]
Jeff Snyder
Well, money is always about trust, and trust is really kind of reputation. Even gold is about trust. You were trusting a metal that wouldn't corrode and wouldn't lose its store value because of its intrinsic physical properties, which we're kind of taking that same idea and moving it into a banked balance sheet, which is an abstract way of doing it, but it's really the same thing, just an abstraction. As we said, we're derivatives of currency, which are already derivatives of money. So it kind of makes sense that it would move in that fashion. And the reason why wasn't because bankers wanted to take over the world and create an evil cartel, as some people like to allege it Was because they were trying to fulfill a role that not only helped the global economy, but yes, it paid off for themselves. But that's not supposed to. That's. That's how it's supposed to work. Right. If it's a lucrative business because it's a worthwhile, what's a worthwhile function, we should want a lot of people trying to do their best to solve that puzzle. And that's really what happened. It's just as we said, because it's money itself. It was very easy to take it in the wrong direction or to take it too far really is what happens.
- [16:14]
Robert Breedlove
Yeah, I would. I agree with you. It's an abstraction or social construct. I guess the problem here is that when you look at something like gold, even though we're using gold as money, we're almost ascribing this social construct of money to gold because it gives you these certain properties. It's not a politicizable abstraction. There wasn't anything anyone could do to distort gold necessarily. But when you get into this banking business of banking, these abstractions, especially when they're just interbank entries, they're very vulnerable to politics at that point. And that seems to open them up to just all kinds of misbehavior over time.
- [16:57]
Jeff Snyder
Well, gold was not free from politics either. Again, we don't want to romanticize that there are any number of problems. And really gold, where the politics came into it was possession. If you possessed gold, the violence tended to happen quite a lot. Gold used to pool into very narrow, a very small number of hands. Yeah, that allowed it in. You know, people being people, they use that to their political advantage as they would. And it's the same. Yeah, you're right. It's the same thing with the Eurodollar system because it privileged these global banks who could create money and authorities and all these national economies were happy to look the other way. Yes, they have exercised their political muscle because they not the Federal Reserve, they hold possession of the printing press. They have been known to use it to their own advantage.
- [17:46]
Robert Breedlove
Yes. So is this almost like a. I'm going to just throw out a term here. I don't know if it makes sense. Like a trickle down fraud from central banking. Because the original fraud of central banking is really just fractional reserve and then ultimately zero reserve banking. This is a contract, this banknote is a contract for gold. And then over time that contract was gradually and then ultimately broken. Does that then is enabling this system of privileged access that we're calling the Eurodollar system that was almost a second order effect of that of central banking itself.
- [18:27]
Jeff Snyder
Yeah, it's tough to separate the two, but it really, I mean the Eurodollar system sort of arose without any central bank influence. And that was kind of by design because especially think about the monetary rules of the 50s and 40s, 50s and into the 60s, we're still depression era bank rules. So I mean the banking system said let's get out from underneath Regulation Q for example, and Regulation D and all those other regulations that were left over from the 1930s, which I mean, sorry, some of them were okay, a little.
- [19:02]
Robert Breedlove
Bit about those just D and Q.
- [19:04]
Jeff Snyder
Regulation Q, which is the big one, which was a really ridiculous read by politicians of what drove the Great Depression. They thought it was the idea that banks competitive deposit rates had led to competition between banks for money and that created a monetary problem. So they said we're going to set a ceiling that banks can pay on deposits that have come into their possession when in fact they set the ceiling. And then the money rates never really ever hit it because that was never really a problem. So in the 30s and 40s, Regulation Q said the deposit ceiling was this and money rates are always less than it. When we start to get to the late 50s and 1960s where things begin to normalize and all of a sudden money rates start to pop up against the ceiling and banks in the United States were then hamstrung, especially when there's this offshore money market for dollars which has no Regulation Q and anybody can offer whatever the competitive market rate would be. So now that you have another reason for the dollar capacities to move outside the United States because of this leftover, ridiculous, absurd regulation queue from the Great Depression, which had no business in the Great Depression but had no business in globalized moving recovery in the 50s and 60s there were others like that Regulation D which set reserve requirements. Initially there were reserve requirements that banks had to hold against their Eurodollar liabilities, which seem like a good idea, but banks are like this is sort of, it's a paperwork, it's a hassle. But it wasn't really, I mean Regulation D isn't really doing what it's supposed to do, not when it pertains to Eurodollars, because banks could manipulate their balance sheet between the US parent and their offshore subsidiary. In fact, that's really where a, a lot of the Eurodollar capacities came from, was that banks would transfer their deposit liabilities outside the United States, usually to a London subsidiary, and then borrow the funds back in an interbank loan from their offshore subsidiary. So they're manipulating their balance sheets in order to get out from under. And there are all sorts of capital controls and all sorts of restrictive monetary regulations inside the United States that just push more and more outside.
- [21:24]
Robert Breedlove
Interesting. So Reg. Is it Reg Q, is that what you said it was?
- [21:28]
Jeff Snyder
Regulation Q was the interest rate ceiling.
- [21:31]
Robert Breedlove
So that's price controls effectively. And that contributed to the demand for offshore dollars versus even onshore dollars. Right. They can just.
- [21:41]
Jeff Snyder
Absolutely. And it's the history of regulation. As soon as you, you know, bad regulation is going to lead to all sorts of participants figuring out their way to round it as soon as possible. That's really kind of.
- [21:52]
Robert Breedlove
Yeah, you could say all regulation distortion like that. Right? Yeah.
- [21:57]
Jeff Snyder
It's really about what it's cost benefit analysis. Right. If the regulation imposes severe penalties, then maybe the regulation works. But in Regulation Q and Regulation D in their case, there wasn't really much penalty at all. In fact, because authorities didn't really understand the Eurodollar system, the banks figured it out long before the regulators did. And so they were able to take advantage of that regulatory blank space and grow this Eurodollar system so that by the time authorities caught up with it, it was too big to do anything about really.
- [22:29]
Robert Breedlove
Yes. Okay, and then Reg D, you said, was capital reserve requirement. Clearly the lower the reserve requirement, the more expansionary it is to the money supply. Is this something then that created non linear effects like if we lowered the reserve requirement in the US this would even increase the Eurodollar supply even more?
- [22:50]
Jeff Snyder
No, I think Regulation D was just a lingering holdover from the past way of looking and even doing fractional reserve lending. Because the Eurodollar system was essentially reserve less regardless of the onshore regulations. It really only imposed a certain liability in a narrow set of circumstances that banks had to adhere to. By and large they figured out how to circumvent that anyway. So by 1969 the Federal Reserve said we're going to go to zero reserve requirement on Eurodollar liabilities because that's the effective reserve requirement that the private system had already gone to. They've already figured out how to manipulate everything anyway, so let's just scrap the regulatory requirement now. They brought it back a little bit later in the 70s, but it wasn't around for very long because again, the effective reserve requirement was zero from the very beginning.
- [23:45]
Robert Breedlove
Okay, so maybe I'm asking about just capital reserves in general. The relationship between that in the US versus the Eurodollar system, if we Lower the reserve requirement in the US that would then expand the ability of Goldman Sachs, for instance, to issue more letters of credit. They can issue more debt against their reserves. That letter of credit could then go to this Cayman island bank which could become exponentially more Eurodollars, I guess you would say. Am I thinking about that relationship correctly, that domestic policy does influence the size of the Eurodollar market, or is it different?
- [24:26]
Jeff Snyder
No, I think those linkages were broken in the very early days. Once the dollar system started, it started itself out in the 50s. It really didn't matter what authorities would do. For example, in the early 1960s, the Federal Reserve wasn't really sure what to make of the Eurodollar system. And so they said, well, let's raise rates domestically to try to get some of the dollars flowing back. Because they really thought like that it's a separate system and it's a foreign currency almost. And so if we raise the domestic money rates, they'll have dollars flowing back in the U.S. well, what they found out was that the Euro dollar system just raised rates outside the US because you know, it's a competitive marketplace. So the Fed tried to get to influence some of those dollars back on short thinking about it wrongly, what they found out was they didn't really have much influence at all because the market would respond to what it's doing in the way the market wanted to respond. And once the system was set up offshore, it really didn't need any more letters of credit, for example, from Goldman Sachs, because they were already there. So now we're just piling on more external derivative reserveless currency on top of original derivative reserveless currency. Once it started, there really was no more need for anything from the US to really feed the system because it was already sort of like a self contained process. It really was a monetary ecosystem all of its own.
- [25:51]
Robert Breedlove
Interesting. So kind of created this dragon in a way with the various regulations and not, and by virtue of being the global reserve currency, not having sufficient supply of dollars abroad, there was a demand for it. These other regulations contributed to its growth. I mean, this is a dragon of.
- [26:13]
Jeff Snyder
It's almost like a perfect storm here. All of these things combined together at exactly the right time in exactly the right way to let the system go. Especially since there was no central plan, there's no design to it, There was nobody that said, hey, let's hold a conference and figure this. It was simply an ad hoc system which allowed it to then respond to all of these very favorable conditions. And it was almost like the Perfect set of circumstances that just allowed this thing to go, including the fact that regulators, especially in the United States, were willing to just look the other way. Because I think, as we said last time, they didn't know how to solve Triffin's Paradox because national currency tied to national reserve trying to be an international currency couldn't happen. But if you have this offshore system, even though it's called US Dollars, there's no link of those virtual dollars to national gold reserves. So we've kind of solved Triffin's Paradox without having to get our hands dirty. So authorities were like, go ahead. This is just one less thing for us to think about. Plus it's outside the United States, so we can say it's not our. Not our.
- [27:21]
Robert Breedlove
Everybody got to look the other way.
- [27:23]
Jeff Snyder
Yeah. The bank of England, even though the banks were located in London, the Bank of England said, you're all dealing with just foreign. Not our job either. And there's nothing in the Cayman Islands. So it's just a perfect set of circumstances that allowed this thing to just start up and then just proliferate like mad.
- [27:41]
Robert Breedlove
Interesting. So it's almost like the cracks in the dam in a way, right? We created the dam around US Dollar liquidity, but there was so much demand for it outside that it just float around it somehow.
- [27:55]
Jeff Snyder
I think it's really good analogy too, because in the 1960s, what happened is, yes, those cracks, the regulations and bad policy and gross monetary ignorance, especially on the part of authorities, that led to the cracks in the dam and then the great inflation starting in 1965. What was that? That was when the dam finally started to really burst in the $0 system, not just offshore, but onshore. There's definitely monetary components to it like repo all these things, once set free into the wild, the thing just went crazy. And the banking system started dreaming with all sorts of different ways to do these reserveless virtual monetary transactions that authorities just couldn't keep up with. It was a period of massive bank as well as money evolution that was the 50s and 60s and into the 70s. By the early 1970s, the Fed, the BIS, the bank of England, everybody just kind of threw up their hands and said, we can't even define money anymore. M1 forget it. M2 forget it. Those things just don't apply because banks are doing all sorts of crazy crap. I mean, how do we keep track of repo? We don't even know what the hell repo is. Now we have currency derivatives, currency swaps taking place all over. We can't keep track of those because they don't get reported. So in one sense, once the dam burst, it wasn't just quantitative expansion, it was also qualitative expansion, which is kind of what gave us the seeds of our own destruction up until 2007, 2008.
- [29:28]
Robert Breedlove
Wow. The other component to this is that because to your point, Post World War II, we were globalizing, we're becoming more productive, deeper division of labor. So what may have otherwise been runaway inflation as a result of all this expansion was probably dampened a lot by increasing productivity, increasing goods and services. So this kind of gave Runway for the Eurodollar system to really get up and running, so to speak.
- [29:58]
Jeff Snyder
Yeah. And like we said before, its original purpose was a good one. It was the original, let's finance the reconstruction of Europe, let's finance trade networks to the Far east and things like that. And just without those kinds of restraints and with privileging the banking system, who can make money? In making money, it led to a set of really bad incentives that it just got way out of control. Especially when, by and large, most people thought we were still on the gold exchange standard of Bretton woods in the 60s when we really weren't, we'd gone, all the functions had been absorbed or most of the functions had been absorbed by the Eurodollar system. And it led to the situation where nobody had their eye on anything. And we're still talking about what is the price of gold compared to the official US dollar rate? When the more relevant money question was, what is the Eurodollar money rate in London and what is it in, say, Montreal or Singapore? That was the real price of money that we should have been paying attention to. And basically nobody outside the system really was.
- [31:02]
Robert Breedlove
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- [32:23]
Jeff Snyder
Especially comparing its spreads to those in New York and some of the other places around the world. You could tell that there was such demand for money and there was the ability to meet that demand for money because it didn't lead to any sort of deflationary crisis. In fact, it went the other way.
- [32:39]
Robert Breedlove
But this happened before anyone realized it. Pretty much as in this shift was occurring, but we didn't really understand the magnitude of it. And gradually, I guess with hindsight, even.
- [32:54]
Jeff Snyder
Today, the great inflation to me is totally misunderstood. The conventional explanation of the great inflation was that the US government started running deficits in 1965 to fight the Vietnam War and to finance the Great Society. And the Federal Reserve had to go along with those because it was still under an even keel policy. Which meant the Alan Meltzer explanation, which is the Fed was financing greater and greater deficits which led to inflationary currency. But that explanation leaves off everything we just talked about, including the fact that by the early 1970s the Federal Reserve, if you read through their transcripts, we don't even know how to measure or define money. That's. To me it's a much bigger problem than the federal government issuing running deficits, which is it can be inflationary in certain circumstances. But the fact that you have this hidden offshore shadow money expansion in all sorts of ways that nobody had any idea was really taking place or what to make of it, I'm going to say the great inflation had more to do with that than it did the Vietnam War.
- [33:58]
Robert Breedlove
That's incredible. Just a quick aside on this. I commonly say that one of the main value propositions of Bitcoin is that nobody can control it. We have this set of equitable rules that people we believe would voluntarily adopt over time. You'd prefer money that doesn't inflate to one that does. But it seems like we, and I thought that was the first of its kind, but it looks like we created something we couldn't control a long time ago. Actually that is this Eurodollar dragon.
- [34:30]
Jeff Snyder
I talk to people, digital currency and crypto all the time and I say, I'm sorry guys, but virtual currency is already 70 some odd years old. It's new, bells and whistle. But the idea was done A long time ago. That also makes sense because what we're really talking about, we talk about qualitative monetary evolution in the 50s and 60s is technology, especially communications technology. It goes right along one and one. I mean, you started talking the early telex machines, for example, that really played a central role in this Eurodollar expansion. Because suddenly you could do transactions very quickly between vastly different or vastly large spaces, which meant that you didn't need to ship currency because now we could have computers essentially talk to each other. We didn't need to intermediate with the physical world. We can intermediate through a digital medium, which is where this really starts to come in. And the more robust the technological innovation, as well as its adoption and widespread adoption, the more we could move into this virtual sphere, which is what actually happened.
- [35:36]
Robert Breedlove
Yes, no, that's very good point. And that gets back to one of the primary definitions of money that I lean on, is that it's just a device for moving economic value across space and time. And with gold we had something that was great across time but not across space because it's heavy and physical. So we moved into all these systems, these systems of deferred settlement, credit or debt based systems actually augment its transactability across space to do transactions more quickly. But that came with all these other risk, largely political and counterparty risk. Right.
- [36:13]
Jeff Snyder
And there was also, as you said, space was always a big consideration. That's really what led to the first paper market in global money, which was bankers acceptances. Because, you know, if you're transacting between say America and Europe, you gotta load gold onto a ship and then you gotta cross your fingers the ship doesn't sink on the way to England because then you're screwed. Not only you screwed, but the British are screwed because money disappears.
- [36:36]
Robert Breedlove
Yeah.
- [36:36]
Jeff Snyder
And so, you know, it's much easier to, you know, a redeemable piece of paper to ship that across the Atlantic. And then if it doesn't go down, then you can rewrite the paper or if that doesn't get there, you can rewrite the paper. Yeah, so there's been this idea of, you know, gold is cumbersome across space and time, so let's use something else, some other kind of medium. And that's always. But you know, to your point, there's always that natural tension because once you move away from that trusted medium into this paper medium, that opens Pandora's box to all of the crappy things that we're going to talk about. Even the urinal system, it's just the tendency to Remove limits leads to the dark side of human nature.
- [37:18]
Robert Breedlove
That's where I would argue most of the systemic risk accumulate actually is that gap between the settlement gap essentially between trade and settlement. And with something like gold or incentivized to have more and more deferred settlement, less and less final settlement. It just stuffs the system with hidden risk over time. Do you see it that way as well? If we had something that was high frequency final settlement, that would clearly eliminate a lot of the BS from the financial system.
- [37:51]
Jeff Snyder
Maybe. But high frequency settlement is, that's what the Fed is working on, that's what CHIPS is working on. Some of these interbank exchanges are moving to real time settlements like CES for example. So they're trying to eliminate any need for really essentially to have too much reserves in the system because you can settle your transactions in real time, essentially.
- [38:16]
Robert Breedlove
Well, I'm thinking more like, you know where I'm thinking is Bitcoin, like high frequency bearer asset final settlement, would that help cleanse the system of a lot of impurities?
- [38:27]
Jeff Snyder
Well, I mean you're talking about essentially imposing a reserve on a non reserved system. I'm not talking about digital bank reserves, I'm talking about the Eurodollar system where essentially there is no physical physical reserve. There is no. Reserves are essentially what one bank says to another and the other bank accepts.
- [38:43]
Robert Breedlove
So there's no final settlement in the Eurodollar system.
- [38:46]
Jeff Snyder
Well, I mean there's no convertibility, there's no real ability to say I have a number on your bank that says I'm one of your customers, I have a deposit, for example, federal, I want physical dollars from you. I can't get gold because that's not convertible, but I can get dollars because the bank will deliver dollars on demand. But it's not the same thing as it would be is the traditional banking setup where banks essentially run by their vault cash or what's in their vault. Whereas nowadays what's in their vault is sort of like a hassle. The bank doesn't want anything in its vault because it's a cost. Essentially their reserves are their retained earnings on the balance sheet. What they have that says we made money out of making money for all these years and now we have retained earnings that we can use to pay off losses if we need to, which is why the basal accords came up and that's why they prioritize capital ratios and things like that. Because essentially in the reserveless system it's these accounting fictions that become the reserve.
- [39:53]
Robert Breedlove
System and those retained earnings or those bank reserves, Those are central bank liabilities, right?
- [39:58]
Jeff Snyder
No, they're accounting liabilities. They're not.
- [40:01]
Robert Breedlove
Who's the counterparty then?
- [40:04]
Jeff Snyder
The bank is itself. What it's saying is I made money that my expenses were less than the revenues that came in. So essentially that's the rent that the Eurodollar system has collected from being the Eurodollar system. Right. Because that's the money they're making by creating money which flows onto their balance sheet as retained earnings.
- [40:22]
Robert Breedlove
So in what medium do they keep those reserves? They keep them in US dollars with.
- [40:27]
Jeff Snyder
The Fed or it's just a number on the piece on the computer screen.
- [40:32]
Robert Breedlove
At the individual bank itself. It doesn't have any counterparty to.
- [40:35]
Jeff Snyder
It doesn't need to be. That's where you really start to get into some of these qualitative ideas about balance sheet manipulation. I think a lot of people know about Enron. In the 1990s. What Enron was doing was essentially adopting this bank model on their own balance sheet, which is essentially. We can get really creative with these things. Think about present value, for example, if you have essentially a financial asset, you can say whatever you want. You can come up with all sorts of sophisticated statistical models and stochastic models that say, tweak your spreadsheet accordingly. Worth X in the future, therefore it's worth X or it's worth Y today, even though it's not really worth. I mean, you're just booking future cash flows based upon modeled assumptions. But because you're saying that it has value and everybody else in the system says yes, that's the value that we agree to as well. Suddenly you don't have any cash, you don't have any money. You just have an accounting fiction that everybody agrees is valuable because you have some model backing it up, not some actual activity. That's really where the system, the Eurodollar system in particular, got itself into enormous amount of trouble, especially in the 90s and middle 2000s because it started going what's called gain on sale accounting, which is essentially really taking this into the ridiculous. Seriously insane. Just making crap up on the fly.
- [42:03]
Robert Breedlove
Wow.
- [42:03]
Jeff Snyder
Because there's nothing behind it except balance sheets. When it starts to go bad, what do you do? Because there's no convertibility option, there's no tangible money behind it. It's just a simply. I gotta, you know, all these banks need to fit together in some way and if they don't start to fit together, this. It just starts to break down.
- [42:21]
Robert Breedlove
Wow. So it's. Wow. So the ultimate reserve is really just the representation of a counterparty.
- [42:28]
Jeff Snyder
Yeah, it's really. That's why the real money in this Eurodollar system is a bank's balance sheet. Which is why I spent so much time talking about bank balance sheet capacities, because that's really the secret behind everything. And in a lot of ways to get a little ahead of ourselves here. That's really what the problem has been pre crisis to post crisis. Why we went from way, way, way too much bank balance sheet capacity and money way, way, well, not way, way to not enough bank balance sheet and capacity post crisis was because people started questioning this insanity and realized that we can't continue doing it. And there's no way to go back to that.
- [43:08]
Robert Breedlove
That's fascinating. Okay, I'm sure we'll get more into that. But. So the bank balance sheets. Typically a balance sheet would be representative of something real, some real assets, but in this case sounds like it's more like just the actual balance sheet, Just the representation of really.
- [43:24]
Jeff Snyder
That's all derivative transactions are. It's essentially modeled cash flows of the future and we're giving them a current value and calling that monetary based on assumptions. I know it's hard to wrap your head around it. It's really hard to understand that. But it's really what it is. We have these virtual transactions that are simply representations of future cash flows and giving them a value and assigning them a value. And then if everybody agrees that that's the value, then all of a sudden we've created money from models.
- [43:55]
Robert Breedlove
The individual bank's balance sheet that's making the representation is also determining the inputs to that model. Right. So they can manage their own. Yeah, that's clearly conflict of interest.
- [44:06]
Jeff Snyder
Yeah, it's huge.
- [44:08]
Robert Breedlove
Yeah.
- [44:08]
Jeff Snyder
Wow. Again, we're talking about why, you know, why banks could make money by making money. That's part of it. And really, you know, that's the. That was the Enron model. The Enron model was. Let's, you know, those banks are doing this kind of stuff. Why can't we do it as an industrial firm?
- [44:22]
Robert Breedlove
Yes.
- [44:22]
Jeff Snyder
And they started doing it. Except it's a little bit harder when you're industrial firm because there are physical properties that you have to, you have to, you know, and then they, you know, they did get into a bunch of criminal activity by taking it too far too. But essentially the Enron model was to adopt balance sheet flexibility in the way that the banking system had years, decades before.
- [44:43]
Robert Breedlove
Wow, interesting.
- [44:45]
Jeff Snyder
Okay, so once you go down that rabbit hole, it's really kind of there's so much there. And then to talk about what we were just talking about, go back to that. You can understand why central bankers just threw up their hands in the 60s and 70s, said what the hell do we do? I mean, what's money here? We can't even, I mean these banks are doing all this stuff. And what the banks were doing were having real world, real economic effects, real financial effects. So it's not like it wasn't money because it was doing things in the real economy that money would do. Just there's no way to define it, there's no way to measure it, there's no way to monitor it. And the central bank said, well, we'll just let the banks do it and we'll kind of cross our fingers and hope that we can influence them in some way that we can at least pretend we have control.
- [45:36]
Robert Breedlove
Wow, Amazing, fascinating story. So it emerges in the 50s and 60s and you know, more well known as the 1971 Nixon shock. But I think you said previously that that was just signing the death letter effectively of what that was just to flip this.
- [45:58]
Jeff Snyder
Whoever, you know, the last person in the room flipped the lights off. That's really all that was because it had ended the other long before then. And really as we said, that was the period of absolutely perfect conditions, including revolution and technology and communication which allowed this balance sheet type behavior to take over. And really you get into the 60s and 70s and then the 80s where it really starts to get weird and interesting and esoteric and that's when it really started to explode globally.
- [46:29]
Robert Breedlove
Wow. Where is it appropriate to discuss the petrodollar in this process and what is its relationship with the Eurodollar system?
- [46:44]
Jeff Snyder
Maybe you could classify the petrodollar as a subset, but I think that's given the petrodollar too much credit. I think what the petrodollar is, some people have observed some of this Eurodollar behavior, intuited that that was the sum total of the entire system. The idea that the oil exporting countries, and especially in the Middle east, the OPEC countries, had struck some sort of political deal with somebody somewhere to exchange oil for dollars and then take those dollars and buy US Treasuries. Well no, that's not what really happened. What really happened was that was a part of this, that was a subset of this Eurodollar based activity. But because so much of the other activity was hidden and out of view, that was the part that we could see. So people started talking about the petrodollar as if that was the thing when it was really the tip of the iceberg that was visible above the waterline.
- [47:40]
Robert Breedlove
Got you. So the oil exporting countries are selling oil for dollars out of, I guess, convenience for the same reason, reserve currency.
- [47:50]
Jeff Snyder
They needed the dollars to trans. I mean, look, you're selling oil, but you don't make any goods. So you need dollars to import manufactured goods. You don't want to get them from the US which would be the easiest, right? I mean, if you're selling for dollars, you just use those dollars to buy US goods. You want to buy them from somebody else, you still need the dollars. And that's really what happened. So the US ran a current and capital account deficit to fight, which made it seem like this petrodollar was a real thing. In fact, it was just the oil exporting countries using that Eurodollar medium of exchange to exchange, as it's supposed to do. Again, we haven't talked about really store of value here. One of the neat factors or elegant factors of the Eurodollar system was that it detached itself from store value in a lot of ways. It functioned as a medium of exchange and unit of account and then offloaded the store value function to financial market U.S. treasuries. Exactly. So that was the store value part of the Eurodollar money system. So when people use the term petrodollar, again, very sympathetic to that use, because that's the part that people could observe and could continuously observe throughout history. But by and large, you're only seeing a part of what's really going on, which is much more robust and much bigger than just that.
- [49:08]
Robert Breedlove
Was that then an incentive for the Fed and US Government to look the other way on this because they're getting additional demand for Treasuries as a result of this Eurodollar?
- [49:18]
Jeff Snyder
You would think so, but they were so freaking clueless, they didn't know what to make of it. And I'll give you the perfect example. This really started to become a big thing in the 2000s. In fact, Ben Bernanke in 2004, 2005 said, this is really some kind of mystery here. And he came up with what he called a global savings glut. And I still laugh because it's such an idiotic idea.
- [49:42]
Robert Breedlove
Savings glass.
- [49:42]
Jeff Snyder
What he essentially said was, because they only look at the domestic part of the system, they don't care about the Eurodollar system. What they saw was there's all this money coming from outside the United States and it seemed to prefer buying U.S. treasuries they're trying to figure out where's all this money coming from. Well, the easy answer was the euro dollar system going crazy, but there is no Eurodollar. To Ben Bernanke. So he said, well, foreign baby boomers must be saving and for some reason they love investing in U.S. treasuries. That's what he actually came up with. So he saw what was going on in the Eurodollar system, but because his worldview was so outdated, the best he could come up with is this global savings glut nonsense which didn't survive more than a couple of years because it was ridiculous. But to your point, you would think treasury officials would be absolutely through the roof about this. But they didn't really know what was going on. All they knew was that there was some foreign demand for Treasuries and they thought, well, this is great. Whereas the Fed thought maybe this is a problem, maybe it's not a problem. I mean, what is this kind of a thing? And when your mandate is only about the domestic part of the system, it really does look like everything else is happening outside. Even though, as we know, it's being transacted in the US dollar denomination, it's not really US dollars in the way that everybody's taught to think about them.
- [51:00]
Robert Breedlove
Yeah, interesting. Wow. It's so funny how you spell this out in retrospect that the people we tend to think are the ultimate masters or proprietors over the monetary system were at times completely blind to the most. It's incredible.
- [51:19]
Jeff Snyder
Wow, that really makes sense too, because now you have to think, okay, money is being done by this banking system and it's gone completely insane into all of these different ways that I struggle comprehending sometimes. And I've been at this for more than 20 years. So you're a central bank, it's 1970, for example. You think M1's obviously obsolete because banks are doing something else. M2 is probably obsolete. What do we do? We're a central bank, we're supposed to do money. We can't even define it.
- [51:52]
Robert Breedlove
Yeah.
- [51:53]
Jeff Snyder
And so the answer came later, in the 70s and in the early 80s where they said, aha. We won't have to worry about the monetary details. What we'll do is an expectations based policy. We'll move an interest rate around here and there, the federal funds target. We'll let people think that we're in charge of the monetary system, but we're really not. What we're doing is we're trying to signal to the banking system we don't know what the banking system does, but we'll let the banking system work out the details because that's what it's good at, that's what it's actually doing. And so what we've been taught all along these last 40 years is that central banks are central to the system when they're really not. But in an expectations based policy you have to believe that they are, otherwise it all falls apart. Right. As soon as you realize that central banks are not in charge, the expectation policy doesn't work or it runs on mythology essentially and legend. So as long as we think don't fight the Fed, the Fed understands all this stuff and that's why we've been told these things over and over and over again. Because the Fed needs us to believe that they're the best and the brightest and they know what's going on. Otherwise it all falls apart. Which is what really happened in 2007 and 2008 was when these two things collided, which was monetary competence, which the Fed doesn't have, an expectation policy that doesn't fix a real money problem. So why didn't the Greenspan put work in 2008? Well, because there never really was one. We were taught and we're supposed to believe that there was. And the reason we were thought that there was was because of this so called great moderation which made it seem like that's really what happened. But what really happened was Greenspan and the Fed was riding the coattails of the Eurodollar systems, widespread success and calling it their own. So once the Eurodollar system broke down, the Fed could no longer ride its coattails and it was exposed as the fraud, the monetary fraud that it actually is. But you can see why I don't really have a lot of sympathy for central bankers, but you can have a little bit for them because here it is in the 1960s, 1970s and you don't know what else to do. It was really an intractable, difficult problem to try to solve. And they just thought, well, let's try it this way and see if it works. And for a while there it did seem like it did. We got caught.
- [54:15]
Robert Breedlove
Wow. So it's super sophisticated confidence game at this point. And then I guess his expectations policy is effectively the Fed or central banks more generally. The Fed largely evaluating their options, realizing they don't have a lot to not a lot of policy levers to control this thing. So they just decide to defer to the market in a way defer to.
- [54:41]
Jeff Snyder
The banking system and say, look, you Know, we're going to raise the federal funds target, which means we want you to start tightening. Yeah, we don't know how it actually works is tightening, but we're going to raise the federal funds target and we're going to let the banking system figure out how that actually leads to tightening. We don't know the details because we just, we can't.
- [54:59]
Robert Breedlove
Right.
- [54:59]
Jeff Snyder
And that's, that's really what it was, what is about. So we lower the federal funds rate. We don't really know how the money gets loose. We're just correlating our lowering of the federal funds rate with loose activity. And then we're telling people over and over again that's what happens, even though it's actually the opposite. So we've all been told essentially a fairy tale. And it's only because for a while there, especially in the 90s, it seemed to work. It seemed to be working out that when the Fed, to Alan Greenspan's limited credit, kept saying throughout the 90s, I'm a little bit nervous here because we don't do money, his famous irrational exuberance speech in 1996 was really about this. What he was saying is, because we don't do money, I'm talking about the Federal Reserve and the central bank, we don't do money. How would we know if the stock market is behaving rationally or irrationally?
- [55:55]
Robert Breedlove
Right.
- [55:55]
Jeff Snyder
We have no way to tell. So he was confessing in the 90s is basically saying, because we don't do money. I'm a little worried that, you know, if things start to go wrong, what are we going to do? Of course, that led to the 2000s and just, you know, when it came time to actually figure out how to, how to, how to deal with a deflationary monetary situation, they were just. There was no chance.
- [56:20]
Robert Breedlove
Yeah, okay, all right, this is all good stuff, but I don't want us to get ahead of ourselves. So, 50s and 60s Eurodollar system emerges. 1971, we signed the death certificate with a Nixon shock. We then get into this inflationary situation in the 70s. Maybe you could just describe the causative factors and then what the policy response was and maybe how the Eurodollar market was related.
- [56:48]
Jeff Snyder
Well, the 1970s, we said we had not just quantitative expansion of the Eurodollar system, but also qualitative expansion, which has made it much more difficult to connect the dots between monetary irregularity, which is what inflation is, it's one form of monetary imbalance, and the real economy results. That's why it lasted as long as it did because nobody could figure out where the hell it was coming from when quite obviously it's an inflationary currency situation. But the Fed, they had this Eurodollar thing and they argued about whether or not they should have Eurodollars and incorporate them in one to try to get a monetary handle. At the same time they kept saying, well, maybe we should stop targeting these monetary aggregates because they're completely useless and simply try to control what we control, which were bank reserves, which should sound familiar to our current ears. The Fed and the government and everybody else was out to lunch here because of all of this evolution and qualitative expansion that made it very, very difficult to connect cause with effect. And that's why it went on year after year. Plus, there's some other factors as well. Milton Friedman correctly identified ahead of time that the idea of an exploitable Phillips curve where central banks said that they would tolerate more inflation to try to reduce unemployment, that was a really bad idea. And that was going to lead to nowhere because you can have a situation where unemployment goes up at the same time prices do, which was the stagflation of the 1970s. So there was all sorts of economic failures in the fact that we don't know what's going on in the monetary system, we have a bad policy regime and just everybody's out to lunch over the whole thing. The inevitable consequence is exactly what happened, which is pretty much what you would expect to happen.
- [58:33]
Robert Breedlove
This Phillips Curve you just mentioned, is that something we're dealing with again? Maybe you could just tell us what that is and then we're dealing with that today in 2021.
- [58:42]
Jeff Snyder
Oh yeah. The Phillips curve has mystified economists over the last 10 years, ever since the unemployment rate started dropping in 2012. Essentially what it was is that A.W. phillips was a British economist, went back into the British, kept very good statistics between labor data, price data, unemployment, employment versus consumer prices, and well, actually wholesale prices at that time. What he found was that there seemed to be a rel relationship. When unemployment went down, consumer prices started to go up, which kind of makes intuitive sense, right? If, if businesses have to compete for workers, they're going to raise rages wage rates because they have to compete for worker, for scarce workers, scarce, scarce, free workers that are already engaged. And that raises the level of wages, which then raises the level of consumer prices. And then because workers are getting paid more, they can essentially accept these higher, these rising levels of consumer prices. So that was the Phillips curve, the relationship between unemployment and inflation. And it's just a simple curve and. Well, it used to be a simple curve. Now it's inflation expectations and all sorts of other things that's been incorporated in econometrics. But what happened in the early 1960s is a couple economists from, of course, Ivy League schools, Robert Samuelson and Paul Samuelson and Robert Sola, said that why don't we exploit this relationship to try to maximize employment? Which meant that if we tolerate a little bit of inflation by this Phillips curves, the way the Phillips curve is drawn, we should get a little bit less unemployment. So a little more inflation, a little bit less unemployment, that would be a good thing. And then we can all control it because we're a bunch of good little enlightened philosopher technocrats and we'll just make the right inputs at the right time. That's when Milton Friedman came along and said, you guys are nuts. This is going to lead to disaster. Of course, which is what it did, because inflation and unemployment can go up together at the same time. Because a simple and Phillips curve, like the exploitable Phillips curve, were just junk economics.
- [60:43]
Robert Breedlove
Yeah.
- [60:44]
Jeff Snyder
Okay, so now we get to the, you know, if you want to talk about what's going on over the last 10 years. Economists had expected that we would see inflation in the real economy starting around 2014 and 2015, because it looked like the unemployment rate had gotten down to around 5% in the United States. And that would be tight, therefore tight employment. Phillips curve. We would expect businesses to start paying more for spare workers. That would lead to rising consumer prices. But what we found out is that the unemployment rate is simply faulty. Right, because it didn't take into account the massive millions amount of hidden workers that were. That are, that don't go into the unemployment rate in the leftover period from the Great Recession, because it wasn't a Great Recession. It was a complete labor market obliteration that left so many people, so many millions outside of the labor force. They don't show up in the unemployment rate at all. They were expecting the Phillips curve to tell them one thing, but they were using the wrong unemployment rate.
- [61:39]
Robert Breedlove
Wow. So this is quite literally a piece of bunk economics. Sounds like this would be correlative at best from data in London, but not.
- [61:51]
Jeff Snyder
From the 19th century to the early 20th century. That's where we're starting from, Right?
- [61:56]
Robert Breedlove
Yeah. And then the labor force too, to your point, I think after six months or something, the populations just get excluded from those numbers entirely. Right. So unemployment could say 5%, but there could be 15% not working something like that.
- [62:11]
Jeff Snyder
If you tell the BLS you haven't looked for work in a year, they will not include. Or they haven't. You haven't work. Looked for work in a month, and you sit idle for more than a year, you're no longer part of the official labor force, whether or not you would take a job or not. And people stopped looking for work in the wake of 2008 because there was no work. There was no point to it, of course. So the bls, you know, they call and say, are you looking for work? And you'd say, of course not. There's no jobs. Why would I be looking for work? And the BLS would say, well, you're not part of the labor force, therefore you don't go into the unemployment.