Markets

The Eurodollar Market

Seal of the Fuggers

I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.

James Carville, chief political strategist to President Clinton

In an earlier article, I wrote that US’ turn to finance “had already begun in the early 1970s. The fixed exchange rate system broke down by 1973. Capital controls were relaxed in 1974 in the US, and in Britain in 1975. The Eurodollar market started growing immediately after.” This chronology is incorrect. The Eurodollar market had been growing at a scorching pace throughout the late fifties and sixties, and already exceeded the world’s official dollar reserves by 1973. In fact, my claim was much worse than a mere chronological error. The causality runs the other way: it was the Eurodollar market that forced the US and UK to relinquish capital controls.

According to Gary Burn, “What, in fact, the City bankers had done by creating this market, was to puncture a hole in the regulated international banking system, enabling capital to escape offshore. But what began as a trickle eventually became a deluge. Until the City ‘came to resemble an “offshore island” much like the Cayman Islands or Curacao’. Although, unlike those islands, where there is an obvious coincidence of territorial and judicial sovereignty, for the City of London, offshore is a ‘de-territorialized economic phenomena’.”[1] [Emphasis in the original.] To be sure the ‘sovereignty’ of the offshore islands is a façade, a matter of some relevance that we will come to in the next post on offshore finance.

‘Good as gold’

The liberal global economic order underwritten by Great Britain that matured in the late-nineteenth century was firmly centered within the one square mile of the City of London. The cornerstone of the international monetary system was ostensibly the gold standard. Yet, the rapid expansion in international trade with the spread of the industrial revolution could not have taken place without a substantial increase in liquidity to settle transactions, insure shipments, extend credit, and so on and so forth. This liquidity was provided by the pound sterling and the Bill on London, with the London Discount Market at the very center of this financial universe. The City functioned as a “transmission belt” aggregating deposits from all over the world and utilizing them to finance international trade and speculation. The exercise of monetary authority was an entirely private affair between the Bank of England – a private institution with commercial interests along with a governance role as a lender of last resort – and the City bankers.

The advent of the First World War brought about a virtual collapse of the open global economic system: tariff walls went up immediately, production was subordinated to the war effort, capital controls were imposed, and the gold standard was effectively suspended. The United States emerged from the war as the dominant economic power and creditor nation. The naval agreement between Britain, Japan, and the US established a battle-fleet ratio of 5-3-5. In effect, the protection of the Atlantic was split between Britain and the US, that of the Pacific between the US and Japan, while the Indian Ocean and the Mediterranean were to remain under British naval control. As good centered realists we would expect a partial replacement of sterling and the City by the dollar and New York. This is precisely what happened. The dollar increasingly came to replace the pound sterling in international transactions, especially in the western hemisphere. The City bankers became convinced that New York was seeking to take over control of international finance.

In a bid to restore the fortunes of the City and resurrect the pre-war global economic and financial order, the bankers launched a major political offensive to return the pound sterling to the gold standard at the pre-war parity of $4.86. In February 1920, the sterling stood at $3.40, so the plan to return to gold at parity by 1925 required drastic deflationary measures. Draconian cuts in government spending (by 30% in the first year of deflation) led to a 6% contraction in GDP, with unemployment rising to a high of 21% in June 1921. The bitter medicine continued until 28 April 1925 ­­­– with manufacturers devastated and wages down 40% ­– when Britain returned to the gold standard at pre-war parity of $4.86.

Unfortunately, the bankers were chasing an illusion. The pre-war gold standard was, in effect, a gold-sterling exchange standard with sterling providing the international liquidity required for the functioning of the global economy. Cutting back the circulation of sterling in order to return to the gold standard was thus self-defeating because it put severe deflationary pressure on the world economy. Indeed, as the international financial crisis gathered pace in 1931, Britain was again forced to suspend gold payments. Instead of the catastrophe forecast by the City, there was instant relief. The anti-climax of the failure of the decade long struggle to return Britain to gold prompted Colonial Secretary Webb to remark, “Nobody told us we could do this.”

The reason why returning to the gold standard at pre-war parity was gospel to the City was political. “Supposedly operating outside of politics, it offered an unchallengeable, technically based rationale for ‘the cessation of government borrowing’, and by extension, government spending. Being free from political manipulation it became a constitutional barrier to the policies of any parliament elected to pursue policies in the interests of the working class. As the Bankers’ Magazine explained, ‘a return to gold would prevent future “unsound” experiments by Socialist Governments which might divert the English people from the only real solution of their problems – economy and hard work’. Or in the words of Cunliffe Committee member, Lord Bradbury, ‘the gold standard was knave proof’.” The gold standard was a shield against the threat of democracy.

The collapse of global capitalism during the 1930s removed any lingering faith in the viability of the free market. The principal architects of the Bretton Woods system, Keynes and White, believed that a liberal order of international trade and finance was fundamentally incompatible. That is, uncontrolled ‘hot money’ made the international system prone to repeated financial crisis, and made the pursuit of rational economic management impossible. The new order was therefore based on a “quasi-public international financial order”. While Wall Street and the City of London managed to block obligatory capital controls, they could not prevent countries having the option of imposing such controls from going through. However, even before the Bretton Woods system proper went into effect in 1958, it had already been circumvented by global finance. The creation of the Eurodollar market was the “first shot fired in the neoliberal counter-revolution”. It was the “dress rehearsal for the full deregulation of international markets that finally took place twenty years later”.[2] But we are getting ahead of the story.

The birth of the Eurodollar

The US state practiced a significant degree of financial repression after the New Deal era regulations went into effect. The most important one of these was Regulation Q, which imposed limits on what interest rates could be offered by banks. The Regulation Q ceilings – the “stop-valves in the plumbing of finance” that regulated the American economy with “hydraulic efficiency” – also played a key role in the birth of the Eurodollar market.[3]

In the summer of 1955, the British Bank rate had risen significantly above prevailing Regulation Q rate in the United States. The Midland Bank, a medium-sized merchant bank in London, was growing desperate to increase its share of the international business which was dominated by the bigger merchant banks. At the same time, it was facing a liquidity crush given the tight monetary environment of that summer. Midland stumbled on an arbitrage which solved its acute liquidity problem. The bankers purchased 30-day dollar deposits at 1.875%, sold them spot for sterling, and bought them back forward at a premium of 2.125%. The sterling so obtained cost Midland 4% when the Bank rate was 4.5%. This arbitrage proved to be enormously profitable and Midland was soon piling in around seventy million dollars a month in this trade.

“Midland’s exchange deals were the first stage of the financial innovation which produced the Eurodollar market. These deposits were not traditional deposits of clients related to their business with the bank. The foreign exchange was not deposited with Midland’s American accounts or converted through the foreign exchange reserves. The deposits were attracted to solve specific liquidity constraints and in response to profitable investment opportunities in the U.K. In this sense they were a new product for the bank’s clients and represented a new source of funds for investment.”[4]

Midland was soon invited for a tête-à-tête at the Bank of England. The Bank came to the opinion that “it is impossible to say to a London bank that it may accept dollar deposits but may not seek for them. We would be wise not to press Midland any further.”[5] The Bank of England thus decided on a policy of ‘benign neglect’ from the very beginning. The innovation spread rapidly. Within a year, Midland’s share of the nascent market was down to about a half. American banks jumped in the fray and soon came to dominate the scene. By April 1963, the nine American banks active in the City took the largest share of the deposits, accounting for about a third of the market. Legendary London banker Siegmund Warburg organized the first Eurobond issue in June 1963. It was the Eurobond market which made the Eurodollars available for international credit, thus creating an alternative international capital market outside any regulatory jurisdiction.

The novelty of the Eurodollar market was twofold. First, it lay outside British banking jurisdiction, and allowed the banks to borrow from one another rather than through discount houses thus creating a new animal, the ‘wholesale inter-bank market’. Second, even though it was in the foreign exchange market, instead of dollars being exchanged for other currencies, they were now being borrowed and lent, and thus lay outside the official system for controlling capital movements. “In this way, operating, as it was, outside both the traditional international capital market and the traditional foreign exchange market (TFEB), became the prototypical escape route offshore, which, very gradually, evolved into a parallel international capital market available to non-bank users dealing in Eurocurrencies.”[6]

Brace for Impact

The Eurodollar market expanded at a fast clip, reaching around $9 billion in 1964 when the Bank of International Settlements first started tracking it, $25 billion in 1968, and $54 billion by 1971. The first significant effect of the Eurodollar market on the international economy began to be felt in the late 1960s. When the Federal Reserve restricted US banks’ access to loans in August 1966, they turned to the Eurodollar market for funds. Germany ran persistent trade surpluses with the US, which lead to an accumulation of enormous dollar reserves at the Bundesbank. The German central bank thus became the principal source of Eurodollars for US banks. This recycling of US dollars began feeding a wage-price spiral already underway due to the military-Keynesian impact of the campaign in Indochina.

Eurodollar market size

Without reserve requirements – or any regulation for that matter – the Eurodollar market’s ability to create money was, in principle, unbounded. This is why the inflationary impact of this offshore credit creation was so significant. To stop the recycling of inflation as well as dollars, the Bundesbank persuaded the Fed to impose reserve requirements on US banks’ Eurodollar borrowings. The unwinding of US banks’ borrowings in 1970-71 unmoored the market from Germany’s official reserves, institutionalizing a vast pool of short term capital, by now roughly the size of the world’s official dollar reserves. This is the appropriate yard stick because central bankers need dollar reserves to defend their currency.

Speculators had already used the Eurodollar market to mount an attack on the pound sterling in 1967, forcing a devaluation in November. Similarly, speculators used the Eurodollar market to exploit arbitrage opportunities that opened up between the revaluation of the Deutschmark in 1969, and the decision to let the market determine its price in 1971. The biggest fish in the tank was tackled in the first two weeks of August 1971, when the US lost $6 billion of reserves amid mounting speculative attack on the dollar. With dwindling gold reserves, the US withdrew its commitment to sell gold for $35 an ounce and the dollar was devalued on the 15th. Statesmen fought to save the post-war monetary order for two more years, to no avail.

The Eurocurrency market, including not only the offshore dollars but also yen and the German mark et cetera, continued its explosive growth over the years. The following table shows the growth of the market in gross terms (as opposed to the net positions reported earlier).

Year

Gross Market Size (billions of dollars)

1963

12

1964

15

1966

27

1968

46

1970

93

1972

150

1974

248

1976

342

1978

550

1980

1,012

1982

1,515

1984

2,153

1986

3,221

1988

4,511

1990

6,254

1992

6,198

1994

7,117

1996

8,309

1998

9,899

2000

10,765

2002

13,375

2003

15,929

Note the doubling of the market in 1978-80. That was due to the dollar crisis of that period amid rampant inflation and capital flight from the United States. The size of the Eurodollar market is so large that it can be considered an independent great power. “It also, by definition, increased the likelihood of currency speculation, as ever larger Eurodollar funds, far in excess of the gold and dollar reserves held by governments and the IMF, became increasingly powerful as ‘market makers’, taking on and winning against national central banks, while, in the process, becoming indispensable as privately owned and controlled disequilibrating international liquidity.”[7]

The existence of the Eurodollar market played a key role in the pressure to deregulate finance during the seventies and the early eighties. The bankers now had a powerful argument at hand: ‘We can already do this in London, if you don’t allow us to do this here in New York, we’ll just write our international business across the pond’.  This is not a special feature of the Eurodollar market, although historically it did play a pivotal role in this dynamic. This is a critical feature of offshore finance. There is much to trace in the history of offshore finance, something I have almost written out and will be posting soon.

“The re-assertion of a nineteenth-century institutional framework for the organization of global credit would be re-convened outside the control of the quasi-public monetary order established at Bretton Woods, once sterling had been replaced with a more robust world money medium. The advent of the Eurodollar market finally allowed the City to regain its autonomy, lost in 1931. British financial elites re-established control of regulatory space and re-imposed ‘a regulatory order largely separate from the central institution of the state’ (Clarke 1986: 19; Moran, 1991: 16). Something welcomed by the American banking community, given that the US would remain tied up in New Deal regulation until Reagan arrived in the White House, by which time there would be more American banks in London than in New York.”[8]

We will see in the next post how the City created a spiderweb of offshore secrecy jurisdictions that have allowed big corporations and the superrich to escape both taxes and regulation in the center countries, and the channeling of ‘dirty money’ into the major capital markets of New York and London. I will conclude these two essays together, so stay posted. 


[1]Burn, Gary. The Re-emergence of Global Finance. Houndmills, Basingstoke: Palgrave Macmillan, 2006. Print.

[2] Durham, quoted in Burn, Gary. Op. cit.

[3] Greider, quoted in Krippner, Greta R. Capitalizing on Crisis: The Political Origins of the Rise of Finance. Cambridge, MA: Harvard UP, 2011. Print.

[4] Schenk, C. “The Origins of the Eurodollar Market in London: 1955–1963” Explorations in Economic History 35.2 (1998): 221-38. Print.

[5] Ibid.

[6] Burn, Gary. Op. cit.

[7] Burn, Gary. Op. cit.

[8] Burn, Gary. Op. cit.

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