The world economy was in a bad shape in March 2009. In the eighteen months before that, the economy took beating after beating. What started as a housing crisis in the United States, turned into a bank run among banks and a financial crisis like the world had never seen before. Central banks pulled out all the stops to shore up banks and the financial market, but each time a different financial bomb exploded in the system. Only after bail-outs by governments – taxpayers – the markets stabilized.
On 24 March 2009, which turned out to be the low point of the crisis, the Chinese central banker Zhou Xiaochuan gave a remarkable lecture (‘Reform the International Monetary System’). He was one of the few at that time to identify the real cause of the credit crisis: the global credit system based on the US dollar. He stated that in the future, the world should never again be dependent on a financial system denominated in the currency of a single country.
Once again, we are experiencing a financial and economic crisis that will leave deep scars. This time, however, it is not a banking crisis, but a dollar crisis. Why has the role of the dollar grown even after 2008?
The (euro)dollar reigns
International trade has been using dollar-denominated credit facilities for several decades now. Dollar financing is used for lending, trading and speculation. Currency derivatives, interest rate derivatives and credit derivatives, swaps, bonds, etc. are traded using dollars. The dollar has even started to dominate loans between non-U.S. parties as a large part of international business investment is financed using dollar loans. Worldwide there are now billions of dollars in loans in which the US plays no role at all.
Since the 1960’s, internationally operating banks increasingly used dollars in their mutual settlements. These dollars circulating outside the US were called eurodollars, because their use originated in Europe. The eurodollar money market was not regulated by central banks and therefore grew rapidly in size. In the global capital market the eurodollar thus became the ‘middle currency’ in transactions, it is as it were the language in which market players communicate with each other.
Head in the sand
The global role of the dollar has been strengthened by deliberate policies of central banks and governments. In the 1980’s there was a wave of trade liberalization, financial deregulation and a policy of fiscal discipline. For practical and opportunistic reasons, deregulation of the money and capital markets was chosen. Practical, because the market was actually too big to regulate, and opportunistic, because it offered great financial advantages. Although by now it was clear that it was an unstable configuration, people stuck their heads in the sand.
The global capital market received an enormous boost from the 1990’s onward when communism fell and China joined the World Trade Organization. An enormous amount of cheap labor entered the world market and investment opportunities increased. Capital flowed freely within and between countries in search of investment and return.
A free capital market is of course not wrong in itself. Artificial and politically motivated trade barriers and capital controls are often counterproductive and do not promote prosperity. However, there are perverse incentives in the system that lead to serial bubbles, crises and loss of real prosperity.
Lottery without losers
A first problem is that government bonds were declared risk-free by central banks in 1988. Since then, the global capital market has become increasingly dependent on government bonds as a safe investment and as liquid collateral in financial transactions. As a result of this increased use of government bonds, governments and financial markets have become intertwined. There is now a shared interest in keeping the government bond market liquid and stable. This has been an incentive for financial parties to take more risks.
A second problem arises because central banks and ministries of finance have played an active role since the mid-1970’s in rescuing banks and financial institutions that were not allowed to fail because of their specific role in the system or because of their size. A failure could drag the rest of the capital market and economy into a deep depression. These perverse incentives make it very easy in the global capital market to borrow a lot and take speculative risks. There is a widely shared confidence in the market that there will always be a helping hand in times of crisis.
The global capital market thus operates under very favorable conditions. The money that is earned by taking risks is put in one’s own pocket, losses due to imploding financial bubbles are covered by taxpayers. There is privatized profit and socialized loss. The US dollar-based global credit system with government loans as collateral is therefore first and foremost a private playground and only secondly a public facility. Thanks to our central banks and governments.
More risk through central bank policy
The 2008 credit crisis could have been a turning point, with structural reforms in the global monetary and financial system. However, the stakes were considered too high to risk the status quo. It is ironic that China in particular was the country that was at the origin of a revival of the eurodollar market after 2009. A lot of dollars were borrowed to stimulate domestic production, in the expectation that over time the West would start importing more Chinese products again. China became the driving force behind the global economy.
Western central banks also contributed to the growth of the global capital market after this crisis. They stabilized the market for government bonds and kept money market interest rates low. Returns had to be sought elsewhere. Financial parties such as pension funds and insurers were therefore forced to take more and more risks in search of return. To a large extent, money flowed to Chinese companies and governments of emerging countries. Many parties became increasingly dependent on (re)financing their debts. As long as the economy grew, there was no problem. It was possible to refinance from stable cash flow.
However, the world is now startled by the corona virus and the economy has come to an acute standstill. Countries and companies that have borrowed in dollars no longer earn money to pay off or roll over their loans. This awareness caused financial turmoil and falling stock markets and in mid-March we experienced an acute eurodollar crisis. The market for US government bonds no longer functioned and the dollar rose sharply, which in turn was detrimental to the dollar debt positions. The eurodollar market became inaccessible for many parties, making (re)financing impossible. The problem is now so big that 85 countries have appealed to the IMF’s emergency fund.
This crisis is a dollar crisis. The Fed is also aware of that. After a number of interest rate cuts and other emergency measures, the U.S. central bank again provided dollars to other central banks via so-called swap-lines. It has also opened a new desk where foreign governments can exchange their U.S. government bonds for dollars. Whether this can prevent illiquidity in the dollar market is for now to be seen. Pay attention to the dollar exchange rate. It’s all reminiscent of Ernst Hemingway’s famous quote: ‘How did you go bankrupt? First slowly, then suddenly’.
This article earlier appeared on Syp Wynia’s blog