The Eurodollar... The Elephant in the Room
When people say Money Printer Go Brrr, it reinforces the idea that when new US dollars are created, they are created by the Fed and the Fed alone. But what if most US dollars are not created within the US at all? In this post, I continue to analyze the Eurodollar in order to understand how international finance really works.
Who Controls The Printer???
The Eurodollar challenges our common understanding of money printing.
In school, it is taught that the expansion or contraction of the money supply is all about government debt and fractional reserves managed by commercial banks. In this oversimplified view, here is how new money is created and enters the system:
The US gov issues debt (aka treasuries) which is bought by commercial banks
The Fed buys government debt from commercial banks with new money which is then credited to the reserve balances of the commercial banks
Commercial banks then further expand the money supply by lending credit based on the fractional reserve system
In the old view of how US monetary policy works, the Fed controlled the money supply by requiring commercial banks to follow fractional reserve requirements. If the economy grew too fast and an undesirable level of inflation emerged, the Fed increased the reserve ratio and, as a result, commercial banks created less money via credit. The economy going too slow? The reserve ratio decreases, commercial bank lending goes up, and money supply expands.
This picture is vastly oversimplified without the Eurodollar.
Eurodollar Goes Brrr
The Eurodollar changes this simple picture because once the US dollar became the world reserve currency post-WWII, it found its way to financial institutions outside the US that are not subject to Fed mandates or US regulations. Specifically, these foreign banks did not have to follow fractional reserve requirements, so they do not need to take their reserves into consideration when lending Eurodollars. Fast forward to today, and now most international trade is priced in US dollars but are settled by Eurodollars (US dollar derivatives) that are financed outside the purview of the US.
Inflation or Dollar Shortage???
So most US dollars are created outside of the US via the Eurodollar, so US dollar “money printing” must be out of control right? We must have too many dollars…
Not according to Eurodollar theorist Jeff Snider. He claims that there is a dollar shortage. So many finance institutions need Eurodollars to settle their maturing debt and other USD liabilities that there are not enough to go around. Jeff even suggests that this is what led to the Great Financial Crisis (GFC) in 2007.
You may ask yourself… Wait, I thought the financial crisis was about Mortgage Backed Securities (MBS)?
It was about that too. Before we dive into how both Eurodollars and MBS were involved in the GFC, we need to understand the following points:
Most international transactions are settled in Eurodollars
It is common practice to borrow Eurodollars to settle transactions
International finance institutions run a fractional reserve on their Eurodollars
These institutions do not follow US regulations regarding fractional reserve requirements, they follow their own judgment
Eurodollar lending is one of the biggest international markets
When borrowing Eurodollars, US treasuries (USTs) are required as collateral
Finance institutions that want to borrow Eurodollars but don’t have USTs first borrow USTs using securities like MBS as collateral
The Eurodollar was a key factor in the GFC because one day, finance institutions had a lot of debt denominated in Eurodollars due at the same time, but UST lenders were no longer accepting MBS as collateral because they were dropping in value. Institutions with illiquid MBSs couldn’t get their hands on Eurodollars. The Eurodollar market froze, causing some financial institutions to go insolvent. According to Jeff, the main issue of the GFC was Eurodollar liquidity and Eurodollar liquidity is still an issue to this day.
Speculations on Inflation and Debt
The current understanding of Fed money printing is that it causes inflation. But, if Eurodollar money printing is greater than the amount of money the Fed prints, does this mean that money printing by the Fed causes less inflation than we think it does? If Eurodollar demand is so high that it causes an appreciating effect on the value of the US dollar, then can the US government safely borrow more money than we think it can?