By Jeffrey Snider
July 19, 2019
What everyone most feared was a relapse. It would have been one more tragedy piled up on top of the biggest tragedy in human history. In designing the Bretton Woods system seventy-five years ago, many were very much afraid that it hadn’t gone far enough. Once the war ended, World War II, the US in particular might fall back into depression.
Then what?
It may sound absurd today, at the time the possibility was taken very seriously. More outside of the US than inside, quite a few economists and politicians warned that when war spending stopped just as America’s victorious legions came back home the economy waiting for them would be too much like the depression they had left behind when they first went off to fight.
There was, some very influential policymakers believed, more than a small risk of it tearing the new monetary system apart and therefore redoing 1929 all over again. The entire purpose of Bretton Woods had been to avoid just that fate.
In the final agreement, in the form of the Joint Statement of Experts on the Establishment of an International Monetary Fund, a clause was inserted in case the world might run short of dollars. A US depression could, in theory, starve the rest of the world of needed currency. As Edward Bernstein recalled four decades later:
“This would allow other countries to impose discriminatory restrictions against the United States if the dollar holdings of the Fund became scarce because of a large and persistent US surplus as a result of a depression in the United States.”
Edward M. Bernstein had received his PhD in Economics from Harvard in 1931 just as the Great Depression was at its worst. Spending the rest of the decade teaching, in 1940 he was given a job as the Treasury Department’s principal economist. Working closely with Harry Dexter White during the early war years, when it came time for Bretton Woods, Bernstein was made the US delegation’s chief technical advisor.
In that position, Dr. Bernstein had a large hand in designing the IMF. He said that the novelty of the fund which came out of Bretton Woods, one that didn’t include John Maynard Keynes’ supranational currency bancor, was that it was like a gold standard but not so rigid as the classical system had been.
There had to be some flexibility built into it somewhere. Recalling one of the chief elements of failure and monetary contagion following the 1929 crash, “the deflationary effects of gold settlements could be avoided if surplus countries acquired foreign currencies rather than gold.” No less than international currency elasticity.
That’s how the world would avoid any kind of global currency shortage.
Which, of course, gold adherents would argue was entirely the point of the classical gold standard. There should be limits to currency, fiat especially (not all currency is fiat). To many classicists, the Great Depression was more about the twenties as a whole than just 1929.
But are the monetary factors the same when superimposed upon international trade and capital flows? That was, to Keynes, the beauty ofbancor; it would be separate from what today we regularly call (everything) bubbles. This international currency wouldn’t be a store of value, merely the medium of exchange whose entire purpose was to facilitate the spread of trade.
This is why, in a letter written to Dr. Bernstein following Bretton Woods, Lord Keynes remarked, “"I should like to see the Board of the Fund composed of cautious bankers, and the Board of the Bank of imaginative expansionists.” Recounting the letter thirty-nine years later, Dr. Bernstein clarified, “Keynes was talking about the bankers of 1945, not those of 1983.”
What had changed about bankers, you ask? For one thing, those in the later group would have laughed at the very idea of a US current account surplus. What had come to define Bretton Woods’ ragged end was the persisting opposite condition. There had been no depression in 1946 for several reasons, chief among them how the new monetary order had worked enough to stabilize the global monetary system so that a truly global economy absolutely starving for prosperity could be unleashed.
And unleashed it had been – which required a ton of monetary resources. To the bankers of 1983, the spread of those resources was quite different than what Keynes, Harry White, or Edward Bernstein had ever imagined.
That doesn’t necessarily make it a bad thing. Indeed, Bretton Woods itself lasted a scant sixteen years. Dr. Bernstein in 1983 regretted how it was coming apart as early as 1957.
“The system broke down after 1957, but not because the United States failed to maintain stability of prices and costs. In fact, the 1958-65 period may have been the most stable in our history.”
The system’s flaws lay in the system’s success, a contradiction no one had anticipated; later to be called Triffin’s Paradox. Especially foreign economists in 1944 who were worried about a new US depression hoarding dollars from the rest of the world.
The world simply needed dollars, and more of them, some amount of elasticity in what did become the global medium of exchange. The gold adherents were also right, in that there could also be too much currency – thus, the Great Inflation of the seventies.
But it wasn’t governments who set the transition from Bretton Woods to the next global standard. There’s been endless talk and scholarship about the seventies, a lot written about the Smithsonian Agreement and whatnot, but it was the bankers who created the succeeding form of international exchange. Unlike 1944, it happened organically without any organized mission.
Economist Paul Samuelson in April 1971 called it the doctrine of “benign neglect.” In other words, politicians had lost out on the purpose of international monetary arrangements. In this brave new global world, they either didn’t know what to do or were too paralyzed by politics to do anything. They knew something needed to be changed without realizing that what was necessary was already changing.
Into that vacuum flowed the international banker. There was no need for governments to do much of anything, except recognize what had already become reality. The official end of Bretton Woods, Nixon’s closing of the gold window in 1971 was mere formality. All the functions and purposes of international exchange had already been absorbed, under cover of benign neglect, by the credit-based currency of bankers – the eurodollar.
In this system where bank balance sheets are supreme, and the international medium of exchange is whatever liability one bank can get another bank to accept, geography no longer matters. The allure of Keynes’ bancor was that it would operate separately in between competing governments. The eurodollar would exist separated from everything.
Offshore and interbank.
This flexibility unlocked massive potential, qualitative possibilities before quantitative expansion. What Robert Roosa in 1984 (at Bretton Woods) called new networks of interbank relations it would be left to Alan Greenspan in June 2000 alarmed about those very “proliferation of products.”
Whose products? Bankers.
My purpose here is not chastise them or to trade in conspiracies about Wall Street. In thinking about how to get out of the mess that’s been left to us by an unbroken doctrine of benign neglect, for authorities did not stop neglecting, we must first recognize what we have regardless of how anyone feels about it.
This is a credit-based system that you can’t just cast aside on a whim, no matter how forcefully anyone might wish to. That’s really the only thing left of Bretton Woods’ successor; the lack of any alternative.
Not that anyone isn’t desperately searching for one. China’s top central banker, Zhou Xiaochuan, all the way back in March 2009 at the bottom of the (somehow) Global Financial Crisis lodged the first official protest. He was also one of the very few to recognize this primary aspect.
“The outbreak of the current crisis and its spillover in the world have confronted us with a long-existing but still unanswered question, i.e., what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth, which was one of the purposes for establishing the IMF?... The acceptance of credit-based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history.”
What the PBOC Governor got right was “credit-based”, overshadowed by what he got wrong – the latter being what led to such vehement counter-protest. The eurodollar is no one’s national currency.
The primacy of a credit-based system is an architectural challenge, not a political question and certainly it should never be made into a partisan one. I’ll give you a recent example to show you what I mean.
In November 2014, the Federal Reserve convened what it called the Alternative Reference Rates Committee (ARRC). As its name implies, its task was to come up with something to replace the current reference rate, LIBOR, as the world’s benchmark. Hundreds of trillions in notional derivatives as well as trillions in debt are priced based on what some might call a fantasy.
A panel of banks in the British Bankers Association comes up with a rate of interest at which they’d lend unsecured money to other banks – if ever asked to. That’s what LIBOR is. It isn’t based on actual transactions, and because of the scandals surrounding it one of the most important numbers in all the world has been made suspect.
On June 22, 2017, the ARRC settled upon SOFR, the Standard Overnight Financing Rate, as LIBOR’s replacement. This official alternative would be calculated by the Federal Reserve Bank of New York starting in April 2018, taking within it data collected mostly in the domestic repo market: private tri-party GC transactions placed through Bank of New York Mellon, Treasury GC tri-party run through FICC, and any bilateral exchanges settled DVP cleared via FICC.
It would be a more robust and reality-based alternative, one grounded in repo by the hundreds of billions in daily volume.
Setting aside FRBNY’s embarrassing launch of SOFR, the branch messed up the initial calculations (April 2 to April 12) which had to be later restated, this sanctioned alternative has gained little traction. According to the CME Group, the Chicago-based derivatives exchanges, SOFR futures in June 2019 averaged 145,179 contracts open interest. That was up 1,053.5% from open interest in June 2018, when there had been 12,586 contracts.
It may sound impressive until you see how over in eurodollar futures, by contrast, there was 12.8 million open on average last month. There were 13.9 million last June. In February 2017, there were about 12.5 million. At the end of 2013, 10.6 million.
Those 12.8 million eurodollar futures contracts represent $12.8 trillionnotional delivery of eurodollar deposits, priced based on 3-month LIBOR. Global banks and investors just aren’t giving up on this interbank scheme no matter how many times authorities nudge them. The London Interbank Offered Rate may be fictional, but the one thing it has going for it is it is in the exact right place. London “dollars”, not New York.
Eurodollar futures and LIBOR pertain the global currency whereas SOFR is only domestic repo. It seems as if the hierarchy should be reversed.
Admittedly, there are links between money markets but these aren’t what they used to be leaving SOFR and LIBOR dealing with somewhat different circumstances. The government isn’t mandating the one over the other – yet – but regulators have made very clear they expect a determined migration.
From the outset, it has largely been ignored.
The UK’s bank regulator, the Financial Conduct Authority, concurrently announced in 2017 that it had secured commitments to continue the voluntary submissions required to calculate LIBOR through 2021. Speaking for the FCA, chief executive Andrew Bailey said the FCA had “spoken to all the current panel banks about agreeing voluntarily to sustain LIBOR … until end-2021”, adding “[t]here has been wide support from the panel banks for sustaining LIBOR for this period.”
This isn’t a matter of fat, dumb, and happy bankers resisting getting with the program for no good reason. There are serious operational considerations that relate to eurodollar as opposed to dollar.
There’s an unthinkably complex and consuming infrastructure that makes up credit-based money. Then a whole lot more putting it offshore. It doesn’t just get switched on and off by fiat (pun intended). This is what the de-dollar protesters never consider – even if Zhou Xiaochuan did.
If regulators run into such reluctance for just a reference and benchmark pricing rate, how does anyone think they are going to replace the eurodollar as world reserve currency? Americans see this as an unwarranted intrusion upon their sovereignty. That ship sailed in 1944, the door held wide open by benign neglect.
In early 2018, the international press was abuzz about the so-called petroyuan – the launch of commodity derivatives pricing crude oil in Chinese renminbi. The Chinese would undermine the US dollar and do it through OPEC. A flood of stories appeared declaring the petrodollar’s day as done.
The Chinese weren’t attempting to replace the dollar, merely to alleviate some of the oppressive pressures of the eurodollar. Indeed, they are no closer because the petrodollar isn’t a real thing. The eurodollar is because that’s what all the banks use. You don’t replace the dollar; by replacing the eurodollar you have to replace the way bankers do things.
In a way, as the SOFR mess implies, it has a stranglehold on them, too.
John Maynard Keynes had famously objected to Bretton Woods being called a gold standard. Standing before the House of Lords, Keynes had declared the early IMF its very opposite. That certainly overstates the matter. As Ed Bernstein said, it wasn’t going to be the same (it couldn’t be since FDR’s Executive Order 6102) but it also wasn’t that different; which is why there had been such a seamless transition into this new and initially prosperous world order.
They at least started out knowing something about the system they were trying to change.
Whether cryptocurrency or SOFR, petroyuan and Audit the Fed, there is actually quite a bit of appetite for doing money differently. So many are dissatisfied though they can’t quite put their finger on exactly why and for exactly what. Even trade protectionism, populism, renewed interest in socialism; these are all symptoms of the same disease.
Things have come full circle anyway; sort of. Faced again with the prospects for an international currency shortage, seventy-five years later it will do no good to sanction the United States for a global lack of dollars. It doesn’t have them, either. Just check the most recent SOFR calculation.
Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor.
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