Eurodollars and petrodollars represent two pivotal conscious decisions within the global financial architecture that still impact currency and economic stability today. Understanding their origins provides unique insights into the complex interplay of currencies, regulations, oil and geopolitics shaping past and future currency regimes.
Defining Key Terminology
Eurodollars refer to U.S. dollar-denominated deposits held in banks outside American jurisdiction. Despite the name, Eurodollars can be held anywhere globally. Petrodollars represent dollars earned from oil exports, predominantly by Middle Eastern producers. With oil contracts universally priced in dollars, petrodollar recycling sees these exporter dollars flowing back as investments into U.S. assets and real estate.
Growth of Eurodollar Arbitrage in 1950s-60s
London banks first began accepting U.S. dollar deposits in the 1950s to fund dollar loans in the Eurobond market, enjoying significant profits from interest rate arbitrage made possible by the Bretton Woods system of fixed exchange rates. By 1957, such deposits had already reached $148 million. However, arbitrage exploded over the next decade as British banks converted deposits into European currencies to fund foreign asset purchases, while simultaneously hedging themselves on currency pegs to eliminate risk. The scale of funds flooding from New York to London is evident in the figures below:
Total Eurodollar deposits in London banks (billion $):
1960 - $148
1965 - $580 (+292%)
1970 - $1,000 (+72%)Authorities grew increasingly concerned about this ballooning, unregulated Eurocurrency market allowing dollars to rapidly exit America funding global trade and lending. To defend the dollar against speculative attacks as European currencies buckled, emergency Federal Reserve dollar swap lines were established with European central banks. However, this tacitly acknowledged the inevitability of Eurodollar expansion.
Collapse of Bretton Woods and 1970s Instability
Hitting its stride by 1970, the Eurodollar market soon faced fresh turbulence as the postwar Bretton Woods system of fixed exchange rates collapsed when President Nixon suspended dollar-gold convertibility to halt a run on U.S. gold reserves. With the Vietnam War flooding global markets with excess dollars, investors grew wary on expanding U.S. debts.
Speculative attacks against European currencies forced repeated central bank interventions and wild fluctuations in offshore dollar interest rates:
1 Month Eurodollar deposit rates 1969-1971
Jan 1969 - 7.75%
Jan 1970 - 8.45%
Aug 1971 - 12.34%
Dec 1971 - 7.75%Seeking to curb expansion, the Federal Reserve raised interest rates in 1969, inadvertently bursting the Eurodollar bubble. Higher U.S. rates sucked deposits back from Europe, causing a global recession hitting Europe hardest as banks faced insolvency.
The 1973 Oil Crisis Reshapes the Landscape
Though initiated in Europe, the landscape radically transformed following the 1973 oil crisis. Outraged by Western support for Israel in the Yom Kippur War, Arab producers slapped an embargo on the U.S. while cutting 5 million barrels per day of production. With prices quadrupling from $3 to over $12 per barrel, the blow to Western economies was immense:
US GDP Growth (Annual %)
1973 - 5.6%
1974 - -0.5%
1975 - -0.2% Flush with billions in petrodollars but wary of Western banks, Saudi Arabia cementing an agreement with the U.S. to recycle surplus oil profits back into dollar-based assets in return for security guarantees.
Saudi Holdings of U.S. Treasuries ($ billion):
1974 - $2
1980 - $25 (+1150%)
1988 - $70 (+180%)
2016 - $117 (+67%)For leading oil producer Saudi Arabia, assets held in dollars now outweighed liabilities denominated in Riyals as currency regimes grew anchored to the Dollar-Oil standard.
Regulating the Unregulated to Avert Crisis
Rapid Eurodollar expansion soon overwhelmed smaller banks, confronting regulators with instability risks after Germany‘s Bankhaus Herstatt failed in 1974 from $200 million in bad currency bets. With liabilities denominated in Eurodollars dwarfing liquid assets, Herstatt’s collapse caused payment failures rippling globally.
In response, G10 central bankers established the Basel Committee for International Settlements (BCIS) in 1975 to govern cross-border banking. The following year, the BCIS implemented risk-based capital requirements for internationally active banks. By forcing smaller banks to hold sufficient capital buffers against their Eurodollar operations, unprecedented offshore growth eventually consolidated into the mega banking giants of today.
Cementing Dollar Hegemony in Return for Economic Growth
With Eurodollar markets expanding exponentially throughout the 1970s-80s and representing the lifeblood of global trade, financial authorities prioritized stability above all else following Herstatt. Moreover, with debts mounting amidst recession, the U.S. took action to protect dollar dominance critical for cheap commodity inflows fuelling growth.
In 1977, Carter administration legislation deregulated savings & loans institutions, leading depositors to pull money from European banks and place them in new high-yield domestic accounts. While European allies protested this loss of capital, America retorted it could not solely shoulder the burden of financing its ballooning debts.
Indeed, expanding debts posed an existential threat if petrodollar recycling waned. Former Treasury official William Simon architected agreements for Saudi Arabia and allies to purchase U.S. bonds directly through Wall Street via offshore private placements financed by Eurodollar deposits:
Share of U.S. Treasury debt held by offshore centers (%):
1977 - 10%
1987 - 40%
1997 - 63%This system powered U.S. deficit spending sustaining growth and military budgets throughout the neoliberal period.
The Faustian Bargains Behind Financial Crises
While the petrodollar system stimulated growth in America, some critics contend its emergence interlinks with financial instability as well. They argue the influx of offshore petrodollars seeking a safe destination provided excess liquidity blowing serial asset bubbles in western housing markets, relaxed lending standards helping fuel the 1980s Savings & Loan crisis. And later, continued deregulation of exotic mortgage instruments in the 1990s-2000s, eventually precipitated the 2008 Global Financial Crisis following the disastrous collapse of the shadow banking system.
Thus the Faustian bargain made by U.S. authorities to cement dollar dominance in the 1970s, set in motion cycles of deregulation accommodating petrodollar flows, which periodically ended in financial turmoil. This cycle has recurred multiple times with increasing severity:
Major U.S. Financial Crises Since Petrodollar Origins
1980s - Savings & Loan Crisis
1990s - Junk Bond Crash
2008 - Global Financial CrisisWith U.S. share of global GDP in steady decline, sustaining persistent trade deficits through continued dollar seigniorage financed by foreign official purchases of Treasuries grows increasingly untenable. Eventually, the system‘s stability hinges on transitioning to a more balanced multi-polar currency regime.
Future Trajectories for Global Currency Regimes
In conclusion, the haphazard origins of the Eurodollar system, later evolving into petrodollar recycling, provides a unique vantage point to assess future currency regime shifts. As faith in the Dollar-Oil standard that has underpinned global trade since 1974 wanes amidst inflationary debts and fraying diplomatic ties with Saudi Arabia, insights from this untold history will prove critical for policymakers and investors navigating coming storms which may engulf not just the dollar but shatter long-standing pillars of the global financial system itself.