Adam Tooze on Dollar Dominance, the Eurozone, and the Future of Global Finance

The Fed’s aggressive responses to recent crises have deepened the dollar trap, and it will continue to have far-reaching effects internationally.

Adam Tooze is a professor of history at Columbia University, and is the author of many books, including his popular account of the 2007-2009 crisis, titled Crashed: How a Decade of Financial Crisis Changed the World. Adam joins David on Macro Musings to discuss the COVID-19 crisis, the Eurozone, and the future of central banking. Specifically, Adam and David break down recent events and risks in the global financial system, the future of the dollar as reserve currency, and the implications of the recent German-Franco debt deal for the Eurozone.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Adam, welcome to the show.

Adam Tooze: Thank you for having me on.

Beckworth: Yes. Great to have you on, Adam, and you've been very busy. Just following your output, you've written long pieces for The Guardian, Foreign Policy, other outlets. You have a multi-series on your blog about the crisis, and then it seems like every day you're also putting stuff out on Twitter that highlights the recent news, which the rest of us benefit from. So, you are staying very busy, and I'm just wondering, are you planting the seeds of another book? A book of this crisis?

Tooze: I have found myself in that position. I was working, I always say somewhat apologetically, very earnestly and very seriously on a book on the climate crisis, which I do think is obviously the urgent and major challenge of our generation up until February, and then the sort of pounding and relentless news of the COVID crisis took over, and after a while, my publishers more or less unanimously said, you know, Adam, could we rethink this? And what we really need is a global history, it's too early to be a history, but an account of the global economic crisis that is clearly coming out of the COVID shock. And so, I have set myself to writing a preliminary stocktake of this truly unprecedented moment. I mean, we've never seen a shock like this on this scale, of this suddenness, of this sharpness, and this generality across the entire world economy. So, yeah.

Beckworth: Well, that is great news. I know our listeners will be excited to get that book when it eventually does come out. I know many of them are friends of Crashed, and your other works, as well, so we look forward to that. In the meantime, we enjoy what you're doing through media, Twitter, and other outlets. So, tell our listeners real quick, how did you get into finance, financial history? You wrote the book Crashed. What led you down the path to really think hard about the global financial system?

Tooze: I got into it sideways. I didn't start out in finance. In fact, I'm part of that generation of I did an economics degree in the 1980s in a place from which I would normally have perhaps been expected to go into the City of London and Wall Street in the late '80s, and I didn't, and I chose not to. So, I kind of opted against finance really in my youth. I wrote a book about economic statistics and the history of the Nazi war economy that were not exactly financial in orientation. Much more real economy. I am somebody who's very interested in production, agriculture, and manufacturing technologies, as well.  But I think it was really working on Deluge, my book about the aftermath of World War I, where I really I think began to think in a concerted way about the way in which money, the circulation of money, both private and public, organizes the global economy and global power. It's clear that America's influence in the world from an early stage, particularly America's, was anchored on dollar diplomacy. It was anchored on the circulation of dollars. This was really the medium in which America began to influence the world. From 1916 is the moment, right? The astonishing thing about World War I is you can comb the annals of 1914 and find no mention of America at all. No one cared really what America's position was on a conflict that was European.

Tooze: By 1916, everyone cares about the outcome of that American presidential election, just in the same way as everyone in the world will watch the election later this year.  And the reason why is money. Because access to dollar credit gave you access to the vast manufacturing capacity of the United States. And from that moment on really, the dollar has been a key index of global power, and that's really how I stumbled into then writing a history of the 2008 crisis, because it was supposed to have been a dollar crisis in the sense of a treasury market crisis. A sell-off. We had all had that fantasy I think of a global sell off, crucially a Chinese sell off of their huge holdings of treasuries. That of course didn't happen, rather the reverse, until 2013 the Chinese could continue accumulating claims on the United States.  What we see instead is an implosion of the transatlantic, North Atlantic private financial system, and disentangling those two things really fascinated me, and that's the central question of Crashed. And then asking, "Okay, so what follows from that?" Does that mean that we're operating in a kind of power vacuum? Is this then a space really just of private transactions, or do we need to explore the framing assumptions, the framing politics, the institutional structures that sit around that? And so, that's just how I've sort of backed into it. In the course of that, I reluctantly and rather late in life have acquired an amateurish, the outsider's interested in the workings of the financial system. I'm no market person. I've never been in the Treasury or central bank as professional.

Tooze: But I've become deeply interested in the way in which both market professionals and economists, and Treasury people, and central bank economists and analysts and decision makers think, and how they map the world.  And they are, I don't need to tell you or your audience, but they are spectacularly illuminating in their own way, and things are said there, and maps are drawn, and data accumulated which are absolutely fascinating and very, very revealing, about how resources are allocated, how money flows, how profits are allocated, and also how power is exercised, to an extent. Though often in a rather subtle and indirect kind of way. So, that's how, and it's difficult once you've got the bug, it's difficult to break it.

Beckworth: Fair point. And for an outsider who stepped in, you've done an amazing amount of work, and we appreciate it. I mean, the book Crashed, your ongoing analysis has been really useful to many of us. I think it opened up many of us to the importance of the dollar swap lines at the Federal Reserve. I have had a growing interest in that and Crashed played a role in sparking that. I think the whole last decade, I mean you mentioned how many people, many prominent people, we won't mention any names here, but many prominent economists were warning about a dollar crisis, right? The large current account deficit the US is running leading up to the crisis in 2007, 2008. And we were blindsided.  Most people did not see this coming the way that it did.

Beckworth: Some were predicting a crisis, but not the crisis that unfolded, and I think since then, there's been this real sharp, steep learning curve of the importance of the dollar. I mean, some people understood it already, but for the large mass of economists, I think there was this steep learning curve, the importance of the dollar, and your work has contributed to that, and other scholars in this field have done so, as well.  Well, let's move from that crisis to the current one. It's a big one, as you mentioned, and I want to go back to March. So, March is when markets really were under stress, and you had this great article in The Guardian titled “How Coronavirus Almost Brought Down the Global Financial System.” So, how close were we to the global financial system coming to a crash in mid-March, and what were the parts at play that almost led us there?

COVID-19 and the Global Financial System

Tooze: I mean, mercifully, we'll never really know. Because we live in a world which is now, as everyone listening to this show will know, constantly manipulated by increasingly massive intervention by central banks. But the scale of their intervention strongly suggests that the people who were very close to the markets and had very good sources of information were incredibly worried about how serious the risks were. It's difficult otherwise to understand why the Fed would have acted the way that it did, and the Fed has really led the way here. The Bank of England also quite dramatically, though not in quantitative terms the same, and the ECB, as well, though again not on the same scale as the Fed. But if we take, as it were, that as our index, then we have to say that folks in the Fed must have been very alarmed by what they saw. And I think really what was probably most concerning was that you had a general collapse of confidence that was as serious and as rapid as we've probably ever seen. It didn't come out of a clear blue sky, because if you go back over the financial media, it's clear that people have been worrying about the news out of China throughout February, but they'd broadly been thinking about what a bear, a hard landing in China would do to the world economy. It's really at the end of February with the Italian lockdowns that people begin to realize that this is actually a global pandemic. In other words, the entire global economy may be suffering a hard landing.

Tooze: And then you get a general panic, and then two things happen. You get a flight into dollars, you get a flight which puts huge pressure on everyone who has dollar funding needs. Everyone, both in the United States and outside, is finding it difficult to get dollar funding, and that becomes a self-fulfilling prophecy because a panic mechanism is induced.  And then, I think most alarmingly, in the second and third week of March, you begin to see something really almost counterintuitive, which is that people are running out of absolutely everything, even in dollars. So, running in the sense of selling assets, and really getting as close to cash as they possibly can. And so, what you might think of as the safe haven of treasuries, of sovereign debt in general, even in the Eurozone bonds, also in Britain in the gilts market, UK treasuries, you see these counter flows of folks selling their government debt. And that's extremely alarming under any circumstances, that in a moment when you would expect, as it were, everyone to be piling into safety, you would hope that would be, as it were, the asset of choice. And instead, what we're seeing is the treasury markets not functioning in a normal way.  

Tooze: We see interest rates going up rather than down. In other words, prices are going down because people are trying to sell them for cash. We see gaps developing between different maturities, which shouldn't develop. There were days when there was certainly not enough market capacity, and people aren't willing to buy them, there aren't market makers, and all of that is from the point of view of the central banks really extremely alarming. We never got to see what might have happened next. We never got to see what might have happened if the full working out of this shock in private credit markets had been about to unfold. We still, of course, are fairly early days, so it's possible the balance sheet hits will pile up in weaker banks, both in the United States and Europe. We might still see some banks being hit.  But it was the scale of this, the speed of this, and these particularly counterintuitive movements I think really indicate the extent of the stress, and it's that which really drove the Fed to lead the way in mammoth bond buying, mammoth asset buying, and now this just extraordinary extension of backstops of all sorts to private credit markets.

We never got to see what might have happened if the full working out of this shock in private credit markets had been about to unfold.

Beckworth: Yeah. It's hard to fully I think fathom for most of us how serious this issue was, and like you said, histories will be written where they've looked deep into the archives, and looked at the data, and have a better understanding in the future, but the fact that the treasury market, which is supposed to be the safe haven of the world, almost collapsed, is pretty alarming. Darrell Duffie has a paper that's come out this week titled “Still the World's Safe Haven?” Which raises questions along the lines you've just mentioned.

Tooze: Yeah. Brad Setser's been asking that question, too. There was a very interesting Twitter debate between Robin Brooks and Brad Setser. Robin Brooks is chief economist at the IIF, and Brad Setser at the Council on Foreign Relations, ex Treasury, and they were discussing what was happening in March. For me, I think I really understood the severity of what happened when Chris Giles, who's one of the leading economics journalists at the FT did an interview with Andrew Bailey, and Ed Conway at Sky had also interviewed Bailey on the events in London on the 18th of March, and I think that's probably the moment when things were maximally disturbed.  And the language out of the Bank of England, which after all is normally a very restrained institution, was spectacular. I mean, they were talking in the way that Paulson and Bernanke were in '08 about the end of the world, it not being obvious the system would still be there the following week. There's this particular moment in the forex markets in London that week, on the Wednesday, when apparently there just was no buy side. And you know, the forex market churns $6 trillion on an average day, and the biggest marketplace is London, and because there was this rumor going around that Boris Johnson was going to shut London down, people just freaked and there was no buy side.

Tooze: And that is terrifying. When the global foreign exchange market gaps, for all currencies other than dollars, the story isn't what it was in terms of an indicator of stress, but I think it moved by five or six percentage points on a single day. Crazy things were happening to institutions with very long memories.  And so, I think those are the signs. And of course, lurking in the background is still this question, the question that both of us were poo-pooing a minute ago. What is the future of the dollar? Could we imagine a huge, the big sell off? And those fears return at moments like that. In the back of our minds, we after all do have this question, how long can it go on for? How long can we have such a spectacular imbalance between the centrality of the dollar in the global financial system and America's waning real economic presence, and its frankly trashed political reputation, right? So, there are deeper fears that get activated at moments like that.

What is the future of the dollar? Could we imagine a huge, the big sell off? And those fears return at moments like that. In the back of our minds, we after all do have this question, how long can it go on for?

Beckworth: Yeah. So, just to be clear on the chronology, it was first the dollar funding crisis, and then the treasury market crisis. Is that right?

Tooze: Happening more or less simultaneously.

Beckworth: Simultaneously. Okay.

Tooze: Yeah, so funding stress on the emerging markets, if you track the IIF data, that's building up already in February, because everyone knows that the emerging markets go with China. So, if China is going to have a hard landing, then every commodity exporter, every manufacturer, the Vietnams of this world, the Malaysias, the Indonesias, the Australias, all of them are going to be heading into rough waters. So, you begin to see a withdrawal of EM funding already in February. Then you get this global shock to confidence beginning on the 23rd of February, but then building really from Monday, the 9th of March. And it's in the following weeks then that we begin to see these eddies, and people who were much more technical than I am point to the unwinding and the perverse actions of various hedge fund strategies in those weeks, where people have basically been betting on the stability of treasury markets or the fact that they would move inversely with equities, and that wasn't happening.  And that then produces basically sort of generalized sell orders. People try and unravel entire books. They were then also getting margin calls of various types, so alarming things of a very technical nature were then forcing technical moves, which in a situation like that, can produce macroscopic effects, right? Where the market is steady, you can have a hedge fund unwinding and losing position without it blowing everything up. But what the central banks were seeing was that the market couldn't cope with that.

Beckworth: I like that point. I want to build on that, the technical challenges in the markets during that time. So, let me speculate here and make the case why the dollar and the treasury is still the save haven and may have actually strengthened. And this is speculation, so just bear with me. But start with the observation that maybe some of the problems we saw in the treasury market were technical in nature, so for example, the bank regulations that caused repo market stress late last year, this is just another manifestation of it. Some people argue that when all the selling took place, that the dealers that typically would be market makers, they couldn't do much because of regulations that prevented them from expanding their balance sheets, so the balance sheet space was limited.  And on top of that, just the size of the shock itself is so big that maybe no market would have been able to withstand that without some kind of government intervention. So, with that said, let me make my case here. So, I would say first, what's the alternative to the dollar and to the treasury market? I mean, you have to come up with something really large to replace it. When you're running a bank, if the US dollar is like the banker to the world, you're running a bank, usually you have an alternative place to go park your funds. What would investors do if they ran on the dollar? What would be the alternative? And I'm not sure I can answer that question. Do you have any thoughts?

Tooze: Well, they'd run into bills, basically.

Beckworth: Okay.

Tooze: Of which, of course, the US Treasury has been issuing gargantuan amounts. In terms of big markets, the only one right now which compares is the Chinese renminbi market, right? The Chinese treasuries now are a huge market. But, I mean no one realistically would imagine those as a viable alternative to the US treasury market. The Euro space doesn't give you the depth of market or sophistication of markets, so I'm completely with you on that. I'm not... I wasn't making the case, I think, or I'm not a skeptic on the dollar's position. I think we're deep in the dollar trap. And probably going deeper.

Tooze: Where I would be more skeptical is where we, and I like the way that you put it, is the sort of position which JP Morgan has articulated and its most articulate form, which is, lift the regulations, give us more freedom, and then we will make the markets, even in situations like that. We have the balance sheet capacity or we could have it if we weren't subject to the kind of restrictions that you've placed on us since 2008. I think that argument should be held at arm’s length, because this was a shock which no amount of private balance sheet capacity could really have dealt with, and the de-risking which we've achieved since 2008 has been very considerable.  So, even if there are truly fortress type balance sheets which could have ridden out a crisis like this, and provided some buffering, which maybe a JP Morgan could have done, it wouldn't have been adequate to the crisis, and in the mean time you would have opened the doors to the bad apples, who will then face you with awesome problems of crisis management of the type that we faced in '08. We haven't had a Lehman or a Bear Stearns type moment so far. The shock has been terrible, but it's been spread over balance sheets which don't pose those kind of risks. And even if that means that we don't quite have the shock absorbing capacity of private market making that we did in '07 and '08, I think that's a balance worth striking.  It does, however, mean exactly as you said, that the central bank will have to step in to make those markets.

Even if there are truly fortress type balance sheets which could have ridden out a crisis like this, and provided some buffering, which maybe a JP Morgan could have done, it wouldn't have been adequate to the crisis, and in the mean time you would have opened the doors to the bad apples.

Dollar Markets and the Dealer of Last Resort

Beckworth: No, I agree with you completely. As you said, the circumstantial evidence is the size of the interventions the Fed has done, it's hard to believe there would have been that much extra balance sheet space on Wall Street to play that role. And secondly, kind of a bigger point, one that I've been wrestling with and I don't have an answer to, is how do you deal with the dollar market across the globe? The euro, dollars, all the dollars that are held outside the US, issued outside the US, I mean the Fed has effectively stepped in as a dealer of last resort, of a market maker of last resort, to a global dollar market, and I've heard two suggestions on how to deal with this. One is you try to regulate all these entities that are creating dollars out of the business, so either you force them with strict regulations, or you put them under some kind of governance that makes them safer. Alternatively, you require more capital funding, so they're less leveraged and more able to handle shocks. But it's not clear to me how you do that on a global scale, and the Fed, I think, is the only entity with the balance sheet space that could step into a global dollar market and respond effectively.

Tooze: No, I agree with you I think, and every time it does what it's done, it as it were reinforces the validity of that bet. I mean, if you are the global actor, and you need an efficient, cheap mechanism for organizing global finance, why would you not use the dollar in light of experience now? I mean, the one way out of the dollar trap would be for the Fed to fail in that role. If it burnt everyone who was engaged in these kind of transactions, and I think that would maybe end it, but that's a price not worth paying.

Beckworth: Right. That's an awful outcome.

Tooze: It would inflict spectacular damage on huge parts of the global economy. And as they grow, of course, they become more and more significant. We shouldn't confuse the world of 2020 with the world of 2008. The big, emerging market economies are much more significant than they were. I mean, first and foremost China, right? Which in 2008, was still relatively new, if you'd like, to the global party. Lot of people I think regard the Beijing Olympics as being the coming out moment, which was that year, and now, of course, it's just simply taken for granted as an absolutely dominant piece. In terms of growth dynamics, the dominant piece of the global economy.  

Tooze: So, this is all relatively new, and I think that really, to me, the question going forward is can we envision a situation in which the Fed-centered system is continuously adapted and expanded to incorporate not just the South Koreas, and the Brazils, and the Mexicos, who are currently part of the EM swap line system, but Indonesia, for instance, what I gather this time around made an application for swap line and was not granted it, which strikes me as surprising, given its scale and given the essentially orthodox, very Western-orientated management of its finances and its central bank in particular. And instead, I think rumor has it that the Fed then improvised this repo facility, which would allow the countries with large reserves in the emerging market worlds to gain access to dollars by means of repoing those reserves rather than having to sell them.  But that, of course, doesn't solve the problems for highly stressed emerging markets without large reserves, of which Turkey is probably the preeminent example. But anyway, yes, I agree. There's no obvious off ramp here, and every time the Fed responds to a crisis in the proactive, supportive way that the Fed has in the last two, it reinforces the depth of the dollar trap. It deepens the dollar trap.

The question going forward is can we envision a situation in which the Fed-centered system is continuously adapted and expanded to incorporate not just the South Koreas, and the Brazils, and the Mexicos, who are currently part of the EM swap line system, but Indonesia, for instance.

Beckworth: I'm glad you make that point, because I completely agree with it. And I feel like I'm preaching to the choir, here.

Beckworth: This is great, though, because I made the case in an article recently that the Fed effectively was setting up branch banking, temporary branch banking, by opening up its balance sheet. So, all these central banks around the world that have direct access to the Fed's balance sheet, to dollars, either through the swap lines, or through the new repo facility, effectively are branch offices, and they're dispensing dollars as they see fit, and I completely agree with your point that that just sends a strong signal to investors around the world that all else equal, why not use dollars? They're safe, they're backed up ultimately by the Fed, and on the margin, it's going to push the reach of the dollar even further into the global economy.

Tooze: Yeah. I mean, I'm not a big moral hazard guy, so I don't think there are many emerging market corporates sitting there going, "Oh, well, they'll do a swap line." I think it's more simply that the system isn't broken, and so no one's fixing it. Every time the Fed does this, it works. It allows the system to go on functioning, and so then the simple calculus says, "Well, these are the deepest markets. This is the most efficient way to do." I don't think there's a lot of preemptive speculation on the coming bail out, which I think is the sort of extreme and rather naïve interpretation of what moral hazard consists of. It's simply that because the Fed maintains the system in existence, people just follow through on the same logics every single time, and that does indeed deepen their entanglement. As the emerging markets grow, the volume of transactions just gets larger and larger.

Beckworth: Yeah, and there's actually a silver lining here for the United States, and that is this should, all else equal, again on the margin, all else equal, it should increase the flow of seigniorage to the US. The stronger this signal is sent, the stronger that the future flow seigniorage, which in turn helps pay for some of the deficits that the US is running. So, it's an interesting picture, and it is something the Fed's going to have to wrestle with. I mean, the Fed is already effectively setting monetary policy for a large part of the world. I had a previous guest on, Ethan Ilzetzki, he has a paper with Reinhart and Rogoff on exchange rate regimes, and they show... This is as of a year or two, that roughly-

Tooze: That's a great paper.

Beckworth: Oh, you've seen it? Yeah, roughly 70% of the world has their currency in some form pegged to the dollar. Which means Jay Powell is not just setting monetary policy for the US, he's setting it for the world. And then you add all these other channels we just talked about, the debt markets and dollars overseas, the Fed is walking in a very careful manner. It has a domestic mandate, but a deep international reach.

Tooze: Yeah, absolutely. And I think one of the surprises has been that that has not produced a disaster this time around. I think many of us, it turns out rather simplistically, anticipated that the advent of the Trump Administration and the vociferousness of the GOP in Congress would make it difficult for the Fed to do this. And of course, it doesn't want to give hostages to fortune. This is still the beginning. Things could get bad, especially if we had a Democratic administration, I think. But the combination of a Republican presidency, a manifest domestic crisis, everyone's minds being on other issues, and the fact that this stuff is quite technical, has meant that the Fed has again, in this crisis as well, had a remarkable degree of freedom in acting. I must admit there was one Bloomberg report which sent a shiver down my spine when I gathered that Erdogan, the Turkish prime minister, asked Trump for a swap line.

Beckworth: Oh, yes.

Tooze: Which was terrifying. A, because it means that President Trump may now be aware of the fact that they exist, and B, that other people want it. And that combination of him knowing that he has something that other people want is a terrifying one. I mean, I joke, but I think it's a real issue, and I know that in places like the IMF 18 months ago, they were really worried about this. I had a conversation with people in the IMF about precisely this scenario, and I think around the edges, I think we saw this constraint acting, but not on the Fed, but on the IMF.  Because in the package that emerged from '08 and we see it in the discussions in the Fed from the minutes that we already have on '08, the likes of Geithner in particular and Bernanke were crafting a vision of the interrelationship between direct dollar provision from the Fed, by way of Wall Street, or by way of swap lines, and last ditch dollar provisions by the IMF, and then they upscaled the balance sheet of the IMF in the spring of '09, so as to give it about a trillion dollars in firepower. And the question in the current crisis is whether these various lines of defense, what they call the global financial safety net, this is the phrase for this, is large enough given the sheer scale of the emerging market funding needs now.  

Tooze: And there was a moment in spring week, in the meetings, at the spring meetings in April, when there was a big push on, led by the Europeans, with support from African nations and everyone known to man for a big push to increase SDRs, which are the as it were self-created currency of the IMF, which would be an alternative that's conceivably to the dollar as a global currency. And the US Treasury stopped that dead in its tracks, and so there was no expansion in IMF resource. The argument at the Treasury was, "You know, we don't know how big the crisis yet. Maybe they've got enough resources. We should reallocate the SDRs which all exist." Which all makes sense, but there was as it were a push there to say, "Look, we need up expand the size of the global financial safety net."  And I gather that one of the key reasons was not just as it were a general skepticism towards that kind of multilateral move, but also a specific anxiety about the reaction of elements of the GOP in Congress to any proposal like that, because amongst the beneficiaries of an expansion in IMF resource, if you do this at a global level, not in a targeted way through the balance sheet of the Fed, one of the beneficiaries or two, the beneficiaries would include Iran and Venezuela, not to mention China. And that is a red flag.  So, part of what makes, if you like, the Fed's expansion possible is that it remains at the discretion of the United States, and you can limit it to players that you trust. Whereas if, as it were, it became a de facto non-discretionary, if it became essentially a genuinely global facility, then it would be unacceptable to hawkish policymakers in the US.

Beckworth: Yeah. Do you foresee the IMF at some point in the future getting its own dollar swap line? Someone suggested that maybe the IMF should get one, and therefore let the IMF be the bridge from that facility to these emerging markets.

Tooze: That would then create substantial, potentially substantial risk for the IMF. I think that's the thing. I mean, they're still doing work, because they on the one hand look like the secret sauce that keeps the entire global financial system operating. That's as it were the grandest interpretation. And then the beauty of them is you can flip them around and say, "You know what? They're a completely riskless transaction. Essentially nothing more than an accounting exercise between two central banks. We have no reason to worry about either of their probity or that they're good for this money." They're nothing, right?  And the beauty of them is they have this sort of genus-based quality that they're the secret sauce that you can't even taste. And the problem, I think, is that you've introduced, and that again has a lot to do with the range of countries that the Fed chooses to include, who are indeed undoubtedly good for it.

Tooze: And so, there isn't any question of any kind of risk arising for the balance sheet of the Fed. If you put the IMF in an intermediary position, the risk would arise for the IMF. Because the way it works locally, in the standard format, is in the classic '08 format, is you extend the swap line to the ECB and the ECB extends it to Deutsche Bank. Now, Deutsche Bank is going to repay the ECB if its executives have to sell their houses to repay the ECB, right? There's not going to be a default on that, so there's really no risk in this chain.  But I don't think the same is true if the IMF found itself in a position of recycling dollars it has received from the Fed to a stressed, emerging market actor, which would then presumably be passing them down the line to a stressed private balance sheet, more often than not. So, then all of a sudden you'd be in a position of basically something closer to banking, which the IMF doesn't really like to think it's in the business of doing.  

Tooze: Anyways, so that I think is one of the reasons why that might not work, but it's a great, it's a neat idea. Because what we're all trying to avoid saying is what we really need is a global currency, managed by a global organization, and the IMF is the only conceivable contender for that role, and that is the idea that was floated after all by the Chinese in the spring of 2009. No one can ever really decide whether they meant that seriously or whether it was just a sort of dig at the US, but it was a well-aimed dig in that it points to this fundamental sort of imbalance in the global economy between the American currency's global role and the fact that it remains rooted in the national power structure.

What we're all trying to avoid saying is what we really need is a global currency, managed by a global organization, and the IMF is the only conceivable contender for that role.

Beckworth: Very fascinating. I could spend the whole show talking about this dollar issue, but I do want to move on to Europe and the future of central banking. Before we leave it though, Adam, I wanted you to put on your historian hat again, and I want to ask about the relative importance of the dollar compared to other reserve currencies in the past. Would you say the dollar is more influential than the sterling pound was during its time, or have there been any other currencies historically that you think paralleled the reach and scope of the dollar today?

Historical Reserve Currencies Comparable to the Dollar

Tooze: Yeah. I do. I mean, I'm the sort of historian, I'm not the sort of historian who likes, as it were, insisting that we've seen everything before that we're currently experiencing, that there are these long continuities or deep sort of repetitive structures of the rise and fall of dominant currencies. I find that all wholly unpersuasive. The pound was a key currency, but it was a key currency essentially within the context on the one hand of the global gold standard, of which London was the anchor. And on the other hand, within a structure of empire of a type that is not our current situation. America obviously has extraordinary global reach in terms of military power, but not formal empire. It doesn't compare to entities like India, which made up a huge part not surprisingly of the British Imperial economy as subordinate elements.  The dollar's unique because it's the lead currency in a fiat money regime. The Bretton Woods phase is really the bit which doesn't describe the unique role of the dollar, because it was a regime of capital controls.

Tooze: It was in any case incredibly short lived. It only really existed between '58 and '71. The authentic era, if you like, of dollar dominance I think is the period not really since the end of Bretton Woods, because the seventies were such a mess, but since '79 and the Volcker Shock, and the definitive reorganization of global finance, initially in the West, around an American currency anchored not on gold, but on a decisive political decision on the part of the American central bank and the forces that support it in Congress on a hard money or relatively hard money public policy, which then was complimented by a policy of what people would call financialization. In other words, the sort of supercharged growth of Wall Street on the other hand.  And that, I think, is a new era, and so there's nothing really that compares with this. It also, so therefore has a sort of elasticity which the pound system never really had, because that was a gold standard system. It was tied to the fortunes of a middle sized empire in decline.

Tooze: America may be in decline, but not in terms of its military reach. That isn't the problem. So, no, I think of this as really sui generis, and I don't find it very instructive. There's colleagues whose work I obviously greatly esteem, I mean most notably people like Barry Eichengreen and so on, who want to draw lessons from previous moments of currency succession, and I just don't find those very helpful.  I mean, if there were an all-out war between China and the United States that somehow remained non-nuclear, and then we had to reconstruct the world economy afterwards, I think it would be fair to say that all bets would be off as to which currency it would take place in. But, I mean that's not a scenario which I think is useful for thinking about the likely future.

Beckworth: Yeah. Very interesting. The question I've often asked guess, and I wonder about myself, is if you could run the world 10,000 times, not possible, but you could do an experiment where you start Earth's history over again thousands and thousands of time, would it always be the case that eventually one dominant currency emerges? Is money such that people want to have a money of moneys, a global medium of exchange? And I think that's a fun question to ponder.

Tooze: Yeah. It is indeed, but we're not in that world, right? So, that great study that you referred to showed that there were three big currency zones currently, right?

Beckworth: Right.

Tooze: Which are relatively independent of each other. They're then articulated by complex interconnections. So, the US is the biggest one, then there's the euro, and then there's the Chinese one. And a large number of emerging market currencies, but also the Australian currency now basically fluctuate in close correlation with the small fluctuations that are permitted in the Chinese currency. So, there are de facto already three. That doesn't mean that there can't be a large ambit for dollar-denominated finance, but it's by no means exhaustive of the entire world. We don't live in a world of exclusive dollar dominance. We live in an asymmetric world with the dollar's reach being far larger than the size, the share of America's GDP in global GDP, or some measure like that. Or the significance of American commodities, or American trade. But it's not overwhelming, like if you look at Germany's imports and exports, they are, apart from certain raw materials, overwhelmingly denominated in euro now. It's a very mixed picture, and I think that's the kind of world that we inhabit. But for finance, in certain growth areas in emerging markets, the dollar does matter, including even in China. That's one of the kind of perplexing things we've discovered of late, is that Chinese privates owe quite a lot of dollars.

Beckworth: Yep. Well, let's move to Europe, the Eurozone. Recently, there was a German Constitutional Court ruling, and it really shook markets, and it raised questions about the future of the Eurozone, but then out of that came a new Franco-German debt deal. So, walk us through that, and then what does that mean for the future of the Eurozone?

The Franco-German Debt Deal and the Eurozone

Tooze: Yeah, so the German Constitutional Court ruling is a astonishingly convoluted legal document. 130-page judgment, which involves basically a series of claims about whether or not German national authorities did their diligence, did their due diligence in insisting that, believe it or not, the ECB provided adequate proportionality, adequate proof of the proportionality of its actions when Mario Draghi launched the massive QE drive in 2015. Remember, Europe was teetering on the edge of deflation most of us thought, Draghi thought so, too, and so he launched QE finally. He'd said whatever it takes in 2012, but not really done much about it, and then in 2015, as deflation appears to be a very real prospect, the ECB launches a very big QE drive, bigger than any one of Bernanke's individual QE drives. Absolutely massive.  And that stirred up German political opinion dramatically. I mean, they had already been excited by whatever it takes, but then a coalition essentially of conservative and right-wing groups, including one of the founding members of the AFD, the far-right party, which has done so much to disturb German politics since 2013, brought a case saying basically that the ECB was breaching its mandate, and it's mandate interpreted here not simply in terms of inflation limitation, because that wasn't the problem.

Tooze: There wasn't inflation. What Draghi was doing was to prevent deflation. The claim is more technical. It is that in doing QE, the ECB was effectively conducting not only monetary policy, but economic policy, too. And that distinction to most of us makes no sense whatsoever, because obviously monetary policy is economic policy, and how do you expect monetary policy to work if not through the economy?  But in the treaties that created the ECB, this line was drawn, and what it really is is intended to firmly identify the mandate of the ECB as nothing other than price stability. So, it wasn't supposed to take account of the economic effects of its policy, which is broadly speaking what everyone has always taken independent central banking forces on the inflation rate to be. It was also a way of ensuring that national governments retained prerogatives over economic policy and all that was made federal was monetary policy, and so the suit alleged that in engaging in QE, the ECB was infringing this boundary. It was effectively conducting economic policy by the back door, and the German court ruled that the ECB had failed to assess proportionately the broader economic impacts of its monetary policy, was therefore conducting economic policy in a haphazard way to the detriment of the plaintiffs, and furthermore that the European courts of justice had failed to assess this issue properly, so it having failed to do so, it was the job of the German court to do so.  

Tooze: It decided that the ECB had failed to properly balance the appropriate interests of it, the plaintiffs against the proper and limited mandate of the ECB, which is inflation targeting, and it therefore demanded that the German central bank, the Bundesbank, withdraw from cooperation. Not with the pandemic bond buying, but from the earlier generation of QE, which is why the markets have not freaked out, because this doesn't immediately affect the immediate bond buying. And the German Bundesbank is required to withdraw three months after this judgment unless the ECB is willing to provide justifications which satisfy the German court that it has adequately balanced this question of its exclusive focus on monetary policy against the de facto impact of its policies in the realm of economic policy.  It's not clear what kind of proof the German court would accept. It's not altogether even clear whether it's expecting the German central bank or the ECB to respond.

Tooze: But this is the limbo that we've been left in. And the supposition, and it really isn't much more than that, various newspapers have attempted to establish a clear timeline, is that this judgment, which is quite destabilizing to the politics of central banking in Europe to say the least, triggered the German chancellery, Angela Merkel's team in the German government, into backing a proposal that was being worked out by her finance minister, who's of a different party. This is part of the German coalition. The Social Democrats. This is Olaf Scholz of the German Finance Ministry, and his counterpart in France, Bruno Le Maire, from the French Treasury, which was a proposal for a European-funded, debt-funded reconstruction package.  And somewhat to everyone's surprise, Merkel signed up to this program last week. And this has come as a big shock. It seems to have open the door. The European Commission has picked up the ball and is running with it. Ursula von der Leyen this morning gave a speech asking for an even larger budget than the Germans and the French had proposed, in part probably with a view to establishing a bargaining position against the so called Frugal Four, led the by the Dutch and the Austrians, who are not keen on this proposal.

Beckworth: Does this proposal open the door for a truly safe asset for the European Union?

Tooze: Conceivably it could. It's the closest we've come so far. The scale isn't the sort of depth and scale of market that you would like. You would want trillions, lots, several trillions, but nevertheless, it's a step in the right direction. It's the first proposal really to allow the EU to borrow on a really large scale. What of course needs to be worked out is the funding stream that would make this debt AAA worthy. That is an issue that's still to be resolved and was not resolved in the Franco-German proposal. Various specific ideas will now be, as it were, people were try and pin various specific ideas on that end of the donkey.  Part of the explosiveness there is that it's pretty clear that the Social Democrats in the German Finance Ministry, so center leftists who offset Angela Merkel's center rightists in the other wing of the government, view the issue of taxation as a major point scoring opportunity for them in the sense that what they would like to push is an aggressive pursuit of tax evasion, both in terms of international tax havens and in terms of domestic tax evasion, and the beauty of that is it would target both Dutch and the Italians, and the Dutch and the Italians are the missing pieces in the Eurozone equation.

Tooze: So, the Dutch are notorious facilitators of large-scale corporate tax evasion, and the Italians are notoriously unable to effectively tax many of the better off Italians.  And this irks the German voter deeply, not that the German taxation is above reproach or bombproof in any way whatsoever, but nevertheless, this is a political issue, and there's little doubt, I think, that neither the Dutch nor the Italian tax systems are above reproach. And so, I think they see that as a wedge issue on which to drive, as it were, the equality line, and to make this not just a common bond proposal, but also a proposal for the common tax. That's a hugely hot potato if they got that direction.

Beckworth: Interesting.

Tooze: Ursula von der Leyen was thinking more in terms of green taxes, so carbon taxes-

Beckworth: There's another way for the Germans to push structural reform throughout the EU.

Tooze: It would be. Absolutely.

Beckworth: Fascinating.

Tooze: And an important one, and one which it's hard to argue with.

Beckworth: Right.

Tooze: Greece and Italy would both be better off if they had better fiscal states, and ineffective fiscal states come in many shapes and forms as we know only too well from the United States, or the Netherlands, or Ireland, which facilitate tax evasion by, or tax, what should we call it? Tax efficiency. Not evasion, but tax efficiency on the part of large American corporations.

Beckworth: Yeah. Interesting. Now, let's say this deal does go through, it takes some of the pressure off of the crisis. Does it completely resolve the problems created by the German Constitutional Court? Could there still be problems down the road for the Eurozone, even if the Franco-German debt deal goes through?

Tooze: It doesn't resolve the fiscal problems, because Italy's national recovery programs from COVID-19 will have to be even bigger than this. I think everyone expects Italian debt to end up at about 150% of GDP in the next couple of years, which puts it beyond, in my view, the conventional austerity talk. Even if you would and I would obviously debate and contest the idea that austerity made any sense for Italy in 2010 or '11 or '12, it certainly doesn't I think make any sense at all once you get to 150% of GDP.

Beckworth: Right.

Tooze: So, it doesn't resolve the fiscal issues. It opens a creative door to a future for Europe, which is positive, but it doesn't resolve legacy issues. Nor does it, no, it doesn't address the specific issue of the mandate of the ECB. And what I would argue, and I'm in no way friendly to the judgment of the court, or the plaintiffs, and let alone to the argumentation of the court, where they claim basically the right to question and call into question the hierarchy of European courts at their discretion, whenever an issue strikes them as sufficiently important. But I am sympathetic to the view that there is a degree of, shall we say prevarication, not to say bad faith, in the way in which an entirely new agenda of economic policy has been shoehorned into the mandate of the ECB.  Now, this has happened with the Fed, as well, but the Fed's mandate is much more capacious. And it's much less legalistically defined. And crucially, the Fed has the legacy of the 1970s in its dual mandate to maximize employment, and the ECB doesn't hae this, and so the ECB has this extraordinarily constraining legal design, which I think it's not unfair to say basically has been blown apart, really, by the range of actions that the ECB is engaged in.

I am sympathetic to the view that there is a degree of, shall we say prevarication, not to say bad faith, in the way in which an entirely new agenda of economic policy has been shoehorned into the mandate of the ECB.

Tooze: So, much as I may disagree with the specific issue being brought by the German plaintiffs and the politics of their suit, and the judgment of the court, as an analyst of central banking and the political economy of military policy, you can't help but agree that indeed the ECB has basically been playing fast and loose with its... Well, no, it isn't. That's not the right word.  It engages in extraordinarily elaborate justifications for policy which it should simply come out and front and center say is necessary for the good of the Eurozone, so as to reconcile themselves to this constraining mandate, so what it needs is a new mandate, which should basically take in what are all the key objectives of modern central banking. Which are, of course, price stability, but also maximum employment. We also clearly need to mandate financial stability in the wake of '08, and I don't think nowadays, and certainly in light of the debates in Europe, we can get around thinking hard about sustainability with regard to the financial system. In other words, part of its financial stability brief should be conformity to the Paris decarbonization agenda.  

Tooze: If you're going to give green issues the priority which Europeans are determined to do, it's inconsistent in my view to have a central bank which is ignoring the fact that the markets are basically pricing in a four degree Celsius temperature increase. So, that would be my vary capacious agenda for a mandate to change, which I recognize is probably utopian. But it does make me sympathetic to the... Well, at least the confusion of the German judges and the German plaintiffs, who have not ended up with the central bank they thought they were promised.

Beckworth: Fair enough. Well, that's a nice segue into the last part of our show and the few minutes we have left. I want to speak briefly on your thoughts about the future of central banking. So, we've talked about how the ECB is changing, and how the Fed is changing as well with this crisis and with the last crisis, and you had a great piece in Foreign Policy titled “The Death of the Central Bank Myth”, and subtitle is, "For decades, monetary policy has been treated as a technical, not political. The pandemic has ended that illusion forever."  So, speak to us as what you see happening to the art and the practice of central banking going through this crisis and into the future.

The Future of Central Banking

Tooze: Well, first of all, I should never take credit for titles and subtitles in a publication like that. The editors provide that extra ingredient of pizzazz, as is their job and their privilege.

Beckworth: It's a powerful title, “The Death of the Myth.”

Tooze: You know, the author always shrinks, and then you benefit from that sensationalism. My point really is that central, military policy, in the history of the United States in particular, has a long and important history of being explicitly political. You know, one thinks all the way back to the foundations of the American republic, and then also in the moment of populism in the 1890s, very much to its credit, American democracy has been able to say money is political. The medium in which we store wealth, in which we value transactions, in which we build credit, this is a political, a key part of the social fabric. It is fundamentally not rooted in anything other than law, and social convention, and agreement. The metallist fantasy that this if fundamentally somehow an inherent, money has value because it has inherent properties is nonsense. We need to grow out of that and we need to find a political legal foundation for this essential basis for our common lives together and our conduct of business.  

American democracy has been able to say money is political. The medium in which we store wealth, in which we value transactions, in which we build credit, this is a political, a key part of the social fabric.

Tooze: And the result, of course, has been throughout history a messy hybrid of state power and private credit creation, and therefore also profit taking on the part of the financial system that was built into this monetary system. And one of the weird things that happens is that that reality gets continuously repressed in the history of money, because it's somewhat disconcerting to think about money as fiat money, as ultimately nothing more than a social convention. And so, there is as it were a kind of forgetfulness cycle that operates, and the most recent of those cycles really begins in the 1970s, and it begins with that moment, really, in which Paul Volcker turns the Fed into an anti-inflation machine.  And that, then, is sort of hybridized in quite an uncomfortable marriage, really, with the Bundesbank tradition of independent central banking as anchored in the post-war settlement in West Germany, which itself reflected a German traumatic history with money.

Tooze: And by the 1990s, we have this sort of identikit generic vision of independent central banking, with a simple price stability target, in a world of more or less floating exchange rates. They were often less than more, but nevertheless, and free capital moment, which is the sort of de facto norm for global financialization from the 1990s onwards.  And in one dimension after another, all across the world, whether it's issues to do with the financial crisis in the US and the asymmetries of the bailout, or whether it's to do with the ability of emerging markets which are tightly integrated with the global financial system to handle their integration, or whether it's to do with the politics of the ECB and the European monetary project, which is unique in its ambition, that paradigm has just... is increasingly wanting. It doesn't describe that paradigm emerging out of the 1970s, what central banks do, and the question is, as it were, how we cope with this. And I think the ECB and the... You can kind of say that three paths have been marked out.  

Tooze: I mean, one is the ECB path that we've talked about, which is a high stakes political, constitutional, legal argument about what the ECB should do, unfortunately conducted on the basis of the most pristine, restricted, limited, and in some senses absurd construction of what that paradigm was, which are the founding statutes of the ECB. Then you have the American model, which is that the Fed basically morphs, and we say as little about it as possible, because it works and it benefits those, broadly speaking, who are quite powerful. And the Fed, to its credit, has also attempted in various complicated ways to reach out and touch Main Street, as well. The Fed is a remarkable institution in that way, and the dual mandate, the full employment mandate has allowed it that flexibility. And we remember Bernanke conditioned QE3 on 6% unemployment. No European central banker could dream of doing that.  But it is tactic, right? There's been this huge falling extension of Fed activity. We were talking about the swap lines, and between you and me, we would probably rather perhaps the issue was never raised in Congress. But it's a kind of tacit remaking of the functions of American government. And then going on in the emerging market world, there's been what I would... I think you could in a caricature say an increasingly sort of Beijing-centered model, where emerging market central banks have acquired over the last 10 years or so many of the instruments, or reacquired many of the instruments which the People Bank of China has been using.

Tooze: Very extensive macro prudential interventions, the build-up of very large reserves to handle shocks, and if necessary, interventions both to steady the movement of exchange rates and up to and including exchange controls, which both the IMF and the BIS will sign off on in bad weather.  So, we see sort of three models, and my piece about the ECB was written for in part an American audience, because it seems to me we need to have a conversation about... The problem, of course, is finding the appropriate time and place and the right political context, but from a normative point of view, rather than a sort of pragmatic point of view, it would clearly be good if we could actually debate what it is we want the Fed to do collectively. Because it does an extraordinary amount. It intervenes in every dimension of commercial life. It reaches down into everyone's everyday lives. And yet, there are people making that kind of proposal.

Tooze: The idea that why not equip every American with a Fed bank account.  So, these are ideas are out there, and the American democratic conversation has been remarkable fertile, once again. We've got everything from gold bugs on the one end to MMT people's Fed accounts on the other. But somehow it's sort of marginalized, rather than being brought to the center of the discussion, and I do wish that progressive politics, centrist politics, people like say a Biden Administration might be willing to actually have this conversation. The question, of course, is whether in the GOP and the Republicans, you actually have a counterpart for a serious conversation about governance in the United States. And that has been the problem now going back to the 1990s.

Beckworth: Well, part of this show's goal is to have that conversation, to foster that discussion, and hopefully make the world a better place on the margin. And as listeners know, one way we have talked about that is through level targeting and other reforms to central banks. But with that, our time is up. Our guest today has been Adam Tooze. Adam, thank you so much for coming on the show.

Tooze: Been a pleasure.

Photo by Mark Wilson via Getty Images

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.