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Robert McCauley on the Global Domain of the Dollar and Threats to Its Dominance
Eight questions on the markets, myths, and macrofinancial policy surrounding the global domain of the dollar.
Robert McCauley is a Senior Fellow at the Global Policy Center at Boston University and a Senior Research Associate of the Global History of Capitalism project at the Oxford Center for Global History. Robert also worked at the Bank for International Settlements for 25 years and the New York Federal Reserve Bank for 14 years, and he joins Macro Musings to discuss questions surrounding the global domain of the dollar. Specifically, Robert and David talk about how the US currency rose to prominence internationally in the 1950s, the size and influence of the global dollar zone, dilemmas imposed by dollar demand worldwide, and more.
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: Bob, welcome to the show.
Robert McCauley: Thanks for having me on David.
Beckworth: It's great to have you on. Now, we have a friend in common and that is Inaki Aldasoro and he directed me to this article we're going to discuss today, which is also the basis for an upcoming book you're going to have on the same topic and this article is the *Global Domain of a Dollar: Eight Questions.* It was a great read and it's a topic that I find some interest in myself. I've dabbled, stuck my toe in the pool of this question, but you are the expert here so I'm tickled to have you on the show today and I'm eager to get into it. Before we do though, tell us a little bit about yourself. How did you get into economics and into this field of dollar dominance.
McCauley: I got into economics by listening to my mother describe the Great Depression. As her mother said, "My grandfather took the easy way out of the Great Depression in 1931 by dying of a heart attack, leaving behind a widow with three children and one more to come, a life insurance policy, margin debt and a crooked business partner." You can take those elements and write the story yourself. But I heard of farmers destroying their crops while people in the city were feeling hungry and I couldn't figure out how this could have happened so that's what took me into economics.
McCauley: I was very lucky when I got to graduate school that Harvard allowed you to go down Massachusetts Avenue and take classes at MIT and so I had the opportunity to take the class with the late Rudy Dornbusch, but most memorably two classes with Charlie Kindleberger in Financial History of Western Europe, that was his graduate course. And then I took his undergraduate course The International Economy and at the end of that, he joked to me that he expected to see me in his kindergarten class next semester. But he had gone from graduate school to the New York Fed to the Bank for International Settlements, the BIS and I ended up following his footsteps and now I followed a third step into Academia so New York Fed, BIS, academia following in the footsteps of Charlie Kindleberger.
Beckworth: That's really fascinating so you have a wealth of experience at central banks and I guess we call the BIS the bank of central banks, they're in Switzerland. Tell me, what is it like to live there, work at the BIS, is it a beautiful place?
McCauley: It's a medium-sized city about the size of Spokane, Washington, but it formerly had three major multinational drug companies in it and it's a much more cosmopolitan place now than when I first got there in 1994. It's very good living to tell you the truth. It's right on the border of France and Germany, the wag say it's the dead center of Europe emphasizing the dead, but it was a marvelous place. I had a failure of self-insight at my going away party at the New York Fed when I told the assembled that don't worry, if I were going to the OECD in Paris, you might never see me again, but since I'm going to boring Basel, for sure you'll see me at the end of the year.
McCauley: Sure enough, I came back at the end of the year but it was to clean out my desk and move to the BIS so it was good living, good place, enjoyed it very much and had the opportunity to go to Hong Kong when they opened an office there and spent 10 years in Hong Kong. A friend of mine said, "Before you know, Bob, you'll be an expert on China." And with the emphasis on the before and that was a marvelous experience too. I feel very, very lucky in having those two employers.
Beckworth: Wow, what a story. Well, let's move to your article and again, it's also the basis of a book that's forthcoming from Cambridge University Press and maybe you can talk more about that near the end of the show. But you go through a series of questions about the global domain of the dollar and we'll provide a link to this article online with the show notes so listeners can go online and find it for themselves. Before we get into the questions that you pose, and then you answer, you provide a history of the rise of the dollar as this dominant reserve currency and you interestingly point to 1950 as an important decade in that story. Maybe share that with the listeners, why that decade?
Dollar Dominance in the 1950s
McCauley: Well, if you back up far enough to the founding of the Federal Reserve, one of the intentions was to get the dollar and securities in the dollar to replace the role of bills in London. Trade in those days was financed very much by London and the framers of the Federal Reserve Act wanted to get that business back, at least for the U.S. foreign trade and maybe for other countries’ foreign trade as well. They gave a tax break as it were, an exemption from reserve requirements for the trade bills, the bankers acceptances, and on the basis of the bankers’ acceptance, the Federal Reserve’s Policy brought the dollar to the point of parity and beyond vis-a-vis sterling some point in the 1920s, this is work by Barry Eichengreen and Marc Flandreau based on archival work at lots of central banks. And so the dollar had surpassed the leading currency of the day between wars, but then when 1931 came along, there was a big run on the dollar as it were and central banks ditch their dollar holdings and got back into gold.
McCauley: The dollar shrank as a reserve currency, sterling shrank less because of the sterling area, basically the colonies and the former dominions with the dominions so on. Sterling continued and again, surpassed the dollar. But I highlight the 1950s because that was when the dollar got out of the United States and Catherine Schenk has shown that it was in 1957 that the first dollar accounts appeared in London. This was sort of the shadow banking of the day. You could get a higher rate on your dollar in London than you could in New York, if you could accept well then who was responsible for it? And I've gone on the internet and looked at people reading BIS work on how many dollars there are outside the United States and they say, "How irresponsible of the Fed to have allowed these things out there." But I think this is a key moment in fact, when the dollar slipped out of the United States and started its trajectory towards the global currency, that is today.
Beckworth: You also mentioned the number of policy choices relating to regulation, interest rate caps, regulation queue that also contributed to the growth of the Euro-dollar market overseas so maybe talk about that for a few minutes.
Policy Choices Leading to Euro-Dollar Market Growth
McCauley: Ironically, the first impulse was somebody else's regulation. Catherine Schenk shows that there were rules in sterling in those days that meant if you could turn your sterling nominally into dollars, but with a forward transaction which really made them sterling, you could get a higher interest rate if you were a local council or some regional government in the UK. It was some regulatory arbitrage that produced the dollar accounts in London in the first place and they were really just sterling in drag.
McCauley: That was the beginning but the next thing you know, the dollar is being deposited there famously by the Russians to avoid the Treasury's reach. But after a while by central banks and there's trade being done in dollars and financed in London. And next thing you know, there are bond issues and syndicated loans in dollars and all of this neatly avoided the [inaudible] of regulations and taxes in effect. In the Fed we were never allowed to call reserve requirements a tax, but that's what they were and so there were no reserve requirements, no deposit insurance, no interest rate caps, none of those things were in London.
McCauley: That version of shadow banking 1960s style basically ate the lunch of the domestic dollar intermediation and London really arrived when the American banks realized that this was going to be really something and they showed up in London. Then when the Fed cranks up interest rates for instance in 1969, you have the Reg Q limits binding on what interest banks in the United States can pay on their CDs. And you have big U.S. companies taking their money offshore, putting it with American banks, the American banks bringing the money back in as a managed liability to finance the rundown in their own deposits because they're losing the deposits to themselves in London. You can see how you're getting around tripping through London, American companies putting their money with American banks offshore and the American banks offshore and bringing it back in to fund their domestic operations and all of that thanks to the self-inflicted wounds of the regulators of the day.
Beckworth: That is super fascinating and it raises another interesting question and that is, there's a number of commentators who look out and I think all of us do, we look out and we see that the global dollar system, somebody called it the global shadow banking system, but all dollar based that there are runs on it every time there's a major crisis. So 2008, 2020, the Fed had to step in, open up these swap dollar swap lines and make sure that that system persevered, there wasn't a collapse of the global shadow banking system and this frustrates some observers because if the Fed is effectively backstopping this global system and it allows firms to develop these dollar liabilities that are very much money and therefore runnable and so they want the Fed to reign that in.
Beckworth: Some have even suggested to me that we have like a new Basel agreement, where we try to curtail shadow banking abroad not just in the U.S. but abroad. And I've always wrestled with that because that seems to me based on the history you just told me, that emerged in part not entirely, but in part to avoid regulations, to avoid the reach of bank regulators. If we did do a new Basel agreement, it seems like maybe the shadow dollar funding would pop up somewhere else to be a whack-a-mole game. But I'd love to hear your thoughts given the history of this market.
McCauley: I think you have to be careful what you wish for. But we haven't done a very good job at home on this front. What did we see back in 2008? We saw big runs on two forms of shadow banks. We saw big runs on non-bank finance companies like GE Finance. We saw big runs on money market funds starting with the breaking of the buck by the number one or the original money market fund, I should say. And what was done about that? Well, General Electric actually has decided on its own to shrink its financial footprint and so it has stopped aspiring to be the number one bank in the country so that's progress, but what do we do on the money market fund side?
McCauley: There were various proposals of how to fix it, but what did we see last March? We saw runs on the money market funds again, that wasn't supposed to happen. And what did we see? We saw not the Treasury this time, but the Fed coming to their rescue. And so once shame on you, twice on shame on me and what prevented us from doing something was that an illustrious group of non-banks clustered in the Investment Company Institute which successfully opposed serious reform. Money market funds are essentially banks without capital and been recognizable as such from day one. They were just an accident waiting to happen. The accident happened once, we didn't do anything proper with it and with them and we have another opportunity and I hope we will, but until we can do something on the home front, there's no sense going out and talking about this to the rest of the world like we have the right answer if only they would take our right answer. We haven't come up with the right answer yet so virtue begins at home.
Money market funds are essentially banks without capital and been recognizable as such from day one. They were just an accident waiting to happen. The accident happened once, we didn't do anything proper with it and with them and we have another opportunity and I hope we will, but until we can do something on the home front, there's no sense going out and talking about this to the rest of the world like we have the right answer.
Beckworth: All right. Well, let's move to your first question that you raise in this article, again the title the article is the *Global Domain of the Dollar: Eight Questions* and we will have a link to this article in the show notes. But the first question you asked really speaks to the scale, how big is the global domain of the dollar? And you asked the question, how many dollars does the rest of the world owe?
The Size of the Global Dollar Domain
McCauley: You could ask the question on the other side, how many dollars does the rest of the world own that are outside the United States? And the answer is not all that different in fact so the answer close to $13 trillion in each case. $13 trillion worth of borrowing by non-banks, who are resident outside the United States. And that's a sizeable chunk, something in the teens percent of the rest of the world’s GDP. That's really quite a lot by any standard and it's built up over the years. It's accelerated, particularly since the Fed’s asset purchase program in 2009, it's been growing very rapidly.
McCauley: One of the purposes of that program was to keep down bond yields and make it easy for U.S. corporations to finance themselves in the bond market. Well, it worked so well. It wasn't just U.S. corporations that financed themselves in the dollar bond market, but foreign corporations financed themselves at a great rate and it worked on both margins. The biggest borrowers in dollars outside the United States from like Petrobras which is a Brazilian oil company with a large hole in the sea floor that is to start producing oil at some point in the not too distant future. They sold a lot of bonds. They were already one of the biggest issuers.
McCauley: But then on top of that, you had African governments that hadn't ever sold a bond or Peruvian companies that you've never heard of and they were able to sell dollar bonds as well to yield to hungry investors. This aggregate has grown quite rapidly. I think the first time we computed I was at the BIS, it was something like eight and change trillion and now we're up to 13 trillion and well, if that's a credit aggregate, who is the funding? Where is the money coming from? You might think that all the dollars outside the United States have to come from the United States in some ultimate sense.
McCauley: Well, that's a reasonable intuition, but it's just plain wrong. It turns out that only a smallish fraction of that 13 trillion is actually bank loans made out of the United States or U.S. investors, PIMCO’s for instance, holdings of dollar bonds issued by Petrobras or the African government or whatever. Most of the dollar borrowing outside the United States as is its corresponding element of balance sheet entry, non U.S. investors holding dollars. Where do they come from? Those dollars essentially are coming by private contracting between two non U.S. residents frequently using British law and the only thing that ever touches the United States in the modal case is the momentary payment flow when the money changes hands for some nanoseconds, it's cruising through a New York mainframe.
You might think that all the dollars outside the United States have to come from the United States in some ultimate sense. Well, that's a reasonable intuition, but it's just plain wrong.
Beckworth: So, Bob, that's a lot of dollars overseas, 13 trillion, but you've done work that shows there's an even bigger number that's in the low 40, 40 trillion amount that these are liabilities that for example, the U.S. has issued to foreigners overseas so foreigners hold treasuries, they hold maybe bank accounts or commercial paper. How do we reconcile those two numbers and what should we make? What number really gives us a sense of the scale of the total dollar reach around the world.
McCauley: Well, if you flip from one side of the balance sheet to the other and ask how many dollars do foreigners own then yes, clearly they own lots of dollars right here in the United States. And at the same time though, they own dollars outside the United States, claims on other non U.S. residents. And those two things are additive really. And the remarkable thing is something like a fifth of the holdings of dollars of investors, pension funds, insurance companies, you name it, outside the United States, something like a fifth are dollars outside the United States, claims on non U.S. residents. The number is staggering, it's like 40 plus trillion, as you say, and that's against the rest of the world GDP of around 100 trillion so something very large in relation to the overall portfolio, which might be 300% of GDP, but 40 plus percent is not trivial even in that 300% of GDP portfolio. There's a lot of dollars and a lot of them have been essentially produced outside the United States by cooperating adult non-Americans.
Beckworth: It's a staggering number for sure. Okay. You ask another question. Are there any other hidden or overlooked dollar debt contracts beyond that official number?
McCauley: Yeah, so that number, the 13 trillion is cash holdings and cash meaning the sense of a claim for money payable in the future, a bank account or a bond. But in addition to that, there's lots of dollar obligations in the foreign exchange market and part of it comes from the fact that the founders of the Federal Reserve were very successful so lots of trade, not only U.S. trade, but trade between other countries is dollar denominated. And so if you're an exporter and you're going to get dollars for something you're shipping now, you're going to get the dollars in 3-to-6 months, you might want to lock-in the exchange rate against your own currency. You might want to sell those dollars forward and we see it in exchanged domestic currency.
McCauley: But still bigger source of dollar obligations in the foreign exchange market come from the investor side. Think of a Dutch pension fund. All its liabilities are denominated in Europe. But it doesn't want to just buy Euro-Securities. Hell, the best of them are yielding negative percent at this point, that's a losing proposition, so far better to come to the United States and buy a U.S. treasury. But you want the U.S. treasury, you want the interest, but you don't really want the dollar, you want to have at the end of the day, some euros.
McCauley: Use the Dutch pension fund, enter it to the market and essentially borrow dollars by selling the dollars forward and receiving euros and when that contract matures in three months, you just roll it over, roll it over for the 10 year life of the US treasury. And so you put together the trade demand for a dollar obligations outside the United States and this investor hedging demand for dollar obligations offshore. And it's hard to be precise about it, but it's certainly over $10 trillion so it's an amount, not very different from the 13 trillion.
The remarkable thing is something like a fifth of the holdings of dollars of investors, pension funds, insurance companies, you name it, outside the United States, something like a fifth are dollars outside the United States, claims on non U.S. residents. The number is staggering...There's a lot of dollars and a lot of them have been essentially produced outside the United States by cooperating adult non-Americans.
Beckworth: Again, these are dollars outside the U.S. and they were issued by entities outside the U.S. in the case of the investors right?
McCauley: Yeah, the way you think about it is, I the Dutch pension fund promise to pay the bank dollars in three months. The way in practice I will equip myself with that obligation is by reversing the transaction with a similar transaction in 3 months and so on and so on and so on. What happened in 2008 and again, presumably last March was all of a sudden that market was seized up. And that's one of the reasons why the Federal Reserve was very happy to lend dollars to central banks in Europe and Japan in order to feed dollars into those banking systems so that these sorts of obligations didn't all come a cropper.
Beckworth: Okay. A lot of dollar assets and dollar liabilities outside the U.S. a large disproportionate number of assets are denominated in dollar form. Now there's more to the story though. You bring up another question and that is how big is the dollar zone, so geographically help us out. What does that mean?
The Size and Influence of the Global Dollar Zone
McCauley: Well, we have to be careful here because some people use the Eurozone to refer to the territory over which the euro is used as the currency. I think that's better to call that the Euro area and that leaves zone to be used in another way. I would say the Eurozone to take the analogy would include countries whose currencies are closely linked to the euro. The most obvious one would be Denmark, which has actually run a fixed exchange rate against the deutsche mark and then the euro for as long as anyone can remember. A less clear case is the Norwegians who have a clear idea of where they want their currency to be relative to the Euro. And if you read the central bank report, they talk about setting their interest rate as a differential against the ECBs interest rate. That's an intermediate case. And then maybe an interesting floating rate case would be the Polish zloty and now that's a floating currency. They've hardly ever intervened in it. But their industry is extremely, closely integrated with that of Germany.
McCauley: The car parts go back and forth across the German-Czech and German-Polish border umpteen times before the final car rolls off the line and given that integration, given the cycle similarity and the results from that integration, given the employment of Poles in the rest of Europe, the zloty trades very closely with the euro. It was not always thus, when it first emerged out from behind the iron curtain, the zloty was managed to be partly a dollar and partly a deutsche mark, partly of Swiss franc and so on, they had a basket arrangement that made it an intermediate and case between the major currencies. That's the Eurozone, would be the larger area where the euro is, if not de facto the currency as in Denmark than the strongest influence on interest rates and the exchange rate of the...
McCauley: So, what is the dollar zone? The dollar zone, you can start off with the peg countries like Hong Kong or Saudi Arabia, but then you start adding other countries where when the dollar moves against the euro, it's a fair bet that the local currency will move more with the dollar than with the euro. And so that's basically the whole of the western hemisphere, although there's a little euro influence even on the Mexican peso and the Canadian dollar these days. But historically it's been true of East Asia and South Asia as well. Russia was an interesting case when it first emerged, it was managed to be half euro and half dollar and it has since moved more in the direction of the euro which can makes sense when you look at where the Russians sell their gas and oil and so on.
McCauley: The upshot is that you can think of a dollar zone as being defined places by the United States, first of all in the countries with pegged exchange rates against the dollar and then the currencies that move more with the dollar than with the euro when those two are trading against each other to create a difference there. And so, it turns out when you add it all up, the dollar area has with quite amazing consistency, been something like 60%, two thirds of the global economy and if you think about it, that's a little puzzling, because I just referred to how both the Russian ruble and the Polish zloty started off with some dollar influence and move towards a euro.
The upshot is that you can think of a dollar zone as being defined places by the United States, first of all in the countries with pegged exchange rates against the dollar and then the currencies that move more with the dollar than with the euro when those two are trading against each other to create a difference there. And so, it turns out when you add it all up, the dollar area has with quite amazing consistency, been something like 60%, two thirds of the global economy.
McCauley: Basically what we now call the eurozone, originally the deutsch mark-zone, has moved east. The line between the dollar and the euro has over the last 15 years moved so that the euro zone has expanded geographically. But at the same time you have to remember unbalanced growth in the world economy and the Asian countries that are largely in the dollar zone were growing faster so even though the dollar was losing as the Martian looked down at the green versus the blue countries from outer space, at the same time, there was faster growth in the green parts of the world and the result is fairly stable sized dollar zone over time.
Beckworth: That's a staggering number and it speaks to the inordinate influence, and powers the Federal Reserve has, the central bank. When it sets policy, even when the dollar itself just exogenously changes in value, has this huge repercussion around the world if your currency is linked to it or the earlier points you made about all these dollar liabilities overseas as well, this huge, huge influence and so people like Helene Rey, talk about the global financial cycle, their global dollar cycle tied back to the Federal Reserve and to the U.S. dollar.
Beckworth: I'm thinking here, they have often been times when even the Eurozone has to be mindful what the Fed is doing or the ECB has to be mindful. If the Fed starts easing, easing, easing or if it's tightening even something as big and as important and as independent as the ECB on some margin is being careful as to what the Fed's doing. Because if they lose for example, export competitiveness, these German autos, for example, they don't want the euro to get too expensive. Even if they're not explicitly following the dollar, could you argue there's even more influence than that 60% through this mindful gaze that the Europeans are watching over their shoulder across the Atlantic, towards the Fed?
McCauley: Well, it's interesting in the bond market, how influential the dollar has remained. I went to the BIS in 1994, they asked me, "What's been going on the bond market?" And that year, which we may look back on from the end of this year, 1994 was a bad year for the U.S. bond markets because the Fed finally got around to raising interest rates and the sense in the market was that the Fed had gotten behind the curve, chairman Greenspan, very uncharacteristically even raised the Fed funds rate 75 basis points in a single go in November of 1994. And the U.S. bonds did terribly. Now at the same time in Europe, the Bundesbank was easing. The monetary leader in Europe was going the opposite direction and what happened to the bond markets of Europe? Well, they traded as bad as the U.S. dollar bond market and in some places like in Italy, they traded worse than the U.S. bond market.
McCauley: So, Wow. Which central bank mattered? A lot of us thought, well, the euro will come along, well that's because partly it's all chopped up in Europe and once they have a common currency, it'll be a bigger ship. And so the waves coming across the Atlantic throwing the ship around, the ship won't move much. It'll be like one of these giant passenger ships that didn't have zillions of people on them and nothing can happen to them. Well, it hasn't worked that way to tell you the truth and even in the past month or so, there've been observations that suggest that as dollar bonds get repriced, I think largely sensibly in light of the fundamental outlook for the U.S. economy, that in Europe, despite very modest, centralized fiscal impulse out of what is a very important, new fiscal union in Europe, it is very important in principle, but it is not and it's going to be big money in Portugal and Spain and Italy. Companies are lining up to prove that they have good green investments and so on.
McCauley: It's going to be big in some places, but for the aggregate of the European economy compared to what's happening in Washington, it's not large. But on some days the bonds in Europe are moving much more in sync. But that said, it is the case that there's a bigger difference than the German bond yields are negative and U.S. bond yields are one and three quarters or something so we've got like a two percentage points difference in the bond yields. That's a big, big difference in the story. All of which is to say that the influence of the dollar, to take your point essentially, that the influence of the dollar is felt even in the center of the biggest non-dollar currency, the runner up. If the U.S. is at 60, 65%, the euro tends to be at 20, 25% on various measures. And you think that would be big enough, that it got more people than we do and similar sized GDP and now they've got their own money. You think that would give them plenty of balance, but they're still looking a little [inaudible] when the waves come from North America.
Beckworth: This is a Fed being a monetary superpower, or somebody say a monetary hegemon. What's fascinating is the Fed has a domestic mandate, but it's reach is so much larger and global and the FOMC though by law has to keep their eyes on what's happening in the U.S. Now of course, they do respond to international developments to the extent it comes back to the U.S. but it is interesting to see such a contrast between what the Fed is capable of doing and often does versus where by law it's supposed to be focused its attention to and that's the U.S. All right, let's go to the next question. Is the world short dollars, is the rest of the world short dollars?
The Global Short of Dollars
McCauley: Okay. I need to set this one up.
McCauley: The setup is, we know that the rest of the world in an aggregate is long the dollar. How do we know that? Well, we look at the U.S. international balance sheet and you look at there and we've borrowed lots and lots of dollars. And some of that has gone in order to plug the deficits in the current account that we've been running so some of it is just to cover the net debt, but we borrowed a lot more dollars than necessary to cover the net debt. And what have we done with those other dollars is, we have turned around and bought foreign bonds and foreign stocks and a lot of foreign bonds admittedly are in the dollar, but not all of them unless the equities are basically all... And we've had our companies go and invest abroad.
We know that the rest of the world in an aggregate is long the dollar. How do we know that? Well, we look at the U.S. international balance sheet and you look at there and we've borrowed lots and lots of dollars. And some of that has gone in order to plug the deficits in the current account that we've been running so some of it is just to cover the net debt, but we borrowed a lot more dollars than necessary to cover the net debt. And what have we done with those other dollars is, we have turned around and bought foreign bonds and foreign stocks and a lot of foreign bonds admittedly are in the dollar.
McCauley: Basically we have on top of financing our net debt, we'd been like a bank is, as Kindleberger described famously in the mid sixties, we'd been like a bank selling dollar IOUs and going out and buying non-dollar assets and making up a tidy profit on the turn. What that structure of the U.S. balance sheet means is that the rest of the world, the one that has been lending us all those dollars in order for us to buy the non-dollars to a considerable extent, the rest of the world has to be long dollar, which means that when the dollar rises, the rest of the world must, in some Nnet wealth sense, be better off, richer and yet it's not all that pretty when the dollar rises. When the dollar rises, we tend to have financial crises in the rest of the world. 1982 comes to mind, the Russian, Brazilian problems of 1999 come to mind.
McCauley: Why is that? Well, in a certain sense, the rest of the world is short the dollar in a behavioral sense. Let's go to Korea. And there the government in the form of the central bank has lots of dollars that is bought doing intervention and so the country itself taken as a whole is long dollars. But if you look at the corporate sector, look at the banks, look at the big companies, the Chaebol, they've got lots of dollar debt and what happens to them when the dollar rises? Well, to the extent they've got dollar revenues, they're hedged, but to the extent they don't have dollar revenues, they're about hedged. And certainly their balance sheet is going to look worse after the dollar rises. Their equity will go down and their debt will go up.
McCauley: They will look more leveraged, more risky and their banks and bondholders will treat them that way. And some research showed by former colleagues at the BIS, including Hyun Shin suggests that when the dollar rises, companies that have dollar debts lay people off or cut back on investment. And so you say, "Well, wait a minute. I thought Korea is richer when the dollar is stronger? Because think of all those dollars sitting in the central bank." Well, there's no channel that takes the profits from the central bank because central bank has profits. It has liabilities in one and assets in dollars. As the dollar rises, it's smelling like a rose, but there's no channel that pumps those profits to the Korean Chaebols. And they're the ones who are doing the investment. They're the ones hiring or not hiring people. And so the country as a whole acts like it's poor when the dollar is risen, even though net-net, it is richer, and that seems to be the broad story for the whole world. The rest of the world is long dollar and at the same time acts like it's short note.
That seems to be the broad story for the whole world. The rest of the world is long dollar and at the same time acts like it's short note.
Beckworth: That is super fascinating so there's some distributional issues on who's holding the dollars, who's getting the benefits and on balance, it's effectively like the world is short the dollar. Okay. Let's go to your next question. You asked, "Does the global demand for dollars impose dilemmas?"
Global Dollar Demand and Imposed Dilemmas
McCauley: Well, almost from the get-go when the dollar first left the United States for London, that was ‘57 because it was 1959 we had Robert Triffin, a very media-friendly professor at Yale of Belgium roots. And he basically revived a story that had been told in-between the wars about the gold-exchange standard. The story goes something like this, there's so much gold in Fort Knox. Okay. And yet the way the world is using the dollar requires that the world has more dollars with each passing year to finance trade, oil the machine of international trade. And how does the rest of the world get more dollars? Well, the rest of the world gets more dollars by having larger claims on the United States said Triffin. And what happens when the claims on Fort Knox get to be larger than the value of the gold in Fort Knox?
McCauley: Well, Triffin said there'll be a run on the bank. And at that point the gold-dollar link would come under big time pressure. Now, my teacher Charlie Kindleberger thought this was wildly overstated at the time. And they're looking back historically, the bank of England operated with very little gold at all. They responded to demands for gold by hiking their interest rates. They were conducting the international orchestra in the famous metaphor. And so the bank of England operated with what the historian of Bank of England, Sayers described as a thin film of gold. And so the whole thesis that basically you're going to have a run on the bank as soon as the run would be successful if nothing else happens was a silly idea in the first place.
McCauley: And moreover the swap network was absent-mindedly invented as the international lender of last resort by Charles [inaudible] at the New York Fed. That's basically a way for the U.S. to borrow foreign currency if necessary to support the fixed exchange rate. But anyway all of that is so much history. People invent various new meanings for the Triffin dilemma and each one of them holds as little water as the next in my view.
Beckworth: All right, next question. Does the dollar confer an exorbitant privilege?
Exorbitant Privilege and the Dollar
McCauley: Well, here's another good old chestnut dating to de Gaulle’s entourage as president in France and in the late sixties. One of the minds responsible for it had a marvelous metaphor and his was this, that if my tailor accepted checks for my suits and he never cashed them, I would have a lot more suits than I have. And so his image was that the United States was handing out checks and buying stuff from Europe and Europe through its central banks wasn't ever cashing the checks that is, coming to the U.S. Treasury and saying, "We want gold. Thank you very much." No, so the central banks, instead of holding on to the checks and the U.S. was of course, ordering lots of suits.
McCauley: Now, the problem with that is that the suit in this case was not goods and services because at the time when this metaphor was applied, the United States was running a current account surplus. We might've been buying suits from Europe but we were trading them wheat and IBM mainframes and whatever else we could sell them, Boeing planes, at the same time. So we weren't just taking suits from them and giving them nothing back. What they were getting, they were getting checks from us, all right. But, what we were using the checks for was to buy equities in Europe. To buy their bonds to lend to them essentially. "Lend long and borrow short." as Kindleberger said.
McCauley: That was a game of banking, not running a trade deficit and controlling everybody just to hold claims on you indefinitely with no hope of repayment. So it was really a very cagey metaphor, but it was wrong. If we restate it properly, it would be something like this. If my stockbroker took my checks and never cashed them, when I gave him the checks in exchange for equities, I'd own more equities. Well, that may be so, but actually, if you think about the way the banking system works in aggregate, that's how people do buy shares with borrowed money all the time. And sometimes it works and sometimes it doesn't.
Beckworth: Okay. That's the exorbitant privilege and your point is it's not so exorbitant and if there is a privilege, it might be something small or non-existent-
McCauley: At the time it was coined to go beyond that history that we were not running trade and current account deficit. We since have run it but there's not a lot of evidence that the econometric passes on the question of what should the U.S. current account deficit be. It is bigger than the cross-sectional and time series analysis would suggest. So there's a series of errors in the estimates that are based on demography and fiscal stance and sort of fundamentals. There is a puzzle in why the U.S. has run, since the mid '80s, as large deficits as it had. One of the stories for that is the reason it has is because the rest of the world central banks had been buying dollars and so they've been forcing us to run a deficit. That would suggest that if you took the years when there was particularly heavy intervention, dollar buying by foreign central banks, you'd find that those were years where you get particularly large U.S. current account deficits.
McCauley: There'll be some matchup in those time series. That's not there, that's not in the data. That doesn't work. It's not at all obvious that foreign central bank buying of the dollar which tends to happen in fact when the dollar is weak, is not associated with pushing the dollar stronger. It tends to be a defensive reaction to the weakness of the dollar. That there's no evidence that is the predictor. And the other things that people think of with exorbitant privilege or people holding $100 bills outside the United States, that's certainly a gift, but it's a very tiny gift.
There is a puzzle in why the U.S. has run, since the mid '80s, as large deficits as it had. One of the stories for that is the reason it has is because the rest of the world central banks had been buying dollars and so they've been forcing us to run a deficit. That would suggest that if you took the years when there was particularly heavy intervention, dollar buying by foreign central banks, you'd find that those were years where you get particularly large U.S. current account deficits. There'll be some matchup in those time series. That's not there, that's not in the data. That doesn't work.
McCauley: They say, "Well, the U.S. gets to borrow in its own currency." Well, only advanced countries borrow in their own currency, that's perfectly normal. They say, "Well, the Treasury borrows at lower rates, because all these foreign central banks hold dollars and dollar bonds." And that may be true too, but we started off talking about how much borrowing there was in the dollar by the rest of the world. If U.S. 10-year rates are lower than they might be because of foreign demand for U.S. bonds, then the rest of the world gets to join in that game by selling the same 10 year bonds so it's not a privilege if it's shared.
Beckworth: You're saying that $13 trillion we talked about earlier that's overseas, they too are benefiting to some, to the extent there isn't benefit.
McCauley: If there's a thumb on the scale of the U.S. bond market-
Beckworth: They're getting it too. Yeah.
McCauley: It’s not just the U.S. that's profiting. Another version of the exorbitant privilege and this really dates back to the 1960s, was the idea that the U.S. banks would have a home court advantage in doing international finance, because they had access to the Fed and they had natural deposit bases in dollars. The foreign banks have a hard time coming up with dollars to lend in the first place. And you think there was something to that, but in fact, the U.S. banks share in dollar banking internationally has been on the low side. It's tended to be that the German, French and Japanese banks have bigger shares over time than the U.S. bank so there's no strong evidence for the home court advantage story. Certainly at the margin it can't hurt the big U.S. banks, but if in fact by global standards, they are pretty domestic operations.
In fact, the U.S. banks share in dollar banking internationally has been on the low side. It's tended to be that the German, French and Japanese banks have bigger shares over time than the U.S. bank so there's no strong evidence for the home court advantage story. Certainly at the margin it can't hurt the big U.S. banks, but if in fact by global standards, they are pretty domestic operations.
Beckworth: Okay. Let's go to your next question, and there you asked this, is the domain of the dollar getting too big for the Fed to backstop.
Is the Domain of the Dollar Getting Too Big?
McCauley: Well, this is a variant of the Triffin story, right?
McCauley: The Fed is thought to be capable of backstopping markets but that capacity only grows as the U.S. economy grows, but the whole world is using the dollar and the whole world is growing faster than the U.S. so at some point it just gets beyond the Fed. I think the evidence from 2008, where the Fed had a half a trillion dollars on loan to central banks and the rest of the world and the evidence from this time last year when the Fed had a smaller amount outstanding, the Fed is prepared to step up to the plate and do what's necessary with the central banks it's prepared to do business with. And so there's no obvious limit demonstrated in what the Fed has done in the way of backstopping the dollar’s global role.
The Fed is thought to be capable of backstopping markets but that capacity only grows as the U.S. economy grows, but the whole world is using the dollar and the whole world is growing faster than the U.S. so at some point it just gets beyond the Fed.
McCauley: There is an instrument question because when you look at those offshore dollars, they're about half and half bonds and bank deposits and so what's the Fed prepared to do for dollar bonds issued by the rest of the world? And you remember about this time last year, the Fed was announcing interventions in the U.S. corporate bond market, not just the Treasury and agency bonds, but it was announcing that it was going to have a program or purchases of corporate bonds as well. And you might say, "Well, that was very domestically oriented. We got this trillions of dollars of dollar bonds issued by non U.S. companies and governments. What's the Fed doing for them?" The answer was nothing, but if you look at those announcement effects, they had great effects in the U.S. corporate bond market as intended.
McCauley: The original announcement had to do only with investment grade corporate bonds, but yet the announcement effect was even larger in junk bonds in the United States. And it was also quite large in dollar bonds issued by non U.S. companies and governments. The actual narrowness of the focus of the Fed’s intervention doesn't seem to be as important as the fact that it's wading into this asset class and in the world of investment, that Brazilian bond is competing with other double B rated bonds issued by U.S. companies and [inaudible] or whatever. And the substitution between the international and domestic is strong enough, so that you see immediate effects of the Fed wading in. Before last March, we were not sure what the Fed would do, if there were something like a run on the corporate bond market. And we learned that the Fed was prepared to backstop that and what we also learned is in backstopping just the U.S. piece of the global corporate bond market, it was backstopping the other bits, too.
Beckworth: That's an interesting observation because we've had this debate on the show and then other places, if you go through the list of facilities the Fed used last year, some people... And I'm sympathetic too, they draw a line between liquidity facilities and credit facilities and that corporate bond there sits right in the middle. You go down to the state and municipality facility, the main street, many would argue, you're getting into hardcore fiscal policy. It's more of a credit facility. On the other end, you look at the money market facilities, it's definitely going to be a liquidity facility. Where does that corporate bond facility sit? And I think the story you just said would paint the picture of it being more of a liquidity facility, at least initially during the crisis, it prevented a run on the global dollar bond market.
Beckworth: You could argue, at least it served the purpose of being a liquidity facility, more so than a credit facility. And maybe later on, you could maybe make some arguments about the junk bonds and stuff, but there was this interesting discussion going on so it's interesting to view the international angle to that and I think that's important. Also, just one other point on this, I would second your statement that and the Fed is very capable. We've seen it. We've seen these facilities and I would argue if anything's gotten stronger, going back to your earlier point about the Fed being the super power. The Fed can step in, it has this ability. The fact that it's used these facilities, it's only strengthening that dollar network on the margins.
Beckworth: I think it's a great question and again, I see the Fed, if anything, it's getting stronger and its footprint is growing around the world. That gets us to our last question, and that is well, okay. We've covered all these questions. The dollar seems pretty sound. What really could be something that would jeopardize the dollar’s global domain and you bring up two potential areas. One is the weaponization of dollar dominance through the over use of sanctions by the U.S. government. And then also the politicization of Fed backstopping these dollar funding markets like we just talked about so maybe walk us through those two concerns.
Two Threats to the Dollar’s Global Domain
McCauley: Well, to take the second one first, again the point I just made, it applies that while scholars like Ricardo Reis have written very nice papers that show that when the Fed announces that it's prepared to do swaps with central banks, x, y and z, but not other central banks, the currencies of the treated central banks, the accepted, the partner central banks to act differently than the currencies of the central banks not in inside the circle, but the same observation as before applies that every, the liquidity or the proper pricing in all of the foreign exchange markets. improves. It improves more where the Fed is actually putting cash on the barrel, but it improves across the market.
McCauley: That said, the Fed is drawing lines. It drew exactly the same lines in March of 2020, as it drew back in October of 2008, the same central bank, same group of central banks. And there have been whole papers written on how they chose the ones they chose and how they excluded the ones they excluded. But I think the long historical point to be made is that when the dollar first got out of the United States, it was pretty much to be found in the main economies of the time, the so-called G10, which included Switzerland. And there were neutral countries included like Switzerland and Sweden, but by and large, the dollar domain was countries that were allies of the United States.
I think the long historical point to be made is that when the dollar first got out of the United States, it was pretty much to be found in the main economies of the time, the so-called G10, which included Switzerland. And there were neutral countries included like Switzerland and Sweden, but by and large, the dollar domain was countries that were allies of the United States.
McCauley: There were multi-dimensional good relation strains, but family fights rather than real fights, but now the dollar is used. And I think that the figure is something like 87% of use of the dollar is in the countries whose central banks got the swap lines. It's still predominantly the case that the dollar’s domain is in countries where the Fed feels itself able to lend, but that's a 13% and growing share of dollar domain where the relationship is not necessarily well-defined or perhaps even has elements of challenge or including non-cooperation or call it what you will.
McCauley: There is a danger and admittedly, the countries that are not in the circle have their own dollar resources. And so they are self-insured to a considerable extent, whereas bank of England essentially has no reserves at all. People's Bank of China has trillions. There's a difference in the self-insurance and therefore a difference in the vulnerability, if the U.S. we're not to help out. But there's at least a risk where the dollar’s domain is larger than the warm feelings. And that brings us to the other risk, which is the weaponization of the dollar. And I'm just getting into this. I'm not anything close to an expert on it, but I do observe that recently there've been sanctions going in various directions.
McCauley: The Europeans have put sanctions on some of the countries that the U.S. has put sanctions on. Those countries have replied by putting sanctions on the Europeans. And so it seemed there for a while that the sanction business was very much a U.S. monopoly, but now it doesn't look that way to me anymore. But the fear is that basically you use the dollar to punish banks for operating with South Sudan or whatever some black bulb, blacklist country. And the next thing you know, you've encouraged countries or whole currency areas to invent their own alternative infrastructure. And it might be very expensive. Might have high fixed costs, might have very uncertain outcome to make those investments.
McCauley: But if you make it look like you're a fairly unrestrained in your use of the dollar’s position to accomplish diplomatic goals, to have responses that look cheaper than shedding the blood of your own soldiers to respond to various fronts, well, then you do encourage that investment. And once the investment is made, we could be in a different world. So how big a threat that is, I can't say now, but that it is a threat, I think it's safe [to say].
If you make it look like you're a fairly unrestrained in your use of the dollar’s position to accomplish diplomatic goals, to have responses that look cheaper than shedding the blood of your own soldiers to respond to various fronts, well, then you do encourage that investment. And once the investment is made, we could be in a different world. So how big a threat that is, I can't say now, but that it is a threat, I think it's safe [to say].
Beckworth: Well Bob, we're reaching near the end of the show and I want to end by just asking, where does this project stand? What are you working on as well related to this topic? Where do you see it going?
McCauley: Well, you kindly mentioned that Cambridge University Press is going to publish this particular effort. The other project I'd like to highlight before we close is that I have inherited, if that's the right word, the writing of the eighth edition of *Manias, Panics and Crashes.* There's a book that I watched Kindleberger finish when he was still teaching at MIT in 1978. He did four editions and Bob Aliber did the fifth, sixth and seventh edition.
McCauley: These are two great economists from whom I have learned a great deal. And I'm very proud and somewhat humbled to step in. The world keeps producing more crazy things all the time. Kindleberger has a line about during the South Sea bubble. It was an undertaker saying that he had an undertaking of great importance that would be described later to investors and he took 2000 pounds from them and then his secret was safe from the investors because he failed to show up to the meeting where he was going to explain what their money was going to be used for. But we always thought this was just wild, that people would hand money to somebody for purposes to be later revealed. But exactly, that is going on with these SPACs, special purpose acquisition vehicles. Trust me with your money, I'll tell you what I'll do with it later. And people just can't get enough of it. It'd be hard to keep this book down below 1,000 pages the way the markets are operating these days.
Beckworth: Well, that sounds exciting and we look forward to it. We'll have you back on the show when you get those books finished. Our guest today has been Bob McCauley. Bob, thank you so much for coming on the show.
McCauley: You’re very welcome David. Thanks for having me.
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