How 2008 broke the Eurodollar banking system & crushed growth
When the banks won't lend we all pay the price
Disclaimer: I’m not an expert, I’m merely a person who has a keen interest in the banking system. To that end I’ve spent a not-insignificant amount of time trying to figure out how this beautiful mess works (or doesn’t, as the case may be). Please don’t take what I’m about to say as gospel, rather view it as a starting point for doing your own research. Let’s begin.
Why the financial system worked better before 2008
The Eurodollar system is a network of offshore banks and money dealers that create dollars and lend them to whoever needs cash. The Eurodollar system, in conjunction with domestic banks (American banks), is responsible for creating money. As I wrote in an earlier article, central banks don’t create money. Central banks only manipulate short term interest rates, do QE, and set expectations policy in a bid to get commercial banks to create more or less dollars.
The Eurodollar system started halfway through the 20th century and quickly picked up steam. After the end of the Vietnam war the world was in a unique place. Cold war antics aside, ~1970 to 2008 was a time of nearly unknown peace and prosperity. With America’s navy patrolling the seas there were no major wars. Shipping lanes were protected for everyone and even the weakest nations could become manufacturing and export hubs. Globalization! And throughout it all, the growth of the Eurodollar. Countries everywhere needed money to fund growth, and the Eurodollar network expanded to fill that role.
Speaking of growth, look at how the world changed from 1970 to 2008. My god! China went from a backwater to a major player, the United States built roads, airports, high-tech manufacturing, etc. Dozens of countries moved up the economic ladder. Everywhere you looked there was tangible proof of people improving their lives and giving their children a brighter future. The great industrialization, and later digitization, of the world.
Growth was made possible by funding from Eurodollar banks and money dealers, and these institutions were happy to lend because they were greedy! They wanted to expand their balance sheets and fund the expansion of the world, because who wouldn’t? The Eurodollar network participants saw global prosperity, and the prospects for even more growth in the future, and they wanted to earn a spread on it. Money flowed freely, and it was good.
Unfortunately, what had worked for decades stopped working in 2008.
The GFC (Great Fucking Crisis)
In 2008 everything went to hell. As Jeff Snider will never get tired of pointing out, the GFC wasn’t really about reckless homeowners, per-se, it was a collateral shortage. The financial institutions took all these mortgages, bundled them up, sliced and diced them into tranches and sold them as MBSs (Mortgage Backed Securities). The MBSs began to see use as collateral in the financial system, and this certainly didn’t end well. Homeowners started defaulting on loans and it turns out that MBSs weren’t structured that well. If a certain percentage of homeowners defaulted on their mortgage, the MBS became worthless.
As the value of MBSs fell off a cliff, a bunch of financial institutions had to scramble to find new collateral. There wasn’t enough collateral to go around and until the Fed saved the day, there was a serious risk that the financial system was going to go boom.
Post 2008
I know that I haven’t given a great account of the GFC, however, for the purpose of this article it doesn’t matter. All that matters is this key point: 2008 scared the hell out of banks and the Eurodollar money lenders. For the last five decades this system had by and large known nothing but growth and good times. There were some crashes, that’s true, but they hadn’t been systemic.
2008 was a whole different beast, since it revealed the fallibility of the financial system. Where before the lenders had been motivated by greed (lend more and earn those sweet returns), now they were held back by fear. Banks no longer wanted to take risks and lend into the real economy, they didn’t want to do their job and fund growth.
Check out this video, starting at 43:00.
Recognizing that the banking system had stopped lending like it used to, governments the world over enacted policies that they hoped would force lending growth.
ZIRP (Zero interest rates)
NIRP (Negative interest rates)
QE
The idea with lower interest rates is that it will make borrowing more attractive, so more people/institutions/businesses will do it. Growth, please! As for QE, central bankers hoped that if they took government bonds out of the financial system it would force banks to earn a yield by lending instead of investing in USTs.
Unfortunately, none of these policies has worked so well. Ultra-low interest rates may indeed increase demand for borrowing, but if the financial institutions are unwilling to lend (too much perceived risk) then it doesn’t matter how much demand there is. The same goes for QE. Central banks can deprive the system of high quality, yield generating assets, but that doesn’t mean that banks will go risk on. The way our system is currently structured, there is only so much that governments can do to force institutions to increase lending.
In summary…
We have a financial system that doesn’t want to lend money into the real economy. Banks don’t want to take risks on entrepreneurs and risky business ventures. It’s understandable why these institutions are risk averse after a near miss in 2008, but without their lending we find it much harder to achieve real economic growth.
Solution?
Two thoughts.
One: we completely reinvent how bank lending works. I honestly don’t know what this would look like. Maybe it’s government backed loans? Banks are mandated to lend into the real economy? Some kind of blockchain solution that makes it easier for lenders to connect with good borrowers? I don’t know, I’m guessing.
Two: this idea is taken straight from Richard Werner and 100% of credit goes to him. We need lots of small banks in communities all over America (or, whatever country). Small banks that are not involved in financial speculation, but that are tasked with lending into the community to fund entrepreneurs and businesses.
This is not a radical idea by any means. Richard Werner has done fantastic work showing how Germany’s decentralized bank network has been instrumental in helping German SMEs to become dominant. Richard even argues that a good part of Germany’s competitive advantage is their banking system.
Endings are always painful
This article reflects my best understanding of what’s happening, why our lending system used to work well and why it’s now broken. If you believe I’m wrong in any aspect, please tell me! My desire is to have the best possible understanding of what’s going on. If you want to learn more about the Eurodollar system and bank lending you should consult with the Jedi Master, Jeff Snider over at Eurodollar University.
