Moral Hazard, part six

Today's financial news provokes yet another digression from me on the origin of the Eurozone. Don't expect this to match official histories.

We have been asking what is this stuff called money, without pinning it down. One common assumption is that money is something issued and regulated by a government. This assumes a political entity must exist before the currency. This is not always true.

In the 1950s, there was a Soviet bank in the U.K. which backed a substantial part of the Soviet Union's trade with western governments. One problem it had was that scarcely anyone outside Soviet control wanted to accept rubles. To pay bills to others it had to keep accounts denominated in hard currency, which at that time meant dollars.

As long as payments from western firms or governments in dollars went into those accounts before other payments came out, everything was conventional. Then one day another bank needed an interbank loan denominated in dollars, and the Soviet bank offered to make it.

Remember what I said about loans causing money to be counted twice? That loan effectively created dollars not originating from the U.S. Treasury. While the bank in question was in the U.K., and its transactions in pounds were subject to British regulations, transactions in dollars were not as simple. Regardless, that loan went through, and the sky did not fall.

What international banks learned was that they could make loans in currencies not directly controlled by their government. There were and are numerous regulations about currency speculation, but a straightforward business loan seemed to be legitimate. It could also be profitable. Soon there was a thriving business in "Eurodollars".

Because these dollars were not under the control of the U.S. Treasury and the Federal Reserve System of central banks, there was considerable concern in the 1980s about the "Eurodollar overhang". What would happen if all the holders of these dollars tried to redeem them in the U.S.? How do you tell which dollars are more real than others?

The situation was bad enough if you had to negotiate with central banks in major European countries about the multipliers they allowed on accounts measured in dollars. What about offshore banks in places like Sark or the Cayman islands? ("Offshore" may also apply to landlocked Andora. In that case the isolation is political.) In some cases the sky was the limit. What's more, reporting requirements for these banks were not adequate to tell what was going on.

A major part of the answer was to create a regulated currency for Europe, the Euro. This required the creation of a political entity which no previous negotiations had ever succeeded in creating. It was not exactly a country or an empire, it was the Eurozone.

Meanwhile, trade in offshore banks outside the reach of regulators continued to flourish. If you were Meyer Lansky you could even set up your own offshore bank, which was a great help in laundering money.

One sidelight on another economic crisis turns up when we note that Enron ("The Smartest Guys in the Room") made extensive use of offshore banks. My own rule about financial due diligence would have caused me to withdraw any investment in Enron as soon as I realized a major part of their business went through institutions where regulation and reporting was lax. If I couldn't understand what they were doing, even after making an honest effort, that wasn't my problem so much as theirs. For some reason, this makes me an unusual investor.

I can't credit myself for great skill or foresight, during the last 20 years I have been unusually aware that cognitive deficits crippled my thinking. It is far too easy for fast talkers to outwit me. Because of this, I have stayed out of two cycles of boom and bust.

Tomorrow, barring still further excitement, I really will try to pull all these thoughts together.


Since I began this series of posts, the stock market has fallen about 10%, though I decline to take responsibility. Other surprises keep popping up by the hour. I feel better about my inability to define the value of money, seeing that others are having difficulty.

One surprise comes from Switzerland, where capital fleeing dollars and Euros has sought refuge in Swiss francs. This has pushed the price of Swiss products so high that Swiss exports have almost stopped. Tourist business is also way off. Financial prudence has caused a large part of that economy to grind to a halt. I feel sure they will find a way out of this quandary.

Italy appears to have its own Tea party, which will push through a balanced budget amendment even earlier than previously proposed. Unemployment there remains under 10%, so that economy is still functioning, albeit poorly.

Spain is also saddled with large debts, and has over 20% unemployment. This is a classic recipe for disaster. Who can come to the rescue? Stay tuned.

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