This One Diagram Explains Why the World’s Economy Is Breaking

The Bretton Woods Monetary Arrangement, which was set up during World War II, was meant to shape post-war prosperity. And it did, initially, playing a key role in pulling the globe out of the Great Depression and its horrific aftermath. It had called for America to back an increasingly global system with its own stores of national gold. This would theoretically allow American currency to be the real medium that actually circulated in payments. Gold doesn't move well and was only meant to be a check on the supply of that medium. It didn't take long for many to realize this wasn't going to work. Economist Robert Triffin said the demand for currency to pay for rapidly increasing trade and economy far outstripped the Bretton Woods base of gold reserves. While America had the most, it still wasn't nearly enough to meet the voracious demand for monetary medium. Triffin called it a paradox. When it was really just poor design, unsuitable for the needs of the increasingly interconnected world, few at Bretton Woods had seen coming. The entire planet was evolving. It had already changed, and this brave new world needed a monetary system that could evolve and grow with the global economy as it evolved and grew. Gold simply wasn't flexible enough. It wasn't mobile. The free market had steadily moved away from rigid store of value money for decades, centuries before this. Ledger money had already come to dominate national currency in America and beyond, long before the breakdown in Bretton Woods. Why not extend ledger money to solve this great international need? What would arise from Bretton Woods during Bretton Woods was this Eurodollar system, ledger money gone global. Because it was virtual currency, a form of ghost money. Eurodollars could connect the whole world together by integrating local, national, and international ledgers. It was a system which resembled a computer network, an elegant solution to Robert Triffin's paradox. Virtual currency would be created, then transacted through the network, whose real purpose was to supply, then move that virtual currency when and where it could be best used. This ghost money would be borrowed and relent from bank to bank to bank until it finally reached its ultimate productive destination. It would flow through the multiples of interbank transactions. Anyone wanting to participate simply had to connect to the network. Once they did, they'd be able to conduct commerce and financial business anywhere in the world with anyone else operating within this Eurodollar framework. But there was still a major problem. While the promise of ledger integration meant being able to connect, say, Swedish banks with their counterparts in Japan, there were still barriers, including the obvious ones. Banks in Sweden knew very few Japanese firms. And since monetary flow depended upon borrowing and relending from one bank to the next, there had to be some degree of trust, at least some familiarity between them. That would be incredibly difficult given the scale and scope. To have money be able to flow all across the face of the planet, and do so through interbank channels, would necessarily mean bringing together thousands upon thousands of banking institutions from every global corner. How could banks who never even heard of one another before be able to seamlessly and efficiently borrow and lend with each other on a moment's notice, and be able to do so without giving it a second thought? There had to be a shortcut, a way to close that gap like closing an electric circuit and allowing currency to flow almost naturally like current and wires. And there was. An answer delivered by these very same international bankers who had worked around Triffin's paradox. They would take something that already existed, had a long-standing history, and adapt it to suit the purposes of international monetary flow. Triffin's dilemma wasn't entirely about what money the system could supply. The other half, a necessary half, was in getting it all to move elegantly, efficiently, productively. In the spring of 1940, legendary physicist John Wheeler was trying to figure out why electrons were all uniform. Protons and neutrons were different and proved to be varying combinations of quarks. Why not electrons too? After all, matter isn't possible without all those tiny bits flying around atoms. Lacking electrons, the universe doesn't work. So what Wheeler proposed was that maybe the reason electrons all look the same is because there is only one of them. This one-electron universe idea was an attempt to understand how seemingly one elemental object could end up being so critical to the function of everything else. And not just for individual atoms, the entire universe. According to this wild idea, the whole cosmos would contain a single electron. This lonely spark would flow back and forth in both space and time. An electron moving forward in time and its antimatter counterpart positron going backward. So that all matter was made possible by a singular standard object with unchanging properties flowing wherever and whenever it needed to be. While Wheeler's novel concept proved to be just that, famed physicist Richard Feynman credited the idea with helping him develop his path integral diagrams. Even if Wheeler's one-electron universe didn't work out in reality, the idea is an interesting way to look at the possibility for where and when a relatively scarce number of objects may be able to do a whole lot more than otherwise might seem possible. And since Dr. Wheeler is credited with coining the term black hole, obviously he already holds a special place here at Eurodollar University. What Robert Triffin was puzzling over had been something similar to Wheeler. How to get a few of one thing to be able to accomplish a whole lot more. In the case of the world's reserve currency, it was adding another fundamental element, like adding electrons to nuclear components and letting them flow in order to make atoms. Doing that for a reserve currency would make it incredibly effective because of what a reserve currency truly is. Commercial buyers and sellers from opposite sides of the world seeking to trade with one another, yet coming from different systems, traditions, laws and regulations, even totally separate currencies. The only efficient way to connect them was through a common medium, an intermediary or vehicle that was both accepted and useful on both ends. As Triffin surmised, this couldn't be U.S. dollars. That was his paradox. Instead, it would have to be something different, and the world chose Eurodollar ledger money. While that solved the one problem of what kind of money would be supplied, it still left just as great of one figuring out how to get it to flow all over the entire world. Reserve currency means movement, but ledger money doesn't necessarily flow all that easy on its own. Like a proton, which isn't really anything more than an inert combination of quarks, there needs to be the electron to make it something. The answer wouldn't come from some government authority, though. Unlike Bretton Woods, which was poorly designed from the top down, the solution to monetary flow came from the bottom up, pieced together from what was already available. Ledger money can work well entirely on its own without additional elements in relatively small areas. It can easily circulate between those in a very small, very familiar group. This kind of limited ghost money had popped up from time to time throughout the centuries to begin with, always constrained to small locations among limited networks of merchants very well acquainted with one another. They would transact, borrow and lend as necessary on faith and reputation. And so it was a difficult, if not impossible, task for early ledger systems to be able to scale up beyond their relatively small reach. For a worldwide reserve currency, scalability wasn't an option, though. It was the entire point. As Bretton Woods broke down, the need for the Eurodollar to shed those long-standing ledger limitations grew as worldwide demand for the medium did. The global free market turned to the small group of bankers who would supply and regulate the creation and flow of this early Eurodollar ledger money. But as demands on that system scaled up exponentially, those bankers realized these historical limitations would be binding without a major stroke of invention. If intimate knowledge and reputation were the key components to primitive ledger systems, then scaling ledger meant substituting for what were really elements of trust. Therefore, if trust was this essential in order for this kind of money to flow, rather than demanding everyone inside the system know and trust everyone else in it, a near-impossible task, why not simply substitute one common ingredient everyone already did know and trust? Fortunately, the answer was already in reach given the style of banks these ledger money purveyors had been. They would dip back into the securities business to rely on financial collateral as a flexible medium of trust. As the post-war world grew more and more interconnected and globalized, we'd bring together financial intermediaries, ledger network nodes of connection, from all around the globe. Banks of all shapes, sizes, and types by necessity for the world's first truly international reserve arrangement. By introducing collateralized transactions at scale, these wildly varying institutions needn't be a daunting challenge. Substituting collateral for reputation meant all anyone had to be assured of was that collateral. It didn't matter what kind of bank was on the other side or what its function and standing. To ledger money providers, they all began to look very nearly the same no matter what. To work as a substitute for trust, the collateral at the center of this operation had to be as close to impeccable as possible. It was to stand in for a top-notch risk-free reputation. Given the historical significance and depth of government bond markets, for euro-dollar ledger money, only U.S. treasuries would fill this monumental need. Banks from around the world could enter the euro-dollar marketplace and fit easily within it by posting treasury collateral. Anyone lending euro-dollar ledger currency wouldn't need to know anything about the borrower on the other side. By putting up treasuries, lenders' need for trust and assurance was fully substituted and satisfied. It didn't matter who was on the other side. From the system's perspective, they all looked like treasury collateral, and that was more than enough to break down the traditional limitations of prior ledger money systems and finally solve this one great constraint. At an individual level, the way in which money flows is through something called a repurchase agreement, or repo for short. The cash borrower is matched with the cash lender by the euro-dollar network. The borrower sells the collateral today for the ledger cash it needs while also agreeing ahead of time to repurchase the bond at a future date, sending back the borrowed cash plus some interest. From the lender's perspective, this is called a reverse repo, or in some cases a resale, and it is exactly the same as before, only here the cash lender buys the bond today and agrees to resell it at the future date, getting its cash back plus interest. And if this seems like overly complicated terminology and a legal structure for what is really a straightforward collateralized loan, we can thank the Federal Reserve for it. The Fed had played an integral part in the early repo market, encouraging its development and that of securities dealers dealing in government debt. Because the Federal Reserve Act forbade the central bank from directly funding what were considered speculative activities, in order to first help sell liberty bonds, the early Fed worked around the law by outright purchasing those bonds from dealers while agreeing to sell them back at a future date. Thus, the Fed could lend on a collateralized basis but also classify it as a purchase and sale transaction for statutory reasons, thereby playing a critical early role in repo. While that left quite a few complications to be sorted out for the Eurodollar era, let's call them growing pains, by the time the Eurodollar came calling, repo had already been a dependable method to exchange collateral and cash. This is a hugely important part of repo. Notice how the cash borrower is at the same time also collateral lender, and how the cash lender is also a collateral borrower. It's almost like Depositron being an electron moving backward in time. The cash lender is also a collateral borrower going in the other direction. There are times when that is the most essential part to making ledger money mobile, because collateral itself has to flow in order to get currency flowing. Now, collateral flow was and remains necessary because there was one last hurdle to overcome. And again, it's about scale. The application of collateralized arrangements began to spread as the Eurodollar system took hold and then took off. As it did, while the adoptions of collateral flow via repo had solved scalability for the demand side of monetary circulation, the reserve currency also had to conquer the equally daunting limitations where it came to supply of collateral. This is where the real secret to money flow comes in, and why collateral is itself a currency in its own right. If there isn't enough collateral to meet the gigantic demand for Eurodollar money, bank operators will simply manufacture it. Think about it this way. If the total demand for ledger currency circulation is something like 10 trillion, just as a hypothetical, even if there was an enormous 1 trillion in treasury debt available to be used as collateral, it still wouldn't be anywhere close to enough. To fill that gap, the system will effectively clone what treasuries are available through securities lending. The biggest dealer banks take the limited amount of collateral and create however much might be necessary in order to match the demand for ledger money circulation. But this is no easy task, and it's the source of much difficulty and pain as we'll see later on in this series. But the truth of the matter is quite simple, no matter how complex it is to achieve. To make mobile money scalable in order to reach the global proportions the world needs, this is, or was, the only way to do it. Without collateral, ledger money wasn't useless, but it couldn't otherwise move in the way it had to. Cash by itself had always been largely unproductive and inert. It languishes, and so too would a world economy bursting with potential, begging for the means, the medium, to truly set global prosperity free for the first time in history. Mobilizing currency on this planetary scale means mobilizing collateral. Every time cash needs to move, the system will clone collateral in order to fill that need. The result has been a near almost binary nature to monetary circulation. It's nearly the electron and positron in John Wheeler's universe, cash moving in one direction and collateral the other. Together, the system had overcome numerous historical challenges, overtaking Bretton Woods by one elegant truth. This framework made the Eurodollar the most useful currency system the world has ever seen. And it is no accident humanity experienced a period of previously unimaginable widespread prosperity as its binary mobility expanded commercial and financial reach and the ability to connect basically every corner of our planet under a single reserve umbrella. Now, the analogy isn't perfect, yet we can't help but notice key similarities. Matter in the universe can't happen without the mobile electron giving atoms substance and building molecules like expanding networks to attain enormous macroscopic scale, transferring energy, making life itself possible. This may not be the fanciful vision John Wheeler once theorized, but it does share these basic fundamental insights. Physical matter is a combination of elements, including the standard electron. Modern ledger money is also an amalgamation of various different fundamental pieces. It is nothing like what economics textbooks describe. Those focus on currency supply and even then get it wrong, focusing on fractional reserve banking rather than bank-centered ledger money. That and its promise are far more complex. Its most critical properties and parts surround circulation, flexibility, and elasticity. To make this all work requires going beyond what had been done before, embracing innovation, expanding with new ideas, experimenting through untested means and methods. It took enormous resources and energy to make it all work using the tools that were available at the time. To create a system that could achieve what previous generations had always hoped for but never thought it practical. Therein lies the trick. For all the legitimate good money of motion had unlocked, there's also the bad which always comes along with any complex human system. Like the rest of us, bankers are not angels. The euro-dollar world they created served its purpose and then some. Making ledger money workable, it required testing methods, but nothing lasts forever. The critical element which made it all possible was always its weakness. Just like cloning animals can lead to genetic problems in later generations, cloning collateral had opened a Pandora's box of negative consequences. That's exactly what we'll explore starting in part two of this series, the downside of collateral currency.