From the FT today:

Michael D. Bordo is Distinguished Professor of Economics emeritus at Rutgers University, a research associate at the National Bureau of Economic Research, Distinguished Visiting Fellow at the Hoover Institution at Stanford University, and Distinguished Visitor at the Griswold Center for Economic Policy Studies. Robert N McCauley is a non-resident senior fellow at Boston University’s Global Development Policy Center and associate of the faculty of history at the University of Oxford.

 

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Dear Senators,

If you approve people to the Federal Reserve’s Board of Governors who are willing to mix political moves in with its policies aimed at stable global dollar markets, you could harm US households and small US firms. You could also convince the rest of the world that the dollar cannot be relied on. Here is why.

Every day overseas banks roll over trillions in dollar borrowing. Such borrowing takes place in a collateralised cash market for repo, where the collateral is highly rated bonds like US Treasury securities. Such dollar borrowing also occurs in the foreign exchange market. There the collateral consists of euro cash, British sterling cash, Japanese yen cash and cash denominated in scores of other currencies. (These foreign currency collateralised dollar loans, known as foreign exchange swaps, are much larger than the bond-collateralised repo loans, in part because firms report such swaps only in footnotes in their accounts.)

On 99.9% of days these dollar loans roll over silently without any difficulty. Once in a blue moon the market seizes up. It did so during the market dislocations of September and October 2008, and again in the Covid panic of March 2020.

The Fed was busy lowering its target interest rate in both cases, aiming to ease monetary conditions. But in both cases, the benchmark money market yield rose as foreign banks scrambled for dollars. US households with adjustable-rate mortgages priced off of this benchmark and small US companies with similarly-priced bank loans faced sharply higher borrowing costs. What the Fed was giving, market turmoil threatened to more than take away.

The Fed successfully short-circuited this vicious market dynamic. It turned to a simple expedient that it had pioneered in the 1960s and had used on a handful of occasions since then, including during the Six Day War in June 1967. The Fed lent dollars to foreign central banks through so-called dollar-swap lines. And foreign central banks lent dollars to foreign commercial banks.

What an ingenious solution! The Fed took only the risk of lending to major central banks. These banks in turn took the risk of lending to foreign commercial banks. US households and small businesses enjoyed the benefit of lower loan rates.

In 2008 the Fed lent about half a trillion dollars to stabilise global dollar funding markets which were 100 times larger. In 2020, with its 2008 playbook in hand, the Fed lent even less than in 2008 to ensure that its easing got through to US households and businesses. The central banks all paid back the dollars and the Fed even earned a spread.

What if something happens in 2026 that leads global dollar funding markets to seize up?

It is essential that the Fed does the job that it knows how to do. But what if doing so strikes someone in power as unreciprocated generosity? Uncle Sucker “bailing out Europe again,” to use the recent, unguarded phrase of the vice-president in a military context? Why not condition the Fed central bank swaps on tariffs, US exports or worthy geopolitical goals — as Stephen Miran, who’s confirmation hearing before the Senate Banking Committee is today, has argued?

The record of attaching conditions to central bank loans in a crisis is not good.

A salient case was the Austrian crisis of 1931. The French authorities, holding lots of golden chips, made their help for the Austrian central bank contingent on no customs union between Austria and Germany. The contingency was refused.

Crisis unchecked spread to Germany, toppling a Jewish-run bank (Danatbank) and leading to a moratorium on German international debts. The pound sterling abandoned its gold peg in September 1931.

Recent research shows that in the German elections of 1931 the National Socialists made particularly strong gains where the Danatbank had a larger presence. France realised that its clever financial plan had gone awry only later, when German Panzer divisions rolled over its border in May 1940.

The stability of the global use of the dollar requires that members of the Board of Governors understand what must be done when global dollar funding markets seize up. Were the Fed not to do what it must, reports of the death of the dollar’s global role — that have circulated without ground for two generations — could prove for once not greatly exaggerated.

Senators, history will not look kindly on your playing politics with your duty to advise and consent on Fed appointments. A wrong Fed could do the dollar in.

 

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Open letter from Michael Bordo and Robert McCauley.