Ireland and the Shadow Banking System

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Ireland and the Shadow Banking System

Bretton Woods and the Eurodollar Market

Conor McCabe

Bubble2Ireland is a tax haven1.  It is a hub in the shadow banking system.  The dominant form of business in the Irish state, the one to which national economic policy shapes itself, is that which accommodates the needs of foreign capital and finance, to the detriment of productive and social activity. This business model is an intermediary model. It is conducted by a middleman class which has positioned itself between foreign capital and the resources of the state. These middlemen are found within law, accountancy, stockbroking, banking and construction.

This is not to say that every successful business in Ireland is a middleman business, but rather that these businesses wield the most influence regarding national economic policy. The type of middlemen may have changed over the decades, but the way of conducting business has not.

The intermediary/middleman business model maintains and reproduces itself through the structures of the state. In other words, the class which benefits the most from this economic policy is also the class with the most influence over the dynamics of Ireland’s legal, education and political systems. Governments come and go but the structural dynamics of the state remain the same. As a result of the structural presence this class has within the state, policy change comes dripping slow.

The current privileged status of international finance and wealth management within Ireland – that is, paper assets over production – is the latest field of play for this middleman class. Upon independence it was live cattle exports to the UK and the transference of credit to the city of London; in the 1960s it was free access to the UK economy for international companies with branches in Ireland, followed by similar access to the EEC/EU, giving rise to construction, land and property speculation; all of this was underpinned by the selling of the State’s gas, oil and mineral rights to whatever bidder took the middlemen’s fancy.

The national resource that is for sale today is the right of an independent state to set its own laws and tax policy. In other words, it is Ireland as a mature democracy and legal jurisdiction, one that is recognised by international law that is traded by this middleman class for the private gain of its privileged players.

The current emphasis on paper assets over production reflects the fundamental changes in economic power relations which have taken place over the past forty years in advanced capitalist countries. This period has seen the financialisation of everyday life and the re-emergence of rentier capitalism. The move towards profit-seeking in paper assets is in part a response to the decline in the rate of profit and a tendency towards overcapacity in global manufacturing industries.2  The pressure to return profits in a world of declining margins has seen reductions in social expenditures by national governments and stagnation in wages. The resultant decline in aggregate demand is an underlying factor in the explosion of price speculation over production.

This is part one of a two-part article on Ireland and the shadow banking system. The rise of the Eurodollar market and the decline of the Betton Woods system is covered here. The emergence of shadow banking and Ireland’s role in its operation will be covered in a future issue.


On 5 September 2007 the in-house journal of the world’s largest bond investment company, PIMCO, published an article by its managing director Paul McCulley which discussed the problems within the American housing and mortgage markets. McCulley, an economist, had recently attended the annual symposium of the Kansas City Federal Reserve bank. It was held at Jackson Hole, Wyoming, on the edge of the Teton mountain range. ‘Not every house on every street corner in America experienced a bubble’ wrote McCulley.3  ‘The key question is whether enough of American homes on enough of America’s street corners are suffering sufficient debt-deflation miseries to jeopardise either financial stability on Wall Street or sufficient spending to generate full employment on Main Street.’

The attendees were in agreement that ‘Wall Street taking a financial bath on dud mortgages, dud structured products and dud leveraged buyouts’ was not in itself ‘a bad thing. ‘The problem was with the ‘good thing going too far, with not just the foolish being taken out and shot, but the innocent too.’  In other words, there was a real danger of the growing mortgage market risk transforming itself into actual systemic risk via a run on what McCulley labelled ‘the shadow banking system.’

This was the first recorded use of the phrase and the system McCulley was referring to was the opaque network of credit creation, lending and asset price speculation which exists, for all intents and purposes, outside of government supervision and regulation.  Its power, size and influence is a return of sorts to the 1920s and the conceptual frameworks which dominated that era. The Great Depression and Second World War saw a realignment within western capitalism, one which consigned the free movement of capital to the status of ‘second-class citizen’ – a position that finance clearly resented and fought long to overcome. 4  The re-emergence of finance as a global force in the 1960s, the breakdown of the Bretton Woods Agreement in the 1970s, the sustained liberalisation of speculative capital flows in the 1980s and 1990s, and the current ‘alphabet soup of levered up non-bank investment conduits, vehicles, and structures’ 5 is commonly referenced as the financialisation of the world economy.6

  ‘…to drive only the usurious money lenders from the temple of international finance.’

Henry Morgrenthau, Secretary of the U.S. Treasury, 22 July 1944. 7

The United Nations Monetary and Financial Conference that took place at the Bretton Woods mountain resort, New Hampshire, USA, 1-22 July 1944, was attended by over 700 representatives from 44 allied nations. The delegates were set with the task of devising ‘a durable institutional architecture for global monetary affairs, an architecture capable of facilitating a massive increase in international trade.’8  It was believed by all that the economic nationalism and currency policies of the 1930s had set the scene for the outbreak of war in 1939. It was also believed that the first decade after the war would be crucial to any hopes of lasting peace and security. Three months earlier a technical group of experts from Canada, China, France, Great Britain, and the United States had issued a joint statement on the desirability of an international monetary fund to regulate the supply, demand and trade of capital between nations.9 The United Nations financial conference was called to devise practical ways of creating such a mechanism. The documents signed at the end of the proceedings became known collectively as the Bretton Woods agreement.

The new system created a currency exchange rate mechanism whereby all major currencies were tied to the Dollar, which itself was tied to the gold standard; it allowed for the use of capital control by individual states; and it established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (later the World Bank). Although it quickly came to be dominated by U.S. and Wall Street interests, the Bretton Woods system was in essence a rejection of the type of liberal financial policies that had destabilised the world in 1931. ‘The plan accords to every member government the explicit right to control all capital movements’ said John Maynard Keynes, the chief negotiator for the British government. ‘What used to be heresy is now endorsed as orthodox.’10 The social contract that post-war Europe and the U.S. demanded was incompatible with the business mechanisms of financial speculators. ‘The bankers’ wrote Michael Moffitt in his book The World’s Money, ‘weakened politically and economically by the depression, finally accepted the agreement because they really had no alternative.’11

The banks may not have won the debate at Bretton Woods, but they did not entirely lose either. There were enough compromises and structural fault-lines placed within the agreement to allow finance a solid base to launch a counter-attack. The IMF was staffed primarily by former U.S. Treasury department officials, while the first presidents of the World Bank, Eugene Meyer and Eugene Black, had strong Wall Street backgrounds.

From the start the agreement faced difficulties. The post-war reconstruction of Western Europe and Japan was financed primarily by the Marshall Plan and not by the IMF and the World Bank. The fixed-rate mechanism was complicated by the trade imbalances which arose between the US and the rest of the world in the late 1950s. The emergence of Germany and Japan as industrial powerhouses cut not only into American exports but added to American imports as well. The economic costs of the Vietnam War compounded the situation. The glut of dollars produced by the U.S. in its role as administrator of the world’s only genuine international currency, as de facto international creditor of last resort, as well as the main market for the world’s products, put enormous pressure on the currency’s link with the gold standard. Finally, the restrictions on the movement of capital were circumvented by the storage and recycling of vast amounts of dollars in European banks and the establishment of the London-based euro-dollar market – the bedrock of the shadow banking system.

… they are particularly suitable for being used for speculative and arbitrage transactions of a disturbing kind .

          Paul Einzig, economist, September 1961. 12

In 1949 the Chinese revolutionary government  began moving its dollar balances in the United States to disguised accounts in the Russian-owned Banque Commerciale pour l’Europe du Nord in Paris. In 1950, with the outbreak of the Korean War, the U.S. issued a trade embargo with China and blocked all Chinese accounts under its jurisdiction. ‘Soon after, the Russian bank in Paris and the Moscow Narodny Bank began disguising their U.S. dollar balances too, for fear that they might be similarly blocked.’13 This was the beginning of the European market for dollar deposits, ‘a kind of dollar market in exile where America’s adversaries could traffic in dollars without fear of political intervention.’14

As the 1950s progressed the supply of dollars worldwide increased, as indicated from 1957 onwards when the U.S. started to experience trade deficits. A significant amount of the excess dollars in Europe ended up on deposit with banks in Europe rather than placed on deposit with U.S.-domiciled banks, as would normally have been the case. The growth of these European-domiciled dollar surpluses added to a market that was completely unregulated. In 1960 the Federal Reserve Bank of New York undertook an investigation into what it called the ‘Continental dollar market’ and estimated that it exceeded ‘$1 billion, excluding any double counting for inter-bank deposits.’15 It found that the dollar balances had been supplied ‘mainly by Dutch, Swiss, Scandinavian and at times German banks, who may be joined by European central banks and by holders in the Middle East and south Asia,’ and that demand for euro-dollars came mainly from ‘Italian, French, British and Canadian banks, and recently from German and Japanese banks, as well as from branches of United States banks abroad.’16

By 1963 the euro-dollar market was causing significant trouble for the U.S. balance of payments. The U.S. Congress sub-committee on international exchange and payments heard evidence that ‘U.S. corporations have placed time deposits denominated in U.S. dollars with the Canadian chartered banks, to the amount of over $400 million’ and that part of that money had ended up in the London euro-dollar market.17 This was a direct drain on the U.S. dollar reserves, and the type of activity that Bretton Woods had been designed to prevent.  The U.S. government responded with the Interest Equalization Tax which was introduced in order to discourage investment in foreign securities and encourage investment in domestic securities. Instead, the restrictions led to a boom in euro-dollar transactions and the creation of a new bond in London which was denominated in the euro-dollar.

Despite the fact that the Bretton Woods system was being circumvented so easily, no coordinated action was taken to ban the Euro-dollar. In fact this new, and entirely unregulated, market was given tacit support by both the U.S. and U.K. governments. As Eric Helleiner points out in his 1994 publication, States and the Reemergence of Global Finance, ‘Britain provided a physical location for the market, permitting it to operate in London free of regulation’ while ‘by the mid-1960s, U.S. officials were actively encouraging American banks and corporations to move their operations to the offshore London market.’18  The euro-dollar market seemed to give both countries a way of placating the demands of finance while facilitating productive growth and high employment within their respective borders. In the case of Britain, ‘it represented a solution to the problem of how to reconcile the goal of restoring London’s international position within the Keynesian welfare state and Britain’s deteriorating economic position.’19 In the U.S. ‘the Johnson administration overtly encouraged [corporations] to use the Euromarket to finance their overseas operations, in order to discourage their opposition’ to the various capital control programs brought in to tackle the U.S. balance of payments deficit.20 ‘U.S. banks continued to finance the foreign activities of their corporate clients’ wrote Moffitt, ‘they just did their lending from London.’[21 Moffitt, 47.]

By the late 1960s the euro-dollar market was estimated to stand at $10 billion, all of it unregulated.21 Moreover, the nature of the euro-dollar made it susceptible to speculators. ‘Gratifying as this progress towards an increasing internationalisation of the monetary system may appear’ wrote the economist Paul Einzig in 1961, ‘a close examination of the dynamic aspects of the new practice leads to some highly perturbing conclusions.’22

The amounts involved – which are large and are increasing steadily – are held in a particularly loose and liquid form, and by their nature they are particularly suitable for being used for speculative and arbitrage transactions of a disturbing kind. Operations in Euro-dollars and similar deposits, instead of producing an equalising effect, are apt to produce in given circumstances exactly the opposite effect…  [The Euro-dollar market] enables banks to expand credit over prolonged periods beyond the limit deemed advisable by the authorities. 23

Less than 15 years after the signing of the Bretton Woods system, the unrestrained credit creation which that system had sought to curb was once again on the rise. Furthermore, this new credit was increasingly being used to fund financial speculation rather than actual productive growth. It was not long until such instability began to manifest itself in the currency exchange system. The US trade deficit and the costs of the Vietnam War added to this instability. On 15 August 1971 the US suspended the convertibility of dollars into gold in what became known as the ‘Nixon Shock’. The pound sterling broke from the Dollar in July 1972. One month later, on 15 August, the U.S. Treasury suspended all sales and purchases of gold. In March 1973 the then six members of the E.E.C.  agreed to break from the Dollar and float their currencies. The Bretton Woods system had come to an end. By this stage the Eurocurrency market was estimated to stand at $132 billion, ‘from a net size of some $8 billion in 1964.’24

The end of the Dollar/gold standard was followed by a formal lifting of restrictions on international capital movements, first by Canada, Germany and Switzerland in 1973, and then by the U.S. in 1974. This was followed by Britain in 1979, ‘Japan in 1980, France and Italy in 1990, and Spain and Portugal in 1992.’25Debt had become the world’s single largest tradable commodity, pushed on developing countries as a Trojan for rent extraction and lobbed like cluster-bombs into assets markets for the purposes of price speculation. ‘The sheer scale and speed of these flows’ wrote John Eatwell and Lance Taylor in Global Finance at Risk, ‘produced a succession of major financial crisis [including] Latin America’s Southern Cone crisis of 1979-81, the developing country debt crisis of 1982, the Mexican crisis of 1994-5, the Asian crisis of 1997-98, the Russian crisis of 1998, and the Brazilian crisis of 1999.’26 As early as 1975, however, the financial crises which came with deregulation were seen by officials within the IMF as the consequences of the moves by national governments ‘to retaliate against, rather than to recognise and adjust to, the realities of this interdependent world economy.’27 The solution was further financial deregulation, not less. And over the next 20 years the IMF officials got their wish.

‘Financial innovation is great, but you have to have some basic rules.’

Sheila Bair, Federal Deposit Insurance Corporation, December 2007.28

Derivatives as financial instruments date back centuries. The market for them, however, was small until 1971, when interest and currency exchange rates became highly volatile in the wake of the Nixon administration’s decision to end its association with the Bretton Woods system. It soon saw significant fluctuations in the exchange rates between currencies – a costly and damaging process for multinational companies who dealt with multiple currencies on a daily basis. These unpredictable fluctuations in exchange rates affected costs and profits. In 1972 the Chicago Mercantile Exchange began trading futures contracts on currencies, as a way of companies limiting their exposure to the market volatility of currency prices over time. The volatility generated by the ‘Nixon Shock’ offered new opportunities. ‘Money could be made out of that instability using financial derivatives’ writes Dr Jan Toporowsaki of the University of London, ‘and no one has yet invented a fool proof way to prevent people with money from using it to make even more money no matter how ruinous the consequences may be for society.’29

The sale of these contracts was given a boost in 1973 when Fisher Black of the University of Chicago and Myron Scholes of MIT published a paper in the Journal of Political Economy entitled ‘The Pricing of Options and Corporate Liabilities’. They had developed an algorithm which advanced the way traders could price futures options in a way that limited risk exposure. It assumed ‘ideal conditions’ in the market for the stock and the option, and concluded that under these assumptions ‘it is possible to take a hedged position on the option, whose value will not depend on the price of the stock, but will depend only on time and the values of known constants.’30The algorithm was further advanced by the economist Robert C. Merton in his 1973 article, ‘Theory of Rational Option Pricing’.31  This modified formula became known as the Black-Merton-Scholes model, for which Merton and Scholes received the Nobel Memorial Prize in Economic Sciences in 1997 (Black had died in 1995, and the award is not awarded posthumously).

The effect of the Black-Merton-Scholes model was to give mathematical security to risk-hedging. ‘Almost immediately’ wrote the economist René M. Stulz, ‘[the model] was found useful to price, evaluate the risk of and hedge most derivatives, plain vanilla or exotic. Financial engineers could even invent new instruments and find their value with the Black-Merton-Scholes pricing method.’32

In 1974 Texas Instruments brought out a calculator that used the Black-Merton-Scholes model. ‘Soon, every young trader, many as second-year college drop-outs fresh from their first finance classes, was using a handheld TI calculator to trade options and was making more profit in a day than the college professors made a year.’33 The development of computers in the 1970s, and the exponential growth in speed, power and programming, made it easier not only to use Black-Merton-Scholes to price derivatives, but also to develop new and ever more complex financial products, even to adapt them for individual clients. All of this was done with one purpose in mind: both the buyer and seller of OTC (over-the-counter) derivatives were trying to beat the market. They were trying to eliminate risk. The growth of the derivatives market also turned derivatives into financial assets in themselves. The sale of a derivative generates revenue. ‘The contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.’34   Furthermore, ‘losses suffered because of price movements can be recouped through gains on the derivatives contract.’35  Instead of helping to limit risk, however, ‘the models were used to justify a bigger appetite for risk.’36

The power of OTC derivatives to destabilise markets showed itself seemingly as an anomaly but became more frequent as the 20th century drew to a close. The multinational firm Proctor and Gamble reported a pre-tax loss of $157 million in 1994. It stemmed from OTC derivatives sold to it by Bankers Trust. The same year, Orange County, California, filed for bankruptcy. It lost $1.5 billion speculating on derivatives. Its dealer was Merrill Lynch. The county treasurer, Robert Criton, later pleaded guilty to six felony counts. In 1996, the Japanese Sumitomo business group lost $2.6 billion on copper derivatives. The Commodity Futures Trading Commission (CFTC) later fined Merrill Lynch $15 million ‘for knowingly and intentionally aiding, abetting and assisting the manipulation of copper prices.’37 In 1995 the UK-based Barings Bank was declared insolvent after it lost $1.3 billion due to the activities of one of its derivatives dealer, Nick Leeson. In September 1998 the New York Federal Reserve organised a bailout of the hedge fund management firm, Long-Term Capital Management (LTCM), which had lost €4.6 billion during the 1997 and 1998 Asian and Russian financial crises. It ‘held more than 50,000 derivatives contracts with a notional sum involved in excess of $1 trillion.’38

The instability, lack of oversight, and toxic concentration of risk that was generated by OTC derivatives led Warren Buffet in 2003 to declare that ‘derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.’ By 2007 the five largest investment banks in the US – J.P. Morgan Chase, Citigroup, Bank of America, Wachovia and HSBE – were among the world’s largest derivatives dealers. Goldman Sachs estimated that from 2006 to 2009 somewhere between 25 per cent and 35 per cent of its revenues were generated by derivatives. The American insurance corporation, AIG, had sold credit default swaps totalling $79 billion ‘to investors in these newfangled mortgage securities, helping to launch and expand the market and, in turn, to further fuel the housing bubble.’39 In 2006 and 2007 the top underwriter of mortgage bonds in the US was Lehman Brothers.  ‘When housing prices fell and mortgage borrowers defaulted’ said the Financial Crisis Inquiry Report, ‘the lights began to dim on Wall Street.’40

It is important to remember, however, that the crisis itself was not the result of specific financial instruments that had been placed in the hands of irresponsible financiers and their employees. Rather, the 2008 financial meltdown is symptomatic of a much deeper malaise. The growth of the Eurodollar market and the end of the Bretton Woods system are not unrelated. They were part of a sustained counter-move by finance in the wake of the Great Depression and WWII. By the late 1970s the financial world was centre-stage once again with monetism and deregulation its rallying-calls. The period saw the British government under the Labour Party move ‘away from wages and incomes solutions to monetary stringency and spending cuts.’41 In 1979, with the appointment of Paul Volcker as chairman of the Federal Reserve, the US undertook a policy of internal deflation. It did so through high unemployment, wage cuts and the breaking of the trade union movement. It also saw the quickening pace of deregulation. Cross-border capital flows – seen as highly unstable by Keynes and the delegates at Bretton Woods – were once again unleashed. The wakening of profit-seeking in production made finance all the more attractive. The relative lack of employment in price speculation activities added to the downward pressure in aggregate demand. The solution – to use consumer credit as a substitute for wages – created its own set of problems.

[End of part one. Part two will cover the rise of shadow banking and the relationship with the Irish state.]




Show 41 footnotes

  1. United States Permanent subcommittee on Investigations, Repatriating Offshore Funds: 2004 Tax Windfall for Select Multinationals Majority Staff Report (October 2011), p.34. (accessed 10 November 2012).
  2. ‘Robert Brenner: A Marxist explanation for the current capitalist economic crisis,’ Links: International Journal of Socialist Renewal (22 January 2009). (accessed 2 December 2012).
  3. Paul McCulley. “Teton Reflections,” Global Central Bank Focus (September 2007). (accessed 17 July 2012).
  4. Lawrence Krause. ‘Private International Finance,’ International Organisation 25 (1971): 536.
  5. McCulley, “Teton Reflections”.
  6. The phenomenon of financialisation is described by G. Epstein as ‘the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international level.’ Quoted from G. Epstein, ‘Financialization, rentier interests, and central bank policy.’ Paper presented at PERI conference on ‘Financialization of the World Economy,’ 7-8 December 2001. (accessed 21 July 2012).
  7. Quoted in Eric Helleiner, States and the Reemergence of Global Finance (Ithaca: Cornell University Press, 1996), 4.
  8. David M. Andrews, ‘Bretton Woods: System and Order,’ in David M. Andrews (ed), Orderly Change: International Monetary Relations Since Bretton Woods (Ithaca: Cornell University Press, 2008), 6.
  9. Joint statement by experts on the establishment of an International Monetary Fund, issued 21 April 1944. Accessed 18 August 2012.
  10. Quoted in Helleiner, Global Finance, 25.
  11. Michael Moffitt, The World’s Money: From Bretton Woods to Camp David (New York: Simon & Schuster, 1983), 24.
  12. Paul Einzig, ‘Statics and Dynamics of the Euro-dollar Market,’ The Economic Journal 71, no. 283 (Sep 1961), 593.
  13. M.S. Mendelsohn, quoted in Moffitt, The World’s Money, 46.
  14. Moffitt, 46.
  15. ‘A Billion Eurodollars,’ The Economist, 19 November 1960, 17.
  16. ‘A Billion Eurodollars,’ 17.
  17. ‘Euro-Dollars Are Our Dollars,’ The Economist, 2 March 1963, 828.
  18. Helleiner, States, 82.
  19. Helleiner, States, 84.
  20. Helleiner, States, 89.
  21. ‘Hambros Bank: The Year of the Eurodollar,’ The Economist, 17 June 1967, 1281.
  22. Einzig, ‘Statics and Dynamics,’ 593.
  23. Einzig, ‘Statics and Dynamics,’ 593.
  24. John Hewson and Eisuke Sakakibara, The Eurocurrency Markets and Their Implications: A New View of International Monetary Problems and Monetary Reform (Lexington, Massachusetts: Lexington Books, 1975), 2, footnote a.
  25. John Eatwell and Lance Taylor, Global Finance at Risk: The Case for International Regulation (Cambridge: Polity Press, 2000), 3.
  26. Eatwell and Taylor, Global Finance, 5.
  27. Hewson and Sakakibara, Eurocurrency, 157.
  28. The New York Times, 18 December 2008.
  29. Jan Toporowski, Why the World Needs a Financial Crash and Other Critical Essays on Finance and Financial Economics (London, 2010), 31.
  30. Fisher Black and Myron Scholes, ‘The pricing of options and corporate liabilities’, Journal of Political Economy vol.81, no.3 (May-June 1973), 641.
  31. Robert C. Merton, ‘Theory of rational option pricing’, The Bell journal of Economics and Management Science, vol.4, no.1 (Spring, 1973), 141-183.
  32. René M. Stulz, ‘Should we fear derivatives?’, Journal of Economic Perspectives, vol.18, no.3 (Summer 2004), 177.
  33. Henry C.K. Liu, ‘Derivative market reform part 1: the folly of deregulation’, Asia Times Online, 3 December 2009. Accessed 7 February 2011.
  34. New York Times, 8 October 2008.
  35. John Bellamy Foster and Fred Magdoff, The Great Financial Crisis: Causes and Consequences (New York: Monthly Review Press, 2009), 46.
  36. Chelsea Wald, ‘Crazy money’, Science, 12 December 2008.
  37. Financial Crisis, 47.
  38. Andrew Glyn, Capitalism Unleashed: Finance, Globalization and Welfare (Oxford: Oxford University Press, 2007), 71.
  39. Financial Crisis, xxiv.
  40. Financial Crisis, xxiii.
  41. Susan Strange, ‘Interpretations of a Decade,’ in Loukas Tsoukalis (ed.) The Political Economy of International Money: In Search of a New Order (London: SAGE Publications, 1985), 21.

One Response

  1. seamus daly

    November 8, 2013 5:29 pm

    fascinating !! but as a non-economist I have difficulty in fully understanding yhe logic !!