In one of the great ironies of history, Richard Nixon failed to grasp the new power he created by his decision to unmoor the dollar from gold. Most tellingly, he failed to make the connection between this historic decision and the new dynamic it injected into the historic Cold War struggle with the Soviet Union. Arguably, this is the most significant of the many apparently unrelated effects of the now dominant and unmoored dollar.

The Cold War

The 1970s were a difficult decade for the United States. From wearying stagflation to the humiliation of Saigon, the sordid shame of Watergate and the surge of the Sandinistas, it was a time plagued by a pervasive sense of national decline.

The debacle of Operation Eagle Claw in April 1980 was particularly painful and seemed to summarise acutely the growing impotence of a great power in inevitable retreat. The bloody failure to rescue US hostages in Tehran seemed stark confirmation of an ongoing loss of influence amid a prolonged Cold War stalemate. Captive hostages at the embassy and dead would-be rescuers on enemy sand were depressing symbols of loss and foreboding. 

Warily managing the messy process of descent seemed to be the inescapable reality for occupants of the Oval Office.

Into this troubled time, a smiling ex-B-Movie star was elected President in November 1980. Facing the implacable foe of the Soviet Union and the apparently rigid constraints of yawning twin deficits, his mantra that it was now “Morning in America” seemed naively optimistic.

Most especially, his stubborn refusal to follow the prevailing policy of containing the threat from the Eastern bloc seemed hopelessly at odds with the long-term reality of effective Superpower balance. 

Indeed, five years into his presidency, in a piece to mark the 40th anniversary of the Cold War division of Europe, and undoubtedly reflecting the conventional wisdom of the time, The Economist magazine confidently concluded that the prospects for change were all but non-existent: “Nothing much will have changed by 2025.”

Click here for part one of the series “Rome to Gold”

And yet we now know that within six weeks of this piece being published, the steady march to rapid Cold War victory was well underway. The smiling President Reagan faced the fragile Secretary General Gorbachev in Reykjavik to effectively begin the process of managing the orderly collapse of Soviet power.

“The impossibly delusional goal of a seemingly naive President remarkably came to pass.”

For Reagan, the unmooring of the dollar by Nixon ultimately paved the way to spend the Soviet Union into submission and ultimately destruction.

As the issuer of the global reserve currency, Reagan faced no constraint in rapidly accelerating military spending and simultaneously slashing taxes, while his Cold War adversary soon buckled under the pressure to keep up.

The impossibly delusional goal of a seemingly naive President remarkably came to pass.

More remarkably still, the fundamental cause of Cold War victory was not the determined optimism of the popular Reagan, but the unexpected consequence of the pressured decision of his generally despised rival to cut money free.

The Geithner doctrine

Freed of the Bretton Woods anchor, the major central banks such as the US Federal Reserve, the Bank of England, the Bank of Japan and the ECB can create unlimited quantities of domestic money. They simply credit the accounts of their member institutions with a keystroke – in dollars, sterling, yen or euro respectively – as and when required.

The extent of this historically new freedom was most clearly displayed in the aftermath of the collapse of Lehman Brothers in September 2008, and the dramatic intensification of the global financial crisis.

The decision by Bush Treasury Secretary Hank Paulson to effectively allow the bankruptcy of a medium-sized US investment bank – Lehman Brothers – sparked a massive contraction in global credit, trade and activity. The lesson was not lost on his young successor, Obama Treasury Secretary, Timothy Geithner.

There are numerous reasons why historians like to characterize significant policy positions as doctrines. Usually, the elevation of a policy to the status of doctrine is a signal of a change with major implications for the future.

For example:

• The Monroe doctrine of 1823 saw newly re-elected US President Monroe warn that “further efforts by European nations to colonize land or interfere with states in North or South America would be viewed as acts of aggression”. The end of European interference in the Western Hemisphere is directly traceable to this doctrine.

• Over a century later The Truman doctrine of 1947 – justifying US involvement in the Greek civil war – set the scene for East/West confrontation around the globe for much of the next half-century.

• More recently, The Bush doctrine following 9/11/2001 – asserting the right of the US to wage preventive war in self-defence – signalled over a decade and a half, and counting, of US military engagement in Afghanistan, Iraq and elsewhere.

The Geithner doctrine has never been formally stated in public. But a policy of protecting bank depositors and their legal equivalents – regardless of the losses of their banks – has been unbreakably in place since his period in office. Moreover, this doctrine has been adopted as an all but universal one around the globe.

Buttressed by the Geithner doctrine, monetary policymakers – confronting the greatest financial crisis since 1929 and undeniably shocked by the precipitous post-Lehman collapse in global trade and activity – aggressively deployed the freedom of unmoored money to effectively guarantee bank depositors and their legal equivalents across the developed world.

The simple, practical mechanics of this extraordinary freedom and promise was summarised at the time by then Federal Reserve Chairman Ben Bernanke, in reply to a question from Scott Pelley on the US TV show 60 Minutes.

Pelley asked: “Is that tax money that the Fed is spending?” Bernanke replied: “It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.”

Click here for part two of the series: “Bretton Woods to Dollar dominance”

Crucially, this promise by the Fed to US banks became an effective promise to major banks around the globe. Prompted by the growing risk of non-US banks facing a run from their dollar creditors, the six major central banks – the Fed, the ECB, the BOJ, the BOE, the SNB, and the BOC – concluded a currency swap deal which in practice saw the Fed make dollar loans to the other central banks as and when needed. In the trauma of the crisis, this deal ensured that all six were now a credible lender-of-last-resort to their respective banks, who in turn were now credible counterparties to their creditors.

Strikingly, while the currency swap deal was initially envisaged as a temporary arrangement to overcome the emergency of the crisis, it became a permanent one in October 2013. In practice, it renders the Geithner doctrine impregnable.

Free to reject the risk of another Lehman, the message that bank creditors in dollars, euro, yen, sterling, Swiss francs, and Canadian dollars will necessarily be made whole in full and on time by the relevant central bank has been made clear and has been broadly understood.

“The consequent collapse in global bond yields and credit spreads – regardless of the individual travails of the underlying debtor – has strongly underlined this message in the period since.”

The Geithner doctrine underpinned the pay-outs by the Irish government to depositors and their legal equivalents in failed banks in Ireland. It also underpinned the UK government pay-outs to British depositors and their legal equivalents in failed British and Icelandic banks. Most recently, in the Summer of 2017, the Italian government similarly made whole the equivalent liabilities of two failed banks in Italy.

The consequent collapse in global bond yields and credit spreads – regardless of the individual travails of the underlying debtor – has strongly underlined this message in the period since.

More particularly, the broad understanding in financial markets that depositors and their legal equivalents in banks across the developed world are now effectively guaranteed by the relevant Central Bank, and ultimately the relevant government, is all but beyond debate.

The recent case of Deutsche Bank is a good example of this general understanding, and of how ‘The Geithner Doctrine’ now stands without challenge.

The travails of Deutsche Bank

The Prussian military victory over France in 1870 proved the decisive event in the forging of a new political and economic colossus.

At the heart of a humiliated France, in the famous Hall of Mirrors at the Palace of Versailles, Chancellor Otto von Bismarck of Prussia proclaimed a new unified German Empire in January 1871. The course of European, and indeed global history had been changed forever.

In parallel with its military success, the Prussian government was consciously seeking to extend its economic reach.

Deutsche Bank was founded in Berlin in the same year as victory over France with a government statute stating that “the object of the company is to transact banking business to promote and facilitate trade relations between Germany, other European countries and overseas markets.” Through the many upheavals of German history since, the central role and mission of Deutsche Bank has remained remarkably consistent.

Characteristically, the author and economist John Kay captures memorably much of the activity in banking and financial markets.

To shave journey time on the motorway, many drivers employ a tailgating strategy of driving very close to the car in front. Consequently, on almost all trips they succeed in arriving at their destination sooner, while very occasionally but often catastrophically, they crash and cause a tragic pile-up.

“Fundamentally, bank assets are generally supported by a relatively tiny sliver of equity, with the vast bulk funded by debt.”

In the aftermath of such a pile-up, there is always a proximate cause offered as an explanation – mechanical failure, driver error, tyre issues or whatever – while the real cause is the tailgating strategy which will inevitably result in a pattern of many small gains followed by a dramatic and likely catastrophic loss. In addition to its broader relevance to much financial market activity, this insightful analogy speaks directly to the recent travails of Deutsche Bank.

The Deutsche Bank share price has fallen significantly in recent years. One notable phase of this fall was sparked at the end of September 2016 by a reported fine of $14bn from the US Justice Department. However, the reported fine is best understood as just the latest bump in the road. The real cause of difficulty for Deutsche Bank, and its banking equivalents across the globe, is a balance sheet which means they are always travelling fast and very close to the vehicle in front.

Fundamentally, bank assets are generally supported by a relatively tiny sliver of equity, with the vast bulk funded by debt.

Across the banking landscape of the developed world, the sliver of equity is leveraged around 20 times – a fall of just 5 per cent in the value of bank assets would entirely wipe out shareholders. Moreover, there is a massive mismatch between the generally long-term maturity of bank assets, and the generally short-term maturity of bank debts.

“While their vulnerabilities may be particularly acute, the interconnectedness of the system means that the chain is only as strong as the weakest link. The Geithner doctrine must be obeyed.”

Almost uniquely therefore, as was painfully highlighted in the period after the collapse of Lehmans, banks are businesses that cannot survive without the backing of central banks and ultimately governments. If there was any doubt, for example, that the ECB and ultimately the German Government stands effectively behind the liabilities of Deutsche Bank, there would already have been a rush to the exits by bondholders and depositors. There has been no such rush.

Banks are different and are treated differently. In the absence of meaningful change, this is not a cyclical and temporary issue; it’s a structural and permanent one. A universal and unchanging reality confirmed once again by the recent travails of Deutsche Bank. While their vulnerabilities may be particularly acute, the interconnectedness of the system means that the chain is only as strong as the weakest link. The Geithner doctrine must be obeyed.

Over the next couple of weeks, I’ll continue to discuss how the legacy of Nixon still shapes our world before concluding with some thoughts on the future.