The Fed’s balance sheet used to be c. 6% of GDP; at its peak, it has reached 36%. Some folks are very worried about this; others are not. To be sure, this article isn’t an endorsement of shrinking the Fed’s balance sheet to any particular level. But this is a very helpful framing of what has become a charged (well, as charged as central banking can get, which isn’t very) topic: should the Fed shrink its balance sheet? If so, how? This is something Governor Miran talks about frequently (here’s a recent speech in which he cites this very article).

If you stipulate that you’d like to reduce reserves, without even potentially shifting to a scarce-reserves operating framework, then this paper lays out some ways to do that. Here’s a nifty table from the paper:

An aspect that this paper concentrates on—and is completely correct about—is that calibrating the size of the Fed’s balance sheet is not merely a supply question, but also a demand question. Say the authors of the paper on the repo volatility that arose from extended QT:

We cannot conclude from repo volatility alone that the Fed’s balance sheet was unable to be reduced further. If precautionary demand for reserves were lower, it would allow less constrained banks to neutralize shocks by lending into the repo market, which would lower the level of the balance sheet at which repo volatility manifested.

That’s totally right, and something that folks in the financial stability space have been talking about for some time (i.e., if we credit banks’ LCR with discount window access, they may do less precautionary “hoarding,” which would be better for everyone). Here, the authors extend that to the monetary policy framework, which is a helpful and clear connection. There are some interesting proposals, such as operating with the Effective Federal Funds Rate slightly above the Interest on Reserve Balances rate, which would also have the effect of ridding the system of an arbitrage performed by the US branches of foreign banks.

The paper is worth reading in its entirety, but the upshot is basically this line: “Modern monetary policy implementation is defined by the boundaries between scarce, ample and abundant reserves. Those boundaries can be shifted down by modifying the policy landscape, reducing demand for reserves.” Implicit (and explicit in the paper) in that “landscape” is regulatory—often deregulatory—changes. Some of the proposals, such as shifting (at least a sizable chunk of) the Treasury’s cash management from the New York Fed to commercial banks, seem unlikely to gain traction. On the whole, though, these authors have clearly laid out the channels through which shrinkage, even while avoiding a return to a wholesale scarce-reserves framework, could take place.

Seniority, Senegal & Sovereign Creditor Violence. Max Hess. Conflict & Credit.

Some personal bias here, I am a sovereign debt novice (but eager learner/fan) and just happen to have been in Senegal two weeks ago in a meeting with some Western government folks in which I heard all about Senegal’s impending sovereign debt gloom, so this struck me as particularly noteworthy. Some other personal bias, I am a big fan of Max’s work, and if you’re not subscribed to his Substack, you should be:

Conflict & Credit

Exploring economic warfare in the 21st century.

By Maximilian Hess

This article gives color to some “intrepid” reporting (agreed) from the FT about Senegal’s position, which is best described as precarious. Some context: the former administration in Senegal—Macky Sall’s—was found to have hidden considerable amounts of sovereign debt, so much so that the current “auditor government” of Bassirou Diomaye Faye has uncovered debt-to-GDP to be closer to 130% than the roughly 75% reported by Sall’s government. So, bad. But it’s actually worse, because after discovering the hidden debt, Senegal borrowed more. Worse still, the borrowed debt was, in technical terms, crazy. Senegal borrowed via Total Return Swaps (TRS), derivatives that are basically levered positions on Senegal’s own credit. Worse still, these claims are senior to existing bondholders.

Max’s piece is worth a read in full, but I’ll just add from my visit that it felt like a crisis not yet coming to a head. Government folks were certainly aware, but it didn’t feature prominently in many discussions (only one or two), and the main economic complaint seemed to be cost of living. But, like all crises, presumably this will be very slow until it’s very fast. Over to you, IMF.

Stablecoin Flows and Spillovers to FX Markets. Iñaki Aldasoro, Paula Beltrán and Federico Grinberg. BIS and IMF.

As we’ve discussed on this site, the stablecoin-offshore dollar-FX nexus is huge and, in my opinion, probably the most underappreciated angle of stablecoin proliferation. Stablecoins are not just not limited to the US—they’re mostly used and circulated outside of the US.

The authors of this paper, one from the BIS and two from the IMF, show, in a nutshell:

1. that there are deviations of funding costs in obtaining dollars offshore via stablecoins versus traditional methods (swaps), which are correlated with stablecoin flows and local FX depreciation;

2. that the global supply of stablecoin liquidity is segmented (in an arbitrage sense), which allows for the deviations;

3. that a “one percent exogenous increase in net stablecoin inflows raises parity deviations by approximately 40 basis points (bp), depreciates the local currency by 5 bp, and widens the short-term dollar 1 premium by 5-10 bp”;

4. frictions across markets are the main cause of these deviations.

As they put it:

Our findings demonstrate that stablecoin markets are already linked to traditional finance, with spillovers that affect currency stability and funding conditions. This has direct implications for policymakers concerned with monetary policy autonomy and financial stability, particularly in emerging markets where these effects are most pronounced.

Key to the story is this underlying fact: stablecoin provision is being provided by balance-sheet constrained intermediaries that act in multiple different countries. When there’s more demand for currency conversion in country B, that intermediary shifts its provision away from country A, which will create parity deviations in country A, even though nothing in country A has changed. In other words, there is limited conversion capacity, so shifts in global conversion demand exogenous to country A will result in parity deviations there. Hence what they term “cross-market spillover” effects.

It turns out that parity deviations (reminder: when local currency price in stablecoins ≠ the price in fiat dollars) are commonplace. Here’s a nice chart from the paper:

Particularly relevant for policymakers, the researchers find that stablecoin inflows are correlated both with these deviations and with local currency depreciation (a finding I have uncovered in a case study in my own forthcoming research). The authors suggest that this, “provides suggestive evidence that flows into stablecoins are not confined to the crypto ecosystem but can generate tangible pressures in traditional FX markets, potentially by increasing the net supply of the local currency in the spot market as users sell local currency to buy stablecoins.” As the authors note, endogeneity is a concern here: if you think the local currency is going to depreciate, you’d probably move into stablecoins (seemingly the case in my case study, but not necessarily true everywhere, as they show with their causal identification strategy).

To get causal ID, they need to do some fancy causal inference stuff, which they do with a special type of instrumental variable. Sparing the detailed empirics thereof, let’s stipulate that they can identify exogenous stablecoin flows, and they find that they matter a sizable amount (horizon is in days):

Here’s the big takeaway, per the authors (citations omitted, emphasis added):

A positive shock to stablecoin inflows causes an immediate, sharp increase in parity deviations of approximately 40 basis points on impact. This effect is highly persistent, decaying only gradually over the following ten days. The persistence of these deviations is consistent with impaired arbitrage of the type that characterizes segmented markets.

Stablecoin inflows also lead to a statistically significant depreciation of the local currency in the traditional spot market. The magnitude of the effect declines over time and loses statistical significance after a few days. This confirms that shocks originating in the stablecoin market spill over into traditional FX markets, exerting tangible pressure on the local currency.

Finally, the shock to stablecoin inflows causes a significant decline in 3-month CIP deviations, indicating a deterioration in synthetic funding conditions (a higher dollar premium). In contrast, the effect on 12-month CIP deviations is negligible in the short-term and statistically insignificant. This tenor-specific pattern suggests that arbitrageurs’ constraints are more binding at shorter horizons, making short-term CIP deviations more sensitive.

Argentina: What happened with the swap?

So, we have the New York Fed/Treasury FX Operations Report for October–December 2025 (hereafter Report), which I’m just now taking a look at. There’s one very interesting part, which discloses some important bits of the Argentina ESF swap drama we talked about earlier. To recap, the United States provided Argentina a $20 billion swap line through the Treasury’s ESF in September 2025. This is different from central bank (Fed) swap lines, and that’s an important distinction to remember because the operational executor of both types of swaps is the New York Fed (as trading desk for the Federal Reserve and as fiscal agent for the Treasury). Anyways, here’s the Easter egg from the Report (my emphasis):

During the weeks following the local elections, Argentine financial markets faced acute, short-term pressure on both the exchange rate and financial stability. Against this backdrop and in order to stabilize Argentine markets and preserve exchange rate stability, in October 2025, the U.S. Treasury, acting through the Exchange Stabilization Fund (ESF), purchased Argentine pesos in the spot and Blue Chip Swap markets and entered into an exchange stabilization agreement (ESA) with the Central Bank of Argentina (BCRA) for $20 billion. Pursuant to the ESA, in October 2025 the U.S. Treasury, acting through the ESF, and the BCRA executed a swap transaction whereby the BCRA exchanged pesos for $2.5 billion. In December 2025, the BCRA fully repaid the $2.5 billion swap transaction when it matured and the swap transaction was closed. As of end December 2025, no drawings were outstanding under this agreement and the ESF did not hold any pesos.

So, first of all, this is still weird. As we suspected in the earlier note on this, the intervention was at least partially driven by ideological affinity for Mr. Milei’s politics, and this report is pretty clear about that, citing the local elections Mr. Milei’s party faced. If you swapped in Malaysia for Argentina, everyone’s eyebrows would be raised.

Second, we got disclosure of the direct (and derivative) peso purchases. We don’t know how many were purchased, but we know they unwound the transactions pretty quickly. Third, we got the swap amount disclosed: $2.5 billion of $20 billion available for no more than ~3 months. The BCRA disclosed the operation and its conclusion two weeks ago. We also know that, after obtaining $2.5 billion through the Treasury swap, the BCRA, on January 7, 2026, obtained $3 billion by borrowing in the repo market against its dollar-denominated bonds, evidently to make a bondholder payment coming due on January 9.

The other bit I missed that happened in October was that the US provided Special Drawings Rights (SDRs) to Argentina so that it could make an interest payment to the IMF (if you don’t know what SDRs are, check out the primer). (Somewhat confusingly, a CRS report said that the US provided “dollar liquidity support to Argentina through transactions in international reserve assets held at the IMF,” but in fact the transaction was a sale of SDRs from the US perspective in exchange for dollars.)

From the October 2025 ESF Financial Statement (my emphasis):

The Special Drawing Rights Act of 1968 authorizes the United States to purchase, sell, and hold Special Drawing Rights (SDRs) through the Exchange Stabilization Fund "ESF". In October 2025, Treasury, through the ESF, sold SDR 641 million to Argentina in exchange for $872 million. The proceeds from the sale were invested in Nonmarketable U.S. Treasury Securities. As of October 31, 2025, U.S. SDR Holdings were SDR 127 billion. Changes in both SDR Holdings and SDR Allocations reflect changes in the foreign exchange rate.

So, my read is that (1) in October the BCRA draws ($2.5 billion) dollars from the ESF swap; and then (2) swaps back $872 million of that for SDRs to make its IMF payments; and finally (3) unwinds the swap transaction in December.

I don’t know, I can’t keep up with Argentina, but it looks like this has settled for now (?). Will we get more details on the ESF swap? Why didn’t the BCRA use it for the $3 billion it got from the repo market? What’s the rate on this thing?

Tokyo Drift?

If you were unfortunate enough to be on X (the artist formerly known as Twitter) or, even worse, LinkedIn, late last month, you’d know that folks online were talking about the New York Fed performing “rate checks” on USDJPY. (I even saw one crypto person claim, incredibly, that the Fed might “crash the dollar by 50%.”) Rate checks are basically when a central bank asks to get quotes on an exchange rate from commercial banks, sometimes allowing or instructing them to let the market know they might be mulling an intervention (i.e., to some degree jawboning the exchange rate). Now that we have the minutes from the January FOMC meeting, we do have the disclosure of this happening (my emphasis):

In the days leading up to the meeting, the dollar had depreciated markedly after reports that the Desk had made requests for indicative quotes, known as "rate checks," on the dollar–yen exchange rate. The manager noted that the Desk had requested those quotes solely on behalf of the U.S. Treasury in the Federal Reserve Bank of New York's role as the fiscal agent for the U.S.

And then, Scott Bessent said the US would “absolutely not” intervene in the yen and reiterated the time-tested strong dollar policy. Oh well, so much for the drama. Hopefully nobody reading this got caught going the wrong direction in a USDJYP trade (sorry if you did, it seemed reasonable). So, what is Treasury’s dollar policy?

Nothing much happens

Things in the rest of the world seemed quiet, according to the Report. We’ll all be glad to hear that offshore dollar funding markets are in rude health. Carry traders are at it again in EMs. One other interesting thing happened recently, though, outside of the Report at hand: there was some FIMA Repo activity: balances were up in the first week of February to $3 billion. Here’s a chart:

I am unaware of any public reporting on this or any chatter, so my guess would be that this recent draw was pretty routine—if so, good to know the pipes still work.

Readers will be familiar with the concept of central banks acting as international lender of last resort (LOLR), providing their currency to foreign monetary authorities when in need. The story of post-World War II financial history has been mostly about Federal Reserve swap lines, given the dollar’s status as the world’s international reserve currency. However, there is a second reserve currency, often underappreciated, the euro. And there is also another form of foreign currency LOLR—foreign currency-denominated repurchase agreements (repo).

We’ve talked about this nearby, but essentially a swap line is when central bank A lends its currency to central bank B and takes central bank B’s currency as collateral (e.g., the Fed lends dollars to the Bank of Japan and takes yen as collateral). A foreign currency (FX) repo is when central bank A lends its currency to central bank B and accepts some “hard” collateral (usually sovereign debt denominated in central bank A’s currency; e.g., the Fed lending dollars to the Brazilian central bank and accepting US Treasury securities as collateral).

The most well-known FX repo facility is the Fed’s FIMA Repo facility, which lends dollars to foreign monetary authorities, taking Treasury securities as collateral. It is, like the Fed’s swap lines, staffed and operated by the Federal Reserve Bank of New York, and has had some recent activity. Somewhat famously, the Swiss National Bank drew on FIMA to provide dollar liquidity to Credit Suisse.

EUREP: silent second

The European Central Bank (ECB) has its own version of FIMA Repo, called the Eurosystem’s repo facility for central banks (EUREP). I published a research paper on EUREP back in 2023, when I felt I was probably one of ten people outside the ECB who knew or cared about it. In contrast to the Fed, the ECB maintains three lines of liquidity defense: swap lines, bilateral repo lines, and EUREP. At least in 2023, the main recipients of the bilateral repo lines were Euro Area-adjacent (e.g., Albania, North Macedonia, etc.). EUREP’s collateral schedule was also narrower than that for the bilateral repos. Counterparts to EUREP are not disclosed by the ECB (though individual other counterparts might voluntarily disclose, as was the case then with the central banks of Kosovo and Montenegro1). For details on the facility, please see the aforementioned paper and the ECB’s website on its liquidity lines.

Source: ECB

Emergency liquidity for new geopolitics?

In a story covered by Central Banking, the ECB announced on Saturday (Feb. 14) that it would “enhance” EUREP. Here’s the meat of the language of that press release (with my emphasis):

The Governing Council of the European Central Bank (ECB) has decided to enhance the Eurosystem repo facility for central banks (EUREP) to make it more flexible and effective in supporting the smooth transmission of euro area monetary policy.

Under EUREP, the Eurosystem provides backstop euro liquidity to non-euro area central banks against high-quality euro-denominated collateral, with appropriate risk mitigants. The updated framework introduces standing access, in principle, for all central banks, unless excluded on the grounds of, in particular, money laundering, terrorist financing or international sanctions. The framework will enable central banks in jurisdictions outside the euro area to address risks of euro liquidity shortages swiftly. These changes aim to make the facility more flexible, broader in terms of its geographical reach and more relevant for global holders of euro securities.

Since EUREP was first introduced in 2020, the world economy has undergone profound structural shifts related to geopolitics and changes in the international financial system. These shifts have altered the dynamics of global trade and financial integration and suggest that the macroeconomic and financial environment will remain uncertain and potentially more volatile. More frequent financial disruptions and possible knock-on effects on euro area financial markets have the potential to hamper the smooth transmission of monetary policy.

Liquidity lines such as EUREP help support the smooth transmission of monetary policy in the euro area. They help mitigate potential negative spillover effects on euro area financial market conditions by addressing risks of disruptions in euro-denominated funding markets outside the euro area. In the context of greater fragmentation and uncertainty, Eurosystem liquidity facilities like EUREP will continue to ensure the timely, consistent and broad provision of backstop funding for central banks.

EUREP complements the ECB’s swap lines, which remain unchanged.

Now, it’s worth revisiting why the ECB has euro liquidity lines at all. The straightforward answer should be financial stability, which it mostly is: per the ECB, the cited motivations for maintaining central bank liquidity lines are to combat “market dysfunctions,” and to be used as monetary policy instruments. But, importantly, also because “they strengthen the role of the euro in international financial markets, thereby further enhancing the effectiveness of ECB monetary policy transmission” (my emphasis).

Look, if I were Europe, having just stared down the barrel of a potential American military invasion of European territory, I would probably be thinking that “structural shifts related to geopolitics” is a conversative way to put it. Note also the date of the press release, which overlapped with the Munich Security Conference. Indeed, this was not a coincidence. As Central Banking reported, ECB President Christine Lagarde gave a speech at the Munich Security Conference on the same day as the ECB press release, opening a roundtable titled “Chain Reaction: Navigating Geoeconomic Shifts and Dependencies.” Here are some excerpts (my emphasis, bolded):

What does this mean from the ECB’s perspective? Let me focus on one key initiative.

The ECB needs to be prepared for a more volatile environment. As industrial policy becomes more assertive, geopolitical tensions rise and supply chains are disrupted, financial market stress is likely to become more frequent.

We must avoid a situation where that stress triggers fire sales of euro-denominated securities in global funding markets, which could hamper the transmission of our monetary policy. And this means we have to give partners who want to transact in euros the confidence that euro liquidity will be available if they need it.

That is why, last week, the Governing Council decided to expand our EUREP facility – our standing facility that offers euro liquidity against high-quality collateral.

This expanded facility provides permanence: central banks outside the euro area can now rely on continuous access to liquidity in euros, not just temporary lines.

It extends scope: we move from a regional to a global perimeter. Any central bank that meets basic criteria can request access, with flexibility on usage.

And it ensures agility: access is granted by default unless there is a reason to restrict it, speeding up the provision of liquidity.

This facility also reinforces the role of the euro. The availability of a lender of last resort for central banks worldwide boosts confidence to invest, borrow and trade in euros, knowing that access will be there during market disruptions.

In a world where supply chain dependencies have become security vulnerabilities, Europe must be a source of stability – for ourselves and for our partners.

That, too, is part of European security. And that is how the ECB plays its part.

So, yeah, this is basically about geopolitics and the international role of the euro, which, fair enough—I’d be thinking the same thing. Jean Monet famously quipped that “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” That line has aged well, and seems a fair description for major European policy initiatives. EUREP expansion may be one of them, but in service of a larger goal: expanding the international use of the euro.

Lover’s quarrel?

One might question whether the European reaction to the latest round of American policy is an overreaction, particularly given Sec. Rubio’s recent Munich speech. But again, the US implicitly (explicitly?) threatened to invade Europe to take physical territory, so it seems reasonable for Brussels to aim for more strategic autonomy on the margin. But this is also too simple a story: recall that Europe’s famous Anti-Coercion Instrument was not borne of conflict with China, but rather with America, years ago. Remember INSTEX, a (not effective) scheme to avoid sanctions? Also America, not China or Russia. This story predates the current American administration.

This is not to say that America is Europe’s main challenge—clearly far from it. And, as Sec. Rubio said, America’s “destiny is and will always be intertwined with” Europe’s. Trans-Atlanticism isn’t dead. But I mean, it isn’t in rude health either, and I don’t think we should be shocked by this showing up in the land of central banking policy-cum-diplomacy.

Will it work?

So, can Europe manage to create a compelling alternative to the dollar as an international reserve currency? Will this EUREP change do the trick? These are two distinct questions.

On the first, yes—to some degree it already has. The euro has safely been the second reserve currency for some time.

On the second, no, at least not in isolation. Pulling from an earlier piece from this site, when I was writing about the provision of swap lines by China to support renminbi internationalization:

Imagine you’re on a used car lot looking to purchase a car. As you walk past a sedan, a salesperson approaches you and says she can offer you an insurance deal on that specific car because she has a special deal with the manufacturer. Do you buy the car? I don’t know. It depends. All else equal, the provision of comparatively cheap insurance with broad coverage would, on the margin, make you more likely to buy the sedan. But not all else is equal: you’d have to want the car in the first place. Swaps lines are somewhat similar. They provide insurance against a liquidity shortage, making it easier and safer to transact in the currency and hold assets denominated in it. But again, you’d have to want to use that currency in the first place. Using the provision of insurance to enhance the desirability of the product is to put the cart in front of the horse.

Backstop liquidity provision—essentially insurance—is a necessary but far from sufficient condition to “internationalize” a currency (whatever that means to you, which seems to be in the eye of the beholder, to some degree). The lack of a generous euro liquidity safety net is not the binding constraint on the euro’s international use.

It’s the lack of more euro-denominated safe assets. Carlos Cuerpo, a Spanish minister, identified this head-on just days ago in an excellent FT Alphaville piece appropriately titled, Europe’s best bet for financial sovereignty is a true safe asset. Agreed! He’s put it better than I can, so I encourage you to read the article (FTAV is free to read). But the upshot is that the world needs safe assets; the US has manufactured them to an unparalleled degree; but there is no reason—aside from political ones—that Europe can’t expand the quantity of euro-denominated safe assets in the world.

In that case, maybe the new and improved EUREP will get some use after all.

Geopolitics matters

I think the main upshot here is less about the specifics of EUREP (although I’m so here for that) and more about the big-picture trendlines. As Bloomberg’s Joe Weisenthal and Tracy Alloway put it on a recent podcast episode (I’m paraphrasing), “we now talk about the Munich Security Conference as a macroeconomic event.” At this point, I think this realization is old(-ish) news, but that even a trans-Atlantic rift is starting to shape European central banking policy is perhaps a surprise in magnitude to some.

“We’re so back.” — geopolitics

China as overseas official development lender

China has long been an international lender, from nearly the founding of the modern People’s Republic in 1949 to today, when Chinese international lending has encompassed the globe, financing dazzling infrastructure projects in the Global South. Chinese overseas lending is, unusually, almost all official, that is, from the Chinese government or its constituent organs. At its 2016 peak, Chinese bilateral lending eclipsed that of all Western creditors combined. While China’s overseas lending crested almost a decade ago, its nominal lending footprint remains massive, and this exposure begs the question: has China’s overseas development lending been a net positive for global welfare?

Chinese lending, 1998–2019

Horn et al. 2019 (6)

Defining Chinese overseas development lending

Sovereign lending is defined as lending by a sovereign, which includes both the state itself, its constituent organs (including state-owned enterprises, SOEs), and parastatals. Usually, sovereign lending (also known as official lending) is to other sovereigns, but sometimes also to non-governmental organizations (NGOs) or even corporates. China’s overseas development lending is almost exclusively sovereign.

Chinese sovereign lending can be categorized broadly into four types:

1. Official development lending (e.g., Chinese policy banks)

2. Other official lending (e.g., sovereign wealth funds, SOEs, often in the form of commodity prepayment facilities and state-owned commercial bank loans)

3. Central bank lending (e.g., People’s Bank of China [PBOC] swap lines and deposit loans1)

4. Indirect lending via multilaterals (e.g., International Monetary Fund [IMF])

I focus here on development lending. This excludes reserve-management “lending” (i.e., China’s holdings of American Treasury bonds or European sovereign debt for purposes of managing its reserves). That is an equally interesting question, but demands a separate analytical framework and differs, both in motivation and mechanics, significantly from sovereign lending practices. I also exclude discussion here of China’s role in the IMF, also an interesting question, but far from the centerpiece of Chinese development lending (for numerous reasons).

Defining global welfare

The net welfare gain (loss) of Chinese sovereign lending hinges on the answers to the following three questions:

1. Does the lending sustainably support growth and resilience while safeguarding debtor sovereignty to a reasonable extent without creating substantial political distortions?

2. Could the debtor country have obtained the same quantity of financing on equal or better terms from another lender?

3. Do the lending practices materially prevent other lenders from being able to participate, in other words, does it systemically complement or systemically hamper the existing network of other lenders and crisis-managers?

A few caveats and clarifications are in order. First, the bar is not so high that there can be no political distortions or limitations on debtor sovereignty—that would be impractical and even at times not preferable. It would also not be comparable with outside options, all of which come with some of that baggage. Second, more is not necessarily better: simply having more financing is not sufficient to be considered a net improvement to global welfare (e.g., the lending could be used to line pockets of cronies, not supporting growth at all while indebting the citizens of the borrower country without their consent). Finally, even if the lending satisfies the other conditions, if it makes borrowing from other sources more difficult, then the bar is much higher for the Chinese lending.

The importance of benchmarking: the counterfactual lender

Doing marginally good lending is necessary but insufficient: if that marginally good Chinese lending displaces even better lending from an alternative lender, that is a net negative for global welfare. Similarly, harmful lending practices are not sufficient to make Chinese lending a net welfare negative: if they are not worse than alternative lending practices, then the marginal effect is zero. Chinese sovereign lending then must be benchmarked against an alternative.2 So, the question must be, ‘is Chinese sovereign lending less sustainable, less growth-supportive, more geopolitically weaponized, etc. than the next-best alternative?’

Does Chinese sovereign lending support growth and resilience?

Numerous academic studies have shown that Chinese lending, inter alia, supports economic growth; supports educational improvement and child health; promotes growth in remote areas; improves poverty alleviation; and helps under-resourced countries meet their infrastructure needs. In this sense, the literature is clear that in nominal terms, Chinese overseas lending has been a boon to growth and development, particularly in the Global South, where it’s most needed.

Of course, the same could be said of traditional multilateral lending, so the question is how Chinese lending supports growth and resilience relative to the next best option. In this sense, uniquely Chinese “circular lending,”3 while perhaps a creative way to avoid graft, raises questions about if more inclusive growth would be supported if the funds actually left the Chinese financial system (e.g., supporting businesses in borrower countries). Similarly, it’s difficult to disentangle Chinese official overseas lending practices from the projects they finance, since the two typically go hand in hand (see aforementioned “circular lending”). In the Chinese lending framework, the norm is “tied procurement” as a part of the package deal, which essentially means the absence of a competitive bid for the project and potentially inflated costs. As researchers at the Center for Global Development point out, “financing terms alone may understate the degree to which borrowers are incurring higher costs relative to what they would have incurred if they selected a more competitive source of debt financing.”

This is all to say that, while Chinese lending supports much-needed growth-positive projects, what is less clear is whether that same growth dividend could be obtained via cheaper and more competitive financing.

Is Chinese sovereign lending sustainable?

Loan characteristics

China’s overseas loans are known to be at considerably higher interest rates and with stricter collateral/balance sheet protection terms than similar loans from alternative lenders such as the OECD and Paris Club lenders. According to scholars at the Lowy Institute (emphasis added):

For the poorest and most vulnerable countries, payments to China make up a quarter of all debt service costs, outweighing both multilateral lenders and private creditors. No single bilateral creditor has been responsible for such a large share of developing country debt service in the past 50 years. In 54 of 120 developing countries with available data, debt service payments to China now exceed the combined payments owed to the Paris Club — a bloc that includes all major Western bilateral lenders.

China’s lending pattern in the past two decades has proven pro-cyclical, as new lending dried up just when it was needed most, with the Paris Club providing countercyclical financing to bridge the gap. It is also true that China’s overseas lending portfolio has deteriorated significantly and divergently from benchmarks. For example, the share of Chinese loan claims on borrowers in distress has skyrocketed in recent years and borrowers with Chinese debt were downgraded by five notches, compared to two notches in a benchmark emerging market index.4

The primary avenue through which Chinese overseas official lending contributes to unsustainable borrowing practices is its non-concessionary nature. Researchers at the Center for Global Development analyzed Chinese and World Bank lending in 157 countries and compared the loan terms. This comparison is particularly useful since the World Bank and Chinese official overseas lending tend to finance the same types of projects (e.g., infrastructure). They found that World Bank financing was considerably cheaper for the borrower and contained larger amounts of grant funding, with a measure of total portfolio concessionality for the World Bank of 42.2% compared to China’s 21.5%. They found that on all metrics—maturity, grace period, and interest rate—World Bank lending was far more debtor-friendly.

Scholars from the Lowy Institute provide an illustrative example in the case of Laos (emphasis added, references omitted):

Heavy borrowing from China and commercial sources delivered a remarkable reversal in the structure of Laos’ public debt. In 2004, three-quarters of debt was on highly concessional terms and only one-quarter non-concessional. By 2019, that ratio had flipped. Higher interest rates, shorter repayment periods, and the expiry of grace periods on large Chinese loans produced a dramatic rise in debt servicing costs. Including amounts ultimately deferred by China, scheduled debt service payments increased over three-fold . . ..

Laotian debt load with respect to Chinese lenders

Barney et al. 2025 (8)

Notably, though, even in the case of Laos, China did provide considerable deferral of debt payments and extended a PBOC swap line, which scholars credited with attenuating the impact of Laos’ kip crisis. There is also evidence that borrowing from China has helped debtor countries’ resilience in the face of macroeconomic shocks. For example, Zhengyang Jiang shows that major China-debtor countries tend to experience less exchange rate depreciation and equity market decline in the face of US monetary policy tightening compared to those that borrow less from China. Other research suggests that borrowing from China is associated with muted severity of capital flight during US monetary policy tightening periods, which scholars have termed the “buffering effect” of Chinese lending.

Restructuring

China’s presence in large, complex debt restructurings has made those restructurings more complex, in part because China has been unusually reluctant to grant relief and in part because of the complexity of China’s fragmented lenders. For example, in the case of Congo-Brazzaville in 2018–19, China did not provide financing assurances required to unlock IMF funding, which resulted in a protracted restructuring that required a separate China–Congo-Brazzaville restructuring. China raised similar complications in the 2021–23 Suriname restructuring, in which China refused to provide financing assurances to unlock IMF funding. Empirical research has found a positive relationship between a proxy for IMF negotiating complexity and stocks of Chinese debt. More tangibly, many Chinese loan agreements explicitly exempt the debt from Paris Club restructurings or comparable treatment. On the other hand, the existence of China as an “outside option” may strengthen the position of debtor countries in negotiations with the IMF. In short, the balance of evidence suggests that the presence of Chinese creditors in a sovereign restructuring makes the resolution of that debt crisis protracted, complicated, and costly, relative to Paris Club alternatives.

Does Chinese sovereign lending safeguard debtor sovereignty to a reasonable extent without creating substantial political distortions?

Some scholars have noted that, since the very inception of Chinese lending, it “has always had a strategic element.” It is worth noting, however, that geopolitical strategizing in official lending operations is rather the rule than the exception, and is a practice widely shared across all major creditors for the past 200 years. So here again, the question is whether or not Chinese overseas official lending has disproportionate political distortions relative to the benchmark.

Some studies suggest considerable political leverage. There are, for example, cases of China conditioning access to its PBOC swap lines to South Korea and Mongolia on geopolitical demands, the former with respect to Seoul’s decision to host an American missile defense system and the latter with respect to a visit from the Dalai Lama. However, whether or not that political leverage is more intrusive to sovereignty than, for example, IMF directives about privatizing state-owned companies, is unclear (and that is a high threshold).

One aspect of official Chinese lending, however, that would surpass even the high bar set by strict conditionality programs of the IMF is lending with sovereign collateral, subject to Chinese repossession in the case of default. Yet, these allegations are often exaggerated and misunderstood. Take the much-maligned and misunderstood Hambantota Port in Sri Lanka. There was no debt-for-equity swap, as is often mistakenly portrayed. Chinese SOEs did not “repo” the port—they negotiated a lease-back, which provided Sri Lanka hard currency cash flows and fiscal space to pay down maturing debts. And in both of the most-cited cases of borrower victimization—Malaysia and Sri Lanka—the at-issue debt programs were initiated by the borrowers, not by China. In many cases, the so-called “debt-trapping” is rather a request by a borrowing country for Chinese finance to support a project of questionable economic viability—not because of self-defeating grand strategy, but simply poor planning, limited capacity for sophisticated analysis, and poor governance.

More common than sovereign land or mineral collateral, in fact, is transactions that allow Chinese creditors to ringfence foreign currency cash flows from debtor countries (e.g., offshore bank deposits, export receipts). In fact, per the authors of a forthcoming exhaustive study of official Chinese lending practices, “contrary to popular stereotypes, physical assets back only 8% of the secured debt in our dataset; bank deposits and revenue streams account for the bulk of the collateral.”

Illustrative example of Chinese official loan collateralization: China Development Bank and Sonangol

Gelpern et al. 2025 (8)

Does Chinese sovereign lending limit or obstruct other lending?

China’s lending complicates lending from other creditors through two channels: data opacity and restructuring complexity.

Data opacity

Opacity in Chinese lending creates numerous problems for other lenders. For the private sector, ambiguity about debt loads and interest expenses makes asset valuation challenging. For the official sector, similar challenges lurk with respect to debt sustainability analyses. Creditors rely on accurate and complete data on a prospective borrower’s financial health to extend credit.

Clear, timely, accurate, and accessible data on Chinese official lending is almost impossible to come by. China does not report its international lending activities—not to the public, not to credit rating agencies, not to the OECD’s Paris Club or Creditor Reporting System or Export Credit Group, and barely even to the Bank for International Settlements. Its lending is also not covered by major commercial providers. The PBOC hardly reports any of its lending via swap lines and deposit facilities; one study including information on PBOC swap line interest rates relied on a leaked digital photograph of a paper copy of the agreement. The primary, if not only, resources on China’s overseas lending are compiled by academics, some of whom report that they expect their estimates to capture only 50–65% of total Chinese overseas loans. So opaque is China’s official lending that scholars have referred to it as “hidden debt.” One estimate suggests that, as of 2019, nearly half of China’s lending is unreported.

Chinese lending opacity

Horn et al. 2019 (25)

This hidden debt is not immaterial: accounting for it dramatically changes the debt loads and debt-servicing costs of dozens of mostly poor countries in magnitudes not previously understood.

Restructuring complexity

China’s role in restructuring has presented challenges beyond simply refusing to provide financing assurances in advance of IMF funding; restructuring challenges are exacerbated by the number of creditors involved and the complexity in bringing them all to the table. For example, in the 2018–19 Congo-Brazzaville restructuring, the IMF approached the PBOC for financing assurances, but the debt was in fact mostly owed to China Eximbank and China Development Bank, over which the PBOC in fact has very little control; not even the IMF knew which Chinese organizations were owed what or answered to whom. In fact, scholars focused on China’s role in sovereign restructurings suggest that one of the most effective avenues to improve sovereign debt restructuring vis-à-vis Beijing is for China to create a consolidated entity to handle and negotiate impaired debts.

Conclusion: Almost There

Has China’s overseas development lending been a net positive for global welfare?

On balance, in the absence of other “better” options, Chinese sovereign lending would be a net welfare positive. However, in light of more transparent and accountable borrowing avenues, including through multilaterals, other official bilateral creditors, and bond markets, Chinese lending does not provide a net gain. Moreover, Chinese lending practices have negative externalities with respect to other lenders: lending practices create asymmetric information that makes it materially more difficult for other lenders, including official multilaterals like the IMF, to provide financing.

Put differently, the answer to our question is: “in nominal terms, yes; in relative terms, no.” That conclusion need not be forward-looking. With simple changes to improve transparency through disclosure, China would accomplish much. A more centralized approach to lending programs, streamlining hiccups along the way, would reduce many of the largest frictions. The straightforward introduction of a competitive tender process for financed projects and the use of local contractors would go far in improving net benefit. The issues that limit the effectiveness of China’s development lending are not so much debt trapping or geostrategic reach, but rather relatively prosaic issues of bureaucratic complexity, lack of identifiable responsibility, cronyism, and opacity. These are solvable issues that Beijing will hopefully address. The world would be better for it.

What is a public policy person, you might ask? Well, if you want to measure it by advanced degree, it’s the MPP/MPA folks from the Harvard Kennedy School and Hopkins SAIS1 and the Wilson School who roam the halls of Capitol Hill, the DoD, the New York Fed, and the Foreign Service. Among the MPP/MPA-holding folks (including SAIS) out there are people like former FRBNY President and Treasury Secretary Timothy Geithner; former general and CIA Director David Petraeus; current Icelandic Prime Minister Kristrún Frostadóttir (from my school!); and current Dallas Fed President Lorie Logan, among many others. If you want to measure it by role or disposition, I would qualify it as a technocrat. There are technocrats-cum-politicians (e.g., Mark Carney), but they are technocrats first, almost always. Technocrats mostly exist in governments, but also in the non-profit sector and, to varying degrees, in the private sector.

It looks different to different people. For me, it means about 70% of my time and energy is spent on economics/finance/statistics, about 20% on political science and international relations, and about 10% on other stuff (e.g., ethics, foreign language, history). But my policy school class includes special forces operators, refugee resettlement experts, finance ministry civil servants, energy engineers, and even an astrophysicist. All to say, by profession, it’s all over the place, but this leads me to how I think about the pipeline of public policy. It is this pipeline that makes all the public policy folks connected.

Policy sausage-making

One way to think about the creation of public policy2 is that there are three distinct but deeply related stages of production: (1) information gathering and knowledge-generation; (2) knowledge synthesis and (yes, normative) analysis; (3) advocacy and execution. The first stage involves deep dives into topics relevant to policy and the production of sophisticated research—think randomized control trials on a cash-transfer program. The second stage involves review of that research, implementation scoping, operationalization, and analysis—think reviewing all the studies on the cash-transfer programs, designing a real-life program, outlining options to implement such a program, and briefing policymakers on the pros and cons of the intervention. The third stage involves essentially legislation, rulemaking, or decision-making—think reading the memos on the cash transfer programs, getting briefed on the approaches on the table, raising it to a Parliamentary/Congressional committee, and ultimately voting on it. There are different groups at each stage.

The first is academic and quasi-academic researchers, often economists in my slice of the policy world, but also sociologists, demographers, political scientists, and experts of all stripes (including in the hard sciences!). These people usually have PhDs and move fluidly between government, academia, and the non-profit/think tank worlds. They produce new knowledge, and disseminate it out into the world, but usually with a particular audience. Sometimes that audience is implicit, sometimes very explicit (e.g., the Congressional Research Service). In the Fed, this usually means the research departments of the reserve banks, or of the Board. In broad strokes, they write and present academic papers with most of their time; they also provide expert opinions, and sometimes cautiously advocate normatively. They love regressions. Bad writing habit: academic prose that’s 10x too long.

The second is the public policy people. These people only episodically write or contribute to academic papers (it varies by person, but usually none). But they read a lot of them. They digest papers and reports, type up 2–3 page memos with key points, brief principles, and attend meetings. They are the technocrats. In general, when they advocate it’s based on cost-benefit analyses, not ideological convictions; you’ll see them working for members of different parties. They are problem-solvers, somewhat akin to McKinsey consultants, but inside a government (incidentally, many do go into government consulting or to McKinsey, literally). They don’t love regressions, but respect them, and know how to read an output table. Bad writing habit: inscrutable acronyms and jargon.

The third group is politicians. In broad strokes, these people do not contribute to academic papers, and only very rarely read them. They read the public policy people’s memos. They are effective advocates, and among those with graduate degrees, they are unusually likely to have law degrees. They are more likely to be party-loyal and, by definition, partisan. They are astute operators of reality and the landscape of political, budgetary, and administrative constraints. I once had a colleague who had been both an advisor in the civil service (read: public policy people) and later a parliament member (read: politician) tell me, “when you’re in the civil service, you get to advocate for the best policy based on outcome; when you’re in the political arena, you have to be the fun-killer, telling those civil service people that X or Y union or lobby group will kill the proposal.” They aren’t terribly familiar with regressions in general, but they’re very adept at explaining the narrative of the stylized facts in a digestible manner. Bad writing habit: poetry that’s light on substance.

A question of framing

The three groups think about different questions, with different framing.

The politician asks: What rights should an individual have to own a gun? What is the trade-off we should make between public safety and individual freedoms? How do constituents (individual, corporate, nonprofit) think and feel about this issue and what is most salient to them about it?

The public policy person asks: I’ve been tasked with reducing gun violence in area X—what does the academic literature say about driving causes, how high conviction am I on those causes, and what interventions can I implement at the highest efficacy and lowest cost, subject to the prevailing political, cultural, legal, administrative, and budgetary constraints?

The knowledge-creator asks: Controlling for as many exogenous variables as possible, can I identify a causal link between numbers of guns per capita and gun violence? Is a randomized control trial plausible here? If not, what do we know about similar causal channels in other historical episodes of comparable issues?

Wheelhouses for days

Related to the above, and unsurprisingly, the size of wheelhouses varies. Spend enough time around truly academic conferences, and you’ll hear a lot of qualification and even downright avoidance of questions that are “outside my wheelhouse.” I have a lot of appreciation for this. Ask a labor economist about health care, and they’re likely to (very honestly!) say, “I have some informed speculation, but I’m not an expert in this area, you should speak with X.” These people spend their lives becoming experts on a topic, stay in their lane, and understandably wish others would too. Sometimes that expertise is too narrow or esoteric to be useful, but it’s true expertise.

Among the policy folk, there are more opinions, but still a fair bit of qualification. They are the types that at dinner parties strike you as widely read. They are comfortable on a range of topics, and are willing to discuss them, though are often appropriately hesitant to draw generalizations and do like to toss around, “I’m over my skis on this, but…”. (This is why they make such good Foreign Service Officers.3) They have a tendency to talk too much about The Economist.

Politicians have opinions on everything, which, I assume, is exhausting. But, to be fair to them, it is literally their job. Imagine asking your elected official about their opinions on child care, and them saying, studiously: “This is a deeply complex topic and one that’s clearly cross-cutting among OECD countries, so not particularly idiosyncratic to the United States. I’m not well-read on this literature, so I’m over my skis here, but my very surface-level read is that we’ve got a supply-side issue to the extent it’s a market failure. I don’t know much about successful interventions, but I’m sure someone has done some work on it, I can get back to you.” Yuck, very uninspiring! In practice, this is why well-functioning governments of elected politicians have a deep bench of policy talent,4 and the politicians themselves have the very difficult task of public-facing synthesis and persuasion.

In many governments, you’ll have all three in the legislative branch (e.g., in the US, we have the Congressional Research Service, policy staffers, and elected officials all in the legislative). Usually, the executive branch is very policy people-heavy, save for the top levels where there are political appointments (hence “career staff” vs “political appointment”). If, for example, you go to a US embassy abroad, almost everyone there, often with the exception of the ambassador themselves, is professional staff (i.e., technocrats).

Picking your poison

I don’t like to generalize very much, and this essay has done that. Discount as appropriate—these are caricatured archetypes. Obviously in the real world it varies. I have policy friends and colleagues who flirt hard with the line of being an academic, and obviously some policy folks flirt pretty hard with politics. Some have done it all (again, see Mark Carney). I hope this is a helpful way to think about it, though, and useful for those considering a master’s degree and what types of work they might want to do.

Dutch Treat: The Netherlands’ Exorbitant Privilege in the Eighteenth Century. Stein Berre and Asani Sarkar. Federal Reserve Bank of New York.

Exorbitant privilege is a polarizing concept these days. For those not in the field, it’s basically the idea that the country that provides the world’s reserve currency can finance itself more cheaply than it otherwise would, and that it has an unnaturally high debt capacity due to the large demand for its debt. It pretty much refers to the dollar (the actual quote is from Valéry Giscard d’Estaing, then the French minister of finance, in the 1960s in reference to the dollar’s growing role). But the US isn’t the only country that’s held the exorbitant privilege! The UK did before, but before that, so did the Netherlands in the 17th and 18th centuries.

I love financial history, in part because it’s just interesting, but in part because it reveals the structural consistency over time—not all that much changes. From the note:

The role of the Dutch guilder as the global reserve currency allowed the Netherlands to have the lowest prevailing rate of interest in Europe, as foreign investors were more willing to exchange their surpluses for financial assets in the Netherlands. One consequence was that foreign investors left large deposits with the leading merchant banks of Amsterdam. Since these deposits paid no interest, they provided these firms with a source of low-cost funding.

This was basically foreign institutional investors placing deposits with the New York Fed prior to interest on reserve balances! Plus ça change.

2034: A Novel of the Next World War. Elliot Ackerman and Admiral James Stavridis, USN. Penguin Random House.

I don’t typically include fiction here, but this novel is likely of interest to Discursive readers. Its description from publisher site is below:

On March 12, 2034, US Navy Commodore Sarah Hunt is on the bridge of her flagship, the guided missile destroyer USS John Paul Jones, conducting a routine freedom of navigation patrol in the South China Sea when her ship detects an unflagged trawler in clear distress, smoke billowing from its bridge. On that same day, US Marine aviator Major Chris “Wedge” Mitchell is flying an F35E Lightning over the Strait of Hormuz, testing a new stealth technology as he flirts with Iranian airspace. By the end of that day, Wedge will be an Iranian prisoner, and Sarah Hunt’s destroyer will lie at the bottom of the sea, sunk by the Chinese Navy. Iran and China have clearly coordinated their moves, which involve the use of powerful new forms of cyber weaponry that render US ships and planes defenseless. In a single day, America’s faith in its military’s strategic pre-eminence is in tatters. A new, terrifying era is at hand.

So begins a disturbingly plausible work of speculative fiction, co-authored by an award-winning novelist and decorated Marine veteran and the former commander of NATO, a legendary admiral who has spent much of his career strategically outmaneuvering America’s most tenacious adversaries. Written with a powerful blend of geopolitical sophistication and human empathy, 2034 takes us inside the minds of a global cast of characters–Americans, Chinese, Iranians, Russians, Indians–as a series of arrogant miscalculations on all sides leads the world into an intensifying international storm. In the end, China and the United States will have paid a staggering cost, one that forever alters the global balance of power.

Everything in 2034 is an imaginative extrapolation from present-day facts on the ground combined with the authors’ years working at the highest and most classified levels of national security. Sometimes it takes a brilliant work of fiction to illuminate the most dire of warnings: 2034 is all too close at hand, and this cautionary tale presents the reader a dark yet possible future that we must do all we can to avoid.

On the scale of tragedy to comedy, this is 100% in the former bucket. 2034 is indeed chilling, not only for its ‘disturbingly plausible’ war scenarios in particular, but for its reminder of the dangers of excesses of human ego and, in the aggregate, of national spirit. If the book sounds far-fetched, an interview with one of the authors (Adm. Stavridis) is worth listening to, as he mentions that Pearl Harbor and the assassination of Archduke Ferdinand also seemed unimaginable at the time. That, he says, is why we have fiction: to avoid the mistake of failures of imagination. If you want some IR-flavored tragedy in your life (or just to think about how scary modern weapons are, or a conflict in the South China Sea or Taiwan might be), this is a must-read. (Incidentally, co-author Elliot Ackerman is currently a senior fellow at the Yale Jackson School of Global Affairs, my current outpost, though I didn’t know that when I was gifted this novel—small world indeed!)

International Lending in War and Peace. Sebastian Horn, Carmen Reinhart, and Christoph Trebesch. Riksbank draft paper.

Debt is a surprisingly opaque thing. Private global lending is huge, and also widely known (at least today), but even it suffers from patchy data. Much more opaque then is public lending, i.e., lending from sovereigns and multilaterals. Horn, Reinhart, and Trebesch put together the first consolidated dataset of official capital flows—mostly lending but also aid/grants—from 1790–2020. They offer six primary takeaways:

1. Official lending is actually huge, often eclipsing private capital flows globally.

2. The main driver of official capital flows is war.

3. In peacetime, the main driver is financial crises (which happen a lot, actually).

4. Geopolitical hegemons tend to be the largest official creditors during their respective peaks.

5. Official capital flows are counter-cyclical: they expand the most when private capital flows dry out.

6. In war or peace, geopolitics and realpolitik are at play, with nations lending to wartime allies and/or major economic partners.

Theirs is a deeply timely study, highlighting two issues we talk about a lot on this site: the rise of China in the global financial system and central bank swap lines. Here’s a great excerpt (my emphasis):

Our paper helps to better understand the profound changes in the current international financial system. It is not widely appreciated that we are seeing a comeback of state control in international financial flows. China’s rise as an international creditor has been underestimated due to a lack of transparency. We document how China has become one of the most important official creditors worldwide, as almost all of its foreign lending is extended by the government and its state-owned banks (see also Horn et al., 2021). Unknown to the broader public, China has also granted billions in rescue lending to developing countries (Horn et al., 2024). China’s extensive use of state finance is emblematic for other new global creditor powers, such as Russia, India, Brazil or the Arab oil states, who are all prone to use state institutions when allocating capital abroad and who have now all become active official lenders to varying degrees. These new creditors are also increasingly prone to create new multilateral lending institutions, including the Beijing-based Asia Infrastructure Investment Bank or the BRICS Development Bank. “South-South” (official) lending is likely to continue to rise – with considerable state involvement. We are also witnessing a resurgence of official financing via central banks. Central bank “swap lines” have grown in volume and relevance, most evident during the crisis of 2008 and the Covid-19 pandemic. We show that this development is reminiscent of the flourishing cross-border central bank lending during the gold standard era.

Their work is particularly useful for its long aperture, avoiding the recency bias we so often succumb to (my emphasis):

The main advantage of studying capital flows across 200 years is that it allows us to look beyond the current, post-1970 era of open capital accounts, US (dollar) dominance, and relative peace. Our data show that in periods of geopolitical turmoil and great power rivalry, private capital flows can come to an almost complete halt, while state-led finance becomes the dominant form of cross-border capital allocation. This long-run view informs our understanding of what may lie ahead for the global financial system . . . .

It’s hard to overstate the comparative size of official capital flows per this data. The authors report that in major upheavals (e.g., WWI, WWII), official capital flows reached 10% of US GDP. And these data actually understate the “real” official flows, since these data only include official bilateral data, thus excluding sovereign wealth fund investments, which in recent decades have been massive.

Another equally interesting finding is their application of the workhorse gravity model (gravity models never get old!). They find, empirically, that trade exposure, geographic proximity, military alliance, and status of being a former colony are highly predictive of sovereign lender-borrower links, all else equal. This is perhaps not directionally surprising, but very cool to see validated empirically. For example, they find that military allies receive a 100% higher bilateral official flow volume than non-allies (although the predictive strength of military alliances has declined over time).

I could sum up more, but a picture says a thousand words, so here are some awesome figures from the paper:

The hidden axis: the left-right spectrum has a non-ideology problem. G. Elliot Morris. Strength in Numbers.

One of my pet interests is political science, in which I would not call myself an expert, but an interested traveler. This excellent essay deserves particular attention. For those who need reminding: the United States does not run ranked-choice multi-member districts with proportional representation. The United States is decided not a parliamentary democracy. The rules of the game in large part dictate the possible universe of outcomes, and in a single-member district first-past-the-post system, we’ll get two parties, more or less. That is not politics; that’s math/game theory. But Americans aren’t so different from other people, so this particular system is reductive to political ideologies. G. Elliott Morris goes to the data to find out what those (considerably more diverse!) political ideologies are. This matters for relatively obvious reasons. In short, per Morris:

What if, instead of making all these assumptions [re survey question design], we simply asked voters straight-up what they wanted their party to advocate for — in their own words? This would certainly get us closer to the result we are trying to draw inferences about.

To this end, in our November Strength In Numbers/Verasight poll I asked over 2,000 Americans to describe, in their own words, their ideal political party. This article analyzes those answers and presents several conclusions for general readers, party reformers, and partisans looking for actual data to guide future electoral strategy.

(For those who have survey methodology questions, please email Morris, I don’t want to talk about two-stage clustering with probability proportional to size and LLMs here. Pls. But yes, N = 2,000 is enough.)

There are some very important takeaways that were not immediately obvious to me, particularly in our hyper-partisan world (where we also often suffer from selection bias in online media). Here are the main three:

1. Many Americans—a plurality (38%)—are not ideological at all but are simply focused on quality-of-life issues.

   

   This is kind of surprising! Note that the non-ideological group isn’t “moderate” or “centrist” on the left-right scale (that’s the purple group); they just don’t really espouse partisan views on much at all. In Morris’ words:

   The vast majority of respondents in this group also don’t use clearly political language at all . . . In that sense, this group is best described as focused on material wellbeing, and not intensely interested in politics — or potentially even aware of the ideological lines of American politics.

2. American voters are mostly revealed-preference left-leaning (but only slightly) on both economic and social policy.

   This one I found perhaps less surprising than some. Per Pew Research, Americans are basically 49% Democrat or Democrat-leaning and 43% Republican or Republican-leaning. This surprises many Americans, but it’s been true for awhile. (It’s probably surprising because of the institutional rules in America, of which the Senate and electoral college historically overweight rural areas and thus make America look moderately more right-leaning than it is in a population-weighted sense.) However, we shouldn’t overstate the magnitude: the revealed preferences are left, but barely. Most Americans are clustered very near the center, ever so slightly to the left:

   

   This space clustered around the center is also the home of many independents. Another interesting finding is that if you bin the “non-ideology” group by their revealed policy preferences, they are pretty much that paragon of the average American—pretty centrist, a little to the left (but more on social policy than economic policy):

   

3. But really, most Americans don’t think very ideologically when they describe an “ideal political party.”

   Note the bimodal distribution(s) here, interesting. Probably because roughly four of ten Americans don’t care that much and just want to buy a house.

   

   Those who were grouped into the “left- or right-leaning” camp were in the 6–7 range of ideological intensity, whereas the non-ideology folks were around 2 (the direction of which is no surprise, the magnitude of which did surprise at least me).

To folks who have at least observed American political science from the sidelines, this these findings are perhaps not entirely shocking, but for most of us, this research is probably a healthy corrective for how we think about the American voter.

Morris’s prediction: both parties should battle to win the non-ideology camp by toning down the ideology. As someone who has long been an ideology-skeptic (of all varieties, not just political), that sounds good to me!

For those interested in this literature, I’d also check out research by Lee Drutman, who got his PhD from UC Berkley studying political science. He’s been beating this drum for some time (and, to boot, is associated with both left- and right-leaning orgs, New America and the Federalist Society). If you don’t know what ranked-choice voting or multi-member districts are and are curious, check out FairVote’s explainer (which has a pro-reform bias, to be very clear, but is eminently digestible and has good external links). This is a sadly under-studied area, but it’s super interesting if you like game-theory-lite stuff (or elections).

DLT Eurodollars as fiscal relief valve?

Stablecoin issuers are already one of the largest buyers of Treasury bills, larger even than the entire nation of Japan, per Ahmed and Aldasoro (2025):

Let’s imagine that our scenario from Part II happens: foreign retail investors measurably net expand demand for Treasury bills via stablecoin/tokenized MMF demand. Some thoughts/reactions:

Short-End Rates

This scenario seems straightforwardly to drag short-term rates down, albeit of course bounded by monetary policy. But the upshot is more demand for bills resulting in lower rates. A stylized finding from Ahmed and Aldasoro (2025) is that a two-standard deviation inflow into stablecoins lowers the three-month Treasury bill yield by 2–2.5 basis points over the course of ten days. As we’ve seen, State Street puts the pressure anywhere between 3 and nearly 9 basis points of T bill yield reduction in the longer term.

Of course, all prices are a balance between supply and demand—at some point, Treasury could increase supply enough to meet the demand, and we might end up back at our initial equilibrium, just with more T-bill stock. But all else equal, more demand and higher prices (lower yields).

Long-End Rates

If you don’t expect Eurodollar stablecoins to be inflationary (more on that below), then you might not expect long-end rates to rise in an expectations-theory-of-the-term-structure kind of way. You might however, think, “oh boy, that’s a lot of debt and its weighted average maturity is decreasing, and the people who are buying it are unsophisticated retail investors in Jamaica; this doesn’t feel great!” and read Reinhart and Rogoff and say, “I’d like a few more basis points of compensation.” That would be rational. In other words, taken with short-term rates, a steepening of the curve.

More mechanically, if the Treasury shifts issuance to the front end, they’d also be reducing supply at the long end. This could in turn have the effect of driving down long yields too.

Pressures will likely pull in different directions, and it’s a tricky general equilibrium question.

Debt Issuance

This is something we discussed in Part II: would potentially lower short-end rates tempt Treasury to issue more at the front end of the curve? My expectation is that Treasury would be tempted to. And they’d be somewhat justified in doing so, if the increased demand at the front end brings short rates down; in fact, one might argue that they’d have an obligation to shift issuance to achieve the lowest cost to the taxpayer, subject to the predictability limitation. One effect here, as State Street points out, is that this makes the overall economy less robust to cyclical fluctuations (i.e., more rollover risk to funding).

Of course, we don’t really have data for this, directly, yet. However, recent academic work from Barthélemy, Gardin, and Nguyen (collectively at the Banque de France and ECB) examining the interaction between stablecoins and commercial paper is at least suggestive. In their study, the authors find that “an increase in the demand for stablecoin tokens caused additional commercial paper (CP) issuance, when tokens were backed by CP.” This shouldn’t be any huge surprise, and the authors then make the natural speculation: “This novel connection may extend to other short-term funding markets, notably Treasury Bills, with effects shaped by issuer supply elasticity.” Right.

Inflation

But that sort of looks and smells like monetizing the fiscal debt? Or at least monetizing more of it at the margin than is usual. Which begs the question: Would it be inflationary? This is a tricky question. In a world in which stablecoins exist only in an autarkic setting of the US, the expectation would be that they migrate money stock out of M1 and into M3, which might not by itself be particularly inflationary, assuming no new net money stock expansion. However, as we’ve seen, once you bring foreign currency into the mix, you’re net adding stock to the US money supply via the stablecoins. (This is all setting aside the interesting question of whether dollar stablecoins will themselves become a proper part of the US money supply in the future.) Per TBAC:

Of course, any inflationary pressure from Eurodollar stablecoins would be to some degree offset by expected dollar appreciation pressures, but the extent would depend greatly on numerous variables, of which a forecast I won’t attempt here. All to say (again): unclear, pressures will likely pull in different directions, and it’s a tricky general equilibrium question.1 But it doesn’t scream inflation, in and of itself, more so than how we’d think about normal bill issuance.

Financial Stability

There is a lot to be said about stablecoins and financial stability writ large (e.g., see here, here, and here). I’m not quite sure how to think about the effects of Eurodollar stablecoins specifically.

Start with the onshore spillbacks. On the one hand, one might think of less sophisticated foreign retail investors as being pretty “sticky” and less likely to run on stablecoins than sophisticated US fund managers; in this sense, they might be a shock absorber for US volatility. On the other hand, if and when they do run, research suggests that stablecoin Treasury buying and selling is asymmetric (more intense impacts when selling than when buying), and this can become a fire sale relatively quickly. And experience shows that electronic foreign retail depositors are the flightiest depositors of all; there’s a good chance stablecoin “deposit” flows would be more, not less, volatile in a state of the world where a large share of USD stablecoin circulation is in the Eurodollar market. That could spell more volatility in the front end of the curve, just as the Treasury sits on more rollover risk.

The effects on financial stability abroad seem less benign. One way to think about offshore retail stablecoin proliferation is that the average citizen can run out of their local currency a lot faster, which might be a shock amplifier. One could imagine a US-origin crisis in which, counterintuitively, purchases of stablecoins offshore help hold US short rates down as spreads widen, while amplifying bank runs and currency depreciation abroad (heard that story before?).

Monetary Policy Transmission

Here again, separating the aspects related to Eurodollar stablecoin issuance specifically (as opposed to stablecoin issuance writ large) is difficult, but the upshot relevant for monetary policy in any case is mainly the expanded base of stablecoins. For one, a shift into more money instruments being composed of stablecoins should reassert the now well-established dominance of the repo markets as prime monetary policy transmission markets. But it might materially impact the channels through which monetary policy functions. As Aldasoro and Ahmed put it:

Suppose the stablecoin sector grows 10-fold to $2 trillion by 2028 (as suggested by the Treasury Borrowing Advisory Committee) and the variance of 5-day flows increases proportionally. Then, a 2-standard deviation flow would amount to roughly $11 billion, with an estimated impact of -6.28 to -7.85 bps on T-bill yields. These estimates suggest that a growing stablecoin sector may eventually suppress short-term yields to an extent that meaningfully influences the transmission of Fed monetary policy to market-based yields. (p. 20; notes omitted)

And it would also work in reverse: with a large stablecoin sector, monetary policy would influence the size of the asset class in ways that research suggests would be different to money market funds (at least for now, given that the main use case remains related to crypto, and given that stablecoins don’t—nominally at least—pay yield).

Fed Balance Sheet Changes

As stablecoins grow as a money-market instrument, the Fed’s balance sheet will likely change too, albeit variably depending on the extent to which the Fed supports this new money market. This is another category for which it’s difficult to segregate Eurodollar stablecoin demand from demand overall, but we’ve established that the former accounts for much of the latter, so we’ll proceed here regardless. For a comprehensive overview on the Fed’s balance sheet in response to stablecoins, see David Beckworth over at Macroeconomic Policy Nexus. I’ve lifted here a great paragraph from David that I think sums this up nicely:

If stablecoins mean greater demand for Fed liabilities, then what kind of balance sheet expansion might this entail? In my view, there are two ways for understanding this process. One view—rooted in the “safe asset shortage” narrative—sees the Fed’s balance sheet expanding to meet an excess demand for safe and liquid assets, with quantitative easing (QE) functioning as a kind of public intermediation service that supplies the safety that private markets cannot. The other view—anchored in concerns about fiscal dominance—sees the Fed’s balance sheet growing in response to an excess supply of safe assets, as mounting public debt pressures the central bank to absorb and manage an expanding stock of treasuries. Stablecoins may intersect both of these dynamics: they could amplify global demand for dollar safety even as they deepen the channels through which the Fed intermediates the government’s swelling debt.

And an awesome table he’s put together for us:

Essentially, the QE story is that there is more demand for USD safe assets than there is supply (e.g., the Global Savings Glut) and the consolidated government (government + central bank) expand the supply of safe assets to meet that demand. This time, the Fed could expand its balance sheet (QE) via support for expanded stablecoin circulation rather than through conventional QE tools. It might do this by providing access—even if in limited “skinny master account” forms—to its financing facilities for stablecoins, and we could live in a world where the Fed’s liabilities include an ON RRP-style facility for stablecoin issuers.

The fiscal dominance story is that the Fed essentially finances fiscal deficits by supporting stablecoins, harking back to the WWII period we discussed in Part I of this essay series. In this universe, the outcome is the same—balance sheet expansion—but it’s the tail wagging the dog.

Of course, it can always be both! Here’s Beckworth again:

Stablecoins, in other words, may cause the Fed’s balance sheet to expand both to accommodate global demand for safe dollar assets and to simultaneously facilitate the absorption of ever-growing treasury issuance . . . Stablecoins, then, may become the bridge between the safe-asset-shortage and fiscal-dominance worlds: private instruments that generate public demand for Fed liabilities, even as they tether the central bank more closely to the Treasury’s balance sheet. The endgame may be a Fed balance sheet that is both structurally larger and more politically entangled—a central bank at the center of a digital safe-asset empire, but one increasingly constrained by the fiscal foundations that sustain it.

That first sentence pretty well encapsulates the thesis of this essay series: stablecoins represent two sides of the fiscal-monetary coin (pun very much intended).

Of course, regardless of fiscal dominance or stablecoin-QE, the composition of the Fed’s balance sheet might change as stablecoins replace other forms of money, as Beckworth lays out in another piece. For one, stablecoin displacement of cash2 could, all else equal, reduce the Fed’s seigniorage income, although a recent proposal for non-interest-bearing “skinny accounts” might limit the disruption. Similarly, there’s the chance that stablecoins eat away at (onshore) bank deposits (I think this is unlikely), in which case, in a world of skinny master accounts, Fed liabilities shift at the margin from banking system reserves to this new form of Fed liability, the skinny master account.

Where this all ends up is pretty speculative at this point, but these are possible worlds worth thinking through.

Dollarization

The scenario we’ve arrived at by way of Part II—expanding new dollar claims from Eurodollar stablecoins—seems unambiguously supportive of the dollar’s role abroad. The bridge between retail investors holding stablecoin Eurodollar liquidity in their crypto accounts or truly expanding offshore dollar usage will depend on other factors, like singleness of money, fungibility with demand deposits, and willingness of businesses offshore to accept them as means of payment. But the path to further incremental entrenchment of the dollar offshore seems clear, if not guaranteed. We’ve talked about this on this site.

KYC/AML/CFT/OFAC

The alphabet soup: sanctions and money laundering. We have talked about this here before, so I won’t spill too much ink on it now, but suffice it to say, I don’t have as pessimistic a view as some on the sanctions/money laundering/terrorism financing risks. Yes, to be sure, Tether & co. have a notorious past—there’s no doubt dollar stablecoins have been used by cross-border crime syndicates, thugs, autocrats, and drug-dealers. But that’s largely a failure of enforcement and compliance, not an inherent flaw of the technology, and the GENIUS Act should bring issuers that want to go legit into the regulatory fold by requiring compliance with the Bank Secrecy Act (see 12 U.S.C. §5903(A)). In fact, the programmability of smart tokens could, if leveraged properly, make them more secure than ledger-based money claims. Further, pseudonymity ≠ anonymity. As Darrell Duffie, Odunayo Olowookere, and Andreas Veneris point out in a recent IMF note, zero-knowledge proofs will allow KYC compliance while preserving users’ identities, showing that the choice between privacy and security is a false dichotomy.

Finally, recall that the US already has a virtually unregulated Wild West of offshore dollar use almost certainly supporting transnational crime groups: cash. Stablecoins aren’t a silver bullet—far from it—but they are leaps and bounds more traceable and enforceable than cash.

All told, while there’s much to worry about, I think we have reason to be cautiously optimistic here. And, as I like to say about policy choices in general, the benchmark matters: the alternative here is dollar cash or Bitcoin, depending on the use case, both of which are far dirtier and less regulated.

Abroad

Going hand-in-hand with dollarization is capital outflows from local currency into dollars, which would put depreciation pressure on local currencies and, all else equal, be inflationary abroad. In the classic Mundell-Fleming framework, these foreign jurisdictions (of which developing economies will be disproportionately affected) will be forced to hike rates or impose capital controls to limit FX slippage.

There will also be temptations to produce local competitors, either in the private (stablecoins) or public (central bank digital currency, CBDC) space. The Eurozone, for example, has taken the latter approach, as have numerous other jurisdictions. China even reacted to the GENIUS Act by publicly supporting a launch of its own renminbi stablecoin with the express goal of circulating offshore. (Although it seems this was quietly walked back.)

And then there’s the question of wealth effects. If the average family living in, e.g., Malaysia, now has a higher share of their financial assets denominated in dollars instead of ringgit, this naturally alters the wealth effects of foreign exchange rate changes. Rashad Ahmed has described this eloquently:

If households adopt significant amount[s] of dollar stablecoins, they have long dollar exposure on their balance sheet now, and they’re going to be exposed to currency mismatch on their balance sheet, and that’s going to be impacted by US monetary policy. If the Fed raises rates, you have dollar appreciation. That’s going to affect the value or the net worth of the household . . . Now, normally this would leave an amplified contractionary effect on the emerging market because they tend to hold a lot of dollar-denominated liabilities, but now they have quite a bit of dollar-denominated assets in the household sector. The value of that household balance sheet is going to go up, and that will hedge a little bit of the short dollar position of the public sector and the private sector.

Put another way, emerging markets tend to borrow—often via the official and private sectors—in dollars, with the household sector more muted, leaving the consolidated nation’s balance sheet short dollars. If households and companies acquire dollar stablecoins, though, this might actually have a balancing effect, where dollar appreciation has both wealth-creating and wealth-destroying effects simultaneously offshore. Food for thought.

Plus ça change

A view of American financial history shows that fiscal authorities have made clever use of channels through which to monetize fiscal debt if and when regular issuance becomes insufficient. In most cases, it takes a war, depression, or extreme disaster to push monetization to the edge. We’re very unlikely to see that kind of outright monetization with stablecoins, barring a crisis. However, we have shown thus far that:

• most stablecoin ownership (stock) and transaction volume (flow) are offshore;

• demand for stablecoins offshore continues to rise;

• foreign retail investors are essentially the “final frontier” of untapped T-bill demand

This supposition—that the fiscal authority will be tempted to take advantage of this newfound ability to shift larger volumes of issuance to the front end of the curve as a result of burgeoning offshore stablecoin demand—does not rest narrowly on stablecoins. Tokenized MMFs or short-term bond ETFs would have similar effects.

So, what if you do?

New monetary-fiscal arrangements are neither “good” nor “bad” in reductive terms. A model in which stablecoins tap foreign retail demand for Treasury bills to some sounds like a weak form of fiscal dominance, while to others it sounds like the US provisioning a global public good. I lean toward the latter side of this debate, but of course both can be true at once. Such an arrangement would provide a global public good in constant demand: safe assets, which to foreign retail investors can serve as a better store of wealth and inflation shelter than local currencies. This particular manifestation of safe asset might also make remittances cheaper and simpler. In this sense, a stablecoin Eurodollar market would be a public good.

On the other hand, such an arrangement could result in more volatility in the front-end of the yield curve, pose financial stability risks, and increase foreign exchange volatility, while potentially having inflationary and/or distortionary effects in the US and exacerbating capital flow volatility abroad.

Stablecoin growth has the potential, like other monetary-fiscal arrangements in the past, to alter the structure of markets and to shift the way the government funds itself. There’s no guarantee that will happen, but we would be remiss to be guilty of a failure of imagination.

This series has benefitted from generous comments from Rashad Ahmed and Richard Berner, and from fruitful discussion and research-sharing with Elliot Hentov and Steve Englander. All mistakes and views are my own, but I want to thank these brilliant people for sharing their time.

There are reasons to be skeptical. As Stefan Jacewitz of the Kansas City Fed argues, people have to buy stablecoins with something, which is usually bank deposits, but could be money market funds, in which case the effects on net new Treasury demand would be attenuated. However, this analysis and many others mostly focus on the domestic system.

Here’s my pitch: stablecoin circulation in the United States (onshore) will mostly (though not exclusively) reshuffle existing demand, but stablecoin circulation outside the United States (offshore) will create genuinely new demand. Further, that’s where most of the growth will be, so the offshore segment should not be overlooked.

How do stablecoins impact T bill demand?

State Street puts this very well (bolding original; italics my emphasis):

There are four primary channels through which stablecoin demand can manifest itself:

1. Displacement of bank deposits: Primarily involves asset substitution, resulting in minimal net-new demand as bank reserves and associated short-term assets on the bank side are simply transferred to stablecoin reserves without any system-wide increase in demand for T-bills.

2. Substitution of Money Market Funds (MMFs): Like bank deposits, this represents an asset swap wherein stablecoins are substituted for MMFs, limiting additional net Treasury demand. We view this as a low-probability scenario as stablecoins cannot pay interest, whereas MMFs do.

3. Foreign deposits converted into stablecoins: This channel represents a genuine net-new Treasury demand, as global investors shift funds from foreign assets into stablecoins backed by Treasuries. Liquidity preferences rather than yield-seeking behavior appear to be the primary driver of this shift, given that stablecoins do not pay interest.

4. Cash and banknotes replaced by stablecoins: Direct conversion of physical currency into stablecoins could generate new, incremental T-bill demand as issuers seek stable collateral backing. We see this as a low-probability scenario in most economies.

Of these channels, only foreign deposit conversion and cash/banknote replacement produce substantial new demand, while displacement from bank deposits and MMFs largely reflects asset reallocation rather than net-new demand.

Agreed! Mostly. One bone to pick: I disagree on the first bit: no system-wide increase in demand for T-bills as a result of bank deposit migration to stablecoins. The reality is that banks own precious few T-bills (only roughly 8% assets in Treasury securities writ large), where stablecoins own a lot of them. As such, a migration from bank deposits to stablecoins likely would result in a material increase in demand for T-bills (this is essentially like migrating to a narrow-bank model).

Here’s a nice figure they have:

Let’s dive into those two net-new-demand-creating categories.

Cash and foreign deposit migration: how do they create new T bill demand?

There are three ways foreign demand reaches stablecoins: (1) from non-dollar holdings (e.g., I spend my lira and buy USDT); (2) from dollar cash abroad; and (3) from Eurodollar deposits (dollar deposits held offshore—outside the United States).

The first is straightforwardly new T bill demand, as State Street highlights, so I won’t cover it separately here: it is a non-dollar claim becoming a dollar claim backed in large part by T bills, so is mechanically net new T bill demand. This is probably the single largest driver of stablecoin growth—good news for our thesis. But how it creates new T bill demand is clear.

Insofar as net new T bill demand is concerned, though, one might quibble about the latter two: they are both cases of one dollar claim migrating to another, so could we be running into the same mere-reshuffling issue again? No; we have reason to think these migrations too will create net new T bill demand:

Cash

Cash isn’t directly backed with T bills. Directly. Cash—currency—is a liability of the Federal Reserve, and sits on the liability side of the Federal Reserve System’s consolidated balance sheet. On the asset side, the Fed holds lots of things, but mostly Treasury securities and MBS. The Fed could back all its liabilities with short-duration assets and do perfect maturity matching, but it currently doesn’t (intentionally). In any case, the composition of the Fed’s balance sheet is variable, and while the weighted average maturity of the portfolio is declining, it’s certainly not a $1 cash = $1 T-bill money market fund. In fact, according to the Fed’s Sep. 25, 2025 H.4.1 release, T bills account for roughly 3% of the System’s consolidated assets, while cash represents 36% of its consolidated liabilities.2 This is compared to roughly 65% T bill composition behind Tether’s USDT, per its reserves report. So, in a crude oversimplification, if someone migrates $100 of offshore cash holdings into $100 of newly minted USDT, we’d expect roughly $62 of T-bill purchases from this transaction in the system as a whole. That overstates the effect,3 but the direction is clear.

Eurodollar bank deposits

Eurodollar bank deposits are a large market, but they are bank deposits, so mostly backed by loans, not Treasury securities, and certainly not short-term Treasury securities. So, migration out of a Eurodollar bank deposit and into a stablecoin would represent a net increase in T-bill demand. Same as for domestic bank deposit-to-stablecoin migration, as discussed earlier, but likely to a great extent.

The assets of Eurodollar banks are tricky to parse, and there’s no great consolidated location for reporting (in contrast to the onshore dollar banking system). But we can take an illustrative example. The Bank of the Philippine Islands is a bank (in the Philippine islands, shocker) that offers dollar-denominated savings accounts. If you take a look at their balance sheet, government securities writ large comprise roughly 17% of their assets, and remember that’s all government securities, not specifically T-bills, or even dollar-denominated assets; presumably they mostly hold peso-denominated Filipino sovereign debt. Now, again, similar to the Fed’s balance sheet, the bank probably does more exact liability matching, and it’s hard to tell exactly “what they buy” with $1 of dollar liabilities. Suffice it to say, though, even American banks hold well under 23% of assets (probably under 10%)4 in T-bills, so it’s safe to say that Eurodollar banks hold even less. If we assume—very conservatively—that our Filipino bank holds 20% of its total government securities in US T-bills, that’s 3.4% of total assets. But we don’t need exact figures to know that the weighted-average Eurodollar bank T-bill asset composition is far less than USDT’s 65%.

This is no surprise: $1 of a bank deposit is mostly backed by bank asset stuff (e.g., loans, mostly, some MBS); $1 of a money market fund (cough cough, stablecoins) is mostly backed with short-term government securities. We know this. It should be no surprise that the same is true offshore.

Total effect

Yes, it is true that not all offshore dollar stablecoin circulation will reflect net new dollar claims, since some fraction of it will be migrated from offshore dollar cash holdings and offshore dollar bank account holdings. But, given the asset composition backing those claims, we’ve concluded that:

cash → stablecoins = increased T-bill demand

Eurodollar bank deposits → stablecoins = increased T-bill demand

One of two things is happening when dollar stablecoins circulate offshore! Either (1) they are net new dollar claims, in which case, definitely new T-bill demand; or (2) they are migrated dollar claims from cash and Eurodollar bank deposits, in which case, still net new T-bill demand (albeit less on the margin).

Fine, but why would foreigners want dollar stablecoins?

And this question implicitly has an addendum: “, when you could get dollar cash or bank deposits.” That’s the rub, though—those options both have serious drawbacks.

Start with cash. Getting cash offshore is not always easy; there is a limited supply of it (literally, and also because of capital controls); you can lose it/it can get stolen; you can’t earn any interest on it;5 you can’t make cross-border (or even cross-country) payments with it; and it has a limited physical lifespan as it naturally wears down.

In the case of Eurodollar bank deposits, they simply aren’t available to many people, especially in emerging/frontier markets; they often come with heavy paperwork that many people can’t/won’t deal with; they’re not very accessible to people in rural underdeveloped areas, where smartphone apps are the easiest way to access financial services; they often come with fees; and they don’t enjoy FDIC deposit insurance and are not backed one-to-one with other money claims, so there is genuine risk in holding them relative to cash or money fund-style instruments.

And then there’s the general question, addendum aside, of why a foreigner would want to hold dollars at all, in any form. But that’s well-trodden ground: for the same reason that they might want to hold gold or some other perceived safe asset—safety and inflation shelter, plus maybe the benefit of cross-border payments/remittances, depending on the payment rails. And here, stablecoins have some advantages: they can easily be obtained via smartphone, payments are fast and efficient, and they offer a nearly instant off-ramp from the volatility and inflation of local currencies. Eye-popping stylized fact: 43% of sub-Saharan African transaction volume is in stablecoins. The proof is in the pudding.

How big really is offshore stablecoin growth?

Well, okay, I’ve privately heard a stablecoin representative once say, more or less, “our path to huge growth at this point is overseas.” So, the direction of travel is clear. But it’s already big.

Unfortunately, though, getting exact figures is tough, since stablecoin ownership is pseudonymous by construction and stablecoin companies jealously guard user data. That said, some laudable attempts have been made, notably by Marco Reuter at the IMF. In his paper, Reuter deploys a large language model to exploit natural language and cultural references in stablecoin wallets, as well as transaction data mapped onto time zones, in order categorize them by region of the globe. Using these data, he’s able to map stablecoin flows geographically in a manner that is considerably more robust than the existing commercial databases, which don’t account for virtual private network (VPN) use, which masks the country of origin.6 His finds are telling: 80% of stablecoin wallets are outside of North America, and 72% of transaction volume7 occurs outside of North America. Now, an immediate response to this is, “well, sure, but they’re all wallets with $20 in them doing tiny transactions frequently, that doesn’t mean the share of actual holdings offshore is large.” And that’s fair! It is true that the median transaction size in North America is large, and the mean North American transaction is even larger. But not by a ton. From Reuter:

And it’s also true that these are flow volumes, not stock, so $1 moved across borders 1,000 times becomes a sizable transaction volume, even when the stock amount is tiny. If that were true, though, we should see much lower median transaction sizes, which we don’t see (Africa is virtually the same as North America). As such, it’s reasonable to infer stocks from flows here, as a ballpark estimate, and say with relatively high confidence that 70–80% of dollar-denominated stablecoins are circulating offshore, consistent with (1) eight of ten wallets residing outside of North America; (2) roughly similar transaction sizes inside and outside North America; and (3) 80% of stablecoin transactions occurring outside the United States.

Finger in the wind

Time for some back-of-the-envelope figures. If the stablecoin market reaches $2 trillion in 2028 as TBAC suggests it might, that’s $1.6 trillion of dollar claims outside the US at 80% foreign composition. Of that $1.6 trillion, if we take Tether as a benchmark, we could expect roughly 65% of that to be backed by T-bills, roughly $1.04 trillion. Incidentally, this figure—$1.04 trillion—while for 2028, happens to be almost exactly the 2030 figure Brookings comes up with using conservative estimates of 3% p.a. offshore dollar demand growth and a low 6% stablecoin penetration rate. (Their middle-of-the-road figure is $1.9 trillion.) We’ll talk more about this in the next essay but, suffice it to say, this figure is relatively moderate, if not conservative.

If T-bill supply stays in the roughly 20% of GDP range as it has in recent years, and we take the CBO’s current growth forecasts at face value, then the ballpark 2028 T-bill supply is around $7.6 trillion. If we think that supply would be met at equilibrium with existing buyers,8 then that’s an extra $1.04 trillion on the sidelines (roughly 14% of supply), which should put downward pressure on yields, edge out other market participants, or some combination of both.

Recall that this completely sets aside onshore stablecoins—this is only an estimate of offshore stablecoin circulation, for which we can have higher confidence about net new T-bill demand.

Why should we care about stablecoins specifically, though?

At this point, the crypto-skeptics might be saying, “sure, but this is just a bad money market fund. Bad because it doesn’t pay interest, and a money market fund because it’s . . . a money market fund.” I am deeply sympathetic to this view. Especially in a world of tokenized (actual) money market funds (e.g., BlackRock’s BUIDL or Franklin Templeton’s Benji), it’s unclear how or why stablecoins would exist and grow, offshore or onshore, aside from their original use case as a crypto off-ramp.

For our purposes here, though, the distinction between a tokenized MMF and a stablecoin9 doesn’t much matter; what matters is that they are tokenized, backed in large part with T-bills, and available to foreign retail investors.

Conceptually (and reductively), you might think about it this way:

Stablecoins (and/or tokenized MMF shares) open up the upper-right quadrant of the second box; that’s basically the innovation here.

Conclusions

In Parts I and II, we have concluded:

• Historically, monetary-fiscal arrangements change over time, often leveraging money demand for debt finance;

• While purely onshore stablecoins might represent a reshuffling of Treasury demand, offshore stablecoins (Eurodollar stablecoins) represent real net new demand for Treasury securities, but we don’t know yet how much;

• Subject to the above, we have a sense that it’s significant, and it is definitely growing;

• Ergo, there exists some new T-bill demand and a means to satisfy it via stablecoins, all while shifting the weighted-average maturity of US sovereign debt shorter.

In Part III, we’ll discuss what it might look like if this occurs.

This series has benefitted from generous comments from Rashad Ahmed and Richard Berner, and from fruitful discussion and research-sharing with Elliot Hentov and Steve Englander. All mistakes and views are my own, but I want to thank these brilliant people for sharing their time.

A lot has changed since we last talked about stablecoins here! Namely, the GENIUS Act has passed, bringing stablecoins fully into the regulatory fold, and thereby providing the imprimatur of regulation needed to bring financial products into the mainstream. There’s a lot one could say about stablecoins, but I want to think here about how they might act as another innovation in financial infrastructure that increases the capacity of the market to digest ever-expanding amounts of debt.

A survey of American financial history shows that the government has made use of the monetary system (monetary authority as well as market structure) to help monetize fiscal debt in ways that support high issuance volumes, usually in times of war, but sometimes not. Today, stablecoins offer a potential new monetary-fiscal arrangement, one in which latent demand for American sovereign debt is tapped in foreign retail investors (foreign institutional investors have long been tapped to help fund American deficits). While the outcome is far from certain, if stablecoins do open a path to new demand for American debt, it will have far-reaching implications for soft power, the international monetary system, America’s fiscal deficit, and monetary policy.

On monetary-fiscal entanglement in American history

“The line between money and the public debt has never been entirely clear or distinct.” — Menand and Younger (2023, 237)

To understand the future of monetary-fiscal entanglements, we need first to understand their past. I’m using the term “entanglement” (or “arrangement”) intentionally—as opposed to something like “monetary financing” or “fiscal dominance”—because, as we’ll see, the role of money markets and their infrastructure in the US has not always been characterized by fiscal dominance or the like, but it’s always been intimately tied to the issuance of fiscal debt (safe assets).1 The source for a readable history here is Menand and Younger 2023, which lays out four ‘fiscal-monetary configurations,’ summarized below:

The National Banking System: 1863–1916

Prior to the National Banking System, the US nominally separated fiscal funding from money markets,2 but this broke down when the financing requirements of the Civil War pushed the United States (and the Confederate States, incidentally) to monetize debt issuance. In 1862, Congress passed the Legal Tender Act, which allowed the Treasury to mint paper money (which was green, hence “greenbacks”) to fund the war effort, but this resulted (predictably) in inflation. As a result, they changed tact: in 1864, Congress passed the National Banking Act, which essentially forced state banks to obtain federal charters. These banks would issue “national bank notes” receivable for payments to the US government, but they had to be backed by Treasury securities: The Treasury deputized the national banking system to buy and indirectly monetize (via issuing notes against them) the wartime fiscal debt. Maturity transformation in support of a war effort, more or less.

A national bank note; Museum of American Finance

The Federal Reserve System: 1916–1951

By 1913, the Federal Reserve System had been created and the primary money instrument of banks had shifted from notes (the paper form of deposits, if you will) to deposit accounts on which checks could be written (“checking” accounts). The new Federal Reserve banks could buy Treasuries directly. A few months after the Federal Reserve System was founded in 1913, though, war broke out on the Continent, and massive financing needs struck again. While the Treasury at first rallied the American populace by marketing war bonds as a patriotic duty, the voluntary fundraising proved insufficient. So, the Treasury deputized the Federal Reserve to help fund the war by use of credit controls and bridge financing for war bonds. By World War II, the Fed intervened to support war finance more strongly, and in spring 1942 agreed to control all borrowing costs of the US government, capping short-term rates at 0.375% and long-term rates at 2.5%. At this point, the majority of war debt was financed by expanding the money supply, in part via direct Fed purchases, and in part via commercial bank deposit expansion funding purchases of government bills.

The Primary Dealer System: 1951–2008

1951 marked the famous Fed-Treasury Accord, wherein the Fed gained its political independence, in part because of the crowding out of bank lending, and in part because of the need to control inflation that arose at the end of the war and the outbreak of hostilities in Korea. The Accord meant the Fed would stop its yield curve control, and the Treasury would focus on smooth, predictable, and affordable debt issuance. A less-remembered episode in the 1950s was soon to follow, though, when Treasury market disruption struck in the spring of 1953, triggering the SOMA manager to alert the FOMC that there was, “virtually no market for government securities at the present time” (FOMC meeting minutes). The Fed intervened at first with restraint (via repo) and then more intensely with outright purchases. This episode exposed to the Fed that Treasury securities dealers couldn’t stand on their own yet, and thus the Fed decided to support the market by financing the trading inventories of nonbank dealer firms via repo.3 The legality of this practice was internally questioned, but ultimately the Fed’s legal counsel determined it was permissible on the basis that the repos were supportive of market functioning, not aimed at helping particular firms. The Fed’s implicit funding backstop engendered the growth of a commercial market for repo to dealer firms. To become a dealer able to participate in direct Fed operations (a primary dealer), dealer firms needed to participate in (i.e., underwrite) Treasury auctions. In essence, the Fed was indirectly supporting the digestion of fiscal debt via backstopping and subsidizing the dealer firms that sold the debt.

The Shadow Dealing System: 2008–2022

By 2008, the conversion of many non-bank dealers into bank holding companies or their subsidiaries introduced new prudential regulations which limited intermediation activity in formerly non-bank dealers (e.g., market risk capital rules and leverage ratios). Other regulations later added to the cost of capital for intermediation activity, which crept away from the traditional banking sector and into the “shadow dealing” sector (mostly principal trading firms and high frequency traders, often hedge funds). These funds began to accumulate long positions in Treasuries and short positions in their derivatives, thus looking like a synthetic version of older dealer balance sheets. However, this approach involved leverage, making the system more brittle, which ultimately showed in the 2014 “flash rally” and the 2020 Treasury market panic. Like before, the Fed needed to support this crucial market and, after first intervening with repo expansion, ultimately took to large-scale asset purchases, this time for financial stability and market functioning reasons, rather than monetary policy.

Upshot

Over time, we’ve seen that the US government, like other governments throughout the world (check out Sweden!), taps all demand available to absorb its debt, with money claims having an obvious appeal (because short-term rates tend to be lower than long-term rates). Whether via the creation of new paper bills, national bank notes, or central bank purchases or interventions, the monetary plumbing has always been intimately tied with the production of safe assets, itself a byproduct of fiscal debt. Contrary to popular belief (e.g., gold bugs), this system has been remarkably resilient and has adapted to the changing landscape of the financial system over time, while naturally finding the cheapest and most efficient ways to finance government deficits and supporting dynamic credit creation. (The elasticity of the currency is a feature, not a bug!)

Do stablecoins represent the next chapter in monetary-fiscal arrangements? Maybe, but unlikely to mirror the scale and importance of previous innovations. For there to be a new monetary-fiscal arrangement, the government would need to find new demand for its debt. The qualifier new is doing heavy lifting there. From here, we’ll need to figure out whether or not stablecoins can actually unlock latent net new Treasury bill demand. That’s where we’ll go in Part II.

This series has benefitted from generous comments from Rashad Ahmed and Richard Berner, and from fruitful discussion and research-sharing with Elliot Hentov and Steve Englander. All mistakes and views are my own, but I want to thank these brilliant people for sharing their time.

Fiscal Dominance: A Primer. Stephen Cecchetti and Kermit Schoenholtz. Money and Banking.

Fiscal dominance is hot again (turns out it’s a very cyclical thing in the thousands of years of human existence). Cecchetti and Schoenholtz are the right minds to bring to bear on this topic. First of all, starting a piece with a juxtaposition of quotes from Thomas Sargent and Neil Wallace on the one hand, and a Truth Social post from Donald J. Trump on the other is (1) funny, and (2) brutal. 10/10 on a great opening.

But this is a sober piece. Embedded in those quotes is that the US is at serious risk of fiscal dominance occurring. Perhaps one of the best contributions of this note is to define, clearly, what fiscal dominance is and how it’s different from monetary dominance. Here’s their definition: “when fiscal policy pressures or compels a central bank to forsake its price stability objective in favor of helping to finance the public debt.” There’s some nuance here in my view: interventions in public sovereign debt markets might justifiably be for market functioning purposes, not backdoor fiscal support. But the line is blurry.

Importantly they tie in sovereign debt, which Americans often don’t think about (my emphasis):

… the central bank faces a tradeoff between satisfying fiscal needs and keeping prices stable. For example, to ease their financing burden, fiscal policymakers may pressure the central bank to lower the policy rate below the level consistent with its inflation target. Fiscal policymakers would benefit in the short run both from the lower cost of new debt issuance and from a surprise inflation that lowers the real value of outstanding debt – analogous to a partial default. Eventually, however, lower interest rates drive inflation expectations, and then inflation, markedly higher, leading to a loss of central bank credibility.

For those who enjoy financial history, there are lots of great Easter eggs, but as the authors point out, you don’t need to dust off history books to see fiscal dominance: Venezuela, Argentina, and Türkiye have had episodes very recently. And they make the point that the US is pretty exposed today, from a standpoint of debt service sensitivity to interest rates: “a sustained one-percentage-point rise in the average yield now adds over one percent of GDP to the annual cost of federal finance: that is more than double what an equal yield increase added in the mid-1980s.” This is not hypothetical with the sitting US president pressuring the Federal Reserve to lower interest rates explicitly to lower the country’s debt servicing costs.

Tariffs, Stablecoins, and the Demand for Dollars. Anantha Divakaruni and Peter Zimmerman. Federal Reserve Bank of Cleveland.

More on stablecoins. This is a recent paper (from August) that uses dollar stablecoin trading as a proxy for dollar trading writ large and analyses how those trading patterns respond to tariff announcements. For those who aren’t FX market plumbers, the core challenge is that most FX trading is over-the-counter (OTC), meaning it’s done bilaterally or trilaterally through dealers, instead of on exchanges. This makes getting disaggregated high-frequency data on FX trading difficult—trust me, I’ve tried.

One way to square this circle is to use market-based trading (enter: stablecoins) as a proxy for broader dollar trading. Now, there are some challenges here, because people trade dollar stablecoins for reasons other than those for which they might trade plain-vanilla FX, but it turns out it’s not a bad proxy (they do some robustness checks for those interested). Specifically, they use limit order book imbalances, which in English means the relative share of orders placed by buyers versus sellers. And they can do geographic identification by proxy of currency used (e.g., folks buying USDC in Turkish lira probably are Turkish—fair enough).

Their findings suggest that in response to “liberation day" tariff announcements, there was increased demand for buying dollars (via stablecoins):

But they can do one better! They then look at differences in announced tariff rates across countries to quantify by how much the tariff rate affected dollar buying (again, as proxied by dollar stablecoin trading). To do so, they run a fixed effects regression model and obtain the following results (my emphasis): “In all five models, we find that a larger increase in the tariff rate on a country is associated with significantly higher buying pressure of dollar-pegged stablecoins with respect to that country’s currency.”

These findings may seem esoteric, but they’re actually pretty important insofar as they relate to the reserve-status-of-the-dollar debate. During the GFC, which, as astute foreign observers oft point out, was caused by the US, the dollar appreciated and there was increased demand for buying and holding dollars, very counterintuitively. This is because of the safe haven status of the dollar, as expressed in the dollar smile theory. These recent stablecoin proxy results show that, even in the face of tariffs from the United States, foreigners tend to buy more dollars in response.

TINA: There Is No Alternative (yet).

Financial Channel Implications of a Weaker Dollar for Emerging Market Economies. Mikael Juselius, Philip Wooldridge, and Dora Xia. BIS.

Speaking of the dollar abroad, the BIS has a nice piece out on dollar depreciation in EMs. Here’s a thought for EMs: trade uncertainty and tariffs = bad, depreciating dollar = good, so it’s all fine? Maybe.

But exactly how depreciating dollar = good is not completely simple, and not universally true. A few channels, the authors say:

• The balance sheet channel: If your balance sheet has local currency assets and (unhedged) dollar liabilities, dollar depreciation mechanically strengthens your balance sheet by reducing liabilities.

• The financial channel of the exchange rate: For global banks, the improved strength of those borrower balance sheets (see above point) means you can expand credit; this channel is supportive for goods trade, among other things.

• The other balance sheet channel: So, the above could be inverted: if an EM company/bank has local currency liabilities, but dollar assets, then actually dollar depreciation would result mechanically in losses. We haven’t historically fretted about this, because traditionally EMs have been more likely debtors and the US has been a creditor, but that is increasingly not the case:

Of late, EMs have increasingly taken on creditor positions, particularly vis-à-vis the United States. This means more dollar-denominated assets on their balance sheets, which means losses on dollar depreciation. To be sure, that’s not to say all or most EMs are net creditors to the US or the rest of the world, but on the margin, they have more long-dollar positions than they used to in aggregate, which attenuates the tailwinds of dollar depreciation.

Of course, if these positions are hedged, then they are less exposed (a 100% hedged dollar position is synthetically a non-dollar position). If you want to see a case study of this, look to Taiwan, the authors say, where large unhedged long dollar positions on the balance sheets of life insurance firms expressed themselves in losses, which materialized in equity prices for those firms. And this matters increasingly because while not all EMs are net creditors, many are, and more are becoming so:

This all implies that the financial channel of the exchange rate might ultimately start working in the other direction: losses on balance sheets resulting in credit supply contraction, not expansion.

Can China’s Long-Term Growth Rate Exceed 2–3 Percent? Michael Pettis. Carnegie Endowment. (🕐)

I read Michael Pettis’ 2023 prediction/analysis on China’s growth, and thought it was worth re-upping.

Some background context for the non-China-watchers: the number one keyword when reading about China’s macroeconomic outlook is imbalance. This refers to the idea that China’s economy is unusually reliant on investment for growth relative to consumption (and, to a much lesser degree, net exports). For reference, for many advanced economies, investment’s share of GDP hovers around 15–20%; in many developing countries it’s as high as 30–35%; in China (in 2023) it was ~43%. As returns to investment start to decline (diminishing marginal returns are everywhere!), every new unit of investment yields less growth. (If this doesn’t make sense, read this footnote.1) This is straightforwardly a challenge, one that policymakers in China themselves recognize.

Pettis argues that this eventual rebalancing isn’t a policy option, but that it must happen/will eventually be forced because of China’s rapidly growing debt stock, which he argues is the other side of the investment coin. There are, then, two ways to get around this problem: (1) do less investment, or (2) increase the rate of return on investment. Pettis thinks the latter is highly unlikely. So, how can China rebalance?

Pettis says, essentially: with considerable difficulty. He draws out five plausible scenarios for China to get its investment share of GDP to ~30% in ten years:

1. Surge in Consumption: To get this done in ten years, consumption needs to grow by 6–7% a year while investment grows 0–1% a year.

2. Current Consumption Rates Hold Steady: Then GDP growth needs to slow considerably. To get it done in ten years, investment needs to contract at negative 1–2% a year, and GDP hovers around 1.5% growth per year.

3. Sharp Decline in Consumption Growth: GDP growth remains flat and investment would need to decline in the area of 3% a year (although net exports would surge, which would help).

4. Sharp GDP Contraction: So unlikely he doesn’t even model it.

5. Rebalance Over an Extended Period: If China takes 15 or 20 years to achieve the rebalancing with consumption growth at 3–4% a year, then GDP growth drops to 2% and 2.5%, respectively.

He summarizes the potential outcomes in a tidy table for us:

Here’s a key bit of his bearish takeaway:

Unless Beijing can somehow manage to set off a surge in consumption growth, which is possible but highly unlikely, it will be very difficult for a rebalancing China to grow at rates much higher than 2 percent . . . China can slow down the adjustment pace to one that is more politically acceptable, but this involves two costs. The first is that a longer period in which debt continues to rise faster than the country’s debt-servicing capacity increases the risk of a disruptive financial adjustment. The second is that, like with Japan, slower growth stretches out over a much longer time period. It is worth noting that in the early 1990s, Japan’s share of global GDP was close to 18 percent. Within twenty years, it was less than 8 percent.

Well, on that bright note, that’s a wrap.

Golden Parachute: Financial Sanctions and Russia’s Gold Reserves. Daniel McDowell. Istituto Affari Internazionali.

This piece focuses in on the Russia’s gold strategy, and expands on work McDowell has done in his book Bucking the Buck. Here he focuses on gold’s value as a sanctions hedge—a uniquely geopolitical consideration. A nice top-line (my emphasis):

Moscow’s rekindled love for gold is a direct result of the accumulation of US financial sanctions programmes targeting the Russian economy between 2014 and 2021 . . . Russia’s gold holdings were no panacea for the Kremlin in the face of these severe sanctions, but unlike CBR’s dollar and euro holdings, its bullion remained under Moscow’s control. I argue that gold reserves helped Russia in two distinct ways during the early days of the conflict. First, evidence suggests that Russia sold some of its bullion early in the conflict as a means of acquiring foreign exchange– something feasible, despite sanctions, because the physical nature of gold makes it possible to hide its origins. Second, as the ruble’s value crashed in March 2022, the Russian government implemented policies to encourage citizens worried about their savings to buy gold. Many Russians heeded this advice. In this way, Russian gold reserves operated as a de facto anchor for the ruble. This may have made severe capital outflow restrictions, which blocked off investments into foreign currency assets, more palatable to Russian savers.

I learned for the fist time about Russia’s sales of some of its gold holdings—likely at a serious discount—in non-traditional markets (some suspect Dubai) and China to support the ruble and its invasion of Ukraine. Also novel to me was the state support for ruble-for-gold sales domestically to blunt the wealth effects of capital controls on Russian savers.

He makes an important point about physical gold, preempting the critique that it’s non-yield-bearing and illiquid. While I’m putting this in my words, my read of his comments is that gold has a payoff structure somewhat like buying far out-of-the-money put options: totally useless in most states of the world—and costly—but immensely valuable in the far left tail. In other words: an insurance policy you pay non-trivial premia for, but for which the coverage makes it make sense, especially to highly risk averse organizations, like sovereigns.

This is awesome paper, worth reading in full; you’ll be rewarded with fun nuggets like this: “Russia used a paramilitary organisation known as Wagner Group to craft ties with regimes in several destabilised, conflict-prone African countries. By providing security services to embattled military leaders, Wagner accepted payment in gold which was then transported by air to Russia” (my emphasis; citations omitted). 10/10.

ICYMI, we’ve discussed this topic, in the context of rising gold prices, around here:

Influence by omission: The IMF’s lending capacity and central bank design. Ana Carolina Garriga and Michael A. Gavin. SSRN.

Lender of last resort (LOLR) meets IMF cross-over episode? All in. Here’s a nice top line (my emphasis):

In this article, we show that declining prospects for international assistance in times of crisis and continued efforts to boost the capabilities of domestic central banks are subtly connected. Unlike existing research which shows how the IMF influences countries by commission, such as through its lending practices, recommendations, and especially loan conditionalities, we argue that the relative size of the IMF’s lending capacity influences states by omission. Our argument in brief is that the inability of the IMF’s lending capacity to match the growth of financial globalization is noticed by the IMF’s potential borrowers and that states respond by strengthening the capabilities of their central banks to combat crises, especially to act as more capable lenders of last resort.

The authors carefully trace the evolution of the IMF’s lending capacity, showing it to decline in size relative to aggregate external liabilities over time. E.g.:

Then, through compilation and analysis of an extensive dataset on LOLR authorities and illustrative case studies like the Bank of Thailand, the authors provide evidence that central banks have filled the gap themselves, preemptively boostrapping their way out of the IMF lending void. They employ standard OLS regression with fixed effects to assess the impact of lower IMF borrowing capacity (relative to external debt stock) on country (okay, monetary authority, sorry) LOLR capacity, with significant results. Finally, they do an event study of the COVID-19 crisis and response, further supporting their hypothesis.

Sovereign Debt Restructuring with China at the Table: Forward Progress but Lost Decade Risk Remains. Gregory Makoff, Théo Maret, Logan Wright. Harvard Kennedy School.

I am a seasonal dilettante in the sovereign debt universe, but these three gentlemen are decidedly experts. This piece does an excellent job highlighting and synthesizing China’s changing role in the sovereign debt landscape over time. For one, it is a useful corrective for Western readers to appreciate the magnitude of Chinese sovereign lending in recent decades: “China’s lending to developing countries has rivaled that provided by the G7 since 2000, and it has had a significant concentration in many of the poorest—former HIPC [highly indebted poor countries]—countries” (my emphasis).

They trace the numerous motivations, geopolitical and otherwise, that drove China to engage so aggressively in this lending, and summarize recent challenges in Congo-Brazzaville, Suriname, and Zambia, and the infrastructural changes made by major Paris Club members and the IMF in response to those challenges.

Perhaps the most interesting addition of the piece is to examine why China struggles so hard to grant debt relief to highly indebted countries, which the authors explain is largely related to China’s internal domestic political landscape and incentive structure, which they sum up pithily as “loss avoidance and institutional complexity.” The authors make a compelling point that China’s administrative foot-dragging on permanent debt relief may risk repeating a lesson we’ve already learned:

China’s position on sovereign debt restructuring, and its significant sway as a large lender, risks a repeat of the lost decade of the 1980s, when international banks insisted on “extend and pretend” restructurings to avoid taking losses. In that period, U.S. banks were so exposed to what was then called Less Developed Country (LDC) debt that they couldn’t afford to take losses. To protect them the U.S. Treasury, the Federal Reserve, and the IMF developed economic plans that assumed sufficient growth to pay off the existing debt. The growth never materializing, this led to serial debt restructuring, which didn’t end until the 1990s, when the countries carried out Brady restructurings with significant debt relief. The Brady plans were a success. After these restructuring nearly all the Brady countries thrived, using the opportunity to reform and improve financial governance to avoid ever going into debt default again. (citations omitted)

They finish with a pragmatic policy recommendation inspired by China’s own handling of its 1990s banking system bad loan problem: that China create a single unified specialized asset management vehicle to manage its bad sovereign debt assets from its disparate creditors.

The Emergence of Tokenized Investment Funds and Their Use Cases. Pablo Azar, Francesca Carapella, JP Perez-Sangimino, Nathan Swem, and Alexandros P. Vardoulakis. Federal Reserve Bank of New York.

One way to think about tokenization is that it’s sort of back to the future with financial assets: the original form of tokenized claim was cash bills and tradable bills of exchange. Now we have tokenized digital assets. Stablecoins have been the first, but they have confounded many of us, since they don’t have (legal) yield. Tokenizing 2a-7 money market funds, though, now that makes some sense. It’s happening! And as the authors point out, it’s not necessarily the payment rails that are revolutionary, but rather the 24/7 trading window. Being able to post and move collateral 24/7 instantaneously is an interesting proposition.

Financial Bubbles Happen Less Often Than You Think. William Goetzmann. Wall Street Journal.

Bill Goetzmann is one of the most accomplished financial historians around, and just so happens to teach at the Yale School of Management. This is an excellent piece about the psychology of crowds, and a refreshing reminder about loss aversion bias. A nice line from the article that sums up the idea:

Since 1887, there have been just four cases where the Dow Jones Industrial Average has dropped by more than 10% in a single day—and two of those were during the big crash of 1929 . . . one of the biggest mistakes an investor can make is to rely on a handful of colorful historical episodes and ignore the long intervals in between: the sequence of quiet gains that stock markets have made over the decades and centuries they have existed.

If that didn’t hook you, perhaps the following will: he discusses the great Mississippi Company bubble of 1719–1720 in what was then French Louisiana. Incredible story, highly recommend.

Argentina Gets a Bailout, Brazil Gets the Stick. What Unites Them. Karthik Sankaran. Barron’s.

Karthik Sankaran is one of my favorite macroeconomic commentators and he has a Substack, The Home-Groan Globalist, which you should check out:

I think of this piece as the analytical pairing to my mostly descriptive recent note on the background of the Argentina aid package, here:

Karthik makes the point that Argentina is the yin to Brazil’s yang in America’s treatment of South American economies, both subject to what is little more than geoeconomic statecraft. He makes another interesting analogy: to ECB treatment of Eurozone countries during the Eurozone Crisis.

Dollar’s Share of Reserves Held Steady in Second Quarter When Adjusted for FX Moves. Glen Kwende, Erin Nephew, and Carlos Sánchez-Muñoz. IMF.

For those in the field, this has been a huge topic of conversation, and to some degree, controversy. The IMF maintains COFER data, which provides aggregated data on the currency composition of reserves (it literally stands for Currency Composition of Foreign Exchange Reserves). If you looked at the data this past year, it looked like the dollar share of reserves had been falling, and that wouldn’t be a crazy conclusion, given the chaos surrounding “Liberation Day,” attacks on Fed independence, massive fiscal overhang, and any number of erratic policy changes in the US. But the trouble is that, as the authors note (emphasis mine):

These shares are reported in US dollars . . . So, when exchange rates shift—even if no central bank buys or sells anything—reported shares change . . . [the depreciation of the dollar] means that even if central banks made no changes to their portfolios, the value of their non-dollar holdings—when expressed in dollars—increased, resulting in a corresponding decrease in the share of dollar holdings.

It’s so important it became the IMF’s chart of the week!

Interpreting Turbulent Episodes in International Finance. Hélène Rey and Vania Stavrakeva. Asian Monetary Policy Forum conference paper.

That capital inflows should move exchange rates and asset prices in the recipient country is seemingly obvious, but it’s one of these tricky things that’s deceptively “obvious” insofar as causal inference is notoriously difficult (because of all the endogeneity) and, as a result, so is quantification of the effect. In this paper, Rey and Stavrakeva take an instrumental variable approach (more 2SLS regressions, yay!), exploiting accounting identities about asset ownership and exchange rates, and identify a causal link.

Some of they highlights:

• Equity finance is larger than debt finance in cross-border investment since 2023.

• Usually, the local exchange rate appreciates on capital inflows, but there are some major and important outliers: USD (and some USD-pegged currencies), JPY, HKD, and CHF.

• Foreign holdings do tend to be supportive of asset prices.

• Cross-border capital markets are bigger and deeper now than in recent history.

But here’s the big one (emphasis mine):

Based on our novel daily decomposition we provide an interpretation of the striking disconnect between the USD and the standard global financial cycle that we have observed since the announcement of Trump’s tariffs. More specifically, the response to the Trump tariff announcement on April 2, 2025, marked a notable shift in global investment behavior, as the U.S. dollar depreciated sharply and foreign investors disproportionately reduced their holdings in U.S. equities and long-term government debt in favour of non-U.S. markets. This stands in stark contrast to prior crises like Covid-19 and the global financial crisis (GFC), where foreign investors typically sought safety in U.S. assets, increasing their demand for U.S. long-term government debt and decreasing demand for foreign equities in relative terms. The tariff shock represents a rare instance where global investors fled U.S. assets more than those of other countries, challenging the traditional “flight-to-safety” pattern.

We also get some very cool pictures here mapping out cross-border investments:

What are swap lines?

Literally, what are they?

Swap lines are arrangements—usually (but not always!) between central banks—to exchange one currency for another at some initiation date and then swap them back at a pre-agreed exchange rate in the future. One way to think of them is that they are repurchase agreements (repos) collateralized by foreign currency.1

I wrote a standalone primer on central bank swaps lines, which I’d encourage readers to check out. Additionally, some more comprehensive coverage can be found at the Fed and the Yale Program on Financial Stability.

Why do we have them?

Nine times out of ten, swap lines are extended because of funding pressures, i.e., spikes in borrowing costs in offshore currency markets. In practice, this means that it gets really difficult/expensive for European or Asian banks to borrow dollars, so to calm those dollar funding stresses, their monetary authorities obtain a swap line with the Fed. This is the answer you’re most likely to get from a central banker, and they’ll tell you about the cross-currency basis swap spreads (the cost of borrowing dollars abroad) rising sharply. This is true not just of the US, but to a lesser degree also for the ECB and their euro swap lines.

In reality, there can be other reasons at play too, although they’re much less common. For example, you might draw on a swap line to obtain large amounts of foreign currency so you can lend to a specific bank that’s on the brink of failure and has lots of foreign currency-denominated liabilities (and/or assets), as Iceland and Switzerland have done. In the context of emerging market economies, you might extend swap lines to help support another country’s currency, as the UAE has done for Türkiye, or as China has done for Argentina; or to try to internationalize your currency (or for other geopolitical means), as China has done.

What’s this ESF/Treasury stuff then?

Are Treasury swaps a thing?

Yep. Earlier I said that swaps are usually but not always between central banks. That is true, because historically fiscal authorities have also done swap arrangements. In fact, in the 1930s, US dollar swaps were extended by the Treasury through the Exchange Stabilization Fund (ESF), not the Fed (although this changed in coming decades). The ESF is a pot of Treasury money2 composed of foreign exchange (technically, foreign exchange, gold, and SDRs) that is held in a segregated account at the New York Fed (segregated from the Treasury General Account, that is). In more recent history, the Treasury has used the ESF to provide swap lines other countries, namely in the 1982 and 1994 Mexican crises. Historically, the use of the ESF, whether via swap or spot transactions, was mostly to do with the exchange rate of the dollar and/or other currencies (and prior to 1971, to gold). But the Treasury has also used it extensively in credit operations to support various countries. (Fun fact: the first use of an ESF credit loan—a few were offered but not used before then—was to Mexico in 1938 for $10 million.)

Intervening to affect the level of the exchange rate—or to aid other countries’ fiscal positions—is a fiscal policy decision in the US, and ergo a Treasury consideration, in contrast to standing or broad-based dollar swap lines extended by the Fed, which are for monetary policy and financial stability purposes. That said, it bears noting that the New York Fed is the fiscal agent of the Treasury (i.e., the Treasury’s bank) so any transactions done out of the ESF are staffed and executed by members of the New York Fed’s Open Market Trading Desk.

Does this make the swaps different?

Definitely. For one, as mentioned above, they are inherently political tools when housed in the Treasury. This also has ramifications for the their use; while Fed swap lines are authorized under Section 14 of the Federal Reserve Act (authorizing open market operations) and approved by the Fed’s Board of Governors, Treasury swap lines from the ESF are authorized by executive authority (via the Secretary of the Treasury with approval from the President). Authorizing legislation for the ESF is the Gold Reserve Act of 1934 (as amended) and Section 7 of the Bretton Woods Agreements Act of 1945 (as amended).

The other obvious difference here is that the Treasury is not the monetary authority and therefore cannot create reserves (and the pot of money is the ESF, a segregated account, not the Treasury General Account in any case). This means the lending is inherently limited. For reference, Mexico’s NAFA swap line with the Treasury is $9 billion; the total size of the ESF3 is $219 billion (of which about $16 billion is harder-to-liquidate assets and SPV investments); and the largest amounts outstanding drawn under a Fed swap line from a single counterparty was over $300 billion (from the ECB during COVID).

There are also reporting requirements on longer duration loans,4 but the 1995 precedent (as well as earlier 1982) with Mexico shows this isn’t a crazy hurdle. I won’t spend too much time on it here, but it’s worth noting that there were some legal controversies in 1995 regarding the term of ESF swaps. This prompted a memorandum from the Attorney General’s office to the Treasury Department on the use of the ESF for long-term (up to five years) swaps confirming the Treasury’s interpretation of the relevant statutes. Of interest is the use of the language “unique and exigent circumstances” which somewhat mirrors the language of the Fed’s Section 13(3) authorities (“unusual and exigent circumstances”). All to say, while there was initially some thought to restricting ESF loans to shorter durations,5 that view was put to bed in the summary memorandum, if not before then in 1982. It is well codified today that the Treasury can lend for long durations via ESF swaps.

In short, the main differences vis-à-vis Fed swaps: (1) governance; (2) purpose; (3) scope/scale.

What’s going on with the US and Argentina right now?

I’ll let Sec. Bessent himself tell you:

The [US Treasury] stands ready to purchase Argentina’s USD bonds and will do so as conditions warrant. We are also prepared to deliver significant stand-by credit via the Exchange Stabilization Fund, and we have been in active discussions with President Milei’s team to do so.

The Treasury is currently in negotiations with Argentine officials for a $20 billion swap line with the Central Bank. We are working in close coordination with the Argentine government to prevent excessive volatility.

In addition, the United States stands ready to purchase secondary or primary government debt and we are working with the Argentine government to end the tax holiday for commodity producers converting foreign exchange.

So, there are really three things going on here: (1) a swap line; (2) potential bond-buying; (3) ending a tax holiday for commodity producers. The purposes of (1) and (2) are the same as in the past: to support the peso and Argentine government debt (which kind of go hand-in-hand). The tax holiday issue is new to me, but also seems to be targeting pressure on the exchange rate.

What prompted the support?

In short, a run on the peso (for the 1,000,000,000,000,000th time)—nothing new under the sun here. To hear Bloomberg put it: “Javier Milei has lost the confidence of investors and he knows it” (!). To hear Mr. Milei put it, “the market is in panic mode.” In just three days last week, the Banco Central de la República Argentina (BCRA) intervened with over $1.1 billion (at a time when markets estimated reserves stood at <$20 billion).

The current situation is pretty standard of this sort of EM currency crisis: markets think the peso is overvalued and want the BCRA to let it float, and fear that they won’t be able to defend the peg. Mr. Milei and the BCRA would like to tame the volatility. This is well-trodden ground for emerging markets, and often ends in tears, without overwhelming intervention force. Context here is important, too: Argentina has had episodic balance of payments crises with such frequency that it has become the punchline in many traders’ jokes. In other words, the shadow of crises past looms large over Buenos Aires.

What might the swap line to Argentina look like?

Good question; not really sure. ESF swaps are done on an ad hoc basis. What we know thus far is that it was announced at $20 billion, and we know that swap lines from the Treasury in the past have come from the ESF.

For some historic context, the peak amount announced for Mexico for its 1995 swap was $20 billion,6 which was roughly 5.3% of Mexican GDP at that time. Today’s announcement of $20 billion would put the swap at roughly 3.2% of Argentine GDP, so well within historical bounds.

Notably, Argentine reporting suggests that a condition of the $20 billion swap will be to use $5 billion to extinguish the swap with China (see more on China below).

What about the bond-buying scheme?

Direct purchases of sovereign debt to support Argentina would be a strong direct intervention, and to my knowledge the ESF has mostly used stand-by credit or guarantees, rather than direct bond purchases. Those do have similar effects, though. For example, in the 1995 intervention, the US government included in its aid package an agreement to guarantee Mexican sovereign debt, which would have the same result of lowering yields (via the risk premium channel rather than the demand/supply channel). Notably, Mexico did pay a premium for that insurance, and there were preconditions.

Where does the IMF come in?

The IMF is the ultimate sovereign lender of last resort, to which Argentina is a frequent patron. (As of April, loans to Argentina, which represents <0.6% of global GDP, represented 34% of the IMF’s loan book.) Currently, Argentina benefits from numerous arrangements with the IMF:

Most recently, Argentina obtained—with strong US backing—a $20 billion EFF package. Now, notably, the IMF and US Treasury are not competitors here, rather collaborators (at least ideally). The statutory language related to ESF use is pretty clear that it should be used, “consistent with the obligations of the Government in the International Monetary Fund on orderly exchange arrangements and a stable system of exchange rates” (31 U.S.C. § 5302(b); my emphasis).

It was overshadowed by the Bessent/Trump announcement, but Milei also met today with Kristalina Georgieva.

How are markets reacting?

Well. It’s pretty soon (and light on details) to tell, but immediate signs are positive, which is no surprise. Reuters provides a nice smattering of economists’ notes, which I would characterize roughly as, ‘this is a material show of strength and lops off the left tail in the short run, but we’ll have to see how structural weaknesses are handled in the medium and long term.’

Is there politics at play?

Well, yes. I mean, there are geopolitics at play insofar as any Treasury swap line (some might argue any swap line) extension is an inherently geopolitical decision to some degree (in fact, Sec. Bessent explicitly said the package was symbol of the “geopolitical strategic importance of the relationship between the United States and Argentina”). There are also some more partisan politics at play;7 Argentina’s president, Javier Milei, is facing midterm elections next month after having suffered a brutal defeat in provincial elections a couple of weeks ago. Mr. Milei is an outspoken ideological ally of President Trump.8 Again, there is precedent here: the US pushed against IMF board concerns to approve a $20 billion IMF package in April (when the potential of a US credit line was first mentioned by Mr. Bessent).

Why is China relevant?

China’s current central bank swap line with Argentina is $18 billion, and its swap line at one point represented nearly 95% of Argentine reserves. In the past, it’s been used to support the peso by “putting money in the window” of the BCRA. I have written about this somewhat extensively, here and here. China’s recent (past ten years) history with Argentina has been significant, viewed as savior-like or with alarm, depending on whom you ask. I surmise from private conversations that Argentina turned to China in the past for wont of more forthright American support, and we’ve talked on this site about how China’s swap lines have been used as a geopolitical tool as much as a financial fire extinguisher. China has even used its swap line as a bridge loan to an IMF package for Argentina.

Taken together, the IMF and China have provided a huge chunk of the BCRA’s reserves in recent years. In fact, as Brad Setser points out, if you strip out reserves from the IMF and the People’s Bank of China, Argentina’s reserves position has looked worse throughout 2025, not better.

Which perhaps begs the question: agnostic to who’s in the White House, is this latest announcement good diplomacy on the side of the US? Probably. I have urged before that the US should be more active in its financial diplomacy, and in particular with this type of situation. That being said, it’s hard to be agnostic to who’s in the White House, and it’s unclear to me how much of this is about aiding Argentina or aiding a fellow right-wing populist politician in Latin America. Time might tell in the end.

Was this helpful? Further questions? Drop me a line at vincient.arnold@yale.edu.

That said, I’m trying something new (maybe just once, we’ll see!) while I work on a two-part essay series (yay), because (1) I like when other people do it; (2) I hope you might like when I do it; (3) I see things I think my readers might enjoy, but about which I cannot justify devoting significant writing and this offers a compromise. I’m going to drop a few links here I’ve found interesting, and maybe say something brief about them. (As a housekeeping issue, I’ll mention that while I’ll always try to include some free/non-gated stuff, there may be pay-walled or journal-walled content. Sorry.) If you love it, lmk; if you hate it, lmk.

Democracy does not cause growth. Guillermo Vuletin, Julia Ruiz Pozuelo, and Amy Slipowitz. Brookings.

This is a succinct piece by scholars of a longer academic study, which nicely summarizes their main argument. That argument is more or less a methodology/econometrics critique, but the upshot is material to development and political economy folks alike. A common causal inference (“does X cause Y”) tool is two-stage least squares (2SLS) regression, d.b.a instrumental variable regression (IV).1 A common approach in the literature was to instrument democratization with waves of democracy—i.e., your country gets democracy because your neighbor got democracy and it spreads contagiously, which is nice because you can say that democratic waves have nothing to do with economic outcomes and then conclude, after running an IV regression, that democracy causes economic growth. These authors critique this argument by saying, essentially, “that’s a bad instrument, you’re probably getting waves of democracy precisely because the economy has hit rock bottom.” And it looks like they’re right: once you control for the economic-origins-of-democracy endogeneity, the growth-causing features of democracy disappear. This sits somewhat uncomfortably with the “institutions matter” camp, although there’s plenty of evidence in their favor too (also using IV!). I’m not sure I’m sold on their conclusion yet (as someone partial to institutions-matter), but credit where credit’s due: the weak instrument critique here is clever.

What would happen if Congress repealed the Fed’s authority to pay interest on reserves? William English and Donald Kohn. Brookings.

This topic has been in the headlines of late and has garnered a rather unusual amount of partisan salience. Good thing, then, that the experts have weighed in with an explainer. Even among Fed-watchers, monetary policy implementation regimes are relatively esoteric, so this is a welcome post.

A couple of points I’ll highlight, in defense of interest-on-reserve-balances (IORB):

• When the Fed didn’t pay interest on bank reserves but forced banks to hold them, it was an implicit tax. This is something the “Fed needs oversight and democratic legitimacy” people should be opposed to, and it was distortionary.

• It is by now the norm among advanced economy central banks (for a reason).

• Ample (and/or abundant) reserves systems are practically relatively straightforward to run. Scarce reserve regimes are harder to run, and monetary policy slippage (losing rate control) is more likely to occur, as well as funding shortages, when you’re in a scarce reserves regime.

The main argument we’re hearing against IORB is that it’s a fiscal cost. Which I find interesting! An interest of mine/this site is that the line between the fiscal and the monetary is blurrier than we give it credit for. But these arguments miss the mark with superficial accounting and belie an understanding of the mechanics, regardless of where you stand on the size of the Fed’s balance sheet debate. It’s a tractable and timely piece.

What the West Gets Wrong About China. Rana Mitter and Elsbeth Johnson. HBR.

This is somewhat trodden territory for China-watcher types, but it’s a nice readable essay from which the non-China watchers among us will benefit. The authors—an historian and management professor—attempt to do some myth-busting about China, in three purported myths: (1) economics and democracy are two sides of the same coin; (2) authoritarian political systems can’t be legitimate; and (3) the Chinese live, work, and invest like Westerners. I don’t wholly agree with the authors in all they say here, which is probably no surprise, and I’m not even convinced most people believe myth number 3. Nonetheless, it’s a well-written answer to the “how did China not become like us” question.

The Rate of Return on Everything, 1870–2015. Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, Alan M. Taylor. NBER.

Something of an instant classic, this is one of my favorite academic papers, if for no other reason than their rockstar title. What a headline. There’s a lot to cover here, which, as I’ve previewed, I won’t do. But this is very much worth at least a student-read (abstract, intro, conclusion, charts). For your convenience, I’ll just paste here the abstract because it’s so cool:

What is the aggregate real rate of return in the economy? Is it higher than the growth rate of the economy and, if so, by how much? Is there a tendency for returns to fall in the long-run? Which particular assets have the highest long-run returns? We answer these questions on the basis of a new and comprehensive dataset for all major asset classes, including housing. The annual data on total returns for equity, housing, bonds, and bills cover 16 advanced economies from 1870 to 2015, and our new evidence reveals many new findings and puzzles.

Also just . . . data on real estate returns from Norway in 1871? Awesome. There are lots of upshots, but the thing I noticed starkly was that housing not only historically has the highest returns, it also has the highest risk-adjusted returns (Sharpe Ratios = excess return/sigma):

Another cool thing about this paper is that it’s both finance and economics, and necessarily has something to say about the macroeconomy, in this case about inequality. If r > g, in other words, returns to financial assets (wealth) are higher than the returns of the economy writ large, you’d expect inequality to expand, and their dataset has something to say about this too:

TL;DR: aside from wars, r >> g. Anyways, the paper is worth a skim at least. Reactions to it could vary from “become a real estate mogul” to “become a communist” so, ya know, idk, pick your poison, but either way, it’s a very cool paper.

***

Fin. Happy reading.

But to shake confidence in America’s dollar liquidity safety net would be to work at cross purposes with the administration’s other goals, like reducing foreign demand for Treasury assets and limiting the trade deficit. The mechanism is that swap lines can serve as a substitute for reserve accumulation, which, all else equal, would result in more purchases of Treasury and Agency debt, sometimes with surpluses created intentionally for that purpose: war chest-building, if you will. To resolve trade imbalances, you have to think about financial flows too.

Please check out the full article over at Barron’s, with a gift link for Discursive Etc. readers, courtesy of the good folks at Barron’s. (It will look like you’re still paywalled at first, but you’re not—just click the carrot dropdown to minimize the ad banner.)

Last week, the Yale Program on Financial Stability (YPFS) published Volume 7, Issue 1 of the Journal of Financial Crises. This one is close to my heart, as it comprises our series of case studies—and survey thereof—on what we’ve termed ad hoc emergency lending. The keystone piece is Ad Hoc Emergency Lending in the 21st Century, with Steven Kelly, Greg Feldberg, and Andrew Metrick (see bios here).

As many readers will know, the work of YPFS involves essentially three steps: (1) identify common tools used to respond to financial crises; (2) review selected case studies in which those tools were used; and (3) analyze best practices and caution areas for future policymakers in using those tools. The tools and case study universe come from a seminal paper by Andrew Metrick and Paul Schmelzing, which catalogues all financial crisis interventions since 1257 AD. For more on this and the way YPFS thinks about financial crises and interventions, see my earlier note on diagnosing financial crises.

You can see the various different case studies organized by intervention tool (e.g., account guarantees, capital injections, swap lines, etc.) on the New Bagehot platform, here, where we’ve compiled hundreds of case studies and thousands of pages of documentation on financial crisis interventions, from capital injections in Napoleonic France to COVID-era currency swap lines in Mongolia.

The Lender of Last Resort, targeted

Emergency lending is one of the most potent and most commonly used tools to respond to financial crises. It is often the tip of the spear—the tourniquet of financial crisis triage: emergency lending may not do the ultimate resolution and rebuilding, but it’s often the first intervention. It stops the bleeding, buying time for complex surgery or transfusions. YPFS has previously examined what we call broad-based emergency liquidity, as well as market-based emergency liquidity (here and here). We defined the former as lending that is available to any eligible institutions (think the Fed’s discount window, or other Lombard facilities), and the latter as lending that is meant to support particular markets (think lending to support the commercial paper market).

But this excludes one of the most important, controversial, and difficult types of lending: bespoke lending for specific firms. These are the Bear Stearns of the world, the Lehman Brothers, the Credit Suisse. It is exactly this—what we term ad hoc emergency lending (AHEL)—that we’ve just analyzed and published last week.

AHEL of a ride: upshots from the review

This project took two years, hundreds of pages, thousands of hours, countless interviews, and an incredible team to complete. I was honored to be a part of it, and to work with my incredible co-authors, from whom I’ve learned so much. I would encourage all interested parties to read our survey of AHEL cases in the 21st century; it’s not long, and we hope it’s quite tractable. Here’s the paper’s abstract:

This paper surveys 22 case studies of 21st century instances when financial crisis-fighters implemented ad hoc emergency liquidity (AHEL) interventions, interventions designed to provide liquidity to a troubled institution that the authorities believe is systemically important. While emergency liquidity support is often introduced with the real or communicated intention of preventing illiquidity from leading to insolvency, the liquidity crisis should instead be viewed as the manifestation of the market’s assessing the firm as nonviable as a going concern. For that reason, authorities should provide AHEL assistance only to institutions that they have deemed viable or that they have committed to make viable through additional interventions, most commonly through a government capital injection or merger with a stronger institution. Despite AHEL assistance, which the authorities in several cases sized to meet all potential funding outflows from the troubled firms, in no cases did liquidity provision alone prove a “cure” to the run on the institution. Crisis-fighters also should not use the terms of an AHEL intervention to manage moral hazard. Moral hazard can be addressed in the more structural policy responses that will need to follow AHEL assistance. AHEL programs should focus on providing sufficient liquidity to get the institution through its acute crisis phase.

I’ll highlight here some features I found particularly interesting.

AHEL interventions are very common. Even limiting ourselves to the 21st century, and even after landmark legislation in the US significantly curtailed AHEL interventions post-Global Financial Crisis, AHEL interventions were often central to the biggest financial crises and the biggest institutions (e.g., Bear Stearns, Credit Suisse, Northern Rock, all that chaos in Cyprus, and yes, even Lehman1, just to name a few).

Actually, it is about solvency. This is one of the key contributions to the literature in my view. While, yes, it is possible that a bank run occurs because of pure liquidity challenges, we find that almost never happens in the ad hoc setting. The run is symptomatic of fundamental solvency concerns. As my co-author Steven Kelly noted in his summary of the paper: “death to the myth of the ‘illiquid but solvent’ bank that needs a rescue.”

Moral hazard is better addressed elsewhere. We are not suggesting that authorities shouldn’t be concerned about moral hazard; they should. But we find that AHEL interventions are used as bridges to more permanent solutions, and punitive terms for the AHEL often end up, counterintuitively, making those other solutions more difficult and/or expensive. For example, in a few cases, authorities tried charging punitively high interest rates to punish the bank, and then realized those interest payments were eroding the bank’s capital, which they were replacing.

Creative thinking about balance sheet protection. Lenders, mostly central banks, are often required by law or internal regulation to lend against collateral, like tradable securities and loans that the central bank can easily value (there is usually a published list of acceptable collateral for standing broad-based lending facilities). Yet it is precisely the lack of eligible collateral that creates the need for an AHEL intervention in the first place: if the bank had sufficient everyday collateral eligible for a Lombard facility, it wouldn’t need an AHEL. As a result, lenders had to get creative, using fiscal guarantees, recourse, forthcoming interventions (like capital injections), and loss-sharing arrangements to limit their risks.

Political economy and the fiscal realities of monetary lending. Of particular relevance to a common theme of this site is the political economy of AHEL interventions. My priors on this were that nearly every lender would be a central bank. I was wrong. In many cases non-central bank lenders were involved, and in four of 22, they were the primary lender. Moreover, fiscal guarantees of central bank lending were very common, occurring roughly a third of the time. This has interesting implications for political economy and central bank independence. I have written about this in the European setting in a Yale blog.

A casual observation is that one can draw a sort of bell-shaped curve, where the y-axis represents something like “autonomous central bank lending as share of total lending,” and the x-axis represents size of lending relative to the economy or banking system. At the very left end, where lending is very small, there can be no central bank involvement at all—this is where we see banking “self-help” interventions or industry loans. In the middle, we see nearly 100% autonomous central bank lending—this is the vast majority of cases in practice. In the far right, the lending gets too large for a central bank to conduct independently, owing to legal or political constraints, and it ends up being a largely fiscal operation, with the central bank taking low or very little counterparty risk itself. This is the subject of ongoing personal research.

Associated pieces

There’s a lot more to be said about AHEL, but it’s all said in the paper, so I’ll leave it here for now. I will highlight the list of cases, some of which authored by yours truly, in case of further interest, all of which can be accessed here:

Source: Ad Hoc Emergency Lending in the 21st Century

You can follow me on Twitter (X) @ArnoldVincient, or connect with me on LinkedIn.

This work is independent from and not endorsed by the Yale Program on Financial Stability or Yale University; all views are my own.

This research comes at just the right time. As geopolitical winds are changing, it is a good time to ask: how might a reshuffling of the geopolitical pack affect trade and financial flows?

Recap: gravity models for days

For those who have studied international trade economics, gravity models will be very familiar. For those who haven’t, here’s the TL;DR:

A fun thing about international trade between countries—almost philosophically cool, even—is that it empirically looks a lot like Newton’s law of gravity, which you’ll recall from high school physics looks like:

The gravitational force between two bodies is related by (a constant and) the mass of object one, the mass of object two, and the squared distance between them.1

Incredibly, if you just sub out some variable names, you’ll find that trade flows look strikingly similar:

So, almost exactly the same: the volume of exports between country 1 and country 2 is related by (a constant and) the size of country 1’s economy, the size of country 2’s economy, and the distance between them.

This has been borne out by plenty of empirical research (for a brief overview, see Chaney 2018, pp. 151–154).

But you don’t have to stop there! Instead of just geographical distance, you can do other stuff, like “cultural distance” (measured usually by social media connections between countries, shared religion rates, or linguistic overlap); “regulatory distance” (measured usually by tariffs, trade agreements, rule of law measures); or even, yes, geopolitical distance™. And you need not limit your study to exports of goods: you could look at services or financial flows (or actually even people—migration).

The note: geopolitical distance, updated

Essentially, the authors do two big things: (1) they explore revised measures of geopolitical distance, drawing on the methodology of a now well-known IMF paper (Gopinath et al. 2024); and (2) use those different measures to explore how they affect trade and financial flow linkages between countries.

I’ll be brief here on the technical aspects, because the note is very short to read, but here are the specifications (IPD = Ideal Point Distance = geopolitical distance measure) in the study, in case of interest:

Source: Airaudo et al. 2025

Essentially, they’ve taken 2021 IPD measures and (a) updated them for 2023 numbers; (b) limited the scores to economic matters only2; and (c) changed the sample period to start more recently (from 1946 initially to 1990). We mostly care about (a)—the updated figures. When changing the specification, points below the 45-degree line have shifted more to the US, and those above it to China (1 = perfectly US-aligned; –1 = perfectly China-aligned).

And they’ve run a nice regression for us:

Source: Airaudo et al. 2025

Takeaways

In my view, there are two big takeaways here.

Elasticity of geopolitical alignment: As the authors point out, updating 2021 figures with 2023 figures (which captures Russia’s invasion of Ukraine) illustrates considerable responsiveness in geopolitical alignment to events over time:

From 2021 to 2023, countries shifted closer to the U.S., albeit from a strong-China starting point. This trend is especially pronounced for Advanced Foreign Economies (AFEs) (light blue dots). This pattern suggests that recent geopolitical developments—such as Russia's invasion of Ukraine and escalating U.S.—China tensions—may have played a key role in reshaping alliances. The fact that the shift is more pronounced among AFEs, which are historically aligned with the U.S., may indicate a tightening of alliances within the Western bloc, particularly in response to economic and security concerns . . . The reclassification under the 2023 IPD implies that countries are reacting to immediate political and economic pressures rather than adhering to long-standing alignments. (emphasis added; citations omitted)

Strength for trade channel, less so for financial flows: While their regression model is quite strong and robust for trade flows, it is considerably weaker for portfolio holdings. This is interesting, not least because it doesn’t seem entirely predictable? I mean, theoretically, trade in goods is a fair bit “stickier” than portfolio investments. Note that the researchers’ measure of portfolio investments strips out foreign direct investments (e.g., an American factory in China—hard to move quickly) and limits it to equity and debt securities (highly liquid and “flighty”). Intuitively: if I’m suddenly worried about country X, it’s a lot faster to sell stocks from country X in my Schwab account than it is to diversify my supply chain of tires/semiconductor chips/whatever away from country X.

And yet . . . trade:

The estimated coefficient indicates that in the post-invasion period, trade flows between countries in different geopolitical blocs are 11.8 percent lower, on average, compared to trade flows between countries within the same bloc . . . This effect strengthens with the 2023 IPD (-24.1 percent), reflecting recent geopolitical shifts.

Portfolio flows:

[There is] some evidence of financial fragmentation, with portfolio holdings between countries in opposing blocs declining by 0.3 percentage points post-invasion in baseline and post-1990 IPDs. However, results are weaker and less robust across specifications, particularly in 2023 and economic votes IPDs. Meanwhile, the coefficients for nonaligned countries remain small and insignificant across all specifications, reinforcing the idea that financial flows among nonaligned countries were less affected by geopolitical tensions.

So, what?

There are some policy implications here.

1. Gravity model aside, the pure elasticity of geopolitical alignment should be a wakeup call for policymakers in Washington: studied diplomacy years in the making can be shifted quickly as the result of a changing geopolitical landscape, and historic alliances don’t count for much. While the period 2021–2023 saw a shift toward the US, it is very likely that recent American policy shifts are moving the needle in the other direction (which we’re already seeing evidence for). The bar for pushing countries—even old friends—away (even if just to “neutral”) is pretty low. In other words, the “loyalty” or “momentum” effects of geopolitical alignment are smaller than we might have thought.

2. This model is explicitly not accounting for tariffs, which I’d imagine will have a weird and somewhat endogenous relationship. On the one hand, tariffs have an additive effect on trade, according to general gravity model logic (i.e., tariffs = less trade). On the other hand, given the way Trump has been messaging about tariffs (because Canada is meant to be the 51st state, etc.), they probably also act through the geopolitical channel. All to say: if the point is to drive trade away from your country, it’ll probably work!

3. Trade and portfolio flows are different, yes, but ultimately will be related in the long run. Research (Gopinath and Stein 2018) shows that a currency’s status in the world often begins with its issuer country’s trade: if I build up a lot of dollars from trading with the US, I’ll have a lot of dollars to invest, so I’ll go buy dollar-denominated securities, or lend my dollars out in the Eurodollar market, or whatever. In short, these things—trade and portfolio flows—are not one-to-one related, but they are ultimately related, even if with a long and variable lag. This means that geopolitical distance, in some way, ultimately will impact the role of the dollar, yields on American debt, and the safe-haven status of American securities.

Wherefore art thou, alternative?

We might ask, speculatively, who stands to gain from a potential reshuffling of the geopolitical pack, according to the model presented in this research note. Probably Europe. The European Union (EU) is, in real (non-PPP-adjusted) terms, the second-largest economy in the world, and the euro is the second-mostly widely used international currency.

Of course, China should stand to gain too, but there are two caveats with China. First, per the research note here, most advanced economies (i.e., where much—albeit less than yesteryear—of the trade and financial flows comes from) are not clustered around a China-oriented geopolitical alignment: they are clustered around a more neutral or US-leaning alignment. So, even if they were pushed significantly from the US, that would put them closer to the center of the geopolitical scale (where I would hazard to guess is where EU nations will cluster), but it would take a lot to get them voting with Beijing consistently. Second, while China is a trade behemoth, its capital account is relatively closed.

The EU’s open capital account, large and developed banking sector, rule of law, deep and liquid capital markets, and internationalized currency with emergency liquidity backstops (swap lines and FX repo facilities) make it a highly attractive location for portfolio flows, even when growth has been disappointing. Recent increases in euro-denominated safe assets as a result of the German-led defense spending spree will only buttress those dynamics. Brussels, it’s yours to lose.

You can follow me on Twitter (X) @ArnoldVincient, or connect with me on LinkedIn.

This work is independent from and not endorsed by the Yale Program on Financial Stability or Yale University; all views are my own.

What’s up with gold these days?

A casual glance at a gold EFT (ticker: GLD) will inform you that gold (some imperfect proxy of it, I know, I know) is up roughly 42% from 2023–2024. That’s a lot!

Zooming out for some context, since 2000 gold’s price has increased almost ten times over, outperforming numerous equity indices. More recently, gold has been in the headlines. Here is a smattering (in no particular order):

The Midas touch: 4,000 years of getting it wrong about gold (FT)

What the surging price of gold says about a dangerous world (The Economist)

Soaring gold becomes top ‘Trump trade’ (FT)

Gold Gains as Traders Seek Safety From Latest Tariff Threats (Bloomberg)

Gold stockpiling in New York leads to London shortage (FT)

Gold hits $3,000 for first time on global growth fears (FT)

It’s not just tariffs and the fracturing of geopolitical alliances that’s back again—gold is back too! But, if you take a look at the above enumerated pieces, you’ll see that geopolitics and central banking are central pieces. In this post, we’re going to explore that: how geopolitics and central banks interact, and how that interaction can affect gold prices.

Looking under the hood

But before we get ahead of ourselves, we can always take a look at this empirically and ~run a regression~, everyone’s favorite method, to give us some empirical guardrails and set the scene. Chiang 2022 is really the gold standard (pun intended) for this, but the data is of course limited to the period ending in 2022. So, here goes:

where:

GLD = the SPDR Gold Trust ETF (and therefore an imperfect but sufficient proxy for physical/monetary gold prices, from which ETFs can deviate); GLD sub t represents the gold price at time t, GLD sub t - 1 represents the gold price one period (month) before, and GLD sub t -2 represent the gold price two periods (months) before;

GPRD = the Caldara-Iacoviello Geopolitical Risk Index,1 which measures worldwide geopolitical risk, inclusive both of threats and actions (for more on the index, see here);

VIX = Chicago Board Options Exchange's Volatility Index (d.b.a. “the fear index”), which captures volatility on the S&P 500 equity index (technically, it gauges future expectations of volatility derived from options);

SPX = the S&P 500 index (you’ve heard of her);

USDI = the real broad effective exchange rate for the US,2 as calculated by the Bank for International Settlements;

CPI = median consumer price index, as calculated by the Federal Reserve Bank of Cleveland.3

Everything here is logged to smooth the data, and for parsimony we consider period effects only for gold prices.

Running the regression, we get:

So, first of all, and I can’t stress this enough, I am not convinced this is a good model. More sophisticated models assume first-order autoregressive effects and regress changes instead of levels. And, mind you, the regression here is very intentionally limited to start in 2020 (because it’s interesting, post-COVID), so I’d hesitate to generalize much on such a small N. All to say: you’ve been warned!

But it’s a model (that explains roughly 90% of the variation in gold prices for this period), and it does use real data, and the assumptions aren’t awful (the residuals plot is fine, e.g.). Note that four (logged) variables are significant at the p < 0.05 level: the one-period lagged gold price (shocker), the S&P 500, the dollar index, and CPI inflation. The model says some stuff. Here’s a non-exhaustive list (beyond the obvious momentum effect of the one-period lagged gold price):

Of particular interest here is what the model says doesn’t really matter: the VIX and GPRD. First of all, they’re nowhere close to statistically significant; second, even if they were, their intercepts are very small. Now, I’m going to try to convince you that they really do matter anyways, but the empirics have given me guardrails and made that more of a challenge (I need to prove a lurking variable, essentially, which I’ll argue is central bank purchases).

• Sidebar, the correlation between the VIX and the GPRD (in this period, of course) is negative 7.2% (on daily data)! This all seems weird? I don’t want to get too into it, but my hunch is that this is because: (1) the VIX is limited to the American stock market (e.g., a terrorist attack in the Eastern Congo might spike the GPRD, but NYSE traders don’t care); (2) the GPRD includes stuff that may not move markets that much even if the subject population were broader than American equity traders (e.g., by construction, it includes threats in addition to events); and (3) the VIX is by construction broader, so while it might encompass geopolitical risk, it’s by definition a catch-all for volatility (which could have to do with non-geopolitical stuff, obviously, like Fed guidance, employment numbers, or a subreddit).

The dollar index matters a fair bit. A 1% increase in the dollar index results in a ~0.4% increase in gold prices. This is all the more interesting because it is contrary to the historic norm. Usually, the relationship is inverse: the two are negatively correlated, and dollar strengthening hurts gold. That’s deductively sensical: when the dollar is stronger, that’s usually because (short-term) rates are higher, so the opportunity cost of holding gold increases. And yet, here we are.

• Sidebar: the dollar index is highly correlated (83% in this period, if you use daily data) with short-term rates (hence why I’ve left them out of this model), which is no surprise. I included it here instead of short-term rates because I think it’s probably the more inclusive of the two: the index is calculated on bilateral rates, so it’s also capturing movements in/expectations of other major short-term rates as well (à la interest rate parity). One possibility here is that in this case, short-term rates are higher because of an inflationary environment, and folks are holding gold as an inflation hedge. Or, other stuff just matters more.

The S&P and inflation betas appear inverted relative to expectations. A 1% increase in the S&P 500 index is associated with a ~0.2% increase in gold prices over this period; for CPI, that figure is negative 0.05%. Nothing illegal about that, but typically you hear about gold being used as a hedge against inflation and market dips, i.e., stocks down (sad), gold up; inflation up (sad), gold up. More on this later, but my hunch here is that folks (institutions) are pushing demand for gold high as a result of other concerns. It is also though worth caveating that, again, the inflation and equities data here are not only temporally limited, they are also geographically limited: this doesn’t account for equities moves and inflation around the world (but email me if you want to see that!).

Ultimately, this model leaves us with more questions than answers. Why don’t the VIX and GPRD matter here? Beyond simple momentum effects (lagged gold prices), the model doesn’t tell us a whole lot: American stock prices matter moderately (but in the opposite way we’d expect); the dollar index matters moderately (ditto on inverse expected relationship); and American inflation matters a little. We’d expect to see slumps in stocks and rises in geopolitical risk and inflation to be associated with higher gold prices, but the data aren’t incredibly satisfying. In part, that may be simply down to a not-adequately-sophisticated model, but it’s also possible that there could be (likely are) lurking variables. I don’t claim to have the whole answer, but you can’t talk about gold as an asset class these days without talking about geopolitics and central bank gold purchases.4 Let’s take a look.

Central bank gold purchases: big and getting bigger

Central banks and gold, needless to say, have a complex relationship. This of course is not a blog about the gold standard, or the gold-backed BRICS coin idea that is in vogue. But probably the right way to think about gold and central banks is that central banks are responders to geopolitical risk, but are both responders to and producers of—to various degrees of influence—other variables that impact gold prices, like short-term rates, inflation, and exchange rates. In this section, we’ll discuss the core theme of this note, geopolitics, before turning to the other bits.

Central banks, like all organizations, have some (observed or unobserved) reaction function to geopolitical risk, but given their nature, are particularly central to the phenomenon of gold purchases in relation to geopolitical risk. Here’s The Economist on this question:

But it is another class of investors [than retail investors]—perhaps the most paranoid and conservative of all—that has really driven the recent rally: reserve managers at central banks . . . Russia’s invasion of Ukraine, and the subsequent freezing of its foreign-currency reserves, was a pivotal moment. It demonstrated to reserve managers that if their country was put under sanctions, American Treasuries and other supposedly safe assets denominated in Western currencies would be of no use.

In fact, OMFIF has put out a fantastic report on this, called Gold and the New World Disorder (OMFIF 2024), which, as its name suggests, discusses the theme at length. Its title pretty well sums it up: the thrust is that geopolitics is a major tailwind for gold, fueling large-scale central bank purchases.

Suffice it to say, central banks have been buying a lot of gold recently by historical standards. And central bank demand matters a fair bit. For context, in 2024, central bank demand accounted for roughly 23%5 of total gold demand. Central banks have generally been net sellers of gold from 1970–2008, only hesitantly re-entering the market on the heels of the Global Financial Crisis. But the pace has picked up a lot since then, with official monetary gold reserves nearing levels not seen since the 1960s. The OMFIF report has a nice visual on this (the World Gold Council is likely talking its book a bit, but still):

Source: OMFIF 2024, p. 7

Source: World Gold Council, 2024 Gold Demand Trends Report

And, consistent with the thesis explored below—that geopolitical risk and macroeconomic uncertainty are key drivers in the central bank purchases—most of the central bank buying in the last year came from countries most exposed to those risks, emerging markets:

Source: World Gold Council, 2024 Gold Demand Trends Report

Moreover, the trend is, according to central banks themselves, set to continue:

Source: World Gold Council, 2024 Central Bank Gold Reserves Survey

Central banks and gold purchases: geopolitics

The OMFIF report suggests that gold’s recent renaissance is attributable to three primary drivers: Russia’s invasion of Ukraine in 2022, inflation, and American sanctions “weaponizing” the dollar.

Sanctions and the dollar

Perhaps some of the best work on this topic comes from Dr. Daniel McDowell, a sanctions doyen and professor of political science at Syracuse University. Dr. McDowell has written an excellent book on sanctions and de-dollarization, Bucking the Buck (Oxford University Press, 2023, here), which I encourage all my readers to explore, and which I cite heavily here. Dr. McDowell was kind enough to share with me an electronic pre-print of the book and has given his permission to reproduce here some of his charts on this question.

As most of my readers know, sanctions jurisdiction kicks in when one interacts with American institutions subject to American laws barring them from providing services with sanctioned entities (if not, see here). Central banks around the world have reserves in different foreign currencies; a large share (roughly 57.4% as of Q3 2024) are in dollars, and the vast majority of those dollars are in custody (digitally) in lower Manhattan at the Federal Reserve Bank of New York. Likewise, many foreign central banks’ gold stores (6,331 metric tons) are also held 50 feet below sea level in the New York Fed’s gold vaults (many also reside in the Bank of England’s vaults). As any good prepper or autocrat will tell you, a safe way to keep unfriendly governments away from your wealth is to hold it in gold bars in territory you control and can guard with guns. So, one way to do this if you think you’re going to be targeted by American sanctions is (1) hold gold instead of dollar reserves (because they’d be legally in New York state, subject to US sanctions laws); and (2) hold your gold physically in your own country.6 Hence, gold as a bulwark against sanctions.

I want to pause here to note some macro issues before diving into this. For one, there is a limit on how much monetary gold is out there. Second, this is costly not just in a paying-for-protection sense, but also in a giving-up-interest payments sense (see fn. 6). Third, paying for things in physical gold remains difficult. In many ways, gold is an inferior solution: what central banks concerned about sanctions would prefer is a liquid reserve currency that pays them interest, but free of geopolitical “meddling.” This gets at a crucial Bretton Woods nature-of-money point: there are only so many safe assets out there. Most are US Treasury securities. There is a far second in euro-denominated safe assets, but (1) not many; and (2) also the EU has sanctioned Russia and Iran, and even frozen the Central Bank of Russia’s reserves, so it’s unclear that’s a better option if you’re an autocrat allergic to the Western bloc (or what’s left of it). You are therefore left with not many safe assets, so gold starts to make some sense.

And it does make enough sense to matter. Here are some illustrative excerpts from the OMFIF report (p. 9):

A third well-known central banker, now retired, provides a similar perspective: . . . ‘US led sanctions have had an impact on dollar markets worldwide. I talk to the authorities in many countries and have noticed that central banks – not just the Russians and the Chinese – are speaking increasingly about putting their reserves into other assets rather than the dollar. Gold is one of the alternatives. It is the ultimate source of liquidity. If a third world war broke out, gold could become very useful.’

In extremis, that is all true. Take, for example, the case of Venezuela in 2015, which Dr. McDowell covers in detail in his book (pp. 61–63), in a section entitled “gold reserves as insurance against US sanctions.” In a nutshell, Maduro’s pariah regime saw the geopolitical writing on the wall and in 2011 began to repatriate its physical gold stocks from Europe to Venezuela. After 2015 when US sanctions hit hard, among other things, the central bank of Venezuela successfully moved gold ingots physically (via Russian planes, characteristically) to neutral countries (e.g., Turkey, the UAE) in exchange for physical euro banknotes. Last year, two central banks—the Reserve Bank of India and the Central Bank of Nigeria—disclosed that they repatriated gold reserves from overseas (they did not say that this was about sanctions concerns explicitly).

Dr. McDowell goes on to empirically show that when countries are hit with American sanctions (measured by sanctions-related executive orders, or SREOs), they are more likely to purchase gold:

Source: McDowell 2023, p. 70

Here’s Dr. McDowell on this in detail (pp. 71–72):

To shed further light on the magnitude of the effect of SREO and sanctions risk on gold purchases, Figures 4.7 and 4.8 display the predicted marginal effects. Beginning with the dichotomous sanctions measure (Figure 4.7), the model estimates that countries not under an SREO increased their gold holdings by an average of 2.3 metric tons a year during the study period. By contrast, countries targeted by an SREO increased their gold holdings by an estimated 15.4 tons annually—a difference of more than 13 tons of bullion.

Source: McDowell 2023, pp. 71–72

And this tracks with recent experience broadly of large central bank gold purchases as geopolitical risk has intensified (although there is more to it than sanctions, as we explore below).

Other non-sanctions geopolitical risk

Beyond sanctions, there are other geopolitical reasons you might be interested in gold. For one, Congressional brinksmanship on the debt limit and the threat of an American default means that the risk of holding Treasury (and, to a lesser extent, Agency) securities is higher now than it’s been in the past. Recent gold volatility has also been driven by concerns about tariffs, with American appetite for the yellow stuff soaring on concerns that Mr. Trump would levy a tariff on gold imports (FT):

Concerns that Trump might place tariffs on bullion have driven an unprecedented surge of gold bars into New York, where stockpiles on the Comex have reached record levels. Since Trump was elected, more than $70bn of gold has been flown into New York, although that flow has recently started to slow.

The World Gold Council in its 2024 Gold Demand Trends Report agrees, noting that “armed conflict giving way to global trade and economic conflict may support central bank’s net buying trend.” To boot, the more you hear from the Trump administration about the dollar (e.g., taxes on capital inflows into the US), the more you might start thinking about an alternative.

Central banks and gold purchases: everything else

Of course, there are other reasons that central banks might care about gold.

Even in the absence of sanctions and geopolitical risk, there are reasons countries might want to shift away from holding huge amounts of their reserves in dollars. For one, the US simply represents a smaller share of the world economy than it once did, so it would make some sense to diversify your currency portfolio to broadly reflect that, and if you proxy “the rest of the world” (after dollar, euro, pound, and a few other semi-reserve currencies have been accounted for) with gold, you’d expect to see an upwards trend.

The recent interest-rate hiking cycle has reminded Treasury bondholders that long-duration securities, by definition, carry serious interest rate risk (cough cough, Silicon Valley Bank).

For emerging market central banks, the recent rate-hiking cycle has reminded reserve managers that foreign exchange intervention may be necessary, and gold offers a way to hedge exchange rate risk (at a minimum by putting “money in the window”) without draining dollar reserves needed to pay for imports.

There is also some herd-mentality sense in holding gold. Imagine you’re a central bank not at risk of American sanctions (like a European central bank). So long as you think gold remains in the game as a reserve asset, potentially because you think other central banks will continue buying (perhaps for some of the geopolitical reasons discussed), then it makes some sense to have exposure to it as an asset. Recall that central banks are generally pretty limited in what they can hold as reserves assets. So, if you’re trying to diversify, gold is one of the few asset classes you can gain exposure to. The Czech National Bank is a good case study (OMFIF 2024, p. 19; emphasis added):7

In percentage terms, the most spectacular increase in gold holdings in Europe is being enacted by the Czech National Bank. Aleš Michl, CNB governor, has outlined a policy of raising gold reserves to 100 tonnes, a 10-fold increase compared with the period before the invasion of Ukraine. The Czech Republic has quadrupled gold reserves since then, up to the end-September figure of 46 tonnes, and expects to make further steady purchases in the next three years. According to Michl, the plan is to engineer an increase in gold reserves alongside equities to boost the return on the reserve portfolio and guard against a return to a loss-making position. ‘We need to reduce volatility,’ Michl has said. ‘And for that, we need an asset with zero correlation to stocks, and that asset is gold.’

This can all be summed up as: gold has balance-sheet protection qualities that exceed its geopolitical hedging characteristics.

Revealed preferences

If we really want to know what’s driving central banks to buy so much gold . . . why not just ask them? Well, the World Gold Council did, and the results are pretty interesting:

Source: World Gold Council, 2024 Central Bank Gold Reserves Survey

The de-dollarization figure is striking: over one in three central banks sees value to gold as a de-dollarization vehicle (either highly or somewhat). And note that this is percent of respondents not scaled for reserves holdings. In other words, if, for example China was concerned about sanctions and wants to de-dollarize, that would still show up as 1/57 respondents, even though China’s share of world reserves is very substantial.8 In other words, you don’t need many central banks to care if those central banks’ holdings are really large.

Geopolitics broadly clearly matters. 65% of respondent central banks said that the geopolitical diversification factors of gold influenced their gold reserves decision highly or somewhat. And geopolitics probably matters more than the headline figures would suggest. How? Concerns about geopolitical instability creep into other categories, like default risk (e.g., geopolitical uncertainty in the US), portfolio diversification (e.g., diversifying away from Treasury bonds), and crisis performance (e.g., war, geopolitical instability, etc.).

Another point to make with respect to geopolitics broadly (inclusive of but not limited to sanctions and dollar policy) is that many of the other measures (e.g., liquidity, historical position) don’t really change much over time, whereas geopolitical risk does. In other words, while those factors may matter more, they are also mostly steady state, and thus unlikely to be driving changes in gold policy. At the margin, which is what we care about for looking at changes, geopolitics certainly matters, and is one of the few factors with high volatility.

Conclusion: geopolitics and volatility as tailwinds

There are of course other things going on. Gold demand generally comes from private investors too, both institutional and retail—although that is related to central bank gold purchases through the price mechanism. For example, last year, Wells Fargo estimated that Costco was selling $200 million a month in gold bars (!). There’s some (mostly) unrelated stuff too, like jewelry demand (although gold jewelry has been used in India to evade capital controls, so it’s not perfectly unrelated to geopolitics). And, of course, there’s more to gold prices than demand—mining output and recycling supply obviously matter. All to say, we’ve focused here in a particular angle because it seems particularly important, but there’s a lot going on.

As we’ve seen, gold tends to rise during periods of crisis, perceived or real. Maybe it’s just a canary in the coal mine about the world becoming more volatile (as if we really needed another message about that). We’ve seen an empirically messy picture; but bringing in evidence on geopolitics and central bank gold purchases, we’ve uncovered a persuasive lurking variable: geopolitical factors are pushing central banks to make more gold purchases, providing a strong tailwind to the asset class.

Trevor Greetham of Royal London Asset Management has put it pithily: “gold can act as a geopolitical hedge, an inflation hedge and a dollar hedge.” Maybe it’s an ersatz panacea for all perceived risks, geopolitical, inflationary, trade war-related, or otherwise. While its usefulness as a hedge is almost certainly overblown (see, e.g., the positive correlation between the S&P and gold, or the inverse correlation between CPI inflation and gold in this period), a central tenant in all things financial is a concept that Noah Yuval Harari has identified, which can be roughly paraphrased as: for religion to work, you need to believe in God; for money to work, you just need to believe that other people believe in money.

Note: You can find the code for this analysis for free here.

You can follow me on Twitter (X) @ArnoldVincient, or connect with me on LinkedIn.

This work is independent from and not endorsed by the Yale Program on Financial Stability or Yale University; all views are my own.

Emergency Liquidity Assistance and Monetary Financing in the European Union: A Case Study in Fiscal Cooperation?

You can follow me on Twitter (X) @ArnoldVincient, or connect with me on LinkedIn.

This work is independent from and not endorsed by the Yale Program on Financial Stability or Yale University; all views are my own.

I attempt to answer that question in a new article out in FT Alphaville.

FT Alphaville is free to read (without an FT subscription!): How to read FT Alphaville for free

You can follow me on Twitter (X) @ArnoldVincient, or connect with me on LinkedIn.

This work is independent from and not endorsed by the Yale Program on Financial Stability or Yale University; all views are my own.