The week of March 14: a (possible) risk to the greenback’s leading role, inflation, the Fed, climate, and more.
In the course of last week’s Capital Letter I touched on various questions relating to the future of globalization. I also wondered whether the weaponization of the dollar and of the global financial infrastructure might, over the longer term, work against U.S interests:
The West wants the damage caused by those sanctions to persuade Putin to change course over Ukraine. That’s to be hoped for. But these sanctions could well come with indirect costs on top of the obvious burden (higher energy costs and so on) they will place on the countries imposing them, for they risk undermining trust in international financial structures that are a valuable, if tacit, source of Western and, more specifically, U.S. power. If risk becomes reality and countries strong enough to do so (or countries with friends that are strong enough to do so) build alternative structures of their own, that will represent a major strategic reversal.
A related danger may well arise out of America’s increasing weaponization of the dollar. The more the U.S. weaponizes the dollar, the more it undercuts the attraction of the dollar as a reserve currency. This is not going to make much of a difference for now. The euro, a frenemy currency, only accounted for around 20 percent of global foreign exchange reserves in early 2020, and the renminbi could only manage 2 percent. Nevertheless, America’s rivals have now been given a strong incentive to diversify away from the greenback, and that, in time could mean trouble. The dollar’s status as the world’s preferred reserve currency (it accounted for 62 percent of reserves) gives the U.S. an enormous edge (not least because of the way it enables the U.S. to finance itself). That’s an advantage that the U.S. should try to retain. The dollar’s reserve role is a function of the strength and size of the U.S. economy, of American hard power and also of America’s institutional reliability, a reliability that didn’t work for Russia. That’s a lesson that won’t be lost on Beijing.
No one should underestimate the advantages that the dollar has going for it. During the Cold War, a time when a good portion of the world was split into two camps, no one was interested in the ruble as a store of value. That is likely to remain the case in the immediate aftermath of the Ukrainian war, but it would be wrong to assume that this will always be so. Russia is resource rich and is likely to stick with a form of capitalism (however badly flawed). Something similar can be said about the renminbi. China is a large market. It may now be moving to the harnessed-capitalism characteristic of a fascist economy, but that has scared off far fewer investors than it should.
Such evidence as there is from the last few weeks would suggest a few dents in King Dollar’s crown.
Saudi Arabia, miffed by U.S. overtures toward Iran, appears to be close to reaching an agreement to price some of its oil sales to China in yuan, a noteworthy step as the Saudis have been selling oil exclusively in dollars since 1974. This would, I suspect, be largely a symbolic gesture, but that doesn’t mean that the symbolism is uninteresting.
Gas delivered through the new Russo-Chinese pipeline (once it is built) will be paid for in euros.
India, according to a report in the Financial Times, is looking at a “rupee-ruble trade arrangement with Moscow that would enable exports to Russia to continue after western sanctions restricted international payment mechanisms.”
The FT (my emphasis added):
India and the Soviet Union co-operated extensively during the cold war era. The Reserve Bank of India ran a rupee-rouble exchange scheme from the 1970s until 1992. The mutually agreed exchange rate only covered specific items, according to Indian government records, and some of the trade was barter.
Indian businesspeople said they expected a new rupee-rouble pact to be exercised through state-owned banks, such as the State Bank of India’s Russian unit in Moscow, Commercial Indo Bank, and Russia’s Sberbank, which has a branch in New Delhi.
Indian exporters hope the mechanism could release money they are owed by Russian clients, who cannot wire cash internationally because of the Swift restrictions. Sakthivel said the total outstanding debt to Indian exporters was not yet known.
India has in the past fashioned local currency arrangements to circumvent western sanctions. A rupee-rial mechanism by two Indian banks let Indian companies buy Iranian oil, bypassing Washington’s sanctions on Tehran.
The foreign trade executive said a rupee-rouble arrangement could allow India to continue buying Russian energy in the event of an oil embargo. Russia was also India’s main supplier of weapons.
Meanwhile, alternative payment systems are likely to be developed or expanded.
Eric Grover, writing in Real Clear Markets:
The more financial sanctions are used, the less effective they become, the less willing countries will be to rely on US-domiciled payment systems. Well-established payment systems like Mastercard, Visa, and Belgium-based bank association SWIFT work, have global network critical mass, and would be enormously difficult to replace. Nevertheless, kicking bad actors out of them encourages the development of alternatives.
After Putin’s 2014 invasion of Ukraine, the US forced Visa, Mastercard, American Express, and PayPal to cut off Crimea. That spurred Russia to launch its long-contemplated national-champion card network Mir and to mandate that foreign payment networks like Mastercard and Visa process transactions in-country, denying the US Treasury Department the ability to turn off the switch. The Russian central bank’s National Payment Card System runs Mir. NPCS also processes all domestic Mastercard and Visa transactions.
Because Russia mandated in-country payment-network processing over which it has control, Mastercard’s and Visa’s prohibitions won’t affect domestic transactions – payments and cash withdrawals by cards issued by banks and used at merchants and ATMs in Russia.
Mir will become Russia’s monopoly domestic card network like China UnionPay in the Middle Kingdom.
To work around the global payment networks’ cross-border-payment bans, Russian banks including Sberbank, Alfa Bank, and Tinkoff Bank, are exploring cobranding with CUP for international payments. While CUP’s global acceptance network is weaker than Mastercard’s and Visa’s, it would provide Russian banks and cardholders some relief.
Although Western Europe is standing alongside the U.S. at the moment, it is worth remembering that Instex — a separate European network — was set up some time ago, although not much seems to be going on with it.
DW provided some details of how it was supposed to work back in 2019:
The new entity acts as a sort of euro-denominated clearing house for Iran to conduct trade with European companies. In effect, INSTEX works as a barter arrangement operating outside of the US-dominated global financial system. Trade is initially expected to focus on non-sanctionable essential goods such as humanitarian, medical and farm products. It is not expected to address oil-related transactions, which have dropped off since last year and are Iran’s primary source of foreign currency.
As the European signatories to the nuclear accord, Germany, France and Britain set up and will manage the clearing house. The entity is based in France with German governance and financial support from all three countries. The three countries have sought broader support for the mechanism from all 28 EU member states to show European good faith in implementing commitments under the nuclear accord and to present a united front against any retaliation from Washington.
As mentioned above, very little use has been made of it — partly, I suspect, because of the fear of U.S. disapproval. A payment might go through, but would it be worth it? Nevertheless, the mere fact of Instex’s existence is worth remembering.
Speaking about a week ago, Janet Yellen rejected the notion that the dollar could lose its position as a de facto global reserve currency, citing the absence of “serious” competition. Of course, she would say that, wouldn’t she, but that doesn’t mean that she is wrong. The absence of competition to the dollar will continue to matter, quite possibly decisively so.
David Fickling, writing for Bloomberg, would agree, and adds an interesting twist to the story. But before getting to that twist, he acknowledges that something has changed:
Saudi Arabia [currently] receives dollars in return for its barrels of oil and refined products, which are in turn exchanged for dollar-denominated securities such as U.S. government bonds. The long-term strategic value of those sorts of assets — especially to oil exporters given to waging wars on neighboring countries — is looking markedly more shaky since the White House imposed sanctions on Russia’s central bank last month. A circumspect government that doesn’t think it can count on friendly relations with Washington in perpetuity might be wise to diversify its foreign holdings into a currency that’s less under the thumb of the Federal Reserve.
Now for Fickling’s twist:
Here’s the thing, though: Such a currency already exists, and it’s called the U.S. dollar.
The greenback’s centrality to trade finance isn’t due to any enthusiasm for U.S. financial regulation, and it’s not grounded on issuance of dollars by American banks regulated by the Fed, either. Quite the opposite — the bedrock of the international financial system is not so much the U.S. dollar as the eurodollar, the rather obscure market in short-term loans and bonds issued by banks outside the U.S. but denominated in dollars.
The eurodollar market owes its origins to precisely the sort of wariness about the U.S. order that Saudi Arabia, Russia and China are showing now. It evolved in the years after World War II so that Communist countries could store their dollar deposits in European banks where they wouldn’t fear their assets might be frozen by the U.S. government. It’s since become a behemoth, with $13.42 trillion in credit outstanding last September, compared to about $4.26 trillion in euro-denominated offshore funding and $412 billion in yen. It’s not an exaggeration to say that international trade and finance would crumble overnight if it failed.
That’s only the beginning of the story. For why the eurodollar really took off these, you can find some good starting points here and here. There is no doubt that avoiding U.S. regulation of one sort or another was a key selling point.
Fickling adds:
The growth of dollar swap lines to backstop the eurodollar since the 2007 financial crisis and the growing willingness of the U.S. to wield secondary sanctions on a global basis have certainly increased Washington’s oversight of this market — but at bottom it remains largely unregulated.
That goes a long way to explaining why the dollar remains so dominant in cross-border transactions. If you don’t want foreign governments meddling with your overseas assets, the eurodollar is about as close as you can get, short of selling your crude in Bitcoin. Even in China itself, investors seem to prefer greenbacks: The value of overseas debt denominated in dollars held by Chinese-based banks jumped $474 billion in the five years through last September, compared to a $127 billion increase in yuan-denominated securities.
If Saudi Arabia doesn’t want a foreign sovereign to control its overseas assets, switching more of its trading into yuan is about the worst way to go about it. China’s closed capital account means that just switching in and out of renminbi requires permission from the government. Add to that the sweeping asset forfeiture rules incorporated into Beijing’s anti-sanctions law introduced last year, and you’d be naive to think that China was any more secure a place for Riyadh to store its wealth in the long term.
In times of peace, it’s easy to forget that whenever you invest or sell a product overseas, you’re dependent on the goodwill of a foreign government to ensure you get paid. Washington has undoubtedly taken more advantage of the dollar’s status in recent years to achieve its foreign policy goals. Those issues are still very far from outweighing the convenience of transacting in the world’s most liquid currency market, backed up by its largest stock of sovereign debt and a system grounded in the rule of law. The yuan is the global reserve currency of the future — and it always will be.
That, of course, leaves the euro (which, as years of anxiety have made all too clear, has substantial structural issues of its own) and may be seen as orbiting too close to the U.S., even if Moscow and Beijing did not seem to think so when it came to that gas deal. Then again, Xi and Putin could have just been making a point.
In the end, however, Washington’s greater reach — and willingness to use it — will have consequences. Even those with eurodollars will have to pay far greater attention to where they park them (their bank, say, may not be American, but does it have an affiliate in the U.S.?) and the chain of transactions through which their money is transacted (is, a U.S. bank, for example, involved at some point?). It’s hard to see how that will not take some of the edge of the greenback’s universal appeal. It’s also easy to envisage that the added weaponization of the dollar of the last month or so will accelerate the move toward the division of much of the world into two distinct economic and political blocs.
To return again to Jon Sindreu’s Wall Street Journal article of a couple of weeks ago:
The risk to King Dollar’s status is still limited due to most nations’ alignment with the West and Beijing’s capital controls. But financial and economic linkages between China and sanctioned countries will necessarily strengthen if those countries can only accumulate reserves in China and only spend them there. Even nations that aren’t sanctioned may want to diversify their geopolitical risk. It seems set to further the deglobalization trend and entrench two separate spheres of technological, monetary and military power.
And the consequences of that?
The Capital Record
We released the latest of our series of podcasts, the Capital Record. Follow the link to see how to subscribe (it’s free!). The Capital Record, which appears weekly, is designed to make use of another medium to deliver Capital Matters’ defense of free markets. Financier and NRI trustee David L. Bahnsen hosts discussions on economics and finance in this National Review Capital Matters podcast, sponsored by National Review Institute. Episodes feature interviews with the nation’s top business leaders, entrepreneurs, investment professionals, and financial commentators.
In the 58th episode David is joined by Andy Puzder, the longtime CEO of CKE Restaurant Group, who became a legendary corporate executive in the fast-food space and has spent his post-C-Suite career doing the unthinkable: actually defending the free-enterprise system that has been so kind to him (imagine that!). David and Andy discuss everything from ESG to labor shortages to private equity.
The Return of the Regional Seminars
National Review Institute is back on the road with its biennial Regional Seminars. This year’s series, titled “Creating Opportunity,” will feature panel discussions and one-on-one conversations that make the moral and practical case for free enterprise.
Notable speakers include William B. Allen, David L. Bahnsen, Jack Brewer, Dale R. Brott, John Buser, Veronique de Rugy, Kevin Hassett, Pano Kanelos, Rich Lowry, Karol Markowicz, Andrew C. McCarthy, Andrew Puzder, Amity Shlaes, Kevin D. Williamson and, less notable, me.
We hope you will join us. You can learn more and purchase tickets here.
Thomas L. Rhodes Fellowship
The Rhodes Fellowship is made available to a new or recent college graduate, up to age 25 (when initially applying) who shows interest and capability in writing on, broadly speaking, current affairs, but with a focus on finance, business, taxation, fiscal policy, economics, and the workings of the free market . . .
Interested? More details here.
The Capital Matters week that was . . .
Inflation
The Consumer Price Index (CPI) measure of inflation clocked in at 7.9 percent for February, marking the highest level of inflation since January 1982. At this rate, consumer prices will double roughly every nine years.
The increase in prices includes many everyday consumer staples. The price of gas in February was up 38 percent since last year; utilities were up 24 percent, and steak and bacon were up 17 percent. Many clothing items were also up by double-digit percentages.
If we can learn anything from this, it is that the Federal Reserve has failed abysmally in its efforts to maintain low and stable prices.
Gas prices are spiking due to Vladimir Putin’s unprovoked invasion of Ukraine. President Biden announced a ban on importing Russian oil, which accounts for 3 percent of U.S. oil consumption and will further increase gas prices. Some commentators are blaming the latest jump in gas prices on inflation. But that is a mistake. The price increases at the gas pump now are driven by a supply shock, and supply shocks are most definitely not inflation, whether due to broken pipelines, regulatory restrictions, or wars.
There is much confusion about inflation right now. That matters because inflation is the highest it’s been in 40 years and is easily the most pressing economic issue facing the country. It’s important to get it right. The right cure requires the right diagnosis . . .
Gasoline prices are nothing if not visible, and that such prices are high and rising is unlikely to help the party holding the White House. Average U.S. gasoline prices have risen from about $2.87 per gallon a year ago to $4.31 (as of March 16), an increase of 50 percent. It is unsurprising, therefore, that the administration now has put forth several bogeymen as the sources of this pain at the pump. High gasoline prices represent “Putin’s price hike.” The oil companies are engaged in “price gouging” and “profiteering.” They are allowing thousands of approved leases on federal land to go unused. OPEC+ — 13 members of OPEC and ten other major producers — is producing too little.
We return to these claims below . . .
Cryptocurrencies
Tomas Philipson and Jeffrey Wernick:
To strike at the coalition of truck drivers demonstrating against his government’s vaccine mandates, Canadian prime minister Justin Trudeau ordered financial institutions to search customer records and sanction both the protesters and those who had given financial support to them. Banks investigated the accounts of anyone identified by the government as being a participant or a donor and froze them, all without warrants or court approval. This was a manifestation of expanding state power, which would have been unimaginable just a couple of years ago in a democracy.
Trudeau’s move to cut off the truckers’ money, aided and abetted by the banking system, was extraordinary, but as government failures become more visible and severe, there is an obvious temptation for governments to take what tools may be to hand to crack down on dissenting citizens. Regardless of your opinion of vaccines, mandates, or the truckers themselves, this display of overreach raises the question of how something like it could be prevented in the U.S. The Canadian episode laid out in plain view that giving a government power over financial accounts is giving it the power to use those accounts as it, not the owners, deems appropriate.
Fortunately, blocking crypto payments turned out to be easier said than done . . .
ESG
The exposure of ESG investors to Russia has already proved something of an (expensive) embarrassment (I wrote a little bit about it here).
And here’s some more on this question . . .
The Fed
Los Angeles Times congressional reporter Jennifer Haberkorn says that Senator Joe Manchin (D., W. Va.) will not support Sarah Bloom Raskin, President Biden’s nominee for the Federal Reserve’s vice chairman of supervision. “Her previous public statements have failed to satisfactorily address my concerns about the critical importance of financing an all-of-the-above energy policy,” Manchin said.
This comes a few days after Manchin said he supports a proposed deal from Senate Banking Committee ranking member Pat Toomey (R., Pa.) in which Republicans would allow four other Biden nominees to clear the committee in exchange for blocking Raskin.
Concerns over Raskin stem from her long record of advocating the usage of financial regulation to enact climate policy . . .
The Federal Reserve is not a replacement for the United States Congress. It is an institution that was created by the United States Congress. And it was created to play an extremely narrow role within a system that is supposed to be dominated by . . . well, the United States Congress. Sarah Bloom Raskin has not indicated that she understands that, and, as a result, her nomination has rightly been deemed inappropriate . . .
What Raskin wanted was to use an illusory “systemic risk” as a device to enable the Fed to push through her preferred policy agenda, an unhealthy precedent, to say the least. And as vice chairwoman for supervision, a position frequently referred to as being banking’s top cop, she would have been in a strong position to get her way, and her way would have been a profoundly politicized way.
Climate
But in terms of wind-power economics, and the problems of integrating huge quantities of wind energy into the power grid, the picture is much clearer.
Wind-power generation is unreliable and expensive. Absent the federal production tax credit, subsidies for interconnecting to the high-voltage power grid that delivers electricity from generating plants to local distribution utilities, and mandates for local utilities to purchase wind (and solar) generation, far fewer wind turbines would be built, whether on land or at sea.
Just ask Warren Buffett, who said the only reason to build wind turbines was for the tax credits . . .
Economics
Cuba could easily solve its inflation crisis by installing a currency board, as Dr. Kurt Schuler and I proposed in Currency Reform for a Market Oriented Cuba (1992). A currency board issues notes and coins convertible on demand into a foreign-anchor currency at a fixed rate of exchange. It is required to hold anchor-currency reserves equal to 100 percent of its monetary liabilities. A currency board’s currency is a clone of its anchor currency. Currency boards have existed in some 70 countries. None have failed . . .
Infrastructure
Californians have achieved impressive feats of water conservation over the past few decades. But that won’t be enough. While we’re drinking, washing, flushing, and irrigating less, demand for water still outpaces supply. Aging dams and canals need seismic retrofits, and new systems for harvesting and storing runoff water —and reusing wastewater — need to be built.
What’s the hold-up? With care, environmentalist concerns over new water projects can be balanced with the need to provide Californians with an adequate water supply. But behind environmentalists, a diverse assortment of financial special interests is betting that Californians are going to live with chronic water scarcity forever.
Climate
The more I look at the energy “transition,” the “race to net zero,” call it what you will, the more it strikes me that it hasn’t been — how to put this — very well thought through. This is not particularly surprising; exercises in central planning rarely are. The only real question is how bad the consequences will be.
Globalization
Gradually, conservatives are recognizing the enormity of their error in embracing a strategy of free trade and globalization after the Cold War’s end. The theory held that trade would help to spread liberal democracy around the world, creating an ever-larger free market to fuel rising prosperity. “No nation on Earth has discovered a way to import the world’s goods and services while stopping foreign ideas at the border,” exuded President George H. W. Bush at a Yale University commencement ceremony in 1991. “What some call globalization is in fact the triumph of human liberty across national borders,” said his son a decade later.
In practice, though, globalization has meant subverting America’s relatively free market for the sake of integration with other markets abroad . . .
The Pandemic
While testing has little benefit, it imposes major burdens. Travelers have to scramble to obtain testing the day before takeoff and worry about the results. A false positive result can ground a passenger, disrupting personal and business plans. Airlines are forced into the role of medical bookkeeper, tasked with collecting passengers’ test results. I, for one, am more concerned with them maintaining their attention to the safe operation of the aircraft. Finally, someone, whether passengers personally, insurers, or taxpayers, has to pay for all those unnecessary tests.
The CDC may feel virtuous by continuing the travel-testing charade. But the time has come to end this disruptive, anxiety-provoking ritual that does little to protect the nation’s or travelers’ health.
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