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West Point Paper -- Part 2/4
"US Dollar Primacy in an Age of Economic Warfare" - This paper was presented at the West Point Symposium on "Order, Counter-Order, Disorder" on February 9, 2023.
Key Economic Pillars of National Power and USD Hegemony
The USD’s status as GRC gives the US “exorbitant privilege” for three reasons: 1) the USD is widely used by central banks around the world and accounts for ~60% of foreign exchange reserves, 2) the USD is the de facto standard for international trade and accounts for just under half of global trade invoicing, and 3) the USD accounts for ~90% of all foreign exchange transactions.1 Perhaps even more significantly, “over the period 1999-2019 the dollar accounted for 96 percent of trade invoicing in the Americas, 74 percent in the Asia-Pacific region and 79 percent in the rest of the world.”2 Figure 1 gives a visual representation of the USD’s global adoption dominance despite a diminished US share of world trade.
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Figure 1: Visual Representation of Global USD Adoption Dominance3
The ”top-down” interpretation of Bretton Woods suggests that it acted like a “Trojan Horse” for the world to get addicted to USD trade because it was backed by gold, only to then abandon that backing with the Nixon Shock of 1971. History suggests, however, that trust in the USD went well beyond its gold backing long before the Nixon Shock.
The USD began to supplant Sterling as the GRC as early as the mid-1930’s with the failure of the Tripartite Agreement, which attempted to stabilize the currency exchange rates between the US, France, and Britain.4 The devaluation of Sterling and the imposition of capital controls by Britain on Sterling in 1957 was a key catalyst for the adoption of USD beyond US borders and beyond US gold backing. The USD became the best alternative, and USD adoption grew organically with the rise of Eurodollar banking throughout the 1950’s and 1960’s.5
Eurodollar banking was the creation of US dollar debts via offshore banks. The exceptional growth of the Eurodollar system by banks outside of the US demonstrates, as Gavin indicated previously, that the global monetary system’s need for additional liquidity exceeded what the theoretical gold backing could provide. Although capital controls lasted only 16 months, the world flocked to the USD via the Eurodollar market as a safe, liquid alternative medium of exchange. This led to a large overabundance of USD not backed by gold. Eurodollar deposits exploded over 250% from just the 1964-1969 period.6 From this perspective, USD/gold convertibility as stipulated by Bretton Woods became a form of capital control in and of itself, and Nixon’s abandonment of gold was enabled by the rise of Eurodollar usage and thus unshackled the USD from an adoption perspective. In short, the USD had already earned its “exorbitant privilege” by the time of the 1971 Nixon Shock, and the world had already given its vote of confidence.
If Eurodollar use arose long before the abandonment of gold backing, what gave the world trust in the USD as an alternative to Sterling? In a world of global capital flows determined by billions of people making independent decisions, the USD must earn its “exorbitant privilege” every day in order to remain the GRC; the mere framework of Bretton Woods did not guarantee the USD’s success. The USD enjoys its GRC status today because of its deep liquidity, widespread adoption, deep underlying government bond markets, and the “safety and soundness” premium conferred by US National Power. Currency strength is always relative to its other currency alternatives; this paper posits that the sources of relative strength and adoption for the USD stem from both endogenous and geopolitical factors as well as cyclical and macroeconomic factors.
Geography’s Economic Advantages and Its Influence On Military Preparedness
One of the most significant determinants of National Power within Morgenthau’s Nine Elements is Geography. Geography bolsters all of the other Elements of National Power. It determines Natural Resource availability and the ability to expand/maintain Industrial Capacity. Geography also determines the hard power of Military Preparedness, because superior geography confers the ability to project power when it’s easy to defend the homeland. It also provides the space required for sustained Population growth, and in so doing, influences the soft power of National Character and Morale. Finally, superior geography confers the leverage for effective Diplomacy and even influences the method and quality of democratic Government.
It has become popular for detractors of the US to cite the burgeoning Debt/GDP ratio and the twin deficits as reasons for the imminent demise of USD hegemony and the consequent loss of “exorbitant privilege.” While many of these critiques raise legitimate warnings about future policy implications, analyses of sovereign creditworthiness should follow the methods of analyzing corporate creditworthiness and not just focus on measures of flow (the cash flow/income statement), but also on measures of stock (the balance sheet).
While it is fair to critique the ballooning liability side of the US balance sheet, few discuss the unparalleled geographic assets that the US boasts on the left side of the national balance sheet. These assets confer significant economic benefits and the ability to project power far and wide. In many ways, these endogenous advantages have allowed the US to make sometimes grievous policy errors and still allow ample margin for course correction, while similarly grievous policy errors in countries with disadvantaged geography have resulted in regime change, as evidenced by Russia’s history over the centuries.
A geographic comparison with America’s closest hegemonic rival, China, is worthwhile. First, the unparalleled waterway networks of the US confer cheap and abundant transportation of goods and people through 14,650 riverine miles versus 2000 miles for China and Germany combined. Next, the US has 360 mm acres of agricultural land versus 104 mm acres in the North China Plain. China’s arable land-to-population ratio is 0.074; the US land-to-population ratio is 1.09. In terms of borders and coastlines, the US has friendly buffer states to the North and South and oceanic buffers to the East and West, which make the mainland not only virtually unassailable but also provide simultaneous access to European/Asian markets; China’s borders by contrast are largely with competing nations. Lastly, the US also boasts 95,000 miles of coastline versus China’s 9000 miles, which endow it with, according to Peter Zeihan, “more port potential than the rest of world combined.”7
Taken together, these geographic advantages have enabled the US to focus its military capabilities to enforce its hegemony abroad as opposed to spending resources like China’s One Belt One Road (OBOR) initiative which attempts to replicate many of these naturally occurring advantages at great economic cost. America is blessed with geographic isolation from many of the world’s problems. Its “splendid isolation” generally permitted peaceful development domestically without the burden of defending its borders.
Favorable geography has also allowed the US to focus much of its military expenditures on force projection abroad in the maintenance of an RBO generally favorable to itself and its partners, as the difference in naval strategy between the US and China demonstrates. Although the PLA Navy comprises a larger number of vessels than the US Navy, its tonnage of ~1.3 mm tons is just about one-third that of the US Navy’s 4.5 mm tons.8 The implication is that although the PLA Navy may be well-suited to patrol China’s coastal “green waters,” it lacks America’s “blue water” force projection capabilities, which have guaranteed global maritime security for the last 80 years. But what happens if it no longer behooves Americans to foot this bill alone?9 A US pullback from subsidizing global maritime security is simultaneously a reduction of the US’ financial liability and an increased liability to its challengers—they will inherit the risks, burdens, and costs to prevent disorder in a multipolar world. Security and stability everywhere is no longer America’s problem alone. Splendid isolation, and focused use of power at home and abroad, will again favor the US and its partners; its challengers will inherit a burden they may not be capable of carrying.
To summarize, the faith in the creditworthiness of a nation and its currency goes far beyond pure Debt/GDP metrics or gold backing. The US “national balance sheet” is far superior to that of China’s or any other country’s because of its natural geographic endowments. The US is naturally long on many resources that China (and much of the rest of the world) is short: food, water, energy, waterways, friendly neighbors, oceanic buffers, not to mention a free-market, capitalist system that values property rights. China must spend massive amounts of capital on artificial infrastructure (e.g. OBOR), whereas the US is blessed with many of these assets naturally, which unfortunately often leads to complacency in enacting politically-driven policies that have the unintended consequences of directly undermining our advantages.
Although these assets are much harder to quantify than the liabilities, these geographical endowments are here to stay and confer upon the USD an ample margin of safety as the US can course-correct some of the more damaging policies that directly undermine two aforementioned Economic pillars of National Power: Natural Resources and Industrial Capacity.
Natural Resources & Industrial Capacity: Economic Pillars of National Power Viewed Through The Oil And Semiconductor Industries
Two key industries that impact both the availability of Natural Resources and Industrial Capacity are oil and semiconductors. As it happens, two of China’s biggest geopolitical vulnerabilities come from its dependence on foreign-supplied oil and semiconductors. The Strait of Malacca sees 12 mmbpd of China-bound oil going past US allies. Taiwan, aside from its geographic criticality in the First Island Chain and its cultural and reputational significance to China, is of paramount economic importance to the entire world due its critical path in global semiconductor manufacturing.
These two industries dominate national security discourse today. They share many similar characteristics and are worthwhile to compare:
They both represent mission-critical gears in the US and global economic machines and have dangerously concentrated supply choke points.
In both industries, the market-driven economy of the US has led to a lack of cohesive national industrial policies/incentives, whereas heavy state-driven subsidies/IP theft from both autocratic and democratic rivals have put America at a disadvantage.
Although the US birthed both industries and initially dominated them, in both cases the US ceded leadership to competitors.
Self-sufficiency on both fronts is a key objective for the big actors in the Great Power Competition.
The result is that policymakers have defaulted to defensive and coercive economic policies like sanctions to
stymie the competition.
Semiconductors have become inextricably intertwined with every aspect of modern society, from consumer to industrial to military applications; today’s information-based society cannot function without semiconductors. Yet this industry is rife with dangerous concentrations of supplier power. Chris Miller’s Chip War: The Fight For The World’s Most Critical Technology provides statistical context for key choke points in the semiconductor supply chain:10
Taiwan supplies 37% of global chips, 41% of microprocessors, >90% of all advanced chips.
South Korea supplies 44% of global memory chips.
Japan supplies 17% of global chips.
China supplies 15% of global chips (albeit low-end).
Dutch company ASML has 100% market share on EUV lithography machines critical for making cutting edge chips.
US supplies only 12% (down from 37% at peak).
The oil industry similarly has critical concentrations of market power. Since the first commercial oil well was drilled in Pennsylvania in the mid-19th century, oil has become the most important commodity in the world. A century and a half later, oil accounts for over two-thirds of transportation fuel and over a quarter of industrial energy use in the US. The world consumes roughly 100 mmbpd; key concentrations of supplier power follow:11
OPEC+ supplies 40% of global oil.
US is currently largest single supplier at 12.4%.
Russia and Saudi Arabia each supply ~11%.
The semiconductor industry was strategically prioritized by Russia, Japan, Taiwan, South Korea, and China; these nations have supported the industry with aggressive state-led subsidies and in many cases with state-led IP theft (especially Russia and China). Japan, a Cold War ally no less, historically engaged in the same kinds of practices China is currently practicing: IP theft, closed import markets, dumping of cheap chips, etc.
Taiwan, home to Taiwan Semiconductor Manufacturing Company (TSMC), prioritized investment in the semiconductor industry as early as the 1960’s in response to economic warfare from China in terms of cheap labor. It backed talent hired from the US and now boasts ~50% of the foundry market. Aside from Taiwan’s critical geopolitical position in the First Island Chain, TSMC alone should make the defense of Taiwan a vital interest to the United States. Taiwan’s Tsai Ing-Wen recognizes the importance of TSMC by calling it Taiwan’s “Silicon Shield.”12
China is now trying to replicate Taiwan’s success. Deng was the first to recognize the importance of the industry and famously said that China’s focus should move from “first machine imported, second machine imported, third machine imported” to “first machine imported, second made in china, third machine exported.” Xi has reframed the debate on chips in more martial terms by “calling forth the assault” in terms of seeking dominance in the industry.13
The recent CHIPS Act is a late but welcome recognition that predominantly reactive and coercive policies like tariffs, sanctions, and export controls are no substitute for proactive industrial policy. Even so, the scale of CHIPS ($52B) falls seriously short of the policies America’s competitors have adopted. China’s succor to Huawei alone in the form of land subsidies, various tax credits and deductions is $75B and doesn’t include other “covert subsidies” like the acquisitions by Tsinghua Unigroup fueled by $22B of state-backed funding.14
As with semiconductors, the oil industry was founded in the US, and after an initial period of American dominance, discovery of large deposits in Saudi Arabia in the early 20th century eventually shifted the center of gravity of the oil industry to the Middle East even as American conventional oil production declined. The formation of OPEC in 1960 further shifted market power away from the US; subsequently, the Oil Embargoes of 1973 and 1979 and the Iraqi invasion of Kuwait in 1990 prompted forceful and continuous action from multiple administrations up until the present. Protecting access to oil clearly became a matter of national security, and securing the Middle East became a vital interest to the US.
Even as US hegemony waned in the oil industry, American ingenuity came to the rescue, and the confluence of technology development in hydraulic fracturing/horizontal drilling, plentiful shale deposits, cheap access to capital, abundant sources of water required for “fracking,” and a legal system that conferred mineral rights to private landowners birthed the shale revolution.
As a result of shale oil, the US is once again the world’s largest oil producer, and yet the oil industry has succeeded in spite of not only lack of subsidization, but also overtly hostile policies and rhetoric from the US government in recent years. In the name of ESG and domestic interest groups, the US government has canceled critical North American pipeline projects like Keystone XL, banned drilling on federal lands, artificially depressed commodity prices by reducing the Strategic Petroleum Reserve (SPR) to levels not seen since the early 1980’s, and threatened the industry with windfall profits taxes and export bans. Unlike the critical semiconductor industry, which is finally receiving industrial policy support from government, the equally critical oil & gas industry is effectively being subjected to “anti-subsidies.”
Compounding the problems of domestic energy policies are geopolitical dynamics that run at crosscurrents to national security and human rights ideals. Iran and Russia, two of the largest OPEC producers, are regional rivals; the former (for now) is engaged in largely asymmetric war, and the latter is in open conflict with Ukraine and the RBO more generally. Even if being hostile to two of the largest producers under an ineffectual sanctions regime cannot be helped, the US government has unnecessarily alienated Saudi Arabia, a once-critical ally in maintaining energy security. SaudiArabia’s recent diplomatic announcements and expressions of intent in partnering with the CCP worsen an already geopolitically fragile energy market.15
If achieving self-sufficiency in Natural Resources and Industrial Capacity is key to preserving US National Power, incongruent policies such as these run counter to this goal. Because of Great Power Competition between the US and China, the US has come to the assistance of the semiconductor industry even as the US still commands critical choke points in the semiconductor supply chain (specifically in semiconductor equipment and design software), whereas China is relatively disadvantaged due to its reliance on imports from geopolitical rivals. It’s therefore ironic that the oil industry, where the US has a natural advantage, is being hobbled by the US government itself in the name of politics.
Policymakers can learn much from the case study of the semiconductor industry, because here at least the US has recognized the threat from without and has undertaken more proactive industrial policy responses. Unfortunately, the oil & gas industry lacks similar attention due to the diversion of attention and capital to the ESG movement, which has incorrectly ascribed Moore’s Law dynamics (which assumes a doubling of transistors, and by implication computational power, every two years) to the world of moving molecules versus bits.16 Energy transitions take many decades, and the West’s blind focus to ESG has strangled investment in hydrocarbons and has left the US and the West in a precarious state of dependency on hostile actors like Russia long before hydrocarbon alternatives can dominate our energy consumption. Even worse, a premature transition to EVs threatens to shift the 40% dependency on OPEC+ (but where the US still commands the leading role in world production at 12.5%) to an 85% dependency on China’s rare earth refining capacity (where the US has de minimus role in production). This is a nonsensical risk/reward tradeoff from a national security and National Power standpoint.
National Power is key to Great Power Competition. The US is dominant in Geography and Natural Resources (US is long oil & gas) but deficient in Industrial Capacity (like semiconductor fabrication); while the US is fighting back on the latter, it is undertaking deleterious policies that undermine its natural advantages in the former. US energy policy is currently misaligned to the geopolitical objective of preserving a US-led RBO.
China, on the other hand, is naturally deficient in Geography and Natural Resources (China is short oil & gas) but has developed great strengths in Industrial Capacity (although not yet in semiconductors). China is spending great national treasure through initiatives like OBOR to counter disadvantages in the former but to also extend its Industrial Capacity strength in semiconductors to emulate Taiwan. Although China is coming from a relative position of weakness, its policies are aligned with its geopolitical objective of wresting hegemony away from the US-led RBO.
CONTINUE TO PART 3/4:
“The US Dollar as the World’s Dominant Reserve Currency,” Congressional Research Service, September 2022, https://crsreports.congress.gov/product/pdf/IF/IF11707#:~:text=The%20dollar%20has%20functioned%20as,in%20dollars%20(Figure%201).
Ozge Akinci, et. al., “The Dollar’s Imperial Circle,” Federal Reserve Bank of New York, December 2022, p.9.
Maurice Obstfeld, et. al., “The Global Dollar Cycle,” Brookings Papers On Economic Activity, September 2022, p.18, https://www.brookings.edu/wp-content/uploads/2022/09/Obstfeld-Zhou-Conference-Draft-BPEA-FA22.pdf]
Perry Mehrling. Money and Empire, p.70.
Catherine Schenk. “The Origins of the Eurodollar Market in London: 1955-1963,” Academic Press 1998, p. 222-223.
Paulina Echavarria, et. al. “Bretton Woods and the Growth of the Eurodollar Market,” Federal Reserve Bank of St. Louis, 2022, https://www.stlouisfed.org/on-the-economy/2022/january/bretton-woods-growth-eurodollar-market.
Peter Zeihan. The Accidental Superpower, (New York, US: Hachette Book Group, 2014), p.47, 51, 63.
Kyke Mizokami. “China’s Navy Could Catch Up to America’s By 2030, Analysts Say,” Popular Mechanics. September, 2022. https://www.popularmechanics.com/military/navy-ships/a40980913/china-to-have-bigger-navy- by-2030/
Peter Zeihan. The Accidental Superpower, p.4-6.
Chris Miller, Chip War: The Fight For The World's Most Critical Technology, (New York, US: Simon & Schuster, 2022).
McKinsey & Company, “Snapshot of global oil supply and demand: November 2022,” November, 2022, https://www.mckinsey.com/industries/oil-and-gas/our-insights/petroleum-blog/snapshot-of-global-oil-supply-and- demand.
Chris Miller, Chip War: The Fight For The World's Most Critical Technology, p.233 & 341.
ibid, p. 268.
Aya Batrawy, “China's Xi Jinping Visits Saudi Arabia to Assert Power and Rival U.S. Influence,” (NPR, December 8, 2022), https://www.npr.org/2022/12/08/1141202088/xi-jinping-saudi-arabia-china.
Carla Tardi, “What Is Moore’s Law and Is It Still True?” Investopedia, July, 2022. https://www.investopedia.com/terms/m/mooreslaw.asp#:~:text=In%201965%2C%20Gordon%20Moore%20posited,and%20more%20efficient%20over%20time.