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West Point Paper -- Part 3/4
"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.
Challenges To USD Hegemony
Despite the natural advantages the US boasts in Geography and Natural Resources and its renewed focus on Industrial Capacity, there are many challenges to USD hegemony. In recent years, US policymakers have relied heavily on the use of financial sanctions to conduct foreign policy against hostiles. This has unfortunately incentivized both allies and adversaries to seek alternatives to the USD system, and that is a direct threat to the US-led RBO.
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Overuse of Sanctions Has Consequences
In addition to misaligned industrial policies that hobble its natural strengths, the US has defaulted into a pattern of using reactive, economically coercive policies to stymie its enemies. This strategy also has deleterious ramifications. The “exorbitant privilege” of the USD’s status as GRC confers tremendous leverage to the US in imposing its will against its foes through various tools of economic coercion. In her recent book Backfire: How Sanctions Reshape the World Against US Interests, Agathe Demarais breaks down these tools into three broad categories: tariffs, sanctions, and export controls; sanctions in turn can take many forms: trade embargoes, financial sanctions, and sectoral penalties, or some combination of all three.1
Financial sanctions derive their coercion by threatening to freeze targets out of the USD system, and it is the USD’s status as GRC that gives financial sanctions teeth. Unilateral actions taken under the aegis of national security but simultaneously advanced US economic interests have alienated allies as well.2 Because they are punitive and reactive in nature, they have achieved less than stellar results over time, especially when regime change was the intended endgame; sanctions against Cuba, North Korea, Iraq, Iran, and now Russia all come to mind. Sanctions have historically proven more effective when enacted multilaterally and combined with other levers like export controls which depend less on USD hegemony alone but still depend on US economic leadership in the sector being targeted.
The bigger problem is that the overtly punitive nature of sanctions combined with the bluntness of the tool in terms of hurting both friends and foes alike begin to fray the edges of USD attractiveness to the world, especially with its increased use in recent years. The Bush Administration imposed 3484 sanctions over 8 years, the Trump Administration imposed 3900 sanctions over 4 years, and the Biden Administration so far has delivered some of the most wide-reaching financial sanctions yet.3 Policymakers need to remember that the way in which the USD supplanted Sterling as GRC was that it became a better alternative and that USD sanctions directly incentivize the search for alternatives to USD.
Because of the endogenous strengths of the USD and because of US economic preeminence, there currently is no better alternative as evidenced by its 60% share of global currency reserves. USD detractors like to point to China’s faster GDP growth as a sign of hegemonic inevitability. Although China GDP is catching up to US GDP in nominal terms, China GDP Per Capita significantly trails that of the US (Figure 2). China’s rapidly aging demographics combined with its low GDP Per Capita does not bode well for its future nominal GDP.
Figure 2: US vs. China GDP Nominal and GDP Per Capita4
USD detractors further cite the profligate spending of the US government and the propensity to import more than it exports (resulting in twin deficits), not to mention the seemingly endless “money printing” by the Fed in recent years as further evidence of loss of USD hegemony. Yet all of the major competing economic blocs have similarly engaged in a combination of these actions, in many cases far surpassing US excesses. Currency strength is determined by relative attractiveness. In a sea of “dirty laundry,” the USD may be the “cleanest dirty shirt,” but is the US overplaying its hand, especially with the overuse of its “exorbitant privilege”?
Many of our challengers are trying to “clean their laundry” by trying to create better alternatives. The Euro (EUR), the most successful challenger to the USD to date, currently has the second largest share of global reserves at 20%. In addition, because of retroactive and extraterritorial sanctions from the US (recalling Nord Stream 2 and Iran/JCPOA), the Eurozone has even come up with Instex, a clearinghouse mechanism to bypass the USD/SWIFT system.5
China is also trying to lay the groundwork to become less dependent on the USD. The Shanghai Cooperation Organization (SCO) is trying to cut out the USD and conduct trade in Chinese Yuan (CNY), Russian Ruble (RUB) and Indian Rupee (INR). China has established bilateral currency swaps with 60 countries (including US allies) and has developed CIPS as an alternative to SWIFT. Moreover, it is also trying to liberalize its sovereign bond market and pioneer the use of Central Bank Digital Currencies (CBDCs) through its Digital CNY pilot program already pushed out to 300 million Chinese citizens across 10 cities.6
Xi’s recent visit to Saudi Arabia and his subsequent call for Saudi Arabia to conduct its oil trade in CNY met with great fanfare and refueled “loss of USD hegemony” narratives. Although nothing has been decided yet, even if Saudi Arabia were to acquiesce, its 1.68 mmbpd of exports to China account for less than 2% of daily oil trade.7 Furthermore, with the Saudi Riyal (SAR) hard peg to the USD and the CNY soft peg to the USD and lack of convertibility, it begs the question of why Saudi Arabia would voluntarily trade down in liquidity and safety. The only way this calculus would make sense is if fear of US sanctions eclipses the disadvantages of leaving the USD system. The recent meeting and announcement by Xi and MBS may be largely symbolic, but it does raise significant issues with regards to their future intent. In many ways, this is typical of CCP “salami- slicing” tactics used elsewhere.8 Just as important, it indicates that a former key ally, who helped ensure both USD hegemony and energy security, is signaling displeasure with its relationship to Washington.
All of these examples demonstrate how turning away from the USD system is much easier said than done. After more than two decades since inception, it is the EUR that has lost share of allocated reserves to other currencies, not the USD, whose share of global reserves remains at ~60%.9 Over three-quarters of EU energy imports are invoiced in USD (even though a de minimus amount of these imports are actually sourced from the US), and until 2020 there were no pan-EU bonds in existence. It is difficult to have true monetary union without political union.
China faces an even more daunting uphill battle despite its efforts. Aside from the lack of similar endogenous geographic sources of strength, the lack of CNY convertibility, the lack of a robust legal system, and the lack of a liquid sovereign bond market all make the CNY a far less attractive medium of global commerce, much less a contender for GRC. In addition, as evidenced by its own punitive sanctions towards South Korea in 2016-2017, China is unlikely to be a more trustworthy and benevolent global actor on the world stage than the US.10
Recommendations To Better Align Policies To Geostrategic Initiatives
Given its natural economic advantages rooted in superior Geography and Natural Resource availability (but not self-sufficiency), the US through proper policy alignment should be able to achieve self-sufficiency in both Natural Resources and Industrial Capacity. The US does not have the same degree of vulnerability to critical industries like semiconductors and oil as China, but it runs the risk of squandering its natural advantages through misaligned domestic and foreign policies.
Proactive Industrial Policies To Defend America’s Flank
While financial sanctions have mixed results, other more surgical forms of economic coercion like export controls can be effective, especially when wielded in conjunction with supportive and proactive industrial policies designed to “defend America’s flank” and achieve self- sufficiency.
Using the semiconductor industry again as an example, extraterritorial sanctions against Huawei and targeted export controls in the semiconductor supply chain started under Trump and expanded under Biden have been effective in choking off IP theft and access to critical advanced technologies to China. At the same time, proactive industrial policies like the CHIPS Act shore up abilities at home.
Economic coercion in the oil & gas sphere is much more difficult to achieve because of the breakdown in relations between the US and key members of OPEC+ due to ill-planned foreign policy actions. The deliberate alienation of Saudi Arabia in early 2021 via halting arms sales, halting support against Shia-backed Houthis in Yemen, the pulling back of the Nimitz from the Middle East, and the deliberate snubbing of Mohammed bin Salman significantly soured relations with this former ally and most influential member of OPEC. This has left America’s flank unprotected before the consummation of a new nuclear agreement with Iran that would allow the unfreezing of sanctions and freeing up of Iranian oil. The oil spike of 2021-2022 then precipitated further poor policy choices, including the draining of the SPR to levels not seen since the early 1980’s (and before a true geopolitical emergency is present) and also threatening US domestic oil & gas companies with windfall profits taxes and export bans, both of which further discourage long-term investment. Figure 3 illustrates the extent to which the SPR has been depleted despite elevated geopolitical tensions.
Figure 3: Strategic Petroleum Reserve 1985—202211
While a fulsome discussion of foreign policy is somewhat beyond the scope of this paper, much course correction can be accomplished through better industrial policy in the oil & gas sector to properly “defend America’s flank.” The first step is to recognize that blind pursuit of ESG objectives like decarbonization, while noble, can seriously hobble America’s natural advantages in Natural Resources and leave its flank exposed. The ESG debate too often considers only the positives of renewables and “green energy” without also considering negative externalities like the environmental impacts of mining and disposal of batteries and wind turbines, and the inevitable strain on electric grids by unchecked introduction of wind/solar at the expense of stable base load sources like coal/nuclear.12 The ill-fated energy policy choices of Germany turning off its nuclear base load while becoming inextricably dependent on Russian gas should be a warning to US policymakers. These poor choices from European allies have direct ramifications on domestic consumers as well; shipping LNG exports abroad to make up for Russian gas shortfalls directly siphons supply away from the domestic market and drives domestic prices up, ceteris paribus.
Although the US is currently the largest oil producer in the world, “US energy independence” is a myth. First, the shale revolution is in decline. For reasons already mentioned, it took a rare confluence of factors to bring about the shale revolution, and now that the best acreage has already been drilled out, and given the sharp decline curves in shale, it is highly unlikely that US production leadership can continue indefinitely at current commodity prices –- especially with overt government hostility towards investment.
Second, there has also been a lack of global investment in exploration and development of conventional sources of supply thanks to the 2014-2020 bear market as well as the ESG movement. There is no shortage of oil in the world, but there is a shortage of cheap oil, and without much higher prices and/or friendlier industrial policies to incentivize development, the world will likely run into a “supply/demand singularity” event in this decade – where global demand exceeds all available spare production capacity. Since commodities price to marginal demand and oil demand is short-term inelastic, such an event could lead to a parabolic price spike. This is a key reason why the US has a Strategic Petroleum Reserve; it should not be drained for political gain. Not only should the government refrain from threatening oil & gas companies with windfall profits taxes, the government should be subsidizing the industry to encourage new exploration and development.
Third, the Department of Energy recently floated the idea of banning exports of oil based upon this erroneous myth of “energy independence.” The politically framed narrative can be summarized as follows: “We’ve had an Export Ban in place from 1975 to 2015; now that we are net exporting oil, we can just reinstitute the Export Ban to achieve lower domestic oil prices.” This narrative completely mischaracterizes reality, and a reinstitution of the Export Ban would be disastrous for not only the oil & gas industry but also for domestic consumers. The original Export Ban came about in reaction to the Arab Oil Embargo of 1973; during the time the Export Ban was in place, US conventional oil production was in decline, and there were no meaningful exports. The repeal of the ban was highly beneficial to the US economy because it incentivized more production and exports, “from less than half a million barrels per day in 2015 to almost 3 million barrels per day in 2019”; yet “after the repeal, total U.S. imports of crude oil remained largely unchanged.”13 How can this be?
The crux of the issue is that US shale produces/exports light-sweet grades of crude (which comprise almost 100% of our oil exports), but US refineries predominantly require medium-heavy blends, which is why almost all US crude imports are heavy grades from the Middle East. This is the reason why US imports were significant before the repeal of the Export Ban in 2015 and remain significant and barely changed after the repeal of the Export Ban – the net exports are mainly light grades that our refiners have limited capacity to process. Although light grades from shale oil now comprise over 75% of the ~12.5 mmbpd the US produces, US refiners still need to import significant heavy grades from the Middle East to blend with these light grades.
It is useful to game out what would happen if an Export Ban is reenacted today, and a glance at Figure 4 illustrates the domestic choke points that render such a policy ineffectual. First, the bulk of our domestic refining capacity located at the Gulf Coast (PADD III) would have to turn back about 2.5-3 mmbpd to Cushing (the mid-continent delivery point), which would fill up to tank-tops rapidly and crash WTI (West Texas Intermediate – the domestic crude oil benchmark) prices like what happened in April, 2020 when COVID forced prices into negative territory. Unlike during April, 2020, when Brent (international crude oil benchmark) prices also collapsed, this time Brent would spike along with other light grades because the rest of the world would be short these 2.5-3 mmbpd now trapped at Cushing with nowhere to go. Ironically, East Coast refineries (PADD I), which would be able to use lighter grades, have no way of getting the excess oil trapped in Cushing/Gulf Coast due to lack of pipelines and Jones Act restrictions (an anachronistic law that should be abolished) on domestic shipping and would have to import more Brent and gasoline, both likely to be spiking due to these artificial shortages.14
Retooling of US refineries to take lighter blends and building pipelines to channel excess oil from the mid-continent to PADD I would take 5+ years and tens of billions of dollars, yet it is exactly the type of industrial policy US policymakers should consider. An Export Ban before such a retooling occurs would force domestic and global consumers to bear the brunt of spiking gasoline prices, even as US shale producers would simultaneously suffer crippling financial losses and cost the country hundreds of thousands of jobs, not to mention billions in export dollars – a true lose/lose proposition.
Figure 4: The 5 Petroleum Administration for Defense Districts (PADDs) and Refinery Locations in The US.15
To summarize, there can be no US energy independence without proper industrial policy to incentivize/subsidize not only more exploration and development but also the retooling and expansion of US refining capacity to take the lighter grades that US geology produces. Mistakes that need to be reversed include restarting the canceled Keystone pipeline to bring in heavier grades from Canada, connecting Cushing to East Coast refiners, and refilling the SPR to full capacity to protect against a real geopolitical emergency, such as the Arab Embargoes of the 1970’s.
CONTINUE TO PART 4/4:
Agathe Demarais, Backfire, (New York, US: Columbia University Press, 2022), p. x, 6.
Agathe Demarais, Backfire, p.100-101.
“Comparing United States and China by Economy - StatisticsTimes.Com,” May, 2021. https://statisticstimes.com/economy/united-states-vs-china-economy.php.
Agathe Demarais, Backfire, p.136. Note: Europe, despite aligning in many ways with the US RBO, seeks alternative exchange arrangements outside of the US system.
Nadeen Ebrahim, Tamara Qiblawi, and Caroline Faraj, “China's XI to Visit Saudi Arabia amid Frayed Ties with the US,” CNN (Cable News Network, December 7, 2022), https://www.cnn.com/2022/12/05/middleeast/xi-jinping- saudi-arabia-visit-intl/index.html
Robert Haddick, “America Has No Answer to China’s Salami-Slicing.” War on the Rocks, August 7, 2015. https://warontherocks.com/2014/02/america-has-no-answer-to-chinas-salami-slicing/.
Credit Suisse. “2023 Economic Outlook: Weaker Growth, Higher Rates, No Cuts,” (December 16, 2022.) p. 28. https://perspective.credit-suisse.com/investment-outlook-2023/a-fundamental-reset.
Agathe Demarais, Backfire, p.155.
Energy Information Administration, “Stocks of SPR Crude Oil,” 21 Jan 2023. https://www.eia.gov/dnav/pet/PET_STOC_WSTK_A_EPC0_SAS_MBBL_W.htm Note: The SPR has been drained to levels not seen since the early 1980’s.
Meredith Angwin, Shorting The Grid: The Hidden Fragility of Our Electric Grid, (Vermont, US: Carnot Communications, 2020), p.365.
U.S. Government Accountability Office. “Crude Oil Markets: Effects of the Repeal of the Crude Oil Export Ban,” 21 Oct 2020. https://www.gao.gov/products/gao-21-118.
Kent, Will, “What Is the Jones Act? Definition, History, and Costs,” Investopedia, January, 2023, https://www.investopedia.com/terms/j/jonesact.asp.
U.S. GAO. “Crude Oil Markets: Effects of the Repeal of the Crude Oil Export Ban,” 21 Oct 2020. https://www.gao.gov/products/gao-21-118.