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West Point Paper -- Part 4/4
"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.
The USD Wrecking Ball: A Geopolitical Lever
It is much cheaper to sow chaos than to defend against it. The US pivot towards guided missiles during the Cold War is a perfect example of this strategy, whereby US strategists “calculated Moscow would need five to ten years and $30 to $50 billion to defend against the three thousand American cruise missiles that the Pentagon planned to field.”1 Rather than resorting to kinetic means, economic warfare can be an effective way to sow chaos and force the enemy into an economically ruinous defense strategy – especially when the “weapon” is masked as domestic monetary policy rather than overtly hostile financial sanctions. The presence of persistently high inflation at a level not seen since the 1970’s presents an interesting geopolitical opportunity for the US to pursue a strong USD policy to not only fight inflation domestically but to advance geopolitical interests at the same time – in effect targeting “two birds with one stone.”
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Triffin’s Dilemma, eponymously named after Yale professor Robert Triffin, speaks to the tension between the USD’s role as GRC in lubricating the world economy with ample supply of USD (thereby stoking domestic inflation) versus combating inflation at home and exporting it to the world by reducing monetary supply and strengthening the USD. A strong USD in a world where our geopolitical adversaries are ill-equipped to defend their own currencies would indeed sow economic chaos, especially when critical commodities like oil are priced in USD.
It is important to not conflate currency exchange-rate strength with currency adoption. The following Strength vs. Adoption Matrix (Figure 5) illustrates the difference:
Figure 5: Currency Strength vs. Adoption Matrix
Quadrant I (low adoption/low strength) conveys the quandary of many EM countries: very little trade/finance is conducted in their home currency (low adoption), and when this corresponds to a period of home currency weakness, it can lead to credit crises especially when debts are US- denominated. The Asian Financial Crisis of 1998 is an example of this, and the German Weimar Hyperinflation of the 1920’s is an extreme example of what happens when there is complete loss of faith in one’s home currency. If it weren’t for China’s capital controls, the Chinese Yuan (CNY) would likely be in Quadrant I.
Quadrant II (high adoption, low strength) illustrates the current challenges facing the Euro (EUR) and Japanese Yen (JPY), the two largest components of the US Dollar Index (DXY), a weighted geometric mean of the convertible currencies of the most significant trade partners of the US (Figure 6). Note the exclusion of the Chinese Yuan (CNY) due to its lack of convertibility. The EUR and JPY both have relatively high global adoption but are experiencing currency weakness due to cyclical and structural reasons.
Quadrant III exemplifies a small cadre of currencies like the Swiss Franc (CHF) that have traditionally served as “safe-haven” currencies and maintained relative strength despite very low global adoption.
Quadrant IV describes the current state of the USD. Although USD exchange rate strength ebbs and flows with cyclical factors (Figure 7), its adoption remains dominant in the world by almost any measure (Figure 1).
Figure 6: Currency Weights in the Dollar Index (DXY)2
Figure 7: The USD Dollar Index (DXY) 1970 – 2023.3
Note: As exemplified by the DXY, the USD has ebbed and flowed in terms of exchange-rate strength over the decades, but this should not be conflated with adoption.
The present macroeconomic climate is reminiscent of the stagflationary period of the 1970’s, because much of the current inflation is likely structural and not transitory, based upon a myriad of factors: aging global demographics reducing labor supply, structural underinvestment in oil & gas that ignited commodity price inflation, and unprecedented monetary and fiscal stimulus that then caused inflation expectations to leap into “stickier” components like wages and rents.
Structural inflation calls for a prolonged period of monetary tightening by the Fed and concomitant reduction of its balance sheet. If foreign central banks cannot keep up with the Fed, their respective currencies will continue to weaken against the USD. Recall the “dirty shirt” analogy – because other central banks have overextended themselves even worse than the Fed and because of the USD’s hegemony in global trade, other economic blocs have limited ability to maneuver and keep up with the Fed’s fight on inflation. It is interesting to note that the Eurodollar system arose in the 1950’s in response to capital controls enacted by Britain on Sterling due to domestic inflationary pressures.4
Central bank “overextension” comes from policies of aggressive asset purchases (mostly of but not limited to sovereign bonds of their own countries/regions). The “Impossible Trinity” of international economics is a key constraint on central banking policy choices (Figure 8). The “Impossible Trinity” is a concept of international economics which states that it is impossible to have all three of the following at the same time: 1) a fixed foreign exchange, 2) free capital movement (absence of capital controls), 3) an independent monetary policy.5
Figure 8: The Impossible Trinity6
When a central bank’s balance sheet is stuffed with its own sovereign bonds, it faces very difficult policy choices in the presence of inflation:
Raising interest rates to combat domestic inflation lowers the value of its sovereign bonds
If preventing a decline in sovereign bonds is important (and the more a central bank owns the more
important this becomes), then the central bank is left with only two choices:
Allow the currency exchange rate to devalue, or
Impose capital controls
The recent spike in the USD is a direct result of the Fed’s aggressive interest rate hikes to combat domestic inflation and the relatively weak attempts by other central banks to keep up with that hiking policy. Absent capital controls (although this is China’s main defense against a rising USD), world central banks have generally sacrificed their currencies in favor of defending their sovereign bond markets. Recent examples of this include Yield Curve Control (YCC) by the Bank of Japan (BOJ) to prevent yields from spiking above a narrow band above zero, the implementation of the Transmission Protection Instrument (TPI) by the European Central Bank (ECB) to prevent spreads of different sovereign bonds within the Eurozone from diverging from one another, and direct intervention in the Gilt market by the Bank of England (BOE) to stem losses in its pension system.
Figure 9 illustrates why the USD is the “cleanest dirty shirt” among major currencies and why the other major economic players will be challenged to keep up with the Fed. The balance sheet of the Fed is the lowest as a percentage of GDP in the G4.
Figure 9: G4 Central Bank Balance Sheets as a Percent of GDP7
Not only do bloated central balance sheets act as straitjackets on economic policies, each of these competing economic zones lacks the resiliency of the US economy. Europe is politically fragmented with competing economic interests within its own sphere, while core countries like Germany have put their economies at the utter mercy of Russian energy flows due to poor energy policy choices. The UK has a fragile pension system that almost became insolvent at the end of 2022 when Gilt yields spiked, not to mention the lack of long-term mortgages which presents a problem for homeowners needing to refinance into a higher rate environment. Japan has battled demographic and economic stagnation for decades, and the BOJ has trapped itself by trying to keep long-term bond yields near zero through Yield Curve Control (YCC).8 Other factors that lend relative strength to the US economy (and therefore the ability for the Fed to hike interest rates more aggressively) at the present include low household debt-to-income ratios (Figure 10) as well as relatively low percentages of variable-rate mortgages in the US (Figure 11).
Figure 10: Household Debt-to-Income Ratios9
Figure 11: Percentage of Variable-Rate Mortgages10
China, despite its reputation as the primary challenger to the US-led RBO, may be in the worst shape of all. Aside from disadvantaged Geography and challenged access to Natural Resources, China’s demographic problem is arguably the worst in the world, projected to lose nearly half of its population by 2100.11 The failure of Evergrande in 2021 and the ensuing fallout in its real estate sector coupled with its quixotic zero-Covid policies have curtailed its economic growth prospects without government stimulus, and government stimulus at a time that the Fed and other central banks are simultaneously tightening policy to curb inflation invites CNY depreciation. Lack of convertibility in CNY masks the potential capital flight from the country if it allowed its currency to float freely. According to Credit Suisse, “if China were to fully liberalize its capital account, 20- 25% of household savings would be geographically diversified away from China.”12
The People’s Bank of China (PBOC) is also conspicuously absent from many central bank comparisons, likely due to the opacity/unreliability of data from China and due to the obfuscatory interrelationship between the PBOC and state banks; that said, many analysts point to China’s debt- fueled boom of the last several decades as unsustainable, as demonstrated in Figure 12.
Figure 12: Total Private Credit13
China and the PBOC face extraordinarily difficult choices. For a country that is heavily export-dependent, China’s policymakers should want a weaker CNY. Why then did the PBOC intervene multiple times in Q4, 2022 to stymie CNY devaluation? The reason is likely because China is critically dependent on importing oil, which is USD-denominated; Figure 13 shows that China imports between 80-87% of its oil needs, depending on the method of calculation. Structural global underinvestment in oil combined with a hawkish Fed determined to keep monetary policy restrictive (and thus keep the USD strong) could coalesce into a one-two inflationary punch for countries like China that are heavily dependent on foreign oil if both USD-denominated oil and the USD itself spike at the same time.
Figure 13: China’s Oil Import Dependence14
Despite decades of USD detractors predicting the imminent demise of USD GRC status, and by extension the demise of the US-led RBO, USD hegemony will be difficult for its competitors to dislodge. Negative balance of payments is always cited as one of the key bogeymen for the USD, but this is a feature and not a bug of USD hegemony. As Charles Kindleberger recognized decades ago, “the US was not running a balance of payments deficit, rather merely supplying the world’s demand for dollars as a liquid reserve.”15 As the US Federal Reserve notes in a recent paper titled, “The Dollar’s Imperial Circle”:
The first key element behind the Dollar’s Imperial Circle is the direction of capital flows towards the U.S. economy as the main destination that has the capacity to absorb saving coming mainly from Asia. This element reflects the massive global asset shortage that is more pronounced in Asia and forces money into the U.S. For example, as emphasized by the IMF, the size of life insurers assets is more than 10 times the size of their respective domestic corporate bond market.16
The same paper also highlights the relative degrees of export independence exhibited by the key competitors in Great Power Competition (Figure 14):
Figure 14: Exports as a Percent of GDP and US Export Independence17
Relative export independence makes the US less susceptible to the negative feedback dynamics typically created by a strong currency.
In summary, if present macroeconomic conditions indeed prove to be structurally stagflationary, central banks around the world will be hard-pressed to keep up with the Fed, ensuring a strong USD. China and the PBOC are particularly vulnerable. Not only are the effects of interest rates hikes magnified in other countries due to a myriad of structural and idiosyncratic economic fragilities previously discussed, the confluence of wide USD adoption with cyclical USD strength (Quadrant IV in Figure 5) make the USD a potent geopolitical lever masquerading as a domestic fight against inflation. National Power lends the USD dominance in adoption, while an opportunistic fight against inflation lends the USD cyclical strength for geopolitical leverage.
The USD’s hegemonic role as GRC is central to the US-led RBO, and its daily usage by the world is a continuously evaluated choice based upon the National Power of the US. Cyclical factors, like temporal differences in monetary policies between central banks leading to imbalances in interest rate differentials, affect daily exchange rates; however, these cyclical factors should not be confused with the endogenous qualities that contribute to the widespread adoption of the USD.
USD hegemony taken together with relative US self-sufficiency make the Great Power Competition a game that is the United States’ to lose. Although the US enjoys many natural advantages in Geography and Natural Resources, misalignment of policies with geopolitical objectives threatens to undermine these advantages and creates incentives for competition for USD primacy.
There is currently an “Axis of the Angered” in the Great Power Competition, exemplified by countries like Russia, Iran, North Korea, and China who have been targets of US sanctions. This is leading to active efforts by them to recruit additional countries and regions like Saudi Arabia and the Eurozone to adopt measures to skirt the USD system. This should be a shot across the bow and a warning to US policymakers, who must look at the big picture and consider what is at stake if the US loses the “exorbitant privilege” that USD hegemony bestows upon US citizens. The US must not allow the “Axis of the Angered” to become an “Alliance of the Alienated.”
Worse, overuse of overt economic coercion like financial sanctions, which are reactive and punitive in nature, may become interpreted as casus belli at some point and lead to kinetic escalation. The aim of this paper is to suggest alternative courses of action that simultaneously advance self- sufficiency while still applying economic pressure on adversaries. Proactive industrial policies that mitigate dependencies on oil and semiconductors ought to be in the arsenal of tools. Simultaneously, a strong USD policy in the name of fighting the current stagflationary macroeconomic backdrop can achieve both the domestic goal of curbing inflation as well as the geopolitical objective of applying economic pressure on adversaries without the use of overt coercion.
Chris Miller, Chip War: The Fight For The World's Most Critical Technology, p.75.
Motilal Oswal. “Dollar Index (DXY) the Barometer for Global Currencies,” https://www.motilaloswal.com/blog- details/Dollar-Index-(DXY)-the-barometer-for-global-currencies/1320
Data source: Proprietary data capture via Refinitiv Eikon. (Michael Kao).
Catherine Schenk, “The Origins of the Eurodollar Market in London: 1955-1963,” p. 222.
James M. Broughton, “On the Origins of the Fleming-Mundell Model,” IMF Staff Papers: Vol. 50, No. 1, 2003. IMF Staff Papers, Vol. 50, No. 1, 2003: On the Origins of the Fleming-Muncell Model by James M. Boughton.
The Economist. “What Is the Impossible Trinity?.” September 10, 2016. https://www.economist.com/the-economist-explains/2016/09/09/what-is-the-impossible-trinity.
Data source: Refinitiv Datastream. https://fingfx.thomsonreuters.com/gfx/breakingviews/1/1344/1946/DataStream-Chart.htm
Sage Belz, and David Wessel, “What Is Yield Curve Control?” Brookings, March 9, 2022. https://www.brookings.edu/blog/up-front/2020/06/05/what-is-yield-curve-control/.
The US has some of the lowest household debt-to-income ratios in the world. Source: Deutsche Bank, 1/11/2023.
Credit Suisse. “2023 Economic Outlook: Weaker Growth, Higher Rates, No Cuts,” (December 16, 2022.) p. 17. https://perspective.credit-suisse.com/investment-outlook-2023/a-fundamental-reset. Note: The US has one of the lowest percentages of variable-rate mortgages in the world. Source.
Laura Silver, and Christine Huang, “Key facts about China’s declining population,” Pew Research, December, 2022, https://www.pewresearch.org/fact-tank/2022/12/05/key-facts-about-chinas-declining-population/.
Credit Suisse. “2023 Economic Outlook: Weaker Growth, Higher Rates, No Cuts.”
Peter Zeihan, The End of The World Is Just The Beginning, p.210.
Data source: Proprietary data capture from Lakshmi Sreekumar, Managing Director of Commodity Derivatives, Capital One.
Perry Mehrling, Money and Empire, p.115.
Ozge Akinci, et. al., “The Dollar’s Imperial Circle,” p.8.