Tuesday, October 9, 2018

Economic Sanctions, Failing Alliances, and the Future of the Dollar


The United States has gone against the wishes of its allies in planning to reinstate sanctions against Iran even though everyone agrees that Iran has been living up to the conditions of the treaty that originally lifted sanctions against it.  The other countries have expressed the desire to continue to do business with Iran, but the United States has threatened them with financial harm should they do so.  How does the US obtain the power to bully other nations in this way?

The Trump administration’s leverage over other nations arises from the size of the US economy and the US dollar’s role as the currency of choice in international financial transactions.  Most international transactions take place via procedures developed to provide reliability and uniformity by a European outfit called SWIFT (Society for Worldwide Interbank Financial Telecommunication).  The US intelligence agencies have developed the capability to monitor all transactions using SWIFT.  Any financial entity involved in business with Iran would normally use this agency and be detected by a US outfit called OFAC (Office of Foreign Assets Control), which has been provided with enormous power that can be used to force others to behave consistently with US policies.

From Wikipedia we get this perspective on OFAC.

“Sometimes described as one of the ‘most powerful yet unknown government agencies, OFAC was founded in 1950 and has the power to levy significant penalties against entities that defy its directives, including imposing fines, freezing assets, and barring parties from operating in the United States.”

“OFAC administers and enforces economic sanctions programs against countries, businesses or groups of individuals, using the blocking of assets and trade restrictions to accomplish foreign policy and national security goals.”

Financial transactions between entities in different countries are normally handled by institutions such as banks.  Getting caught facilitating flows of currency between Iran and another entity would place at risk a bank’s ability to do business in the US.  There are few, if any, of significant size that don’t have a US presence as part of their business model.

Wielding this power is acceptable if the policies driving it are arrived at with voluntary acquiescence by a significant number of international players.  That has essentially been the case for decades.  But now the Trump administration is saying to its traditional allies it will do whatever it wants to do—because it can.  That attitude does not rest easily with other nations, generating interest in alternative mechanisms that would free them from US domination.  Should such a thing come to pass, the US would face a much different financial future—one with significant consequences.

Peter Coy addressed these issues in a Bloomberg Businessweek article The Tyranny of the U.S. Dollar.

“By the latest tally of the European Central Bank, America’s currency makes up two-thirds of international debt and a like share of global reserve holdings. Oil and gold are priced in dollars, not euros or yen. When Somali pirates hold up ships at sea, it’s dollars they demand. And threats to be cut off from the dollar-based global payments system strike terror into the likes of Iran, North Korea, and Russia. It’s no exaggeration to say that the dollar’s primacy is at least as valuable to the U.S. as a couple of aircraft carrier strike groups.”

Coy indicates that dissatisfaction with the current system is growing.

“Political leaders who once accepted the dollar’s hegemony, grudgingly or otherwise, are pushing back. Jean-Claude Juncker, the president of the European Commission, said in September that it’s ‘absurd’ that European companies buy European planes in the American currency instead of their own. In March, China challenged the dollar’s dominance in the global energy markets with a yuan-denominated crude oil futures contract. Russia slashed its dollar holdings this year, claiming (inaccurately) that the greenback is ‘becoming a risky instrument in international settlements.’ And French Finance Minister Bruno Le Maire told reporters in August that he wants financing instruments that are ‘totally independent’ of the U.S., saying, ‘I want Europe to be a sovereign continent, not a vassal’.”

It is difficult to know if any of this will lead to changes in the future, but the US should at least recognize what losing the dollar as the dominant currency would mean.  Coy indicates several consequences.  The first is that the cost of borrowing to service our national debt would increase.

“’In a hypothetical scenario where the U.S. withdraws from the world,’ damage to the dollar’s standing could cause average U.S. interest rates to rise by 0.8 percentage point, according to a December paper by Barry Eichengreen of the University of California at Berkeley and two researchers from the European Central Bank.”

An extra 0.8% in interest on $21 trillion is about $170 billion in added expenditures each year, or $170 billion deducted from other budgeted items.  The net effect could be even worse if the world should decide that US debt is no longer a good investment.

“If the dollar loses its central role—to be sure, not an imminent threat—the U.S. will be more vulnerable when there’s a loss of investor confidence. The Federal Reserve might even have to do what other nations do when global investors panic: jack up interest rates to painful levels to keep speculative money from flowing out. As it is now, when trouble breaks out, investors flood into U.S. markets seeking refuge, oddly enough even when the U.S. itself is the source of the problem, as it was in last decade’s global financial crisis.”

There is also something called the “Triffin dilemma.”

“Belgian-American economist Robert Triffin observed in 1959 that for the U.S. to supply dollars to the rest of the world, it must run trade deficits. Trading partners stash the dollars they earn from exports in their reserve accounts instead of spending them on American goods and services.”

The good that comes from this is that the need for dollars means that the US can consume more than it earns from the health of its economy without having to raise interest rates.  In other words, consumers can “live beyond their means.”  Should the dollar lose its exalted status, countries would begin buying more US goods as they diminish their dollar reserves. This would generate a short-term boost in business for the economy, but forevermore, US consumers would be “living beneath their means” as the cost of servicing the debt would increase.

The Trump administration is playing with fire here.  Short-term advantages can lead to long-term disadvantages.

“America First” is not necessarily “America Best.”


The interested reader might find the following article informative:




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