financial statecraft

Over at Politico, Eamon Javers notes an odd trend in the Drudge Report: 

On Tuesday, Matt Drudge ran a headline about the weakening U.S. dollar on his website, Drudgereport.com. In and of itself, that would be unremarkable, except that it was the 18th time Drudge had posted a link to a story about the weak dollar this month.

And October was only 20 days old.

Clearly, Matt Drudge has developed a fascination with the declining U.S. dollar.

“He’s fixated on it,” said Tom Rosenstiel, director of the Pew Research Center’s Project for Excellence in Journalism. “There’s no question that Drudge can alter what people are paying attention to.”

Market watchers say it’s unlikely that Drudge is actually moving the currency markets with his relentless attention.

“I don’t think that anyone who seriously trades currencies reads The Drudge Report before making important buy or sell decisions,” said Chris Roush, a professor of business journalism at the University of North Carolina at Chapel Hill. (emphasis added... because that's a priceless quote)

Drudge isn't the only one obsessed about the dollar.  Last week, James Pethokoukis blogged the following for Reuters: 

The aftershocks of the global financial crisis may now be propelling the dollar back to the political forefront. The greenback’s continuing slide makes it a handy metric that neatly encapsulates America’s current economic troubles and possible long-term decline. House Republicans for instance, have been using the weaker dollar as a weapon in their attacks on the Bernanke-led Federal Reserve.

For more evidence of the dollar’s return to political salience, look no further than the Facebook page of Sarah Palin. The 2008 GOP vice presidential nominee — and possible 2012 presidential candidate — has shown a knack for identifying hot-button political issues, such as the purported “death panels” she claims to have found in Democratic healthcare reform plans. In a recent Facebook posting, Palin expressed deep concern over the dollar’s “continued viability as an international reserve currency” in light of huge U.S. budget deficits.

She might be onto something here, politically and economically. A recent Rasmussen poll, for instance, found that 88 percent of Americans say the dollar should remain the dominant global currency. Now, the average voter may not fully understand the subtleties of international finance nor appreciate exactly how a dominant dollar has benefited the U.S economy. But they sure think a weaker dollar is a sign of a weaker America.

OK, let's be as plain as possible about this - as a reserve currency, the dollar is not going anywhere.  Really. 

The dollar's slide in value has been predictable, as the need for a financial safe haven has abated.  By and large, a depreciating dollar helps the U.S. trade balance (though it would help much more if the Chinese renminbi got in on the appreciation).   

Even the Chinese, who have spoken like they want an alternative to the dollar as a reserve currency, are in point of fact not doing much to alter the status quo.  Why?  To paraphrase Winston Churchill, the dollar is a lousy, rotten reserve currency - until one contemplates the alternatives. 

Because all of the alternatives have serious problems.  The euro, the only truly viable substitute for the dollar, is not located in the region responsible for the largest surge of growth.  It would be unlikely for the ASEAN +3 countries to agree to switch from the dollar to a new currency over which regional actors have no influence (the Europeans wouldn't be thrilled either, as it would lead to an even greater appreciation of the currency).  Oh, and the European Union has no consolidated sovereign debt market.  The euro is worth watching, but it's not going to replace the dollar anytime soon.  

The other alternatives are even less attractive.  Most other national currencies beyond the euro - the yen, pound, Swiss franc, Australian dollar - are based in markets too small to sustain the inflows that would come from reserve currency status.  The renminbi remains inconvertible.  A return to the gold standard in this day and age would be infeasible - the liquidity constraints and vagaries of supply would be too powerful.  There's the using-the-Special-Drawing-Right-as-a-template-for-a-super-sovereign currency idea, but this is an implausible solution.  As it currently stands, the SDR is not a currency so much as a unit of account.  Even after the recent IMF authorizations, there are less than $400 billion SDR-denominated assets in the world, which is far too small for a proper reserve currency. 

So, what's really going on here with the dollar obsession?  I suspect that with the Dow Jones going back over 10,000, Republicans are looking for some other Very Simple Metric that shows Obama Stinks.  The dollar looks like it's going to be declining for a while, so why not that?  Never mind that the dollar was even weaker during the George W. Bush era -- they want people to focus on the here and now. 

The thing is, I'm not sure this gambit is going to work.  People who already think Obama is a socialist will go for it, sure, but that's only rallying the base.  I'm not sure how much fence-sitters care about a strong dollar, however.  If anything, populist movements tend to favor a debasing of the currency rather than a strengthening of it. 

Still, I'm just a political scientist -- I'm sure that, "theories on political behavior are best left to CNN, pollsters, pundits, historians, candidates, political parties, and the voters." 

So, have at it, readers!  Will the falling dollar be a source of populist outrage if Drudge links to it enough? 

UPDATE:  contrasting takes from Kevin Drum and Megan McArdle. 

Your humble blogger has a rather long essay in the Fall 2009 issue of International Security.  What's a lowly IPE scholar doing publishing in a high and mighty security journal?  Assessing whether China's massive holdings of dollar-denominated assets is a big deal or not.  The title may or may not give away my argument:  "Bad Debts: Assessing China's Financial Influence in Great Power Politics."

Here's the abstract: 

Commentators and policymakers have articulated growing concerns about U.S. dependence on China and other authoritarian capitalist states as a source of credit to fund the United States' trade and budget deficits. What are the security implications of China's creditor status? If Beijing or another sovereign creditor were to flex its financial muscles, would Washington buckle? The answer can be drawn from the existing literature on economic statecraft. An appraisal of the ability of creditor states to convert their financial power into political power suggests that the power of credit has been moderately exaggerated in policy circles. To use the argot of security studies, China's financial power increases its deterrent capabilities, but it has little effect on its compellence capabilities. China can use its financial power to resist U.S. entreaties, but it cannot coerce the United States into changing its policies. Financial power works best when a concert of creditors (or debtors) can be maintained. Two case studies—the contestation over regulating sovereign wealth funds and the protection of Chinese financial investments in the United States—demonstrate the constraints on China's financial power.

Read it and weep. 

For reasons that will soon become clear, your humble blogger has been reading up on Iceland's financial boom and bust in recent years.  So I noted with interest that yesterday, Iceland's Prime Minister Jóhanna Sigurðardóttir took to the pages of the Financial Times to vent about her country's treatment at the hand of big countries... like the Netherlands.  See if you can spot the contradiction in her statements:

In its efforts to conclude negotiations over compensation for foreign savers in failed banks, Iceland has been accused of a tendency to imagine a British or Dutch conspiracy behind any bad news.

Iceland has no such tendency. It is battling the effects of severe banking and currency crises and a recession that is affecting our part of the world as much as any other. My government, which took over in February and gained a majority in general elections in May, has to deal with the aftermath of the fall of nearly all of Iceland’s privatised banking sector....

The FT has reported how the Dutch opposed the IMF lending to Iceland in order to enforce their demands on Icesave [an online bank headquartered in Iceland that attracted upwards of 300,000 British and Dutch depositors--DD], claiming the UK and Germany as allies. The perception is that Treasury officials in the UK and the Netherlands used their bargaining power against a much weaker party when the Icesave deal, now being debated in the Icelandic parliament, was struck.

This has made it difficult for Iceland’s government to convince the parliament and Icelanders that an agreement on Icesave accounts with the UK and the Netherlands is un-avoidable.

Here's the funny thing -- if you click on the link from the FT about how the Dutch are using the IMF to put the screws on Iceland, you get this story which sources those suspicions to.... Icelandic officials.  The story also goes on to say that, "The view in London is that Iceland has a tendency to imagine a British or Dutch conspiracy behind any bad news." 

To be fair to Sigurðardóttir, she wasn't in power when Iceland got itself into this mess.  Furthermore, Iceland did have help getting into this mess -- reading up, it's clear that EU banking regulations are even more screwed-up than US banking regulations.  And it wouldn't stun me if the Dutch were putting the screws on Iceland. 

Still, reading up on the mess in Reykjavik, it is truly stunning how little Icelanders seem to blame themselves for their current plight (and how much they thought their run of success was completely deserved).  The fault always seems to lie with cabals of hedge funds, rating agencies, foreign central bankers, etc. 

Iceland has had its share of bad luck, and until recently had a political class that was by far the most incompetent in the OECD area (and the competition in this arena is admittedly intense).  Still, reading Sigurðardóttir's op-ed, I can see why Henry Kissinger once described Iceland as the most arrogant small country he had ever encountered. 

As you can tell from my last post, I think here's an excellent chance that the status quo persists in Iran, with a small chance that the entire edifice crumbles in the wake of a social movement unafraid of security forces.  What does this mean for U.S. foreign policy towards Iran? Here's a dirty little secret -- this might actually be the best possible outcome for the Obama administration. 

Well, not for the next few days. The administration is going to have to tap-dance for the next few days in order to avoid the Schylla of a "Chicken Kiev" moment and the Charybdis of going all in with the reformers only to see them crushed. 

After that, then what? Well, I think the only way the reformers win is with Khamenei going down, which would mean a genuine regime change, which is a game-changer. A new Iranian regime is not going to give up its nuclear program lightly, but I do suspect that negotiations with a reformist regime would be pretty fruitful. 

What if, as I suspect, the current regime keeps its grip on power?  Well, the Obama administration still has a stronger hand to play.  Here's why: 

1)  Tehran's influence in the region is going to ebb. Iran's power in the Middle East in recent years has emanated from a mix of hard power (nuke progam, oil, support of Hebollah) and soft power (Ahmadinejad's economic populism, ranting against corrupt Arab elites, and general pugnaciouness towards Israel).  Regardless of the result now, the election has killed their soft power in the region.  This doesn't mean that Iran's influence disappears -- see all the hard power stuff.  Still, with each passing day of protests, Ahmadinejad looks more like a bully than a leader of a transnational social movement. 

2)  Multilateral coordination just got easier.  Just as with North Korea, it gets ever easier for the United States to create a united front among its allies and other great powers when dealing with Iran going forward.  The reaction in the West has been pretty uniform on the election results.  When the nuclear negotiations break down -- and they will break down -- it should be easier to coordinate both the security and foreign policy responses.

3)  No more two-level games for Iran. If Mousavi had won outright, the Obama administration would have been in a serious bind on the nonproliferation question. The president of Iran doesn't control the nuclear program; the supreme leader controls it. With Mousavi as the public face of Iran, however, it would have been tougher for the Obama administration to describe Iran as unyielding when it refused to make any serious concessions on its nuclear program.  Furthermore, Mousavi could always ask the Obama administration to back off on the nuclear question because of hardliner resistance back home. That gambit won't play, now.

This doesn't mean that nuclear negotiations will go swimmingly -- I expect they will fail.  What it does mean, however, is that the rest of the world will be hard-placed to blame the end of the negotiations on the Obama administration.  Iran is going to look like the intransigent actor from here on in. 

Just to be clear:  I'm not saying that this outcome is a great one for the United States.  Washington has a weak hand to play.  My point is that, compared to the counterfactual of an Iran with Mousavi as its public face and Khamenei remaining the true leader, this is somewhat preferrable. The "pleasing illusions" of clerical power in Iran have now been stripped bare.

My pace on commenting on Iran has been about as sluggish as CNN's.  By my rough estimate, I'm now approximately 4,567 posts behind Andrew Sullivan on the Iran election. Let's try to get back in the game! 

In this post I want to look at what's likely to happen in Iran; the next post will look at what the Obama administration's response. 

OK, so, Iran. There are protests, riots, and Twitters galore -- will it amount to regime change? 

Alas, I think the answer is no.  I don't want this to be the answer.  No matter how I slice the data, however, I get to that outcome.

Let's stiputlate that the election results were rigged.  Here's the question -- why were they so blatant about it?  The speed and skewness of the "official" results seemed design to trigger disbelief. Was that intentional? 

Hey, you know what, I think it was.  University of Chicago political scientist Alberto Simpser has written about why authoritarian leaders like Khamenei would engage in electoral corruption (.pdf). The answer is not pretty: 

[A]n overwhelming victory today can send a powerful signal to the citizenry tomorrow – a large margin of victory can deter opposition turnout, discourage opposition coordination (e.g. when the opposition is fragmented into a number of parties), and increase the winner’s bargaining power with respect to electorally important social actors by rendering it less likely that they are pivotal in a winning coalition.

I suspect that this was the intent in Iran. The question is whether it will work. Khamenei has backtracked a little from his endorsment of Ahmadinejad as the winner, and now wants the Guardian Council to investigate allegations of election fraud. I suspect this is an effort to play for time, however, in order to get his security apparatus prepped for a more brutal crackdown. Twice in the past 10 years (1999 and 2003), this regime has been perfectly willing to crack down on reformist groups to secure its hold on power. I see no reason for Khamenei to hold back this time around. 

In other words, unless Iran's security apparatus starts to split, I don't see how this ends in any outcome other than Khamenei staying in power. 

What does this mean for the rest of the world?  On to the next post! 

The New York Times runs two op-eds today on the future of the dollar's status as the world's reserve currency, particularly with regard to China. 

Victor Zhikai Gao's essay doesn't actually say a whole lot on the matter, except for this excerpt: 

Beijing recently called for a greater role in international trade for the special drawing rights currency of the International Monetary Fund. But China is also fully aware that the United States can veto an I.M.F. decision. China’s call was more meant to sound an alarm to the United States.

Many Chinese people increasingly fear the rapid erosion of the American dollar. The United States may want to consider offering inflation-protection measures for China’s existing investments in America, and offer additional security or collateral for its continued investments. America should also provide its largest creditor with greater transparency and information.

As Brad Setser points out, it's a bit rich for the Chinese to fret about U.S. inflation, since if the renminbi started appreciating, many of the macro imbalances currently plaguing the international monetary system might be lessened.  Of course, talking about "currency appreciation" puts the onus on Beijing, while talking about inflation conveniently puts the onus on the United States.  

The other op-ed is by Nouriel Roubini -- a.k.a., Dr. Doom.  It's a good primer on the benefits that accrue to the United States from having the dollar as the world's reserve currency.  That said, this part confused me: 

We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports (emphasis added).

The other parts of that paragraph make sense, but that last sentence mystifies me.  Wasn't part of the reason that oil and other commodity prices spiked last year was the declining value of the dollar? 

In general, both op-eds urge the U.S. to get its financial house in order.  I certainly don't disagree with that recommendation.  Still, it's a bit disingenuous to suggest that the U.S. is the only country at fault for the current overhang of dollar reserves.  Beijing needs to take a good hard look in the mirror on this issue. 

One of the great ironies about the Sino-American financial relationship is that most Americans believe that China has been screwing the U.S. over through their massive accumulation of dollars, while most Chinese believe that America has been screwing China over through.... their massive accumulation of dollars. 

Well, what if the accumulation is not so massive?  Yesterday's New York Times story by Keith Bradsher suggested that China was buying far fewer dollars than it used to, and therefore we can all breathe easier about China using its dollar holdings as a form of foreign policy leverage:

Chinese reserves fell a record $32.6 billion in January and $1.4 billion more in February before rising $41.7 billion in March, according to figures released by the People’s Bank over the weekend. A resumption of growth in China’s reserves in March suggests, however, that confidence in that country may be reviving, and capital flight could be slowing.

The main effect of slower bond purchases may be a weakening of Beijing’s influence in Washington as the Treasury becomes less reliant on purchases by the Chinese central bank.

Asked about the balance of financial power between China and the United States, one of the Chinese government’s top monetary economists, Yu Yongding, replied that “I think it’s mainly in favor of the United States.”

He cited a saying attributed to John Maynard Keynes: “If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy.”

I don't disagree with Yu, but I do disagree with Bradsher.  It's necessary to separate China's willingness to use its reserves as a lever from the expectation that such a lever will net it significant concessions. 

As long as China is heavily dependent on the U.S. market as a source of economic growth, it is fundamentally constrained in using its reserves in a strategic manner.  Regardless of its feelings towards the United States, Beijing will not take actions that shoot itself in the economic foot. 

If, however, China manages to decouple its economy somewhat from the U.S. market, then the calculus of compellence changes.  Such a decoupling would contribute to the unwinding of the macroeconomic imbalances caused by the Bretton Woods II arrangements.  It would also reduce whatever constraints economic interdependence has placed on China's financial statecraft.  

This is the paradox -- the more leverage China has, the more reluctant it will be to use it.  The more willing China is to use its reserves in a strategic manner, the less likely such statecraft will yield anything in the way of meaningful concessions. 

[This sounds.... familiar.--ed.  Oh, shut up.]