US Financial Sanctions and Dollar Dominance with Daniel McDowell

Is US Dollar dominance going away? No. Let's get that out of the way immediately. Rasheed Griffith and Daniel McDowell sit down for a much more serious and interesting conversation, grounded in the reality of economic and political history. The US dollar has been the reserve currency of the world since Bretton Woods in the 1940s. How did that come to be and what effects do sanctions have on the global standing of the greenback?

"Demise of the dollar" predictions are nothing new, often surfacing during periods of economic turmoil and on the heels of what some perceive as "dollar weaponization" via US sanctions. The status of the dollar as the world's transactional currency was not some happenstance occurrence. De-regulation in the 1970s and access to one of the world's largest markets made the US dollar a de facto choice post-gold-decoupling.

With its currency now connecting every major corner of the financial world, the Fed would need some way to keep tabs on the new Eurodollar ecosystem. They could directly intervene via swap lines but the optics in Congress could cause increased scrutiny, especially with regard to less reliable benefactors. That's why we have the IMF, a semi-autonomous organization originally created to maintain foreign exchange rates, now repurposed to extinguish monetary fires in the developing parts of the globe.

It's not the only tool the United States has on hand for maintaining stability. Sanctions, despite their unsavory connotation, may just be one of the greatest financial innovations ever devised. With sanctions, Washington can exert control over pariah states and other actors, without the use of military force. These too have evolved over the years and have become much more intricate in their execution.

Join our CEO and Dr McDowell as they unpack the finer details of this complex financial system, the various players, and the wider implications of their actions in this episode of Caribbean Progress.


Resources
Bucking the Buck: US Financial Sanctions and the International Backlash against the Dollar by Daniel McDowell

Brother, Can You Spare a Billion?: The United States, the IMF and the International Lender of Last Resort by Daniel McDowell

Contact info
Daniel McDowell on X (formerly Twitter)
Rasheed Griffith on X

Transcript

Rasheed Griffith: 0:00

So right now the talk of the town is the Bricks currency, but in your view, how feasible is it?

Daniel McDowell: 0:06

I think it's not feasible at all. I cannot imagine a future in which there is a functional Bricks currency.

Rasheed Griffith: 0:13

Hi everyone, welcome back to Caribbean Progress. On this episode, I am joined by McDowell, an associate professor of political science at the Maxwell School of Citizenship and Public Affairs at Syracuse University. We will be discussing Daniel's new and fantastic book called Bucking the Buck US Financial Sanctions has an international backlash against the dollar. This was a truly, truly enjoyable conversation, so let's dive right in, Hi Daniel, and thank you so much for coming on the podcast today.

Daniel McDowell: 0:56

Thanks for being here. I'm really excited to be here with you.

Rasheed Griffith: 0:59

So there is this popular saying the part to create is a part to destroy. And I think your books actually both of the books you have first, imf and the National Land and National Historic, and also the most reasonable about sanctions policy play to the same game where, yes, the US can do a lot of sanctions policy because they have this big reach, but they have this big reach because the central to the Fed and US dollar actually creates stability in the system. So you have that, both sides you're going to play on. And before we get to the sanctions and the kind of future discussion, I want to go back a bit and discuss some of the early use cases of the Fed and the US dollar in this global stability paradigm. And I want to go back even before the gold standard collapse, nixon shock, as we call it sometimes. Why was it? Do you think that the US dollar became this key currency? Using the capillary Charles Kinderberger, for example?

Daniel McDowell: 1:57

This is this sort of historical question. How do we get here, to phrase the talking heads hit from the 80s, how do we wake up in this dollar dominant world? The first thing I would say is we can't ignore the legacy of Bretton Woods, which is that system put the dollar at the center of the global monetary system. By design, the system was based, of course, on pinging the dollar to gold that was the only currency that was convertible to gold at the time. And this is coming from a world where, a few decades prior, before the First World War, where thinking of money absent a commodity backing was antithetical to the way anyone had thought about money at the time. When you move to the 1945 Bretton Woods world where, all of a sudden, the dollar's the only currency that has that backing of gold, that elevates the dollar over all other global currencies because it has this commodity link to gold, the one thing that the world had considered, money, going back thousands of years. And so I think that creates a built-in advantage during the Bretton Woods era. And you want to hold dollars because not only that is the currency of the world's largest economy after the Second World War. The United States is exporting a ton of dollars around the world through the Marshall Plan and providing foreign aid and all sorts of things, building post war systems that it developed. And so dollars are readily available as well. But again, I think that gold link is really key.

Daniel McDowell: 3:10

And then, post 1971, when the dollar is dealing from gold yes, the US economy is faltering. At that point in time that's when you really start to first hear these conversations, which we'll get into today, right about the end of the dollar and de-dollarization. That's happening in the 1970s. Of course it's quite premature at that time and that's not what happens. And in that sense what happens is the United States further deregulates its financial system and creates essentially the world's deepest, most open financial system in the world, which allows foreigners to invest in all the same sort of financial products that American residents can invest in. And this again creates a sort of unrivaled system where no other currency can compete with the types of investment options that are available in the US dollar, both by virtue of America's size but also, again, the sort of speed with which the United States developed these new open markets.

Daniel McDowell: 3:59

And so I think those are all elements that go into it. We could talk about network effects and, of course, once your competitors and once other market participants adopt a standard pricing goods in the dollar, for instance, then you're incentivized to do the same thing, and so that's a part of it as well. It's multifaceted. Obviously the US deal with Saudi Arabia in 1974 plays a big role in that Pricing oil and other commodities in the dollar. So I guess the long answer to your important question is that it's all these things and they're self-reinforcing, and that's why to think about a change in the system, I think is it's something that's been talked about for a long time but we haven't seen it happen. Because all those things that sort of reinforce the dollar's dominant role as it was becoming solidified, continue to reinforce it even in an era where there's frequent questions and complaints about its dominance.

Rasheed Griffith: 4:44

Is the argument also that during the expansion of the dollar, offshore a lot of the offshore participants this is the euro dollar market in London, for example they actually set it to their own free will and so on to price goods and make loans in dollar even though there's no US banks in jurisdiction at a time. Is that also, you think, an important aspect of the story, or is that usually too overplayed in terms of the dollar rise globally?

Daniel McDowell: 5:13

I think the development of the euro dollar markets is important for a few reasons.

Daniel McDowell: 5:16

One partly it's important because it shows the leakage in the capital controls of Bretton Woods.

Daniel McDowell: 5:21

You had the development of these markets despite the fact that in practice, there were supposed to be barriers to cross-border capital flows of at least of liquid capital at that time, and so that added to the pressure that ultimately led to the elimination of those capital controls, which further internationalized the dollar.

Daniel McDowell: 5:35

The other important element of the euro dollar markets is that, as you said, the pricing of products in the US currency. It does create a sort of momentum. We know from more recent research in economics, for instance, that what effectively happens within a particular market place is when a firm or an actor in a particular sector finds that its competitors are pricing goods in a certain currency, that they're incentivized to move and price their goods in the same currency as well. Because effectively what happens is you want to stabilize the price of your exports relative to your competitive exports, and if you're pricing in a separate currency and there's fluctuations in the price of distinct currency that you're invoicing, for instance in, then you're going to face a disadvantage against your competitors, and so that does create that pile-on effect where, once a focal point is chosen among the majority of participants in a particular market, everyone else is incentivized to pile on and move in the same direction.

Rasheed Griffith: 6:24

One element of the Bretton Woods set. While the gold standard of profitability did eventually falter, the institutions that emerged from that kind of conversation are still around in very different orientation perhaps than they were originally designed, but one in particular that I had an interest in for years now. Growing up in the Caribbean, the IMF is ever present in economic and political conversations. For the time it was before it was born. In many ways, I've always wondered this question why then does the IMF origin from the Bretton Woods conference? Why does the IMF actually give this kind of stabilization funds Then? If it's given just in USD, why not the US government itself just actually gives the funds directly to the borrow nation? At a point in both the payments crisis? That's a great question.

Daniel McDowell: 7:10

You're right. The IMF is a fascinating institution, in part because its own role evolved Right, of course. It's created in 1944 at Bretton Woods. Its original role was primarily to help maintain the fixed exchange rate system, and so the stabilization fund was part of the IMF as a way to help countries deal with short-term imbalances and their balance of payments. So the lending function was there really to again to help countries keep their fixed exchange rates in place, because that was really viewed as the key element of Bretton Woods, as controls on cross-border capital flows and fixing all currencies to the dollar, with the dollar fixed to gold, of course, in 1971, we've brought this up now a couple of times which is it is a critical moment in history, right, the US basically delinks the dollar from gold.

Daniel McDowell: 7:49

Over the next few years, the major economies move towards floating exchange rates, so the need for the IMF to function as this provider of short-term balance of payments assistance to stabilize exchange rates for your major economies goes away, and so the IMF evolves In the 1980s. It's really the debt crisis in Latin America where the IMF gets its second lease on life. Okay, we've got all these developing countries that are having debt crises and this will be how we reinvent ourselves for this new world where our old function is no longer needed. And you had a period right in the 60s, 50s, 60s and even early 70s where you've had major economies borrowing from the IMF. We don't see that today. It is now primarily a lender to smaller, developing and emerging countries in crises. So that's an evolution right there.

Daniel McDowell: 8:29

But to your question of why not the US doing this versus the IMF and, as you mentioned earlier, my first book really looks at this sort of interplay between US emergency lending and IMF lending. So I guess the first part of the answer is sometimes it's both right. Sometimes the United States is providing bilateral bailouts, if you will, alongside the IMF, but it is true that most of the time the IMF is doing that lifting. So I can give you several reasons why I think that's developed, and part of it is just that, if we think about the United States' own sort of preferences and interests here, the United States, for political reasons and say the US government, the president, whomever that is has an interest in letting the IMF handle these things. Because over time, if the United States is providing financial assistance to country after country in crisis, what you're almost certainly going to have is you're going to have hearings in Congress asking about why in the world are we providing money to this country? That's, in all this economic trouble, we're putting American taxpayers' dollars at risk. So the United States wants to have a system in place, the architecture in place, that can help stabilize these countries, because it has distinct economic interests in those places.

Daniel McDowell: 9:36

Again, go back to the Latin American debt crisis. American banks were significantly at risk to from countries like Mexico Argentina argentina, Br and so on, and so the United States was very involved in managing that, mostly through the IMF, because it was trying to protect the stability of the US banking systems. But it would prefer for the IMF to do most of that work, because it gives a layer of separation between US funds and the US is the primary funder of the IMF. It is, of course, not the only funder. It is the primary funder in that its pot is the largest, and that, I think, helps to deal with some of those political issues. The other issue is it's burden sharing. That's part of it here. If you think about again that post-war order, even think about something like NATO, what's the big complaint about NATO from certain elements in the US political discourse today. It's that Germany and European countries that are part of this are not spending enough on defense. They're not paying their fair share, if you will, to the group's defense.

Daniel McDowell: 10:26

The IMF is designed to make sure that it's not just the United States that's putting up the funds to help countries that are struggling.

Daniel McDowell: 10:34

It's a collective effort and, yes, the United States is the main funder of the IMF, but it isn't the majority funder.

Daniel McDowell: 10:39

It's quoted somewhere around 17, 18 percent.

Daniel McDowell: 10:41

The rest of the funds come from, of course, all the other member countries, all the way down to some of the smallest economies in the world. That's, I think, another element of this as well, that it is a way of preventing the United States from having to do everything. But, as I said earlier with the book, it was that when the IMF is either short on funds or a particular reason, or maybe it's not moving fast enough, if the situation is one situation here, meaning like a crisis in a foreign market, is significant enough to threaten the stability of the US financial system, then, as I argue in the book, the United States will step in and say, okay, we'll move either alongside the IMF and help with that loan, or maybe we'll provide an emergency loan that will last for a couple of months until that IMF credit is out the door, because it can take quite a bit of time to get those things negotiated. So the US will step in from time to time, but only in those circumstances where its self-interest is really at risk. It's not acting altruistically.

Rasheed Griffith: 11:41

There is a separation of power, put that way that you pointed out, especially in the first book, where you have, for example, the Fed and the Treasury having these new currency swap lines that are primarily for large, big economies, but the IMF is mostly used for these small, developing economies. Why do you think that kind of dichotomy started to happen?

Daniel McDowell: 12:02

Yeah, that's a cool question. It's fun for me to revisit some of this stuff. The Treasury, especially in the 80s and 90s, as this sometimes was pejoratively referred to in the US as a slush fund, it's called the Exchange Stabilization Fund. It dates back to the 1930s. It was about stabilizing the dollar's value at the time. But it's basically this discretionary fund that Congress set aside for the US Treasury and the Treasury Secretary can use those funds as he or she sees fit for various needs, until Congress might change legislation to regulate the uses of those funds. And in the 80s and 90s what happened was that the Treasury started using those funds, as I was saying earlier, to provide these bridge loans to developing countries that were again waiting for the IMF to provide them some assistance. But it was taking too long for the IMF to get that deal negotiated and get those funds out the door. The analogy I like to use here is the fire truck arrives too late to the fire and the house is already burned to the ground. That doesn't do you any good. So the US would step in and provide that sort of fire brigade response until reinforcements arrived. If you will.

Daniel McDowell: 12:56

The Fed, as you noted, especially in 2008,. There are previous periods where the Fed used these swap lines with foreign central banks 1960s, briefly in 2001,. But it's really in 2008 that they become now a central part of the global financial system, and they still are today. And initially the Fed extends these to five major central banks, or five or six major central banks, and extends it up to 14. Most of those, as you noted, are your advanced industrialized economies in Europe and Japan. There are some emerging market countries in there, Mexicos in there, of course. Countries like Korea and Singapore are also involved. So it does grow to be a bit more inclusive. But the United States famously rejects swap lines with many other countries, including a country the size of India, which is a sort of a notable case that asks where a swap line was ultimately denied. Others were as well. So the Treasury handles some of these, I think.

Rasheed Griffith: 13:43

I India India India still has a swap line with Japan for instead instead US dollars, including a swap line with the US for US dollars.

Daniel McDowell: 13:51

You're exactly right, and that's another sort of separate phenomenon, which is just the existence of these US dollar swap lines between third party countries, right, where the United States is not involved, basically your major reserve holder. So Japan, right, has historically and continues to hold a huge amount of US treasuries, and so it can, on its own, if it wants to, with a country like India, provide dollars through a swap line as well. That's what we're talking about here. Right, it's really liquidity in times of crisis, dollar liquidity in times of crisis and, yeah, what we see is the Fed sort of handling sort of one group of clients, if you will, and then the Treasury and the IMF handling a different group of clients. I think part of this is that the Fed so to get to, why that? Why do we have that division of labor?

Daniel McDowell: 14:31

A couple of things I would say. The first thing I would notice is that Treasury is not doing this anymore. It's been gosh 20 years since the last time Treasury was involved in a bilateral loan in this way, and part of that was because, in the 90s, the Clinton administration stepped in to use the exchange stabilization fund to help provide guarantees for some Asian countries during the Asian financial crisis and the result of that was a political brouhaha. There were Republicans in Congress at the time that basically said it was the line I said before we're risking American taxpayer dollars, why are we doing this? And so that sort of scared off, I think, treasury from continuing to use that in the future. They were worried that you might actually have legislation in Congress that would curtail its ability to use these funds at all. We haven't seen as much of that as for the Fed.

Daniel McDowell: 15:09

Why has the Fed sort of been so selective about who it participates with or provides these swap lines or credits to? That's a question that I think people are still digging into. But my answer here is mostly it's similar, which is that the Fed's also worried about congressional encroachment on its independence. The Fed is a theoretically politically independent institution. That's a core part of its ability to achieve its mission. It's still mandate and if the Fed were providing swap lines to countries that maybe would have trouble, and if we could imagine a situation where a country that drew on a swap line and then had problems paying that back, that would put the Fed in a politically very precarious situation, even if financially it didn't cause a hit. I think you would almost certainly have members of Congress. That would be saying we should be rethinking whether or not we allow the Fed to have these abilities. It's trying to be quite circumspect about who it participates with in these swap lines, and so it's quite picky about where it draws the line.

Rasheed Griffith: 16:03

I'm curious if you have a strong opinion on whether it was somewhat justified for most of these countries to move away from the single fixed reference rate called Bretton Woods policy into this more commonly now accepted idea of free-floating exchange rates. I asked that at any point. In the very fancy columns in Caribbean he said we are in a dark age of monetary policy because of all these separate exchange rate policies in floating exchange rates instead of just a normal fixed exchange rate for one single world currency.

Daniel McDowell: 16:35

Yeah, I mean that transition away from the fixed rate to a largely floating exchange rate system in the world, which is accurate. A lot of it stems from some of the things we were speaking about earlier. Once the United States moves away from the gold-backed dollar, it sets in motion this cascade where increasingly, other countries begin to float their currencies. There were some real pressures in balance of payments and balances that were building up in the world, and moving to the floating exchange rate system was supposed to help alleviate that by automatically adjusting to these imbalances. So you have a massive current account surplus, your currency is going to appreciate and that will, over time, reduce the current account surplus and bring you back into balance. Theoretically and for smaller countries, I think what ends up happening? Again, we can go back to these moments of crises where, of course, in the 80s and 90s the Latin American crisis, the debt crisis and then the East Asian financial crisis, which are these critical moments where emerging and developing countries themselves, which had been maintaining fixed exchange rates, have these eruptions of economic crisis that require substantial outside support and in many cases, that support comes with advice or conditionality saying move to floating exchange rates because, effectively, the global economy today is going to punish or penalize any country that's maintaining a fixed exchange rate that is out of balance with reality. So this is the currency speculation of the 90s, especially that I'm thinking about, where any country that has an open financial system allowing in for an investment but also is trying to maintain a stable exchange rate, is ultimately going to be in a position where that exchange rate is increasingly at odds with reality and the speculators are going to bet against it. The central bank in that country is going to run out of dollars and it will be forced off the peg and there will be this dramatic evaluation, which will be incredibly shocking and harmful to the economy. This shift there is. As is often the case for smaller economies in the world, it's almost outside their choice set anymore. This is the way I think about it is a system changes without their consultation or consent, that sets in motion a series of pressures that ultimately makes a particular policy choice increasingly non viable.

Daniel McDowell: 18:34

And then you add to that the use of capital controls, which throughout the 80s and 90s, in the early 2000s especially, were increasingly viewed as heterodox policy. And so countries that might want to use capital controls setting aside China, the one case where those are maintained and have been used quite effectively. Other countries are trying to attract foreign investment, and so you've got this competition among developing emerging countries to attract in foreign investment. That's the pathway to development in theory. If you want to attract in foreign investors, you can't be at the same time limiting capital freedom in the flows of cross border capital, and so you've got to embrace open financial markets.

Daniel McDowell: 19:07

And if you do that again the capacity to maintain a fixed exchange rate is going to be seriously jeopardized because those cross border capital flows are going to put significant pressure on any fixed exchange rate. So what we've seen now, of course, is a world where the US raises interest rates, and if you're a developing or emerging country, in many cases you're going to deal with the significant swings in your own exchange rate over time. It's just going to move with the flows of global capital which are responding to what the Fed is doing. It's a significant challenge for so many countries in the world and a real vulnerability that they have to face. But I guess my own take on that is that they didn't necessarily sign up for this world, but it's the world that developed and now they're living in.

Rasheed Griffith: 19:46

I have a different story on that, a different take on that, using the military freeman argument right where it is, that we keep saying they have these fixed exchange rates but they don't have fixed exchange rates. They have semi fixed exchange rates, which is what he called a peg. So he had to see that comes to a trichotomy where it was fixed, pegged float and not fixed float, because obviously if you have a truly fixed exchange rate, then your currency is only a clone of, let's say, us currency, where you only hold the exact amount involved, where in a pegged exchange rate you have this sterilization aspect, you have a domestic monetary component based money aspect, but in a truly fixed or it's no domestic component it's completely on autopilot at the exchange rate level, which is more or less similar to what it was the case in mostly Caribbean back in the colonial period where they had the currency. Boards are somewhat to Hong Kong these days but, for example, they had currency crisis I mentioned the, let's say, in Thailand because they had a domestic component and a foreign component.

Rasheed Griffith: 20:47

They had the potential mismatch in balance of payments. But if they had a truly fixed or a clone currency was only determined by the exchange rate and foreign inflows, then you couldn't have a mismatch in balance of payments policy. So that's why, as I mentioned, this is something comes to Caribbean called like a dark age of monetary policy, because he's saying that especially for small countries. You're right, they don't choose the world they're in, but they pretend they'll actually left the old world into a new world when in reality the old world is still there. They don't have these really unoptimized policies that have the worst of the old and worst of the new, instead of just having the actual fully on fixed exchange rate or even go further and have actual dollarization policy.

Daniel McDowell: 21:28

Right, which is the debate in Argentina right now. Right.

Rasheed Griffith: 21:31

Exactly, exactly, yes, actually, on that point, one of the biggest counterpoint to things like a truly fixed exchange rate or dollarization is this idea that you know what? Yes, right now the US dollar is really all in car full and he King on the hill, but soon from now it will not be, and therefore dollarizing your economy is a bad idea. That's the flavor of that kind of argument. What, then, do you say to a person who said okay, the reserve currency status of the US is in decline. Is it actually in decline?

Daniel McDowell: 22:19

Yeah, as we were discussing earlier, maybe it's not on a predictable cycle, but there are certainly many examples in the last 50 years where the hand-ringing about the dollar's future has become quite audible, and we're in one of those moments right now for various reasons.

Daniel McDowell: 22:33

A lot of it's geopolitics. But is the reserve role declining? If you look at the Cofer data from the IMF, which is the best publicly available data we have, people will point out that the dollar's share of global reserves has declined from roughly 70% down to below 60%. Now there are different ways of weighting the exchange rates and even making it look worse than that, and so the sort of period of decline over the last 20 years or so is held up as evidence of the diminishing importance of the dollar in the world. But one of the things that I would point out to push back against that, and so I guess my answer is no. I don't think the dollar's reserve role is significantly diminished or significantly in threat, and one of the reasons I would say that is because what we're seeing with reserve managers today and again I hate to keep pointing back to this, but maybe this is helpful for continuity in our conversation is you have these crises in the 80s and especially in the 90s, and focus on the East Asian crisis for a moment. You have these dynamic economies that had been growing really fast held up as economic miracles and then, largely because of a mixture of things, some domestic economic policy failures but also, clearly, pressure from external investors that we're speculating against their currencies, and so that was not their fault. Just this reality of the new 21st century coming in. In the late 20th century they were forced to accept adjustment programs with the IMF that were politically unpopular, that in some cases affected the social stability of those countries or at least coincided with social instability whether it caused it or not, that's a bigger debate but politically became quite fraught for these countries to have relationships with the IMF in the future.

Daniel McDowell: 24:07

So what do you do? You hoard reserves. So you start to see, after the 1990s you see the sort of buildup of these massive caches of dollar reserves around the world. Because what are you doing? Were you self-insuring against a crisis? You want to make sure that the next time there are similar conditions as there were in 1997, 1998, that you don't have to go to the IMF. You've got enough treasuries that you can sell and you can crush the bears in the market yourself. You can take on the speculators, and that trend, I think, has not slowed down. We talked about Japan earlier, but you could add China, of course, who's the largest holder of reserves in the world. But add in country after country. Russia before the war was massively increasing its stockpile of reserves.

Daniel McDowell: 24:46

And what happens here is, at a certain point you get enough dollars where you can deal with your liquidity needs, and so most of your liquidity needs, so intervening in foreign exchange markets, servicing, say, trade. So the old rule of thumb is you should have three months of imports, payments in the currency in which you're going to settle those imports, and all of your short-term debt you should be able to cover with your reserves. And if your short-term debt is in dollars and you trade in dollars, then you're going to hold dollars for those liquidity needs. And maybe you even go double up on that, maybe you go beyond that, but at some point you have enough dollars that you feel pretty good about your liquidity needs. And so now you start to think as a reserve manager about what reserve managers would call the investment tranche of their reserves, and if you're China with three to four trillion dollars, or another country with a trillion or just ungodly number.

Daniel McDowell: 25:29

You don't want to have all your eggs in one basket, because now you're thinking, like you or I might think, about our retirement accounts, but you don't want to have all Microsoft stock.

Daniel McDowell: 25:37

It's a pretty good stock, it's been doing pretty good and that's a that might be one you want to be longing, but you also don't want to have everything tied up in one company. So these countries that have these massive war chests of foreign exchange reserves, they're diversifying into these non-traditional currencies like Australian dollar, canadian dollar, in Europe perhaps a bit more, but it's these Swiss francs, these smaller currencies that we don't typically think of as reserve currencies. That's what we're really seeing most of. Yeah, we're seeing a bit of interest in you on, and we could talk more about that and some of that geopolitical. But I would describe a lot of that decline in the dollar share in the Kofir data to just diversifying, because you've got countries that actually have more reserves than they used to have, which is true If you just look at the stats. The share of reserves that countries hold on average globally has gone up over the last 20 years, and so you've got central bankers thinking more like hedge fund managers than just liquidity tronch managers.

Rasheed Griffith: 26:23

It's like that they're also investing in other assets like ABSs and actual equities and so on.

Daniel McDowell: 26:30

Yes, 100%. That's another thing we saw, especially go back 10 years when US Treasuries were yielding nothing. That post crisis era where the Fed has cut to the zero lower bound and is actually doing quantitative easing to further lower long term yields on Treasuries. In that era, central bankers around the world are increasingly frustrated with their dollar reserves because they're yielding nothing. And what are private market participants doing that era? They're going heavy into equities in real estate, other investments that are actually providing some yield, and so central banks start to do some of that as well. In fact, there are some central bank surveys out there. On fifth had one back in 2015, 2016. And yes, central bankers are saying things like we're starting to hold equities. I don't think it's a huge part of their portfolios, but it becomes something that we start to see develop in that era. And look, we could extend this out further. Look at the Saudis Now there's some of this sovereign wealth fund money. They're buying golf leagues. That's effectively the new form of reserves. Today it's a different world.

Rasheed Griffith: 27:23

That's true. They push on people out of PG into the solid detournament.

Daniel McDowell: 27:28

Yes, they did yeah.

Rasheed Griffith: 27:37

There's no. This other argument that comes up and this is coming to your second book now, because you have the probably the best kind of elongated analysis of it. I will ask it this way Do you think that US financial sanctions has been one of the greatest financial innovations of the 21st century?

Daniel McDowell: 27:55

That's a great question the greatest financial innovations of the 21st century. I feel like, if I were to say that I'm sure I'm missing many innovations that are probably greater and more important. I would think of something like credit default swaps, or even all of the innovations that ultimately led to the crashing of the entire global financial system in 2008, are probably more consequential than financial sanctions.

Rasheed Griffith: 28:16

But think about that though, because I preempted your conversation for your own book is that you did show how that economic sanctions were actually much, much more wide reaching than most people have a thought for, and you necessarily were to hypothetically do an opportunity cost analysis on the damage that economic sanctions gave to large populations, relative now to financial sanctions. It's perhaps where you wear that against all the other things, perhaps quite more outsized.

Daniel McDowell: 28:43

That's right.

Daniel McDowell: 28:44

I do think, if we look in the sanctions space, the ability to use financial sanctions, which can be used quite surgically you can blacklist or list as a specially designated national, which is the way the United States effectively directs banks operating in the United States, which include most of your major banks in the world, directs them to cut off business ties with any of these specially designated nationals.

Daniel McDowell: 29:05

And that could be the central bank of Russia, it could be a really big political institution in a foreign country, but it could also be an individual who's part of a drug cartel and you can effectively make it impossible, or at least incredibly difficult, for that individual to use the global banking system to move their wealth around the world or to access the wealth that they already have. It can be frozen, and this is quite an innovation. And so to your question from earlier. Yeah, I mean it is revolutionary when you compare to the old way of using a trade embargo to try to affect change in a foreign adversary or to perhaps encourage regime change in a country, those kinds of policies. As you can imagine, when you're cutting off trade with an entire country, the collateral damage to use a phrase that's probably familiar is much larger than the ability to just specifically target the bad actors in that state that you're really trying to get leverage over. So that's a huge innovation, absolutely.

Rasheed Griffith: 29:58

Now, most of our listeners will not be as familiar with the rise of financial sanctions. So could you explain then why these sanctions are this kind of I won't call it foreign policy, but it is really foreign policy how this aspect of foreign policy became to come to be so prominent, at least to be concerted prominent, in last, essentially last, 10 years particularly?

Daniel McDowell: 30:20

Absolutely to become prominent. It's become maybe the United States go-to tool for dealing with most of the foreign policy challenges in the world. You could argue and I say that because there are now more than 10,000 SDNs we look at the executive orders that have been issued that effectively direct treasury debt to launch new sanctions tranches, and in the year 2000, there were less than 20 of these executive orders. Today, as of my latest count from a week or so ago, it's over 100. The growth of these things is quite impressive and that just shows how frequently the United States, in particular the president of the United States over multiple administrations, is pushing the sanctions button. To deal with various challenges like human rights violations in a foreign country, we'll use financial sanctions. Or democratic backsliding in another country, we'll use financial sanctions. Or a security threat from it, we'll use financial sanctions. It's coming the answer to all these challenges. So why? A couple of things. The first is what we talked about earlier, which is that the old kinds of economic sanctions fell out of fashion, lost favor of policymakers because of that collateral damage story. You were hurting civilians, innocent people who were not your targets in the first place, and so they were viewed as a combination of ineffective policy but also harmful to people that didn't deserve to be hurt in that way. Another part of it is again to go back to the moment when this innovation really happens. It's around the turn of the century, of course.

Daniel McDowell: 31:34

2001, 9-11,. The United States, for a period of many years, wore on terror. The threat of international terrorism really becomes, for most policymakers in Washington, the greatest foreign policy threat that the United States faces, even though it was obviously not the greatest foreign policy threat that the United States faced. But that was politically what policymakers were pushed to focus on and trying to rein in and limit terrorist organizations' ability to use the banking system, which was a real thing. They were in fact moving money around the world and so the United States was able to use financial sanctions to target terrorist organizations.

Daniel McDowell: 32:07

You can't embargo al-Qaeda, so you can't use that tool, so financial sanctions are a tool there and it also develops. Financial sanctions become popular, attractive in this period where you also have growing disillusionment with the use of US military force. I don't think that's the main part of the story here, but if we think about the Obama administration, maybe a boilerplate characterization of Obama's foreign policy was that we're not going to use the US military to solve all these problems around the world, because the previous administration was too haughty, too believed in US military strength too much and misused it. And now we're in these wars that we can't get out of, that are politically unpopular. So if you're not going to use boots on the ground, you use your banking system, and so I think all of these things play into the rising use of sanctions over the last 20 years or so.

Rasheed Griffith: 33:00

So the most potent example of the sanctions policy recently was obviously Russia against Russia after the Ukraine war happened. Now this caused many of you was my turning point in thinking about US currency and other transactions, foreign reserves and all these big macro concepts. How was it that US was able to essentially cut Russia off of its reserve account of the US dollars?

Daniel McDowell: 33:27

This gets the world's attention back in 2022, february actually March when the sanctions were announced. Within a month of the war starting, russia has something like $600 billion in FX, in gold reserves something on the order of $300 billion of that is frozen by the United States and its allies. So how does that work? The first thing to say is that foreign exchange reserves. What we're talking about here, it's not cash dollars held in a vault in Russia. What we're talking about here are mostly US treasury bonds that are effectively held in accounts in the United States, and so it's actually the Fed or the treasury that custody a lot of these accounts. And so it's just like you going to your bank.

Daniel McDowell: 34:06

Most of us we have a savings. We're not stashing cash in our mattress Maybe some of us are, but most of us, right, have bank accounts and that money is custodyed by the bank. And if the bank decides tomorrow that it's not going to let you get to your funds, what can you do? And so it's a similar kind of logic the central bank in Russia maybe wants to sell some of his treasuries and liquidate them and get some dollars to deal with its economic problems or to fund its war, and the United States is not answering the phone, it's not allowing those funds to be accessed and, effectively, the Europeans and the Japanese have followed suit with that.

Daniel McDowell: 34:39

That's the main way to think about. This is that foreign exchange reserves are effectively outside of your country and outside of your own control, and they depend. Your access on them largely depends, as we know now, on your relationship with the country in which you've invested those reserves. Now a few countries have found themselves in a situation like Russia, but it is not unprecedented. The United States had frozen reserves of other countries, including Venezuela, including Libya before, or Afghanistan more recently as well, becoming increasingly common, though, again, it's still quite a dramatic move.

Rasheed Griffith: 35:10

Can you pinpoint exactly why is it so dramatic?

Daniel McDowell: 35:14

I think it's dramatic because what it does is it pierces the idea that the US dollar and dollar reserves are the purely economic concept.

Daniel McDowell: 35:25

They're inherently political. What I mean by that is, the United States has, through using financial sanctions, both by freezing foreign exchange reserves and blocking actors from using the dollar in the international banking system, has effectively shown its adversary, shown the world that access to the dollar, to those reserves, depends on political factors as much as economic factors. An economic crisis like 2008,. That might lead to a seizing up of the global dollar system and lead to liquidity problems, but for Russia, it didn't take a financial crisis. It is a massive deterioration of your political relations with the United States and its allies that have led to a similar liquidity crisis due to political factors rather than economic factors. So it's really the politicization of the dollar system, and so that's why I think it's quite dramatic is it's always been there, it's always been a possibility, but now it's becoming one of these things that I think countries increasingly have to factor into their decisions about the currencies that they use and what they invest in.

Rasheed Griffith: 36:29

Suppose I'm now China, I am the CCP head and I'm thinking. I'm not recently thinking, but for a long time I've been thinking this is very dangerous that we have so much USD reserves. And then, in 2013, I created this imaginary concept called Belt and Road and I pushed the money all over the world mostly USD money, not R&B so I can get money out of Treasury Holdings, put it in some investment product or construction product or industrial road or anything like that kind of devolved from the US holding into some other asset across the world. That didn't go anywhere. I had very bad returns. I made some very crazy bets. I lost a lot of money. Then it's really blew up. Now, going forward, I'm in the same situation. There's literally nothing changed. That happened, but now Russia got its accounts blocked as an adversary somewhat, of the US. And now I am here still with that same sentiment. But what do I do?

Daniel McDowell: 37:24

China's in a tough spot. They're in a real tough spot when it comes to these sorts of concerns. If you're not China, if you're Russia, if you're Iran, if you're Syria, if you're insert any country that similarly sanctioned or worried about being sanctioned, you might be looking to China and saying we'd like to hold more of our reserves in yuan, but if you're China, you can't hold reserves in your own currency. So who's the alternative here other than Treasuries or, as you said, continue to go after these white elephant projects that are not paying off and maybe creating other debt challenges around the world? You can hold some more gold. Russia did this, starting in 2014. China's doing this. We do know China's gold reserves have been rising and I view that as a doomsday prepping approach to where concerns about sanctions.

Daniel McDowell: 38:03

Holding physical gold in your own vaults is something that cannot be touched by the United States. Russia still has access to. It may have sold some. It doesn't report these data anymore, but still has access to something like $130 billion, $140 billion of gold. This would mean it hasn't liquidated a lot of that. It may eventually be forced to. It may be eventually forced to fly some of this gold around the world to, say, UAE or Turkey and try to get some hard currency for it, because it's obviously dealing with some dollar shortages right now. That's the logic behind that. But China can't go all in on gold. It still has to function in the world economy.

Daniel McDowell: 38:35

To go back to that conversation earlier the liquidity tronch versus the investment tronch China is still the world's top trading country. It needs dollars. There could be an economic situation that could cut off more limit dollar liquidity, like 2008, 2009. It needs to be prepared for that kind of scenario to support its exporters and so forth, so it can't divest of dollars. But I think what you're asking is what's the hedging strategy here? How does it minimize its risks? And I think that is a real challenge.

Daniel McDowell: 39:01

It wouldn't surprise me to see the Chinese perhaps try to shift, continue to shift, a bit more into something like the Euro. That had limited value for Russia, and I think the Russians were expecting that the Europeans would be less likely to go along with sanctions because of their dependence on Russian energy. And so Russia, prior to the war, did shift out of dollars, US treasuries and more into Euro securities, which were subsequently frozen, I think, probably to the surprise of some in Russia. So if you're China. You're watching that and you're thinking what's the scenario in which our dollar assets might be frozen Was it a war with Taiwan or something like that that we would see that response from the United States.

Daniel McDowell: 39:37

Will the Europeans go along? Will they do the same thing that they did in the case of the Ukraine invasion? Will they move and lockstep with the United States? If so, then Euro securities are not going to be a safe haven. If you doubt that the Europeans will go along, or you think there's a greater chance that they won't, then maybe there's an argument for moving more in that direction. So, again, could hedge a little in gold, maybe a hedge a little in euros, maybe go on some of these nontraditional currencies, hoping that they don't all move in step with the US in the event of that kind of a crisis. Maybe a hoard more oil, Like China has massive energy needs. I think that's the Zoltan-Pozar argument that you just start hoarding other commodities that have value, Right. Of course, there's the concern over time, but you got to use the oil Again, hold it forever. But there are options, but none of these are solutions.

Rasheed Griffith: 40:19

Yeah, so I'm looking at this landscape here. Let's say they wanted to invest more in Euro. There's no real Euro market not Euro dollar, but Euro market itself. So it is the limit of how much you put in a particular location. And then, as you say, these smaller currencies are too small, and then these projects are too risky for these alternative asset projects. So what are you going to do with a $3 trillion of the US reserves? That's why I'm always being very amused by that way of these kind of conversations about all these alternative paths forward. I'm like, okay, but where exactly is the path forward? To know? The path to your is Bricks currency. How feasible is that?

Daniel McDowell: 41:00

I think it's not feasible at all. I cannot imagine a future in which there is a functional Bricks currency. It's fascinating to me that it's gotten as much conversation as it has. I think recently I have seen a bit more of the conversation turned towards the position that I think you and I share, which is that this idea is fantastical. But the Bricks themselves the Bricks as a group, as a counterweight to the United States, has, in my view, been something that's overhyped in many ways because the group has obviously significant divergent interests within it, notably India and China, which on many areas are complete disagreement with one another. The main thing that this group agrees on is some economic autonomy from the United States, from the dollar. That is an area where there is alignment. But the notion that five different countries that have very different economies again have these other areas where there's significant foreign policy and economic disagreement would be able to have some sort of functional common currency is just nuts To me. What's more likely is if you're going to see the group embrace the dollarization or the idea of reducing your dependence on the dollar.

Daniel McDowell: 42:04

China's currency is a trade settlement currency. There's some room for growth there, especially in trade with China and China's keen to see that develop. Other countries are going to try to encourage the use of their own currencies in trade, but there's very little appetite for that Right. India and UAE just did an oil trade recently in rupees, but these are really just proof of concept. Reaching scale is really unlikely. Again, to me, a Bricks currency is a crazy idea. I don't see any world in which it happens. I do think you're going to continue to see conversations about the dollarization, exploring different options. The yuan may become the focal point, especially in those countries trade with China. We may see more of that, but I don't expect a revolution here.

Rasheed Griffith: 42:42

This leads me to the same conclusion as Eswar Prasad. He wrote the dollar trap years ago. He said, yes, it might not be the most politically palatable situation to be in, but we are in a dollar trap. He didn't mean any derogatory way. He says that you're in the system and there's no real feasible path, credible path out of the system. That's why it is this view of truly is this kind of world currency that we are embedded in. Based on that, I'm curious what your thoughts are to my last segment. Your thoughts are on this idea of dollarization. You have one big country now, Argentina, that is potentially going to dollarize early next year if a particular candidate wins. Do you see that as a good policy choice in 2024?

Daniel McDowell: 43:28

I guess, when I think of the Argentina situation, one I sympathize with policymakers in Argentina, just in that this is a country that's had so many crises over the last, losing count of how many decades 40 years now, perhaps longer where the credibility is just.

Daniel McDowell: 43:42

That's the issue. So much of this comes down to credibility, and do markets trust that policymakers are going to make the tough decisions to get the economy in the shape that it needs to be in to be stabilized? I think that's the main impulse here. Behind Amilay's idea for dollarization is that this is the way to credibly commit to markets Effectively. We're going to give up our own monetary independence and use the dollar, and this would effectively eliminate the hyperinflation situation and debasement of the currency. Me personally, I don't feel like I'm the right person to advise on whether that's a good call or not for Argentina. My sense is, though, that's an extreme solution to the problem, in that fiscal prudence and focusing on things like an actual balanced budget and smaller steps could, if consistently applied and followed through, would probably be a better choice for Argentina in the long run than the extreme of dollarization, but, again, I wouldn't position myself as the right person to advise on that one.

Rasheed Griffith: 44:41

Sure.

Rasheed Griffith: 44:41

I would say, though, keeping the conversation coherent in our dollar system essentially is if all your exports are pricing USD, if your imports are pricing USD, if your international bonds are pricing USD, if your people need you to actually get anything outside of your currency because you don't have a proper Argentinian Australian dollar exchange platform, I'm going to go through the vehicle currency of USD.

Rasheed Griffith: 45:05

Then it's something I always say, where I think people too often frame the conversation of zero dollarization to full dollarization, where most countries are like 80% dollarize already, so it's only a 20% change actually use cash, because that's the only thing that really changes into the practicality is you use cash that has a US printed US, and then you still have to go and fight your fiscal battles. You're still going to fight your banking regulation battles, so you're still going to fight your financial integration, world market battles and so on, but that 20% eliminates a lot of uncertainty that currently crisis would cause, while not actually changing your economy that much. Fundamentally, in my view, it's like there's very little downside, if any downside, to dollarization in a country like Argentina, because it's more kind of already are primarily dollarized in any kind of real global market mechanism.

Daniel McDowell: 46:00

I appreciate that take and I would just add that one of the things I find interesting about this conversation, especially in the context of Argentina, is Argentina has been getting a lot of attention for using the Yuan for trade settlement with China's, partly as a function of its swap line with the PBOC, and of course much of the impulse behind that is really trying to deal with dollar shortages, to limit exchanges for dollars and prevent outflow of dollars. So really most of that is about the dollar, not about the Yuan or interest in the Yuan. And in this case, now moving to a world where the conversation or the debate in Argentina is about whether to fully dollarize or not really just completely upends the narrative that the Yuan is somehow ascendant in Argentina or Latin America more broadly. I think that's a potent illustration of why that's not true.

Rasheed Griffith: 46:44

Daniel, thank you so much for coming on a part of Castile. This has been a delightful conversation.

Daniel McDowell: 46:50

I've really enjoyed myself and I enjoyed the range of the conversation that we had, so thanks a lot for having me on here.

Rasheed Griffith: 47:06

That's it for this episode. Please do check the links to Daniel's book in the show notes. If you have any comments or questions about this episode today, you can find me on X for our Twitter at rachivgoal. You can also subscribe to the CPSI News Zellers at CPSImedia for updates on the latest blogs, analyses and podcast episodes. See you next time.