By Nicholas Sargen, Darden School of Business
Russia’s invasion of Ukraine poses one of the biggest challenges to the post-World War II order, and it could portend further problems ahead if the conflict is protracted, as General Mark Milley recently warned.
Shortly after the invasion began, the United States and its NATO allies invoked sanctions against Russia that a VOX CEPR report called “the most powerful and costly punishments imposed on a major economy at least since the Cold War.” The actions included freezing Russia’s foreign exchange reserves that resulted in an initial plunge of the rouble. They forced Russia to impose capital controls, hike the central bank’s policy rate to 20 percent and close the stock market while Russia’s sovereign credit rating was lowered to junk status.
As a result, Russia’s economy is on the brink of a steep recession that could exceed what it experienced in the 2008 global financial crisis. But the sanctions have not deterred Russia from committing war crimes, as the U.S. government and others claim.
Consequently, the United States and the European Union are now contemplating additional measures. The most impactful would be for European countries to cut back purchases of Russian oil and natural gas, as Russia earns about $1 billion per day exporting energy. Reaching a consensus on this issue is not easy, because European economies import about 40 percent of their oil and gas from Russia, and 55 percent of Germany’s gas came from Russia before the conflict. The dilemma is determining how much economic pain Europe is willing to accept to deter Russia.
Beyond this, some observers are concerned that the “weaponization of finance” could undermine the international financial system and the dollar’s role in it.
In an interview with the Financial Times, Gita Gopinath, the IMF’s first deputy managing director, indicated that financial sanctions on Russia could gradually dilute the dominance of the dollar and result in a more fragmented international monetary system. Others go much farther. In an Asia Times commentary, David P. Goldman writes: “Pessimism used to be for monetary cranks; now even Goldman Sachs warns the dollar will go the way of the pound.”
Concerns about international trade have some validity, as pressures to curtail trade have been building for the past four or five years. Former President Trump’s actions to impose tariffs not only on China but also on U.S. allies have yet to be rescinded by President Biden. Meanwhile, the coronavirus pandemic has disrupted global supply chain links, and the fallout from Russia’s invasion resulted in a 2.8 percent decline in the volume of world trade from February to March.
But worries that sanctions will erode the dollar’s role in international trade and finance are overblown. As Sebastian Mallaby observes: “Russia, China and other U.S. adversaries would love to escape the financial hegemony of Uncle Sam. But they have been trying for years and have little to show for it.”
To understand why this is so, consider how the U.S. dollar emerged as the pre-eminent currency after World War II.
As the most powerful country in the world with the strongest economy, the U.S. was widely viewed as a safe haven, and there was a shortage of dollars in the 1950s. Even Soviet bloc countries sought to hold dollars but did so outside the United States, which gave rise to the eurocurrency market. It then took off when the U.S. government enacted the Interest Equalization Tax (IET) in 1963 that levied a federal tax on the purchase of foreign stocks and bonds by Americans. In the process, multinational corporations obtained dollar funding abroad, and the role of the dollar as a vehicle currency for conducting both trade and finance became entrenched.
The main challenge to the dollar as the world’s key reserve currency occurred in the 1970s, when the U.S. abandoned convertibility between the dollar and gold. As U.S. inflation surged, the Bretton Woods system of fixed exchange rates gave way to flexible exchange rates. Thereafter, the dollar weakened steadily against the West German deutsche mark, the Swiss franc and the Japanese yen. Throughout the decade, the issue of whether the dollar could retain its status with high U.S. inflation was debated in official circles.
In the end, the dollar prevailed for two reasons. First, the Federal Reserve restored confidence in the dollar when U.S. inflation was reined in from the mid-1980s onward. Second, Europe, Japan and China lacked the breadth and depth of the U.S. capital markets. Also, both Japan and China have been reluctant to allow capital to move into and out of their countries without restrictions, and they prefer trade surpluses.
Today, the dollar’s share in official foreign exchange reserves is about 60 percent. This compares with 21 percent for the European Union (EU), 6 percent for Japan and 5 percent for the UK. And while China is pushing the use of its currency in international trade and as a reserve asset, the renminbi represents only 2 percent of global reserves.
Given this perspective, there are two reasons why the dollar’s role conceivably could be called into question. One is the Federal Reserve could encounter difficulty bringing inflation back toward its average annual target of 2 percent. Thus far, however, investors have not lost confidence in the dollar, which has appreciated against other key currencies since the Russian-Ukrainian conflict began.
The other is the U.S. could use sanctions and/or tariffs more prevalently in the future. In imposing sanctions on Russia, however, the United States wisely did so along with NATO members and Japan rather than acting unilaterally. Even Switzerland adopted the EU sanctions, and both Sweden and Finland announced they are considering joining NATO. This highlights how egregious Russia’s actions are and why no democracy is accusing the United States of acting irresponsibly.
Nicholas Sargen, Ph.D., is an economic consultant with affiliations with Fort Washington Investment Advisors in Cincinnati and the University of Virginia’s Darden School of Business. He has authored three books, including, “Global Shocks: An Investment Guide for Turbulent Markets.”