On February 26, 2022, the United States, the United Kingdom, Canada, France, Germany, Italy, and the European Commission issued a joint statement that might very well change the global economy forever. In it, these countries pledged to freeze the Central Bank of Russia’s foreign currency reserves in response to Russia’s invasion of Ukraine two days prior. These reserves, which were estimated at around $630 billion, had been accumulating since they were run down the last time Russia intervened in Ukraine in 2014. When they were frozen, they were at their highest level since data was collected.
This action could mark a tectonic shift in the global monetary system comparable to the U.S. dollar breaking its peg to gold in 1971.
Economic War, 2014–2022
Russia had been accumulating foreign currency reserves for precisely the sort of crisis its economy faced when Western countries responded to Russia’s invasion of Ukraine with economic sanctions. The Russians had learned this lesson during their previous Ukraine incursion. After they intervened militarily in 2014, the rouble crashed. At the time, the Saudis were also increasing their exports into an already soft oil market, and oil prices fell precipitously. The Russian economy fell into recession.
The situation in 2022, however, is very different from the situation in 2014. In 2014, global growth was lackluster and inflation was muted. In addition to this, the oil markets in 2014 were still pricing in the enormous surge in oil production in the United States that was enabled by the “fracking revolution,” which doubled U.S. oil production. In 2022, on the other hand, the global economy was running hot, and inflation was the highest it had been since the 1970s. The fracking revolution had long been priced into global oil markets. Even if the Saudis wanted to crash the oil price in 2022—and they gave no indication of wanting to do so, going so far as to refuse to answer President Joe Biden’s phone call—the economic conditions likely meant that they would not be able to.
This time, the rouble was rattled by the sanctions, but not as badly as when it had been hit with falling oil prices in 2014/15. In 2014/15, the rouble fell around 48 percent against the U.S. dollar; in 2022, it fell around 25 percent. This fall is even less dramatic if we recall that, in 2014/15, the Russian central bank was free to dump foreign exchange into the market to stabilize the rouble’s price, while in 2022 they could not.
This is not surprising given the behavior of the oil market. In response to the invasion of Ukraine and the threat of energy sanctions against Russia—a country that produces around 13 percent of the world’s oil—prices increased and volatility spiked. Everyone in currency markets knows that the value of the rouble is firmly tied to the oil price. Controlling for inflation, regression analysis on the Russian exchange rate shows that around 64 percent of changes are explained by changes in the oil price.
From this exercise we have learned that sanctions are a far weaker economic weapon against Russia than interventions in energy markets. It could even be argued that Russia did not need access to their foreign exchange reserves this time around thanks to the impact the invasion and the sanctions had on oil prices. If history does judge the seizure of Russian foreign exchange reserves as a largely fruitless exercise, it will be a cruel irony because, as we shall see, the act of seizing these reserves could have long-term effects on American financial hegemony.
A Crisis of Confidence
On March 16, 2022, Russian president Vladimir Putin gave a speech in which he outlined his economic plan moving forward. One section of that speech immediately started circulating on social media. Putin said,
The illegitimate freezing of some of the currency reserves of the Bank of Russia marks the end of the reliability of so-called first-class assets. In fact, the U.S. and the EU have defaulted on their obligations to Russia. Now everybody knows that financial reserves can simply be stolen. And many countries in the immediate future may begin—I am sure this is what will happen—to convert their paper and digital assets into real reserves of raw materials, land, food, gold, and other real assets which will only result in more shortages in these markets.
While policymakers may have initially dismissed the speech as yet more bluster from the Kremlin, people in financial circles had already been discussing precisely this point for some days. Reserve currencies, like all currencies, rely for their value on trust. Countries choose which currencies to hold in reserve based on the stability of these currencies. Currencies whose value is regularly inflated away are not used as reserve currencies. But at a more basic level, a holder of a reserve currency must be confident that the asset will not simply be seized. If a country thinks that the country issuing the reserve currency might simply seize it—especially at a time when it is most needed—then it would be unwise to hold this reserve currency if there are alternatives on the table. Seizing reserves is a trivial exercise in technical terms, as the reserves of a country’s currency are held in an account at that same country’s central bank. The issuing country always has full control, but until now few countries have been willing to weaponize it on such a large scale.
In freezing Russia’s foreign reserves, the United States, the United Kingdom, and the European Union signaled to the world that other countries’ access to their reserve holdings in dollars, pounds, and euros is contingent on their approach to foreign policy. The world will pay attention to this development, most obviously in the case of China. China has long run large trade surpluses with the Western countries and in doing so has built up huge amounts of foreign reserves. But now the Chinese must view these reserves through the lens of their foreign policy. If, for example, China decided to seize the island of Taiwan, it seems almost certain at this point that the reserves would be frozen. Would they be frozen even as a result of a less ambitious incursion on China’s part? Nobody knows. But you can bet the Chinese are discussing it.
All countries will now have to consider their foreign currency reserves in light of their foreign policy. India will have to consider whether tensions with Pakistan could lead to their assets being frozen. Africa is subject to constant turmoil and often the tensions there generate resistance from the West. Many African countries will have to reconsider their reserve holdings too. Saudi Arabia, which holds huge amounts of reserves, will remember the Western reaction to the murder of the journalist Jamal Khashoggi. The Kingdom is already in discussions to sell some oil in Chinese yuan. Every Middle Eastern state will be looking at their list of alliances on the one hand and their bank balances on the other.
Of course, these countries will not want to be entirely dependent on China or any other single country’s currency and goodwill, either. With the EU, UK, and Canada joining the U.S. effort, their currencies will also be less attractive as competitors. And there are other (at least short-term) obstacles to de-dollarization. The point is not to suggest that the complete abandonment of dollar reserves is on the horizon, nor is it happening overnight. Even a moderate degree of increased diversification away from the dollar over time, however, could still have a meaningful impact.
Did Western policymakers understand all this when they seized Russia’s foreign reserves? I have heard that question asked many times these past few weeks. Some think that they did, and they understood the action as accelerating the shift to a multipolar world. Others think that they did not, that the Russian invasion of Ukraine took them by surprise, and they were forced to look like they were doing something—especially with a frenetic social media amplifying the war drums. I think that the latter is a better interpretation, as there also seems to be evidence that they did not consider how the sanctions might benefit the Russian economy by driving up oil prices—something that should have been obvious to any competent macroeconomist.
Dollar Hegemony: The Long View
In the summer of 1944, delegates from forty-four nations met in Bretton Woods, New Hampshire, to hammer out a global monetary system for the postwar world. In addition to establishing the World Bank and the International Monetary Fund, the conference settled on a system of global exchange rates pegged to the dollar which in turn was pegged to gold. Not everyone was in favor of this. The British economist John Maynard Keynes, for one, proposed a more multipolar solution which he called the “bancor,” which would have provided a much more flexible and equitable framework for global trade. But the Americans wanted to dominate the system and since all of Europe was heavily indebted to them after the war—especially Keynes’s own Britain, which had sold the family silver to the Americans to fund its war effort—they won the day. The dollar standard was born.
For a few decades the system worked as it should. This was due to American dominance of the world economy after the Second World War. While Europe and Japan rebuilt their economies, America pumped its exports onto world markets. As the manufacturing capital of the world, America ran consistent trade surpluses. This meant that the United States never owed any of its gold to any other countries in any meaningful quantities. With the gold in the bank, the dollar was stable, and the system worked like clockwork.
This started to change in the late 1960s. Lyndon Johnson was bogged down in Vietnam and subject to massive domestic pressures for reform. He opted to run a “guns and butter” economy and tried to fund both the war and new social programs—mostly through deficit-financed government spending. As a result, the U.S. current account fell into deficit with the rest of the world in 1971/72. This meant that countries that were owed money by America could ask for their payments in gold.
French president Charles de Gaulle had long had a chip on his shoulder when it came to the Americans. After the Second World War the Americans demanded that their allies grant independence to their colonies. De Gaulle was enraged by this and saw it as none of America’s concern. But he was brought to a heel in 1945 when he had to ask the Americans for a billion-dollar loan to rebuild the French economy. France would have its revenge when in August 1971 President Pompidou sent a battleship to New York harbor to take the gold that France was owed. The gold would be removed from the New York Federal Reserve Bank and transported to the Banque de France in a striking symbolic challenge to American financial power. Soon other countries would follow suit. This was the international equivalent of a bank run.
In mid-August, the Americans realized that they were stuck. If their trade partners kept asking for gold to be shipped, they would soon find America’s vaults empty. President Nixon appeared on television on a Sunday and said the following:
We must protect the position of the American dollar as a pillar of monetary stability around the world. In the past seven years, there has been an average of one international monetary crisis every year. . . . I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States. Now, what is this action—which is very technical—what does it mean for you? Let me lay to rest the bugaboo of what is called devaluation. If you want to buy a foreign car or take a trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today. The effect of this action, in other words, will be to stabilize the dollar.
Did the government know what would happen when they floated the dollar? Were Nixon’s advisers as confident as Nixon appeared to be on television that Sunday? No. Gold pegs had often been broken in history, but usually under emergency situations like war. In war, people knew that the government would have to opt for paper money, but the assumption was always that after the war the gold standard would return. The Americans, however, were clearly signaling that the dollar would be a paper currency moving forward.
The first to describe the new system that emerged was the American economist Michael Hudson. In 1972 Hudson published a neo-Marxist book entitled Super Imperialism: The Economic Strategy of American Empire. Hudson’s book was ruthlessly critical of the U.S. system. He claimed that the new nonconvertible dollar was going to be used to extract huge quantities of goods from the rest of the world in exchange for paper. In the preface to the second edition in 2003, he writes:
The book sold especially well in Washington. I was told that the US agencies were the main customers, using it in effect as a training manual on how to turn the payments deficit into an economically aggressive lever to exploit other countries via their central banks. It was translated into Spanish, Russian and Japanese almost immediately, but I was informed that US diplomatic pressure on Japan led the publisher to withdraw the book so as not to offend American sensibilities.
To this day, the Americans have used the hegemonic status of the dollar to live beyond their means; they have taken a critique leveled against their monetary system by a neo-Marxist economist and turned it into a tool of geopolitical hegemony. The reserve currency status of the dollar props up its value even though for many decades the United States has run enormous trade deficits with the rest of the world. The cheap imports that American consumers buy, especially from China, would be a great deal more expensive if not for the reserve currency status of the U.S. dollar.
The Impact on American Living Standards
The question now raises its ugly head: how much more expensive would imported goods become for ordinary Americans in the event of the dollar becoming just one currency amongst many? That depends on how much the dollar relies for its value on its reserve currency status. No one knows that because no one can know it. Since the dollar has always been the reserve currency in the modern, postwar era, we have no point of historical comparison. Thus, we have no idea whatsoever how much of the U.S. dollar’s value derives from its reserve currency status. “Whereof one cannot speak, thereof one must remain silent,” as Wittgenstein put it.
What we can say, however, is how much various depreciations of the U.S. dollar would raise domestic prices—and erode living standards in a heavily indebted country. The table below estimates the likely impact of various dollar depreciations on both consumer prices and import prices, obtained by linear regression analysis.
Before interpreting this data, we should state two points so as not to be misled by the numbers. First, the model used to derive these estimates can only capture first-order effects. Since the initial price increases will likely feed into other price increases, the actual impact on overall consumer prices could be higher—especially if these price hikes occur in an already inflationary environment. Second, while a rise in domestic consumer prices can usually be balanced out for workers through a rise in their wages, a rise in the price of imports cannot. Therefore, these estimates show a permanent hit to the living standards of the American consumer; they cannot be reversed through domestic wage hikes, as these hikes will only further drive down the value of the U.S. dollar. The American consumer will have to eat them.
With that in mind, we can now discuss how bad these estimates are. A 10–20 percent decline in the value of the dollar would be painful, particularly for poor and working-class people who are more impacted by rising import prices, as cheap Chinese imports are disproportionately bought by these groups (especially relative to their budgets). The average American would rankle at a permanent loss of 3–7 percent of their purchasing power, but it would not break the bank. Anything over this, however, would be incredibly painful. A 30–50 percent decline in the value of the dollar would mean imported goods rising in price 30–50 percent and overall prices rising anywhere between 10 percent and 17 percent. That represents a permanent decline in living standards of 10–17 percent. Never in history outside of wartime have Americans felt such a shock, and never in history have they faced such a permanent shock. This would be a contraction in living standards that could easily generate chaos and social unrest.
Import Substitution: A Therapeutic
There is good reason to believe that the cat has been let out of the bag. Western countries have already signaled that their foreign exchange reserves can and likely will be weaponized in the future. The terms on which they will be weaponized are vague and have not been clarified. Diplomatic efforts to persuade the world otherwise would be more than welcome, and it is strongly in the interest of the Western nations to pursue this channel. But doing so will be an uphill struggle.
There is no policy that could reverse the effects of the fall of the dollar reserve currency completely. But there are policies that could help ease the transition: a therapeutic, not a cure. The most promising is a policy of import substitution. This could be done simply enough. The United States—and other countries worried about their currencies—should set up an investment bank. This investment bank should have its debt backed by the central bank, which should be allowed buy this debt at a 0 percent interest rate. The debt contracts will be perpetual, and the bonds will never be redeemed. Limits should be set on the issuance of this debt according to the needs of the import substitution program, preferably on the basis of a five-year plan in order to avoid political interference.
The investment bank should be staffed with economists and market analysts. They will strip down the import statistics in search of easily substitutable products that are currently imported mainly because the price of the equivalent foreign product is lower. The investment bank will then work with domestic industry to produce these goods and will subsidise the price difference between the domestic product and the foreign product. So, for example, if a Chinese-manufactured toaster costs $10 wholesale and an American equivalent costs $15 due to higher domestic labor costs, the investment bank will subsidise the American equivalent to the tune of $5 per unit.
An import substitution program such as this will ease the transition away from a world dependent on the dollar reserve currency. It will also encourage high quality domestic manufacturing jobs. It can even be used as a regional development strategy. So, the investment bank can request that companies availing themselves of the subsidies build their factories in poorer regions. This could lead to a revival of the areas devasted by the flight of American manufacturing abroad.
Perhaps something will change in the coming months. But it seems possible that we have reached the end of an era—one that began in 1945, shifted gears in 1971, and may now be approaching its terminus. A multipolar world is emerging before our eyes, while the unipolar power of the United States and its allies is slipping away. It is time to begin thinking more strategically.
About the Author Philip Pilkington is a macroeconomist and investment professional and the author of The Reformation in Economics (Palgrave Macmillan, 2016).