Christine McDaniel on the Russia Sanctions and Their Impact on Globalization and the Russian Economy

Russia has paid a steep economic price for waging war on Ukraine, and the effects will be felt internationally for years to come.

Christine McDaniel is a senior research fellow at the Mercatus Center where she focuses on trade and intellectual property rights issues. Christine previously held several positions in the US government, including deputy assistant secretary at the Treasury Department and senior trade economist in the White House Council of Economic Advisors. She has also worked in the economic offices of the US Department of Commerce, US Trade Representative, and the US International Trade Commission. Christine rejoins Macro Musings to talk about the economic sanctions applied to Russia, and their implication for the Russian economy and globalization more generally. Specifically, David and Christine also discuss the structure and effectiveness of the Russia sanctions, the war’s heavy impact on food shortages, the role of dollar dominance in geopolitics, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Christine, welcome back to the show.

Christine McDaniel: Hi David. Thanks for having me again.

Beckworth: Well, it's great to have you on, it's great to have a colleague like you who is really deep in the weeds on a very topical issue, the Ukraine-Russian war, and what's going on and what these sanctions mean. As you know, I'm a big fan of trade policy, but it's kind of outside my lane. I come to people like you for wisdom and insights. I wanted to talk about Russia with you today, because you have several pieces out. You've got a working paper out that's pretty interesting on the effects these sanctions could have if we had complete sanctions on Russia and we'll get to that in a minute, Christine, but maybe we should step back for a minute and just talk about the state of affairs in terms of the Russian sanctions. What's happening now? What have we seen develop recently? Anything to take note of before we get into your research?

Russian Sanctions: The Present State of Affairs

McDaniel: We've seen a number of things. We've seen this amazing response of over 40 nations come together in concert and coordination to impose trade… economic financial sanctions on Russia, Russian entities, and Russian individuals. That alone I think is worth really noting. I know anyone who's been following this is well aware of that. It is sort of ironic that Putin probably wanted to weaken NATO, but if anything, he's just strengthened it. That's been one thing. We've seen sanctions on Russia's central bank and a number of individuals, a number of other private banks, and oligarchs, and other companies. Sanctions is a pretty broad term, but targeted sanctions can be very effective.

McDaniel: We've learned that, for economic historians, even just going back to the, when was it… the 80s wheat embargo of Russia, that other invasion, they found that that was fairly ineffective. Right? Because Russia just circumvented the wheat embargo, found other sources, and meanwhile US farmers were really upset and President Carter never lived that down. Some economic historians will even tell you that that really hurt his reelection chances. Anyway, over time economists, economic policy makers, lawmakers have turned to more targeted sanctions and sometimes people call them smart sanctions. The idea is to cut off flows of goods, services, money, resources, information to any entities or individuals that are aiding and abetting in the unsavory practice. Right? That's what we saw the US and several European nations do back in 2018. That's what we're seeing happen again but now in a much bigger fashion. These targeted sanctions have been shown to be more effective.

Over time economists, economic policy makers, lawmakers have turned to more targeted sanctions and sometimes people call them smart sanctions. The idea is to cut off flows of goods, services, money, resources, information to any entities or individuals that are aiding and abetting in the unsavory practice.

Beckworth: Yeah. We see signs of that Russia is undergoing really high inflation right now. There's a contraction in the economy. There's been some complaints it's not enough. As you know, the complaints against the energy sector being exempted from these sanctions. It was interesting to see over the weekend and we are recording this right after Memorial Day and on this weekend, a news story came out that the EU will agree to a partial ban of Russian oil imports. My understanding is that this will cover more than two thirds of oil imports from Russia and ban 90% of Russian oil imports by the end of the year. There's still a few exceptions, but they really are taking a big chunk of the last remaining piece of the puzzle on the sanction table, taking that off and putting in and out of play. What are your thoughts on that most recent development?

McDaniel: Yeah, so that has been a big question mark. What is Europe going to do next? Obviously, the energy exemption, that was a huge hole in the allies sanctions package. We've been waiting to see what Europe is going to do and these are hard discussions that have been going on inside Europe because not all European countries are as tied to Russia in terms of energy as others. Then, there are other countries in Europe that… one could characterize it as friendly toward Putin, namely Hungary. There's been a wide variety of views in Europe and the ability and the will to embargo energy, oil and gas imports from Russia's been heterogeneous across the European country. But they finally came to an agreement where it looks like they are not going to let Hungary completely derail their goals. They basically, yeah, announced they would embargo about 90% of oil import imports from Russia by the end of the year. They still have well over six months to do that, but two thirds of that embargo is going to happen pretty quickly. That does leave some wiggle room there for countries like Hungary. That's a whole other discussion I don't know if you want to get into. This is not trivial. Over the next few months, we'll be following the energy expert discussions to see how Europe is going to be adjusting to new suppliers and whether or not this is really going to kickstart their energy transition that they've been discussing.

Beckworth: Yeah. We'll come back to your paper in a few minutes where you do a general equilibrium exercise where you think through what this could mean or sanctions like this could mean. I want to go back to the sanctions that we have had in place. Prior to this big EU announcement about oil imports, there's been debate about how effective has the existing sanctions been. I'm just going to give one example of a conversation I saw. This is on Twitter. There's two camps. I guess my big picture view of this discussion is the glass half full or half empty when it comes to sanctions. In one camp, there were individuals that have in fact been guests on this show before, Robin Brooks, Hanno Lustig, Ben Moll and they were making this point that Russia's current account surplus is just blowing up. It's getting really large, which implies they're earning reserves. They said we needed to hit it. We need to undermine Russia's ability to acquire these financial claims on the rest of the world, the ability to get hard currency via energy exports.

Beckworth: Maybe what we've seen again from the EU ban, this will take care of that. Their concern was Russia was still acquiring hard currency and they can use the hard currency to help pay for the war effort. Everything from paying mercenaries to soldiers to keeping things on track. Of course, I think you've noted before or elsewhere that it's getting increasingly hard to maintain and produce additional weapon systems if you're in Russia, because you don't have the key inputs coming in. But they're still concerned. These individuals are concerned and others that not enough is being done. On the other side were people like Matthew Klein and Paul Krugman. They're like, "Look, the only reason the current account surplus is blowing up is because imports have compressed into Russia." It's not as if you know the typical story you see when you see large current account surpluses. We should be grateful for the success we've had. The fact that Russia is strangling, its economy is shrinking. Paul Krugman also goes on to note that even those countries that aren't allied with the 40 countries you mentioned, even some of them are being cautious and some of their engagement has also dialed back. Do you think the sanctions prior to this big announcement were fairly effective in slowing down Russia's war efforts?

Assessing the Structure and Effectiveness of Russian Sanctions

McDaniel: Great question. I get asked that a lot and a lot of other people much smarter than me get asked that a lot. I think that you've got to think the answer is it depends on your timeline. Right? It also depends on how do you define effective. I was talking to a former chief economist at State. She told me, look a lot of policy makers, they want a slam dunk. Unless you are willing to take military action and endure much more cost and pain, you're not going to get a slam dunk with economic sanctions alone, at least not immediately. Then the question is if you define it as effective, okay, has it been effective in terms of slowing down or making Moscow pay for their actions? Yeah. Undoubtedly, yes, absolutely it's been effective.

Unless you are willing to take military action and endure much more cost and pain, you're not going to get a slam dunk with economic sanctions alone, at least not immediately. Then the question is if you define it as effective...has it been effective in terms of slowing down or making Moscow pay for their actions? Yeah. Undoubtedly, yes, absolutely it's been effective.

McDaniel: They have had to pay in terms of economic growth, in terms of ability to mobilize their assets. No doubt about it. We've seen the central bank, half of their reserves are frozen. There's no more money flowing in from oligarchs at least to the extent we had seen prior to the Ukraine invasion. There's no more money flowing in from Western businesses who have left. Russian citizens, in terms of getting access to Netflix or traveling like they used to, or shopping, even the average person is feeling it. Russia has a lot of reserves and even just think of the US economy. If we were to completely shut our borders and kind of start moving toward autarky if you will and by autarky what we mean is no longer trading or doing business with other countries, basically just completely relying on everything with inside your own borders, we would probably be okay for a few months, the US definitely more so than Russia because we've got a lot more in terms of human capital and we're just larger and more diverse. We're not overly reliant on a commodity like energy, like Russia is.

McDaniel: That said, Russia isn't really in autarky yet. Right? Like you were saying, they're still selling oil and gas. In fact, latest I heard, 7 to 8 million barrels a day of crude. Mostly to Europe, but increasingly they're diversifying to India and China. They're bringing in half a billion to a billion dollars a day. That's not trivial either. Even if they were to cut everything off, they could still get a half a billion to a billion dollars a day just from energy and is it going to be enough to keep their economy the size it was? No. But is it going to be enough to survive? Probably. We're already seeing reports of their central bank governor has spoken a couple times now about the state of the Russian economy and she's used this term, “structural transformation” and then other so-called thought leaders in Russia and their op-eds to the extent Google Translate is doing a good job for me, they're talking about inching toward autarky and they're talking about the role of import substitution. They're talking about the need for the state to step in and not allow private companies to just cut headcount.

McDaniel: Basically forcing companies to reduce work hours, cut down on pay, but just don't let people go. All signs are pointing to Russia's economy is shrinking. Right? Will it survive? Yes. Will it look like what it did 5-10 years ago? Probably not. It will get smaller. They will get poorer. Then the big question is, to the extent they're still selling energy, where does that capital flow to? Straight to Putin's coffers? Is he going to spread it around? There's just so many unknowns. I think most economists are well outside of our comfort zone of doing this gaming out scenarios.

Beckworth: That is a nice way of framing this, a structural transformation in Russia, but even without Russia's own policy efforts, it's going to go through some major changes. This is something you point to in a piece you wrote recently for The Hill and the title of the article was, *We've Never Seen a Country Go Backwards As Quickly As Russia.* Independent of what maybe Russian policy makers are doing to become more self-sufficient, it's been forced on them. There's been a lot of things that have happened that's going to affect their long term capacity for growth. Walk us through what you argue in that paper.

McDaniel: Well, so first of all this is a co-authored piece with two of my former colleagues from Sidley Austin, Kornel Mahlstein and Simon Schropp, and also a former colleague of mine from the US International Trade Commission, Marinos Tsigas. This is kind of a neat team because the Sidley guys, well, they're in the trade and arbitration group at Sidley, so access to a deep well of knowledge of these sanctions and ability to use ROSAT, your Russian statistics which really helped inform our policy shocks, and then also their knowledge of how the sanctions may or may not work. And then, of course, with Marinos on the general equilibrium side, so it was a really neat team and it was kind of fun to get the band back together on that one. But look, this is an ex ante analysis. Okay. So that means looking forward as opposed to an ex post analysis, which is looking back. With ex post, we would use a different tool, say econometric analysis, but this is an ex ante, so looking forward. So what are potential economic effects of these various sanctions? And so we looked at a few different scenarios but we call it an allied embargo. And our allied embargo includes an embargo on imports from Russia, an embargo on allied exports into Russia and curtailing or suspension or partial withdrawal of foreign direct investment by allies. And then also the cost of just the economic and financial sanctions that are spread around the world to anybody doing business with Russia.

All signs are pointing to Russia's economy is shrinking. Right? Will it survive? Yes. Will it look like what it did 5-10 years ago? Probably not. It will get smaller. They will get poorer.

McDaniel: So we have four components of these sanctions. And then the way we model it, we're able to decompose to see which types of sanctions have differing effects. And so the import and export embargoes, we basically modeled it as a prohibitive tariff. It's not costless for the allies but the costs are uneven. So unsurprisingly, the countries that are more economically entwined with Russia, namely European countries like Germany, Netherlands, and so on, they're more hurt than others. The adverse effects on the US are pretty minimal. And then the export embargo not that devastating for most of the allies. The FDI withdrawal and suspension… that is pretty devastating for the Russian economy. And so there we tapped into this really large economic literature on the role of foreign direct investment in countries, including Russia, and looked at the productivity effects, spillover effects, the upstream-downstream spillover effects of FDI.

McDaniel: And we looked at the allied share of foreign direct investment in Russia by sector. And then we looked at the potential economic effects of reducing productivity in those sectors to that extent accordingly. And that is pretty devastating to the Russian economy. And then, the trade and economic and financial costs of doing business with Russia because of the allied sanctions… that showed up in an interesting way too. So the non-allies... So the countries that don't join the allied embargo, so they benefit to the extent that they get trade diversion from Russia. So there's more of Russian goods and services to go around. They probably can get it at a discount. We surmise this and it actually turns out that's what we're seeing now. I've never done a CG paper where the events are so quick to materialize as this one. And I'm definitely not in the forecasting business. So don't get any ideas there macro people.

McDaniel: So these results are really interesting. The non-allies benefit from the trade diversion but they’re hurt even more by the costs of the sanctions. So even on net, the non-allies lose, and it's because of the reach of those sanctions. So these financial sanctions, the trade sanctions, it's all making it more costly to do business with Russia. It takes longer to get your stuff there, it takes longer to get your stuff out of there, it's more costly to get funds in and out, and the legal and administrative costs are also pretty high. So that all showed up in the model that way. And then we looked at a few other extensions Simon wanted to look at, this has turned out to be pretty interesting, the effects of China joining the embargo or not. Turns out that Russia... The adverse effects felt by Russia of China joining the embargo are there but they're not huge, and the allies are actually hurt too by China joining the embargo. And that's not surprising.

McDaniel: China is one of our largest trading partners, you pull them into this, and, of course... So the takeaway there, I guess, from a policy perspective is don't wait on China, the bang for your buck may not be worth it. And I mean, that's strictly in terms of these particular results. Obviously, there's other non-economic factors at play there, but overall, the sanctions are costly to the Russian economy. The withdrawal of FDI is the most costly and a powerful sanction tool. And you see this... I went back and... Putin gave a speech. I think I talked about it in that Hill piece, but he gave a speech a number of years ago in 2009. And he talked about the importance of the private sector, the importance of foreign direct investment, he even went out of his way to say that privatization must be "fair and honest." And he was promising a reduction in state intervention.

McDaniel: And he was basically trying to gin up a lot of interest from foreign investors into the Russian economy because he knows as does his central bank governor that the long-run growth is largely tied to productivity growth. And if you're a country like Russia where you're heavily reliant on a commodity and exports of that commodity and you're pretty weak on the human capital side, that productivity is going to be really important. And how do you get that ties to the external economy, foreign direct investment being one of them. So, in the longer term, this pullout is going to be quite painful for the Russian economy and the Russian people.

These financial sanctions, the trade sanctions, it's all making it more costly to do business with Russia. It takes longer to get your stuff there, it takes longer to get your stuff out of there, it's more costly to get funds in and out, and the legal and administrative costs are also pretty high.

Beckworth: So just so we're clear, I brought up the Hill paper that you wrote or the Hill article that you wrote, which draws upon this working paper. And I want to make sure we get the name of the working paper out there. And that is, *Estimating the Economic Effects of Sanction on Russia: An Allied Trade Embargo.* So, we'll provide links to both of those pieces as well as a Vox EU piece where you kind of summarize the results from the working paper, but just to go back to the findings in this working paper, you show, and correct me if I'm wrong, that Russia would lose about 15% of GDP in the baseline case. And it could go as high as almost 25% with some of the extensions to your baseline case. So that's a sizable amount. Now, what is the horizon like over a certain number of years, over one year, how quickly would they lose that much GDP?

McDaniel: Well, in these models, the effects are typically interpreted as sort of medium to long term effects. That is once input factors have had time to adjust. Now, we did make some tweaks to the model. So we could interpret these as the short to medium run effects. For instance, we tightened up some of the substitution elasticities to make it harder for companies to change from one type of labor to another, or one type of capital to another to make it harder to change from one import source to another. Although it turned out that didn't actually make up that big of a difference on the modeling side, which was kind of surprising to me. So the timeline here... You have to think of this on average, think of one to five years out probably is going to be different for different industries, industries that in Russia that were much more dependent on imports, say the automotive industry or the large commercial aircraft industry that are heavily dependent on imported parts, high-tech equipment, those industries are going to feel it probably sooner than others. In fact, we're already seeing that. Just today, I read how [Aeroflot]... Russia's largest airline is needing to cannibalize their own aircraft for spare parts because they cannot get access to imported parts, but then there might be other industries say, food or energy, they're less reliant on imports. And so they won't feel these adverse effects in such an immediate timeframe.

Beckworth: Yeah. You also found in the paper the loss for the allies ranged between 0.1% and 1.6%. So 1.6% is not pleasant. It's definitely a recession, maybe a mild recession. And I'm guessing that number, the bigger number goes to Germany or to Netherlands those countries that are more-

McDaniel: Yes, Germany and Netherlands.

Beckworth: Which it's sad. It's not great but if the counterfactual as we have this menace and Ukraine is overrun, it's a trade-off worth considering. So the losses for the allies 0.1%, 1.6% versus the loss for Russia 15% to 25%. So big difference there in the numbers. And what's interesting that you point out in your Hill piece is that these losses are on top of the existing problems in Russia, their declining population. Well, we've seen some evidence of the lack of state capacity, the military has not performed well at all, surprising many people, add all these things in… corruption, life expectancy falling, population going down, and 15% on top of that is going to make a big difference over the long run. Any thoughts on that?

McDaniel: Yeah. And that doesn't even include the hemorrhaging of human capital that we're seeing happen. We did not model that in our scenarios which would be a further drag on productivity. So in that sense, you could look at our results as the lower bound. And in fact, we were fairly conservative in some of the policy shocks as well. And we state this in the longer European University Institute working paper why our results could be viewed as the lower bound of those. But we're seeing it... Also, on the human capital side, like I said, I just saw a report. Russia has lost over 300,000 people. And the people fleeing Russia are those that have access to finances, to capital, to external contacts. Those are usually the people who tend to be in the science and technology, education fields.

McDaniel: So if you think that even if half of those people are among the more knowledge-intensive workers, then that's going to be a further drag on their longer-run productivity prospects, which will further shrink their GDP. But a lot of this like you were saying in terms of the effects on the West, I mean, it is uneven, and how countries deal with that is going to be really interesting to see if they want to share the costs or they just figure out... The macro community might have some more interesting things to say here but a lot of this is going to depend on how much the West is willing to pay to defend its principles, in a way. I mean, you can't invade a sovereign nation if those are the principles the West is standing by, well, to defend those principles is not going to be free.

Beckworth: One more thing from the Hill article I want to bring out, Christine you and your co-authors have mentioned, are the perspectives of businesses or foreign firms who might go into Russia in the future. And one concern is going to be uncertainty, maybe you don't want to go back into a place where the state capacity's low, there's always the chance of these sanctions being imposed again. But another thing... And we've talked about this before I believe on a Twitter Spaces is even if you return Russia to some perfect state or it's on a path towards better state capacity, better institutions, better governance, you still have to take a lot of time to rebuild business relationships. When you destroy a relationship, it's quick, you terminate your relations.

Beckworth: We talked about some like Boeing going in and tearing up manuals for planes and some of the fleets of planes that were leased out from other companies and all these relationships have been destroyed, oil companies pulling out, human capital pulling out, and to restart that, even in an ideal environment, would take a long time. And I want to read an excerpt from the Hill piece. You guys state, “Nearly 1000 companies have already curtailed operations in Russia. Economic and financial sanctions make it costly to do business there for risk of getting caught up in legal problems. There is also the reputational risk.

Beckworth: A spokesman for Goldman Sachs said that the investment banking company is winding down because operations in compliance with regulatory and licensing requirements. French luxury giant Chanel shut its Russian store, stating the need to comply with EU sanctions.” So you give some examples there. But I want to really stress this point. Really good economic activity relies in part on relationships and establishing them and building them up over time. Just like any human relationship, you can quickly destroy a friendship. It takes time to build it back up. And I think it's something to be considered here in the case of Russia and the rest of the world.

A lot of this is going to depend on how much the West is willing to pay to defend its principles, in a way. I mean, you can't invade a sovereign nation if those are the principles the West is standing by, well, to defend those principles is not going to be free.

McDaniel: Yeah, exactly. And I mean, the human factor is the core of all this. And so the reputational risk... for instance, Goldman pulling out, well, yeah, part of that probably was, yeah, due to the cost of legal and economic sanctions, and just it's tightening even the noose around their neck in terms of their ability to function. But they probably could have still made some money there. But they've got shareholders, they've got a reputation, they want to sit at the table with Treasury. And their reputation in the US and in the West and around the world, that's really hard to keep up when you're actively making money in a country that is invading another country and causing Just horrific loss that the world is seeing every day. So, even Chanel shut its stores. So, from Goldman Sachs to Chanel and many, many others, the reputational risk, it's... Because, remember, a lot of these multinationals, I mean, you just look at the difference between their market value and their book value, their book value on even the S&P 500, it's about an 80/20 split. That just goes to show you the value of branding, intangible assets, name recognition, and all that other firm specific capital, but that branding is not trivial for so many multinationals. And a number of them are just not willing to risk that on a country that is less than 2% of the world economy.

Beckworth: So, let me ask you a question about the art and science of actually enforcing sanctions. So, I think to China, China has these capital controls to prevent lots of capital flowing across borders. There's some exceptions that are made. But it's a very porous restriction. I mean, people find ways around the capital controls. People in China send their money abroad. They find ways to work around it. And I'm just wondering, is it possible that the sanctions we have in place now will begin to see leakages over time, will find ways around the sanctions that are imposed? I mean, the profit incentives could be really, really large. There's reasons why black markets emerge. Or is it the case that there's such a unified front here that these sanctions are unlike anything we've seen before, and it'd be very hard to break down or see them lose their efficacy over time?

McDaniel: Well, right. I mean, the longer this goes on, the more creative people are going to get in terms of getting around the sanctions. Right? So, a lot of this will be the incentive structure that the western governments and banks put into place, how strictly enforced these sanctions are, but then, also, how many Russian oligarchs there are still around the world who still are free to move Putin's money around. There's about 100 oligarchs, by many counts, and so far, the sanctions have really only hit a couple dozen. So, there's still a lot of room there for the sanctions to go in terms of targeting individuals. You don't even need to go black market. You can just use these oligarchs and their connections that have not been tagged yet by the sanctions.

Beckworth: So, one other area of interest related to the Ukraine-Russian war, and that is the food supply. Russia is blocking ports on the Black Sea for Ukraine grains to get out to the world, and particularly parts of Africa, there's stories, UN's reporting that there's going to be great food shortages there. Any thoughts on that development?

The War’s Impact on Food Shortages

McDaniel: So, this has been a really fascinating story to watch for data people like me because when this thing first started, remember that New York Times article, the headlines, 25% of world's wheat supply at risk, Right? Like, oh my gosh, everyone was asking about it, wanting a comment. But then you look at the data... And Tim Harford of the Financial Times who has that great book, *Data Detective,* and that really nice podcast, More or Less, so he has this piece that points out, well, number one, that's incorrect. Russian/Ukraine are not 25% of the world's wheat exports, or wheat production. Russia/Ukraine are 25% of the world's wheat exports. But in terms of their share of world production, it's about six or 7%. So, then you think, "Okay, six or 7% at risk. How sinister is that?"

McDaniel: Well, if that was the only problem, that would probably be more manageable than what we're seeing now, which is an increasing number of countries starting to institute restrictor trade actions, so restricting their farmers from exporting, export controls, export restrictions. Then whenever that happens, even with one or two countries, it's like a domino effect. Right? We saw this back in... Remember the 2008 food crisis? So, the International Food Policy Research Institute, IFPRI, they have a great piece on this, and they look back at that 2008 food crisis and they say, "Okay, what are all the factors that led up to that?" and with 20/20 hindsight, of course.

McDaniel: But now we can learn from their 20/20 hindsight that they've done. They show that there were exogenous effects that nobody could control… the weather, a number of things nobody could really control. But then there were other things that countries could control, but they didn't, and they just made it worse by bad policies. So, export controls, trade restrictions, subsidies here, restrictions there. And all of these things exacerbated the problem, led to panic buying, hoarding, and that was really what led to the food shortage becoming a food crisis. And so, we're hoping we don't see that happen again.

McDaniel: You heard the WTO Director General recently discussed this, but remember, after the 2008 crisis, that's when AMIS, the Agricultural Market Information System, emerged. And after that crisis, countries got together, or at least the economists from these countries got together and said, "Look, we can't control what our policymakers do, but we can at least work together and get more information and transparency out there in terms of who's producing what, who's planting what." So, basically, trying to sketch out a timeline of supply and demand for each of their respective countries and looking at all the factors that affect supply and demand. And that has been a huge success, and we're hoping that all countries continue to participate in AMIS, continue to share information about supply and demand. And it's really, it's got to be the economists in their agricultural agencies and ag departments in each of these countries.

McDaniel: The economists and statisticians in each country's governments are all agnostic in terms of their politics and just trying to do their jobs, and that is what AMIS was really set up for. And that information can be a huge help and damage control, so we're really hoping that is continuing right now. But yeah, six to 7% of the world's production of wheat from Russia and Ukraine going offline. It probably wouldn't alone be devastating, but that combined with some very, very bad policy choices, that could make it a crisis indeed.

Export controls, trade restrictions, subsidies here, restrictions there. And all of these things exacerbated the problem, led to panic buying, hoarding, and that was really what led to the food shortage becoming a food crisis. And so, we're hoping we don't see that happen again.

Beckworth: So, that means we're going to have high food prices for some time even here in the US?

McDaniel: Yeah.

Beckworth: Yeah.

McDaniel: Yeah, yeah. I mean, prices were already going up even before this.

Beckworth: Right, right.

McDaniel: But yeah.

Beckworth: On top of that. Well, it's worth noting along those lines that President Biden had an op-ed out today in the Wall Street Journal on how to deal with inflation, and he correctly pointed out that the Fed is the primary agency responsible with dealing with it. And he went through some other suggestions. One thing he did not mention, though, explicitly is dropping the tariffs the US has in place left over from the Trump administration. Something simple as that that could at least temporarily ease the inflationary pressures. And yes, there's pressures caused by too much demand from fiscal and monetary policy over the past couple years, but there's also all this inflation from the supply side. So, we discussed the wheat, the supply shortages. So, there are things that can be done. You mentioned policy choices can be made that can alleviate these price pressures and that seems to me to be an obvious one.

McDaniel: Absolutely. And it's never just one thing. Right? I mean, even going back to the 2008 food crisis, it wasn't just one thing; it was a number of things. Same thing about inflation. It's not just one thing; it's a number of things. Cutting the tariffs, I think there's a couple studies out, one out of the Peterson Institute that shows that it could cut off about one or one and half percentage points of price inflation. And then people will point to that and they'll say, "Oh, well, look, it's not going to really do much," but they're looking at it all wrong. That's not the point. There's not just one thing that anybody can do to bring prices back down. It's got to be a number of things. Right? Think of it as like a bandaid. You're going to need a lot of different bandaids to try to stop the hemorrhage.

McDaniel: So, cutting the tariffs, that could take maybe one or one and a half percentage points off, but guess what? If you stop the tariffs, cut those tariffs, that is also, though, going to help you get a bigger bang for your buck on the other things that you could also do. Right? So, by cutting the tariffs, you're going to give more fire power to the Fed in reducing rates. You're going to give all the other policies that we're trying on the fiscal and monetary side… will have more fire power without those high import taxes. And then there's also a discussion going on, well, if we are to cut some tariffs, what would it be better to do it on the final consumption goods or better to do it on the intermediate inputs? And economists would say, "Well, that's a no-brainer. You should do it on the intermediate inputs because of the effective rate of protection." Right? So, we know that the effective rate of protection is much higher when the tariff is on an imported intermediate product than it is when it's on just a final consumption product.

Beckworth: Is anyone in the Biden administration discussing this as a possibility?

McDaniel: Well, I would hope so. I mean, we've seen Secretary of Commerce Raimondo discuss the importance of a few sensitive sectors like advanced batteries and other areas, and to the extent those policy efforts are serious, then you would have to consider the importance of the ability to access intermediate inputs for those products, the importance for US manufacturers to have access to globally competitively priced inputs.

Beckworth: Okay. Well, let's circle back to the sanction discussion, and I guess a big overarching question I have is what does this experience and our use of sanctions on Russia tell us about globalization and our interdependence? Does it shed any light on any theories? So, let me start with one that is a silly theory, or maybe a fun one, I'll throw out there, then you can get more serious since you're the trade scholar here.

There's not just one thing that anybody can do to bring prices back down. It's got to be a number of things. Right? Think of it as like a bandaid. You're going to need a lot of different bandaids to try to stop the hemorrhage.

McDaniel: Oh, no.

Beckworth: So, one that we talked about a lot in the past is this McDonald's theory of peace, that any country that has a McDonald's in it, they've reached a level of economic development where they're going to be interconnected with other parts of the world, and it's not in their interest to go to war. Well, lo and behold, Russia had McDonald's and started a full scale war with Ukraine. Now, to the credit of the author... I think Thomas Friedman was the person who started this idea. To his credit, and I'm not sure this really saves the theory, but I believe they've taken down the McDonald's in Russia. So, you could say there's no longer McDonald's in Russia. But with that said, that kind of story, that free trade promotes peace, creates interdependency, so it's not in your interest to go to war. Has that argument lost some of its effectiveness because of what we've seen, or do you think it's still a valid point?

Does Free Trade Still Foster Peace and Interdependency?

McDaniel: Well again, this is all about the timing that you look at this. Right? I mean, life is a repeated game. So, right now, all eyes are in Russia, but think of all the other countries around the world that McDonald's is in. Right? Yeah. I mean, look, I mean, as an economist, as just a person, I mean, this is all very sad and horrible and really sad for the Russian people because they're the ones that not only have been robbed by the regime there, but now they're going to be suffering even more economic harm from the consequences of this. This could be a whole other podcast, David. We shouldn't give up on the peace and prosperity notion. Right? I mean, it largely has worked pretty well since World War II, but probably not for the reasons that we think it has. Okay?

McDaniel: If you go back and read the transcripts of Bretton Woods, it's funny, a lot of people think, "Oh, trade and globalization and peace, those were always the goals of our forefathers.” Go back to the transcripts of Bretton Woods, and it really wasn't that. They had two common goals. One, rebuild from the war. Number two, make it way too costly to ever have to go through that again, okay? Now, from that discussion came this whole idea of global interdependence, right? Well, we do more business with each other across borders, and there's going to be more pressure on our governments to go to war with each other because our citizens are ... they've got a lot of skin in the game, right?

McDaniel: The peace and prosperity, doing business with each other for peace and prosperity, that comes out of the Bretton Woods discussions of wanting to rebuild from the war and never have to go war like that again, so you've got to keep that in perspective. Look, this has largely worked for decades and decades, but once in a while things like this happen, and countries have to do some soul-searching and figure out what's more important, to get $4 or $2 or $3 for a gallon of gas, or make a stand for other principles. This is largely up to the public of the U.S. and other Western nations, and it will be really interesting to see how this plays out.

Beckworth: You could make the argument that Russia has been really surprised at how coordinated and unified the efforts have been against them, and that they themselves rely on this interdependency to function. In some ways it's teaching them a lesson. It is very costly to go to war, because it's going to affect your trading partners' relationship with you.

McDaniel: Yes. In fact, remember the Magnitsky Act ... which, I don't know, some of your listeners might know about ... but this was a piece of legislation that allows the U.S. government to freeze assets of a foreign person that is committing horrible acts. That was ... well, of course ... named after Sergei Magnitsky, who was Bill Browder's lawyer and tax advisor, who was killed in a Russian prison for uncovering how Putin's regime was stealing hundreds of millions of dollars from the Hermitage Capital Fund, and even across the broader Russian public. Putin's reaction to the Magnitsky Act I think is really interesting, because the Magnitsky Act itself basically threatens Putin's ability to amass wealth and use that for power. Countries are more and more willing to freeze assets, but it doesn't happen lightly.

McDaniel: This just shows you how effective Putin has been at spreading his wealth around the globe. We're seeing this in Hungary, for instance, a member of the EU. They're pretty close with the Putin regime, and a number of Russian companies put a lot of money into Hungary's economy and even political system, and arguably have had an influence in Hungary's elections. This is happening in Europe's backyard, right? Maybe this is a big wake-up call to countries on the importance of peace and prosperity and interdependence, but also the importance of sovereignty and democracy, and maybe a call for more transparency in our governance and legal institutions.

Beckworth: Well, don't you think the concerted effort by the allied countries, 40 of them, and even the non-allied countries, they've been very measured in how they engage with Russia, but the fact that it was so organized, so unified. They too realize what's at stake. They don't want to get on the wrong side of this issue, the wrong side of the sanctions. It may be that that too speaks to this peace and trading argument, that it's important to avoid conflict if you want to maintain these trading relationships. Many countries joined. Again, as we mentioned, President Putin was surprised by this, but maybe he shouldn't have been. Maybe if he had taken seriously this interdependency argument, he could have expected this to happen.

McDaniel: Yeah. Look, I mean, I don't think this really is any shock to U.S. policymakers in terms of the economic repercussions that we're feeling. If anything, I think, yeah, you're right. The cohesion, the unified front that the West is showing, that does seem to have taken Putin by surprise, but in a way it's like you can only poke the bear for so long. I mean, the past three administrations have really looked the other way, and tried to look the other way. Remember President Bush, how he talked about how he looked Putin in the eye and he saw his soul, and President Obama said how we need to reset relations. President Trump said Putin is a good guy, and then here we are now.

Maybe this is a big wake-up call to countries on the importance of peace and prosperity and interdependence, but also the importance of sovereignty and democracy, and maybe a call for more transparency in our governance and legal institutions.

McDaniel: All of those administrations looked the other way when Putin did terrible stuff. I mean, he invaded Georgia, took Crimea, bombed civilians in Syria, poisoned people in the UK with these nerve agents. No consequence, no consequence, no consequence, but with Ukraine, it just feels like that was just too far even for Germany, right? Even for countries that are heavily reliant on Russia for their economic survival with energy. It does seem like Putin overplayed his hand. We'll see. There's some people that speculate ... well, backwards ... if the West had done these sanctions before February 24th, even sanctioned a handful of oligarchs or sanctioned some of these other assets, that maybe Putin would've thought twice, but they didn't, and now Putin is really in it.

McDaniel: What's going to happen now? If we do nothing and just try to make peace with the current situation, what's next? Estonia, Poland? It does not seem like the West is willing to live with that, but it also doesn't seem like ... I mean, obviously nobody wants to escalate this too much immediately, but on the third hand, the West does seem to be willing to play the long game here, finally, and to eventually bleed out Putin's large holdings, and over time. It's not going to happen overnight, but look. I mean, if the EU really is serious about weaning itself off of Russian oil and maybe even gas, that over time is going to change the geopolitical makeup of the world economy. It took a lot more than a few months to get here, and it's going to take a lot more than a few months to unwind it, but it seems that the West has just structurally shifted their thinking about what they're willing and not willing to do with respect to Russia. I don't think anybody would've predicted this about a year ago.

Beckworth: For sure. Well, we are running low on time. I want to leave with one question. This is an area that is one of my hobbyhorses, and this is dollar dominance. A lot of talk about the U.S. government stepping in and imposing these financial sanctions could harm investors around the world wanting to hold dollar-denominated assets. I think what we've been saying is actually probably the opposite. It's a signal that you want to be with the bloc that's doing the right thing, and that's part of the 40 countries, the allied countries.

Beckworth: I came across an argument that I'd never seen before, and I want to run it by you. This argument actually says that what the U.S. and its partners did is actually going to reinforce and strengthen the dollar's dominance. I'd never seen this before, but it relies upon someone like your expertise, something you can evaluate, and that is it relies upon theories of trade and investors, preferences and stuff. I'm going to run it by you, and you can give me your sense of it. This is from a paper. It's called, *U.S. Sanctions Reinforce the Dollar's Dominance* by Michael Dooley, Peter Garber and David Folkerts-Landau.

Beckworth: Their argument is that, because countries hold dollar-denominated assets as safe stores of value as a reserve currency, and because the U.S. government can seize it, and vividly demonstrated this with Russia, it provides a signal to investors that this is a safe country to go in, because if the country doesn't behave, they could actually lose all those dollar reserves. They could lose all those assets. If a country like China holds lots of dollar reserves, the argument is it's a signal, a sign of good housekeeping. "You can trust us. We're willing to lay it all on the table. Come, park your funds here, because if we misbehave and Uncle Sam takes our money, that tells you we're serious."

Beckworth: I'd never seen that argument before. Their hot take, if I can call it that, is that what we've seen in Russia is only strengthening the dollar's role in the world, because now investors will demand that if I come into your country, I want to see that you're holding dollar reserves, because I know it's going to make you behave better, which in turn is going to secure my investments. I don't have to worry about trouble and having to pull it out in the future. Any thoughts on that interesting take on these recent developments?

The Role of Dollar Dominance in Geopolitics

McDaniel: Yeah. David, thank you so much for sending me that paper last week. That was really fascinating, and I guess it makes sense. I mean, macro still eludes me, I have to say. The only way I can really understand macro is just to close my eyes and just get back to the basics. If you do that, then it does make sense, because first of all, you have transparency with the dollar. With the Russian ruble, if anything, there's less and less transparency. The demand increase we're seeing for the ruble is largely an arguably artificial demand. In fact, I think The Wall Street Journal said the ruble is in a central bank-induced coma, right? The central bank's creating all this fake demand for the ruble. If you can't even trust the value of a currency, I mean, how badly do you really want to keep it?

McDaniel: Then also, you get it, you get the ruble, and you're going to be limited in what you can do with it. Why would you want a currency that you don't really ever know the real value of it, it could be volatile and you're not going to be able to use it very much, and it could be under all these sanctions because it's under the control of a government that is not very friendly with the West? Secondly, the value of any currency is so strictly tied just to the psychology of the people around the world who use it. What we've seen since February with the West coming together, this unified front, if anything, yes. I think, in my mind, that's what's really has strengthened ... and I think that's what this paper was talking about too ... that's what's really strengthened the dollar, because when the rubber hits the road, guess what? It turns out the West is going to stand behind the financial regime that has been put up since World War II. They're not ready to give up on it, by any means. If anything, they're going to use it for furthering their long-term goals. Then that all leads you to a strengthening of the U.S. dollar. When I put it in those terms, then, yeah, that really makes sense to me.

When the rubber hits the road, guess what? It turns out the West is going to stand behind the financial regime that has been put up since World War II. They're not ready to give up on it, by any means. If anything, they're going to use it for furthering their long-term goals. Then that all leads you to a strengthening of the U.S. dollar.

Beckworth: I can imagine there's some listeners out there right now saying, "Oh, yes, but what about the Chinese yuan?" I'll just give my quick response to that, is in order for that currency to become a truly global reserve currency, three things at a minimum have to happen. Number one, China would need to fully open up its capital account so capital flows rapidly across the border, but they don't want to do that because then they lose policy control. They have to empower markets to move capital quickly. That's a big leap.

Beckworth: The second leap would be, in addition to opening the capital account, they would have to run trade deficits, sustained periods of trade deficits, because that's how you get yuan-denominated assets held by foreigners overseas. If you run trade deficits, you're going to be extending liabilities to others outside your country and they hold them, just like the world holds Treasuries. Again, trade deficit policy is not something China wants. They want to run trade surpluses. Finally, the last big hurdle is, even if you get past those first two, you then have to trust China, and we see how quickly they change from one policy. They bash tech industry, now they're trying to support tech industry. They support housing, now they're trying to rein housing in. It's unpredictable, the uncertainty. The lack of a good rule of law there I think makes that last one unlikely. I think China's a long, long ways from ever becoming a major reserve currency. It's just not in their interest to make these radical changes that it would require.

McDaniel: Yeah, 100%, transparency and trust, which all gets back to rule of law, governance, institutions, and democratic institutions. That makes total sense to me.

Beckworth: Okay. With that, our time is up. Our guest today's been Christine McDaniel. Christine, thank you so much for coming on the show again.

McDaniel: Thank you so much. It's so fun to be here. Thank you.

Photo by Contributor via Getty Images

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.