Dan McDowell on *Bucking the Buck: US Financial Sanctions and the International Backlash Against the Dollar*

Financial sanctions have become a powerful foreign policy tool for the US, but fears of dependence and coercion may cause an international pivot toward de-dollarization.

Dan McDowell is an associate professor of political science at Syracuse University, and he is the author of a new book titled, *Bucking the Buck: US Financial Sanctions and the International Backlash Against the Dollar.* Dan joins Macro Musings to talk about this new book and the prospects for de-dollarization around the world. David and Dan also discuss the mechanics and effectiveness of financial sanctions, the renminbi as a rival to the dollar, Russia and Turkey as case studies, 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: Dan, welcome to the show.

Dan McDowell: Hey, thanks David. I'm glad to be on your podcast.

Beckworth: Well, Dan it's been great to interact with you on Twitter and your book was an amazing read. I really enjoyed it. I learned a lot from it, and you have a very clever title, Bucking the Buck. It's also very timely because right now we have a lot of commentary on de-dollarization and it seems to have picked up recently and we'll come back to discussing maybe why later, but this makes your book very timely. In fact, Paul Krugman had an op-ed out, I believe yesterday, and it was titled, *What's Driving Dollar Doomsaying?* He goes into discussing this uptick. In fact, for the show, Dan, I went and I looked at Google Trends, I looked up de-dollarization and, in fact, there is a pretty pronounced increase in searches for it. Your book should be selling really well about now with all these trends that are happening. Even then, I'm glad to get you on and talk about your book, but tell us about your journey into this area because your book is about not just de-dollarization but US financial sanctions. Tell us how you got into that area.

McDowell: Yeah, I was actually not someone interested in sanctions as recently as five years ago. I was in grad school during the financial crisis and as you said at the beginning, I'm a political scientist, I'm not an economist. I was studying international relations and I was interested in political economy. The financial crisis starts unfolding before our eyes and I had just bought a house. I was 25 years old. My wife and I had just bought a house and quickly realized we had negative equity in this house. She was a public school teacher. We didn't have much money to begin with and this was a pretty significant financial hit. I became pretty interested in just how United States was managing the crisis and really got locked in on the Fed and the Fed swaps. That ended up actually becoming my dissertation.

McDowell: I wrote my dissertation on, basically, the United States… the politics of the United States acting as an international lender of last resort, went back beyond the Fed swaps to the '80s and '90s use of the exchange stabilization fund at Treasury and even back to the 1960s swap lines. I was interested in money, in finance, from an IR perspective to begin with in grad school, and as I was working on that I also got interested in China's currency and RMB internationalization. As I'm studying the US swap lines, I start to notice in December 2008, China and Korea opened the first swap line with PBOC. That was interesting to me. I thought, "Well, okay, there's a need for dollar liquidity, but nobody really needs RMB. What is going on here?" One of my earlier papers with my co-author Steven Liao, who is at UC Riverside, back in 2014, was on trying to understand what countries were working with China on these swap lines and what was the motivating factor there.

McDowell: That was part of it, and then we did another paper on RMB reserves, really looking at how political affinity with China encourages countries to hold RMB as a reserve asset. That was really before, I think, the current era of conversations about de-dollarization. I had these interests, but the sanctions were not part of it. That happened back, I guess, it was around 2017, I couldn't tell you when. I read an article that was discussing then Treasury Secretary Jack Lew, a speech he gave in 2016 where he's warning against sanctions overreach. I know you've read the book, and so I talk about this in the book a bit, and I found that really fascinating. The Treasury Secretary is saying, "Hey, dollar dominance gives the United States this capacity to use sanctions as a coercive tool. And yet the more we use sanctions, the more we are encouraging our adversaries to look for alternatives to the dollar." That really intrigued me. Because of my interest in currency internationalization and the dollar and in the politics of international finance, it just hooked me. That became the motivating factor behind the book. Everything on sanctions in the book was material that I had to learn myself as I was doing the writing process. I'm relatively new to that space too. Now I feel pretty hooked and it's hard to quit my interest in the topic.

Beckworth: We can thank Secretary Jack Lew for partly inspiring this book, that speech he had.

McDowell: Absolutely, without question.

Beckworth: Great. Now the title of your book is really clever, Bucking the Buck, the first part of the title. Tell me about that. How did you come up with that title?

McDowell: That was just a moment of inspiration years ago. I was outlining the idea for the book in probably 2018 or so, early in the development. I don't know, it popped in my head, I wrote it down, and strangely enough, stuck with it. I guess sometimes inspiration is better than hard work in certain circumstances. I'm glad, in that case, that I had an idea and I was mostly worried for the last five or six years that The Economist magazine would have a headline like that on the title and scoop my planned book title and I had to come up with something else, but thankfully that never happened.

Beckworth: Good for you. You got the title. Again, it's got to be really great for marketing right now and being very catchy and very timely given the interest in de-dollarization and financial sanctions. Well, let's begin our discussion, Dan, by a story that you bring up in the book about Iran and the sanctions and then when President Trump comes to power and he changes the agreements of the Iran plan. Walk us through that story and why it's a good illustration in the issues that you cover in your book.

The Global Economic Importance of Trump’s Iran Plan

McDowell: I think it's a really important story in part because this is a moment in May 2018 where public conversations and public debate about sanctions and the dollar and de-dollarization reach, I would say, the pre-Russia-Ukraine war high watermark. There was a period where you started to see more conversations about the surrounding… what happened with the JCPOA or Iran nuclear deal because the Europeans in particular were so vocal in their opposition, and of course, JCPOA negotiated in 2015 under the Obama administration, providing sanctions relief to Iran as part of a multilateral deal that would require them to provide more information about their nuclear activities and commit to not developing a nuclear weapon. In 2018, in May, the Trump administration formally withdraws, have been saying this was a goal of theirs for a while.

McDowell: That's when it formally happens and when the United States pulls out of that deal, what it does is it immediately reinstates wide-ranging financial sanctions on Iran, right? These are measures targeting the Iranian economy, the Iranian financial system. Also, SWIFT sanctions, we'll talk about SWIFT later. Those are reinstated as well in 2018. There are secondary sanctions involved and we can talk more about that a bit later. What that basically does is it effectively forces European banks and businesses to follow US sanctions law as well. European businesses and banks that had been reentering the Iranian market after the nuclear deal was agreed to in 2015, basically now have to accept losses on all those new business relations and pull back out or suffer themselves being sanctioned by the United States. You have a number of high profile policymakers in Europe, the finance minister of France, the German foreign minister, even the European Commission president, all saying, "We need more independence from the dollar and from the US financial system. We need a more muscular Euro policy that will internationalize our own currency, so the United States can't force us to go along with its foreign policy through measures,” like we've seen reinstated on Iran. That issue, where you're seeing a wedge between Europe and the United States on the dollar, as a result of this nuclear deal, sort of surprising, but really, I think, signifies the idea that the United States, from the perspective of some foreign countries, has abused dollar dominance in certain ways and therefore the response needs to de-dollarization to improve autonomy from US coercive capabilities.

Beckworth: This speaks to the central claim of your book, if I understand it correctly, and that is the use of US financial sanctions leads to a perceived increased political risk and using the dollar by these other countries and in turn creates the desire for them to de-dollarize, and the more we use these financial sanctions, the greater this desire. Is that right?

McDowell: Exactly right. This is like the Jack Lew hypothesis, effectively. The more the United States uses financial sanctions, the more it uses the dollar as a coercive tool, it demonstrates to foreign actors, foreign governments that dependence on the dollar leaves you vulnerable to US coercion, right? Therefore, if you're worried about that, how should you respond? Any rational actor to that would try to figure out ways to reduce that dependence to try and increase autonomy, increase resilience to that sort of coercive pressure. That's effectively what the argument of the book is.

Beckworth: That's your central claim, but you have a secondary claim as well if I read it correctly, and that is that even though these countries may have a desire to de-dollarize, it's not very easy, right? It's not very certain that they're going to be able to do what they want to do.

McDowell: Yeah, it's exactly right. I try to distinguish between what I call anti-dollar policies. These are policies that governments put in place that are designed to reduce dollar dependence, but many of them fail, right? Venezuela introduced the oil-backed cryptocurrency and it did not go over well. That's an anti-dollar policy. It's an attempt, maybe a flailing attempt, at de-dollarization that doesn't work. Yes, US sanctions, the first layer of the argument is, they should increase the likelihood that governments pursue these anti dollar policies, and whether they succeed or not, that's a separate story. In some cases, as I demonstrate in the book, they have been marginally successful. None of this implies that sanctions are going to be the thing that triggers the end of the dollar or the end of dollar dominance. That's not at all the book's claim.

Beckworth: Now I'm getting ahead of myself, but I want to ask, since we're talking about it, why has there been this uptick in the use of financial sanctions by the US government? What is it about them? Is it easy, convenient? Why has the government found it such an attractive policy choice?

The Attractiveness, Effectiveness, and Mechanics of Financial Sanctions

McDowell: Yeah, it's an important question and maybe it's worth walking through for a moment, the extent to which the use of these measures have increased. One of the things I try to document in the book is how the United States goes about putting these in place and maybe we'll walk through some of the plumbing later, but typically a new sanctions program is introduced by the president through signing an executive order. If we look as far back as 2000, the year 2000, turn of the century, there were four countries that were targeted under the Treasury financial sanctions programs and there were 20 different, what I call sanctions related executive orders, that were basically providing the legal justification for those programs. By the time you get to 2020 when the analysis and the book mostly ends, there are 21 countries, roughly 200 sovereign states in the world, so, roughly 1 in 10 countries in the world under a US sanctions program linked to 90 different sanctions related executive orders.

McDowell: Then if you want to really get into the granular details, roughly 10,000 actual actors, entities, individuals, institutions, businesses that are targeted under those; so, really a dramatic growth. And the real increase starts to pick up between 2008 and 2010. Really, it's the Obama years that we start to see that rise, and so your question, what's behind that? I'll try to answer briefly here so we can keep having a conversation. Part of it is a disillusionment with the old form of sanctions. You think back to traditional economic sanctions, things like trade embargoes, right? The 1990s, the trade embargo against Iraq as viewed as a failure, right? It leads to mass malnutrition. It doesn't really hurt Saddam Hussein's regime. The collateral damage is significant and it's not really having its intended effect. Then the financial sanctions really are innovated at the Treasury again around the turn of the century, and they're a lot more precise. They're called smart sanctions. It's almost like we think of in military terms like carpet bombing versus a precision missile strike.

Beckworth: Okay.

McDowell: Right? A lot less collateral damage. You can actually hit the actors that you're trying to impose costs on without hurting innocent people, right? That's part of the switch from that traditional way into this more financial side of things. The other element here is terrorist groups. You can't use a trade embargo against Al-Qaeda, right? But you can use financial sanctions.

Beckworth: Right, okay.

McDowell: That's part of it. Then another part of the story... This might be overblown in terms of the narrative about sanctions, but another part of this is, look, the Obama White House comes in after a period of maybe the height of the neocon era, this belief that the US military can be used to reshape the world in a more democratic way towards US interests. Of course, the years of war in Iraq and Afghanistan tired the American public on the use of military force. The idea that sanctions are a non-lethal way to have this coercive power over bad actors in the world, that may be part of it. I don't think the United States would be going to war in every country where its using sanctions. That's probably overblown, but at least it lends itself to this idea of a more restrained foreign policy when it comes to the use of force. Sanctions offer you an alternative.

Beckworth: Okay, well, let's walk through the mechanics of actually imposing a financial sanction. You have chapter two titled, “The Source and Exercise of American Financial Power.” It was very interesting. I learned about primary sanctions versus secondary sanctions. Walk us through that. How does the US government actually implement it and why is it so effective?

McDowell: Yeah, it starts as I said, with an executive order where the president basically provides Treasury with a list of targets. Again, those targets could be non-state actors, could be these could be drug cartels, but in many cases these are individuals or businesses or government institutions in foreign countries that are being targeted because of foreign policy concerns. What happens is the Treasury, it takes that executive order and these entities that are included in that executive order are added to what's called the Specially Designated Nationals list. The SDN list. You can think of this as basically the Treasury's blacklist of all the entities and actors around the world that the US banks and banks that have operations in the United States are not allowed to do business with, right? This is really the critical thing. By virtue of the world economy's preference for using the dollar for cross-border transactions and for investment, that puts the US financial system really at the center of the global financial system.

McDowell: American banks, especially a core group of banks that are part of the Clearing House Interbank Payments System or CHIPS, this is less than 40, 50 banks, somewhere between 40 and 50 that are in the middle of around 95, 96% of all dollar clearing or dollar payments in the world. All of these banks have to follow US law. If US Treasury says, "All right, here's a list of actors, of businesses, individuals that you can't do business with." Then those actors are going to basically find themselves disconnected from the banks that are at the heart of the cross-border dollar payment system and they're going to be unable to pay, to service their dollar debts. They're going to be unable to receive payment for exports in US dollars. All of the things that are the financial transactions that make the world economy go, you're going to be cut out from that.

Beckworth: Now that's the primary sanctions. It reaches out to all of the banks that are in the US or foreign banks that have branched in the US and they are prohibited from engaging with anyone on this list, this SDN list. Now, it also works through, as you mentioned in your book, the Treasury's Office of Foreign Asset Control, or OFAC. Tell us about that.

McDowell: Yeah, exactly. Just to clarify, OFAC is really the group at Treasury that oversees and enforces the SDN list that we talked about a few moments ago. One important part of the story here that we didn't discuss and that I should probably mention is how enforcement works with these primary sanctions as we're discussing. This list is put together and there are all kinds of laws in place for banks in the United States. You have to know your customer. You have to know who's on either side of the... Who is the originator or the beneficiary is. That's information that, as a bank, you have to record and you have to provide that information to Treasury. If an SDN turns out to be on either side of that deal, you are obligated to freeze that transaction and report it to Treasury immediately. If you don't and it's found out later, Treasury has ways of finding these things out. Again, they get this data themselves. They're screening it on their own, but the banks are monitoring it with their own software to make sure they don't have a violation because they recognize if they do, they're going to face significant penalties. There are examples in the last five to six years where banks have been fined up to roughly $10 billion for sanctions violations and individuals that work at the bank, they can face jail time and penalties as well. The banks self-enforce, right? Because they don't want those penalties. They don't want the reputational damage. The United States periodically will punish banks that violate these as a way to send a signal that, "Hey, you better be policing yourself otherwise we'll have to do it for you."

Beckworth: That leads us to the next form of sanctions, the secondary sanctions, which was interesting to learn about it. It provides a way to get those actors that we're going after that somehow avoid the primary sanction. Tell us how that works.

McDowell: Yeah, the Iran examples are useful here because in the Iran case, secondary sanctions did apply. To be clear, secondary sanctions are used a lot less frequently than the primary sanctions. They tend to create the most blowback. They're viewed as an, "Extraterritorial means of the United States exerting control over the world economy." Basically, the way this works is, we think about Iran. If you use primary sanctions, what you're basically doing is telling banks in the US that you cannot do business with these Iranian targets. And if you do, you'll face these fines. You'll suffer these penalties. But primary sanctions do not, on their own, prohibit, let's say a bank in Europe that doesn't have any ties to the US financial system. It doesn't have a branch or operations in the US. Primary US sanctions don't prohibit a European bank like that from doing business on behalf of a company in Europe and an Iranian a partner on the other end. Okay?

McDowell: What secondary sanctions do is they really just scale up the impact of sanctions because they tell the rest of the world, especially banks operating outside of the United States, that if you, in that example I just gave, conduct business on behalf of an Iranian target with this European firm, then we will add this European bank to the blacklist, to the SDN list. Then what you do is, you force these foreign banks to make a decision between, "Okay, do we want this small little business deal between our European firm and an Iranian partner, or do we want to maintain access to the dollar system?" Almost uniformly banks are going to decide to cut ties with Iran. What it does is, it basically, again, forces the hand of foreign banks to now start enforcing US law the same way that American banks are.

Beckworth: As I read that, I found that very fascinating and my mind began to wander, probably watching too many spy movies. Is it possible for an actor that we are worried about to be several layers down? Could you have a bank that lends to a bank that lends to a bank? It would be hard for OFAC to know for sure, or does the OFAC have such a great network... You mentioned in the book that OFAC has accessed records to SWIFT, maybe you talk about that, which really improves its accuracy and ability to reach in these extraterritorial endeavors.

McDowell: Right. Yeah, in the first question, sometimes that happens, right? If we think about cross-border transactions, again, those CHIPS banks typically are the hub. Yeah, I would describe them almost like O'Hare or any major airport where all of your small airports are largely connected to a handful of major airport hubs. That's what these CHIPS banks operate as for the most part. Sometimes when you're going on a flight around the world, you might connect in multiple hubs, right? You might go through more than one airport, and that can happen with a banking transaction too. This idea of could you go several layers deep and hide the fact that an SDN is on one of those ends; I think largely no, because, again, the know your customer, KYC standards, that are in place, and a lot of this is like anti-money laundering too. It's not even sanctions.

McDowell: Banks have to know who the originator and beneficiary is on either end of that transaction, on the full start and the full end. They have to know who those actors are, right? That's part of what is required. That information is all going to be included, even if it's going through multiple layers. I think where you see the skirting happen is when targets are trying to find ways to use shell companies to hide their identity. That sort of thing, I think, does happen. I didn't really talk about it in the book, but there's always that whack-a-mole thing where you're always trying to catch up to the evasion strategies.

Beckworth: How important is SWIFT to doing all of these enforcements?

McDowell: Yeah, SWIFT is important because, again, because just to be clear on what SWIFT is, this is the industry standard for bank messaging. SWIFT doesn't actually move money. It is how banks communicate with each other. A bank will message a correspondent bank and say, "We're going to move money from X account to Y account through Swift." Then the actual funds will be transferred through those shared accounts, those correspondent accounts. That's important to recognize first. SWIFT isn't moving money, it's messaging. But it's important because, for one, SWIFT is the industry standard messaging for payments in all currencies. CHIPS, which we've talked about a couple of times already, which is the main cross-border system for moving dollars around the world, clears something like $2 trillion a day. But SWIFT is involved in something like $5 trillion a day of payments messaging.

McDowell: That tells you that a majority of SWIFT's volume is actually in non-dollar payments. They had information about payments in euros, payments in sterling, payments in yen that maybe aren't involving US banks. Having access to SWIFT data, which the United States reached an agreement after 9/11 with SWIFT and with the European Union to have access to that data, gives the United States the ability to know what potential adversaries are doing even outside of the US financial system. Again, that would give you the ability to leverage secondary sanctions if you wanted to really scale up the sanctions because you recognize that, let's say a lot of activity was happening again between Iran through European banks. Now, maybe we want to use secondary sanctions to crack down on that, having access to SWIFT data lets you monitor what's happening even outside of the United States.

Beckworth: This is all so fascinating because I often approach this subject from the perspective of dollar dominance affecting the cost of financing for the US to run budget deficits. But the flip side of that is that its reach is everywhere, and therefore the US government has a look into every spot, almost on the planet earth and can impose these financial sanctions. Well, let's move on from the mechanics of the sanctions to some actual case studies of sorts. You provide a number of countries recently that have been affected by these sanctions, North Korea, Venezuela, Syria, Iran, as you mentioned earlier, but also Russia and Turkey more recently. Russia's probably the most well-known one. It was interesting to read the history, but it actually precedes the Russia-Ukraine war. Walk us through that early history, 2014 to the present. Just give us an assessment of how it's working and what you think about it.

Evaluating the Russia Sanctions: 2014-Present

McDowell: Yeah, this is, I think, a thing that's missed in the current dialogue about the Russia sanctions and de-dollarization. As you said, Russia's history and experience with US financial sanctions predate, by about eight years, the start of the war. As I'm sure all of your listeners remember, it's 2014 when Russia illegally annexes or seizes Crimea, and that's what begins the first wave of financial sanctions targeting, at the time, some Russian government officials and some defense firms. The Obama administration imposing, again, through OFAC and Treasury, some sanctions to impose some costs on Russia for that move. And it continues. This is the important thing. In 2015 and 2016, there are cyber related sanctions through Treasury, going after some of these actors in the Russian military who are involved in cybercrimes against the United States, including battling in the 2016 election.

McDowell: Then you've got, in 2017, the Magnitsky sanctions, which is basically a law passed by Congress that gives the president authority, through executive order, to impose sanctions on individuals for human rights violations, and so you've got some Russian targets hit in 2017 with the Magnitsky sanctions. Then in 2018 – this is the critical inflection point, I think – the Trump administration imposes what were prior to these sanctions following the 2022 invasion of Ukraine... In 2018, these were the most severe suite of sanctions targeting Russia. They're hitting something like 17 government officials, seven Russian oligarchs, a dozen major Russian companies. We're starting to talk now, not about defense firms, which are more strategic, but including major exporting industries in the metals space, in other energy companies as well; so really targeting the core of the Russian economy. If we look back at that history, how does Russia respond?

McDowell: Well, in 2014, the initial response is publicly railing against the dollar, the Kremlin saying, "We're going to dump our Treasuries." They don't, but they're recognizing that the dollar is to blame here. They start to move more into gold. I know we'll talk more about that later, but that's the one move you see after 2014, almost immediately, is that the Central Bank of Russia picks up the pace of its gold purchases, but it's really in 2018, it's those April 2018 measures that move the needle the most in Russia. And within that year, Russia implements a pretty big shift in its currency composition of its foreign exchange reserves. At the start of 2018, something like 45% of Russia's FX reserves were in dollars. By the end of 2018, it's down to around 20%. Okay? Right there you see reserve diversification away from the dollar moving into RMB for the first time, and then moving more into euros.

McDowell: You also see some shifts in the use of the dollar as a payments currency, mostly here with China. At the start of 2018, around 80% of Russian exports to China were paid for in dollars. By the end of 2018, it's down to around 30%. Again, within one year, a real dramatic shift. Now they shift mostly into euros where basically China's paying more for Russian energy and other exports in euros. You start to see Putin out publicly asking trade partners to pay in euros, because he's concerned about the sanctions that are in place and also the potential for future sanctions. Even with India and the European Union, we see some moves towards de-dollarization around that time. Russia has a long history with US sanctions, and you could argue... I would argue, actually, that they were anticipating the measures that were imposed on them following the invasion of Ukraine, in part because of their experience over the last eight or nine years.

Beckworth: Russia is a great data point that confirms your theory or your central point of the book, that increased use of financial sanctions, even the expectation of that increased use, leads the country to diversify its reserves away from the dollar. Now, a couple of questions about the case of Russia. It's really fascinating. It's a rich history in terms of the stories you tell in the book. It seems to me, and I may be wrong here, so correct me, but it seems to me that these financial sanctions, when they go after people and entities, they always go after maybe some important people in the inner circle, but they don't go after the top dog. They don't go after Putin, I believe, until past year or so, right? Is that typical to go after people close to the top ruler, just to make them uncomfortable? What's the idea behind that approach?

McDowell: Yeah, it is typical. It's pretty rare. You're exactly right that it wasn't until after the invasion, and even then it took a while. I think, to be honest, it was mostly a PR move because what you had is, after the invasion, you had some people publicly saying, "Well, we haven't even sanctioned Putin himself yet." Right?

Beckworth: Yeah.

McDowell: I think, realistically, Treasury realized and the Biden administration realized that sanctioning Putin directly wasn't going to do anything. It's not like Putin has billions of US dollars in American banks. He recognizes his own vulnerability. It's not the source of his wealth. I think that move was really more to placate the domestic audience that wanted, symbolically, to see that. Again, this gets to the heart of the popularity of financial sanctions. The thinking is, basically, you want to target actors that have voice within the political system that if you impose pain on them, if you're hitting them at their pressure points, if you're seizing oligarchs’ yachts, and if we think these oligarchs have influence over Putin, they're going to wince and scream a little and they're going to go to Putin and they're going to say, "Look, change your policies because this is really hurting us." I think the question there, of course, especially with Russia, is whether or not those actors really have any influence. I'm not an expert on Russian politics. I've got colleagues who are, in my senses from their conversations, is that the Russian oligarchs don't have a lot of influence in Russia, and so imposing costs on them probably isn't going to really change things. But you're right, the idea is hitting people with close ties to the decision makers, that those folks are going to whine, complain, and perhaps sway the decision makers to move back in a direction more consistent with US interests.

Beckworth: Alright, my second question about the case of Russia is when we went after Russia after the invasion of Ukraine, it was a coordinated effort, right? It was the Europeans, it was the US. Did this coordinated effort actually restore some of the strained relationship from Iran? Did you see them actually be happy that the dollar was dominant? Before, they were complaining about it because Trump went on his own and went solo, but now the US is working with the countries and a lot of the Russian reserves were in euros so we needed their participation as well. This team effort, did it improve relationships? Did it change their outlook on dollar dominance at all?

McDowell: Yeah, I do think it at least for the time being, has changed the tenor of the conversation around that more muscular euro. You're absolutely right, 2018, you have the Europeans who, A, don't really like Trump and his style, period, right? And then they vehemently disagreed with the Iran decision. Then you add to that the economic costs, and that leads to this harsh rhetoric against the dollar. But then the Biden administration, I think, really went to great lengths to... You could criticize the multilateral sanctions in part because the accommodation of Europe's own strategic vulnerabilities on energy weakened the impact of those sanctions. I think the view there, this is just my hunch from the Biden administration, is as you said, A, you need buy-in from the Europeans. I think Putin did misjudge whether or not the Europeans would join in with the United States on a multilateral package of sanctions like they did.

McDowell: Otherwise, why would he have moved more into euros for payments and in reserves if he didn't think that that was a more secure place to be? I think the Biden administration recognizes that you’ve got to accommodate their interests and their vulnerabilities. Really, this is about restoring trust and confidence in the Trans-Atlantic Partnership. I think to the extent that Europe feels like it's a partner in the flexing of dollar dominance for strategic purposes, there's going to be less interest in pursuing that independent muscular euro. Whether or not that would ever have happened anyway, that's another conversation, but at least I think it does tamp down that rhetoric.

Beckworth: One last thing on Russia, so the amount of reserves that Russia had built up prior to the sanctions being imposed after the Russia-Ukraine war starts, it was over 600 billion, right? It was a big treasure chest of reserves, and most of that effectively was taken away from Russia. Most of it Russia had little control over. Is that right?

McDowell: That's exactly right. Again, because of the multilateral nature, you basically freeze the... The euro and dollar assets are the biggest part of that. Again, the dollar assets, they weren't drained down to zero. There are some reports that I've read about cash dollars at CBR, so they might still have some dollars sitting in-

Beckworth: Physical cash.

McDowell: Physical cash. I think that was part of sanctions prepping. Their RMB reserves, which I'm going to say at the start of the war were maybe around 16, 17%, those are obviously still liquid, and they're gold reserves, 130, 140 billion depending on the price of gold at the start of the war where it was in physical gold, much of that held on Russian soil. That's really what's left. The broader conversations after those sanctions was, it's flows more than stocks on that matter, and you still had hard currency flowing into the Russian economy through energy exports for a while, but at least in terms of the reserve assets, the majority were basically frozen.

Beckworth: You speak to an interesting phenomenon you document in your book, and that is the geography of these assets being moved into safer places. In the case of Russia, they literally brought gold into Russia. They brought physical US dollars into Russia, and you have an entire chapter on the gold phenomenon, I think chapter four titled, “The Anti-Dollar Gold Rush, Central Bank Reserves and the Age of Financial Sanctions.” It was really fascinating to see how these central banks have been building up their gold reserves and you know that some of it might be purely economically driven to diversify your portfolio, maybe you're a little more nervous about the dollar, but a good portion of it is also driven by this concern about financial sanctions, right?

McDowell: That's right. Yeah, I try to acknowledge the economic motives. And as you said, you start to see... If we take the long view, really from the 1990s until 2010, gold is losing, sort of out of fashion as a central bank reserve asset. Central banks are net sellers through that entire period. In fact, in 1999, central banks have to reach a multilateral agreement to limit how much gold they can each sell because it's effectively tanking the price of the commodity. That shifts after the financial crisis. I think the initial resurgent appeal of gold following 2008, there's a clear economic story there. It’s, okay, what's considered a safe asset? I know this is an area of yours, right? Okay, well, triple A mortgage-backed securities that we once thought were safe are not safe, and there are questions about rising government debts, and, again, the expansionary monetary policy, what's that going to going to do to the value of the dollar or euros? Gold becomes attractive as a hedge. There's no default risk with gold. It doesn't bear any interest, but there's no default risk. It also moves inversely with the value of the dollar. If you're built up heavily in dollars, and we know between 2010 and 2011 the dollar was not performing well relative to other currencies, reaching its weakest point in trade-weighted terms back in 2011.

McDowell: Gold is a way to offset those potential losses. That's not the whole story, I don't think, at all. I think the political story is important. Because gold, especially physical gold held in your own vaults, it can't be frozen. Those Treasury bonds held in custody in the United States, it doesn't matter if they're more liquid, far more useful as a reserve asset than physical gold is, because if you're Russia, you found out pretty quickly that the liquidity of US Treasury bonds can completely be turned on its head by the US government. On the other hand, physical gold, especially held in your own vaults, is not highly liquid. You have to go to great lengths to turn that into cash or something else. But it's, short of a military invasion, it’s safe from confiscation. I think that's the appeal. It's a trade-off between liquidity and security. But if you're really on the wrong end of US sanctions, you might be willing to put a little higher of a proportion of your reserves in a secure, less liquid asset like gold.

Beckworth: This reminds me also of Afghanistan when the Taliban took over. Afghanistan had a huge stash of reserves at the New York Fed, and they instantly lost it once the Taliban took over. Okay, let's move on to another country, Turkey. Really fascinating for me at least because it's a member of NATO and a member of NATO is responding to financial sanctions imposed on it by the US. Walk us through that story.

The Story of Financial Sanctions on Turkey

McDowell: Yeah, similar to the Russia story, the main difference here is the sanctions targeting Turkey are a lot smaller in scope. In the US Congress in 2017 actually... Congress can take action to impose sanctions as well. In 2017, there's a bipartisan group of senators that are basically threatening Turkey with sanctions because Turkey is looking to purchase military equipment from Russia, which is a violation of their NATO pact. Then in 2018, Erdoğan unlawfully detains an American pastor, Andrew Brunson. Under the Magnitsky Act, the human rights law that I talked about earlier, the Trump administration sanctions a couple of government officials in Turkey. Between 2017, those threats of sanctions in 2018, what do we see in Turkey? We see a similar playbook to what we described in Russia. We see Turkey start to invest more heavily in gold. Between 2017 and 2020, Turkey buys something along the lines of 300 metric tons of gold, which is a lot, especially for an economy the size of Turkey.

McDowell: And it had been flat prior to 2017 for years. You see this interest in gold popping up, bubbling up around the time that these political concerns with the United States are rising. Then if you look at Treasury data on Turkish holdings of US Treasury bonds, the TIC data that Treasury publishes, you basically see the dollar holding falling off a cliff around the period of time that the sanctions are happening. Turkey's a little less public, Erdoğan a little less forthcoming about the motives. He does rail against the dollar. He talks about gold as not having a political allegiance. You see similar steps to try to de-dollarize payments, signing currency swap agreements between the Turkish Central Bank and foreign central banks. Turkey doesn't have a lot of success on the payment side, much more just with the reserve allocation, but I think it's a secondary example of a country that's recognizing, "Hey, the United States is willing to use financial sanctions against us, use the dollar as a weapon against us. Maybe we need to get ahead of this thing."

Beckworth: Now you cover a few other countries in your book, Libya, Venezuela, North Korea, and I will let listeners check it out. For the second of time, we're going to move on though and get to some other areas that I want to cover with you. I want to move on to the part of your book where you discussed rivals to the dollar. We've had this use of financial sanctions. In the case of Russia in particular, they lost over $600 billion, not just dollars, but euros as well. They may be looking elsewhere. They might be looking to China as another partner in terms of keeping their financial assets in a safe but flexible place. There's this talk about moving to a rival. We've also touched on earlier how there's been a lot of discussion about this in the news. I mentioned the Paul Krugman article. You and I are both are on Twitter, it seems like every other day there's a tweet, someone just hyperbolically saying, "Hey, the dollars days are doomed."

Beckworth: Even the Financial Times has stories. I'm looking at a Financial Times story from early April and the title was, *Renminbi's Share of Trade Finance Doubles Since the Start of the Ukraine War.* That's pretty alarming and if you go down and you look at this chart, you see that it's gone up. In fact, it's gone up above, I believe, the euro share. But then compared to the US, it's a drop in the bucket. The magnitudes are so vastly different. It's easy to lose sight of that. There's just a lot of that going on, and if you could, because on Twitter, you've been great about this, a lot of these articles talk about how the renminbi is… it's share of international trade is going up and up and up, and you have stressed a lot of that has to do with Hong Kong. Walk us through that. What's actually happening and what does the Hong Kong angle have to do with it?

The Renminbi as a Rival to the Dollar

McDowell: Yeah, this was, I think, a Bloomberg story, at least that's where I saw it just a week or so ago, that was reporting on the first time ever that China's currency, the renminbi, had overtaken the dollar in China's cross-border transactions. Now, that's all encompassing, right? That includes trade settlement, but it also includes financial transactions, so investment, and the numbers were something like, the RMB was at 48% of cross-border transactions, whereas the dollar had hit 47%, so more or less at parity. But they point out that the dollar had an 83% share in 2010. That would suggest a really big sea change, this idea that China is conducting more of its cross-border economic activity in its own currency. Yes, it is rising, but that number, 48%, is significantly inflated because if you read the article… and the statistics they're using includes transactions between the mainland in Hong Kong. Okay?

McDowell: China has been doing more for the last decade to try to integrate markets in Shanghai with Hong Kong. There's something called the Shanghai-Hong Kong Stock Connect Program, and what that allows is traders in Shanghai and Hong Kong to basically trade shares in either market and use local clearing systems for that. Those numbers are showing up, are included in that top line number that Bloomberg reports. And to look at SWIFT data, SWIFT publishes some breakdown on their website about the RMB use. If you look at the share of Hong Kong in the RMB's cross-border role with China, it's something like 73%. This is current, this is just from March 2023. 73% of all RMB's use in China's cross-border payments is with Hong Kong. Take that out and that 48% number is going to look a lot smaller and the dollars number is going to look a lot larger. Some of this is just creative accounting in terms of what we're including.

Beckworth: Well, it sells a good story. That's for sure.

McDowell: It does. You're right. It gets clicks.

Beckworth: It gets clicks. What you're saying is, it sounds like there's a lot of double counting going on, that you're counting stuff that should be netted out if you view Hong Kong and China as one country, and instead we're double counting these flows. That's very useful information. Well, let's move to China as a potential rival. Maybe we can go to Europe after that. There's a lot of talk about the internationalization of the Chinese currency, the yuan or the renminbi. China has put forth efforts. You mentioned in your book, they're trying to make their own payment system. How are they doing?

McDowell: They have a long way to go.

Beckworth: Okay.

McDowell: A long, long way to go. I'm not sure they're ever going to get there, at least in terms of a real rival to the dollar. To zoom out a little more, the most important thing, I think, we need to inject in this conversation is, I think, stories and debates about this seem like they tend to either involve... On one end people saying, "The RMB is coming for the dollar, and we're only a decade away from China controlling the global currency system," which is obviously wrong. Then the other side is, "There's nothing to see here. We shouldn't really be paying attention to this because dollar dominance is so entrenched." I'm more on that side of things. But I think there can be a middle way where we say, "We should be paying attention to China's efforts to internationalize the RMB."

McDowell: It can be meaningful and important for the effectiveness of American financial power in the future, which might be called upon at some future point in US-China relations. I think that middle way is to say that really what is motivating China at this moment is not a desire to topple the dollar. I don't think there's a real strong movement within China's senior leadership to provide global safe assets to the world economy to rival US Treasury bonds to radically open up the capital account in China, or even to promote the RMB as a payments currency between third countries necessarily. I think the interest in China here is almost entirely defensive, okay? You've seen what the United States has done against Russia, against Iran, against other adversaries. You recognize that China's relations with the United States are not on a promising trajectory. On just about every front, it's getting worse.

McDowell: You're not crazy if you are in China's senior leadership to think that you may one day be a target of financial sanctions similar to what these other countries have faced. Therefore, you should be trying to get ahead of that curve. You should be trying to insulate yourself. What that means is, promoting RMB internationalization primarily with your own major trading partners, with your critical trading relationships. The story about China working with the Gulf countries, I think it's mostly defensive. China's not trying to promote a global petroyuan, but would it like to have at least some systems in place with Gulf countries where they're pricing some oil and accepting payment for some oil in RMB? I think they would, because if, in fact, they come to face a day where the United States imposes wide sweeping sanctions against Chinese banks, they want to have an alternative, right? It's really about Chinese resilience in autonomy. That's the motivating factor here. We should be looking at it through that lens, right? It matters if we think the diminishment of US coercive financial capabilities might be a problem in the future. It doesn't matter for the dollar’s dominance, right? That's silly.

Beckworth: Now, Dan, you mentioned a future scenario where the US might impose sanctions on China. I'm just wondering whether that would actually ever happen or could it happen? It's one thing to impose financial sanctions on Russia, a relatively small economy. Have you gamed out in your mind how that would actually look or how would we as Americans feel if we impose sanctions on China? Because it seems to me it would be pretty well felt back here as a consumer on the US side if something like that happened.

McDowell: One hundred percent. The economic blowback from sanctions against China, if you had a Russia style program against the Chinese economy, would be enormous. The United States is not that intertwined with the Russian economy, unlike Europe. There were far fewer costs there for the US economy. This is a great question. I think it depends on the scenario in which the sanctions are used. If we want to go to the most extreme scenario, obviously, and I don't want to get into this fanning the flames of conflict over Taiwan, which I think is also something that's so hyped these days, probably hyped well beyond the actual risk. But let's imagine that worst-case scenario where there is a Chinese effort to forcibly reunify Taiwan with the mainland. If we take President Biden at his words right now, that the United States would be engaged militarily in the defense of Taiwan; in that scenario, I don't think financial sanctions are off the table. If we're talking about the US and China actively at war with one another, the economic shock to the system already would be enormous.

Beckworth: Fair point.

McDowell: Right? So, what's the marginal cost of adding financial sanctions when the United States and China… are at war with each other?

Beckworth: That's a good point.

McDowell: In that extreme scenario, I think, not only are they on the table, they're probably in play, right? Now, there are many gradations of economic and strategic conflict that would develop before that. I do think the United States would be more reluctant to use them against China for small... In fact, you've seen a lot less of this. The United States used the Magnitsky sanctions against Russia for relatively small human rights violations. The United States hasn't hit China with sanctions for Xinjiang, right? And why not? Well, because the cost to the United States would be much greater. I think that's definitely a part of the consideration.

Beckworth: Well, Dan, let me run by you something that I say repeatedly on this show, and I'd like to get your thoughts on this, and you can correct me if I'm wrong here, but I'm very skeptical that China could ever fully internationalize the renminbi at the level of the dollar for the following reasons: number one, it would have to fully open its capital account. The Chinese leaders, the communist party would have to let go of control over how much money flows in and out of the country. That doesn't strike me as particularly something they want to do. Secondly, they'd have to run sustained trade deficits. If you want the world to accumulate Chinese denominated assets, you want assets overseas, you've got to run trade deficits so you're handing out these financial claims on China. That would go against their export driven growth strategy, their high saving strategy. You'd need better rule of law. As an investor, would I want to put my money in China, if the leader of China will go after tech one year, real estate the next year? There might be a lot of uncertainty there. And then finally, just the future of China, the aging and shrinking population. If anything, they might be the next Japan. There's going to be a lot of savings there as well. I look at those factors. I'm just highly skeptical China could ever play the role of a major dominant reserve currency. But maybe I'm wrong.

McDowell: I don't disagree with you on any of those points. The capital account point is maybe the most important. China has shown no real interest in fully opening its capital markets. When there's the first sign of instability in 2015, their response is draconian capital controls. Even if tomorrow China did implement some dramatic opening, it hasn't earned a reputation over the long term as a country you could trust. I don't even know if that would necessarily result in... It would result in capital inflows, I have no doubt. But I don't know if there would be confidence that there wouldn't be some regression on that opening at some point in the event of some future calamity. And then as you said, there's the political issue, rule of law. Jinping, since 2012, has just increased the centralization of power in one individual. And you gave some great examples, from our perspective, very strange regulatory crackdowns that come out of nowhere. It's not transparent. That's not the environment that creates a high level of trust in the safety and liquidity of foreign assets in a politically authoritarian, opaque system. Even with full opening, I think you'd still have clear reasons why you wouldn't have massive buy-in. I'm with you 100%.

Beckworth: One other thought that came to mind as I read your book is that you have Treasury imposing these financial sanctions. The argument of your book, central claim of your book, is that actually, on the margin, leads to de-dollarization, at least the desire for de-dollarization. How successful countries are is an open question, but it at least pushes them in that direction. I think that's a great observed fact. Russia is a great example of this, as we noted. On the other hand, you have the Federal Reserve, and this is interesting to see how these two entities work and maybe a crossroads here. On the other hand, you've got the Federal Reserve who's willing to step in and backstop the global dollar system during 2008, 2020. In my mind, what that does, is it sends a signal to the world, "We've got your back. If you hold dollars, we've got your back. We've got the back of the global dollar system." That would encourage more people to hold dollar denominated assets. On one hand you've got the Treasury and financial sanctions pushing you away. On the other hand, you got the Fed doing things to bring you back in. Who knows, maybe it's a wash at the end of the day, depending on how extensively each one is used, of course. Any thoughts?

McDowell: No, I think what you're describing there, we can go old school here. This is very Charles Kindleberger. I don't know how far you can take the metaphor of the global dollar system as a public good. Maybe you could critique that on some narrow grounds. The world benefits from a singular dominant global currency because of the benefits of network effects. Part of the responsibility, if you are the provider of that public good is when you have market breakdowns, you've got to provide liquidity, right? Charles Kindleberger would've argued a long time ago, that's the role of the dominant economy, the dominant hegemon, if you want to use that term. In the United States 2008 through 2010, during the early days of the COVID crisis, when we saw dollar funding market seize up, reopens the swap lines, actually increases the size of them. I do think the Fed's willingness to step in on a global level as an international lender of last resort further establishes confidence in the stability of that system where again, you wouldn't have that so much if there's another actor playing that role because you don't have that established history and credibility of a backstop in case of that sort of an event.

Beckworth: Yeah, and I've been someone who's been critical of the Fed's large balance sheet, but at the same time I've also been someone who recognizes what you just said. The Fed has to step in given its role, given the growth of the global dollar system. The Fed almost has its hands tied, it has to step in. When it does that, it's effectively opening up its balance sheet. It's effectively backstopping. There's a thread recently on Twitter that made the link between the Fed's operating system, which affects the size of the balance sheet, and the fact that it plays this international role. I never had put those pieces together that this is maybe the inevitable outcome that we are stuck with, even if I'd prefer a smaller Fed balance sheet. Well, along those lines, let's wrap up with another development that's happening. We are recording this here, it's May, and we have just been told by Treasury that the potential X date, the date when the US would literally default on its debt, could be as early as June. This would have a bearing on the desire for folks to hold dollars if they know that the US would default. Again, this would be a default, not driven because we can't afford it. It'd be a political choice, a decision that could have been avoided. What ramifications do you see this having on the issues we've been discussing today?

The Impact of US Debt Default on the Global Strength of the Dollar

McDowell: I think it's a useful point to bring up because it's another form, you could argue, of political risk. If we think about the potential for a political act to increase the expected costs of using the dollar for a reserve currency or for cross-border payments; in this case it wouldn't be sanctions, it would be Congress playing politics with the debt limit. That's still politics intervening to affect the appeal of the dollar as a global currency. It's a really interesting question like, "How would financial markets respond to a US default?" It's almost unimaginable, right? Because it's never happened. It's hard not to say the effects would be catastrophic. My own instinct here is just, I don't believe it's going to happen. It's almost like, "What's the point of entertaining this scenario?" I think back to... I want to say it was 2011, maybe it was 2013, it was one of the previous times that this was being kicked around as a political football.

McDowell: If I'm remembering right, S&P downgraded US government debt, just a step. But it was a really notable thing. They were actually downgrading it because of Congress threatening to not raise the debt ceiling. If you looked at, actually, what was happening in Treasury markets… nothing. Right? S&P was like, "The risk of a default is rising, therefore we're going to downgrade US Treasury debt." The actual traders were just shrugging it off, “We don't believe it's going to happen.” I guess that would probably just add to the argument that if it did happen, it probably would be catastrophic, simply because I don't think anyone believes it will happen. If it did happen, it would probably be just a nuclear bomb going off in financial markets.

Beckworth: Right. A whole set of other important issues. Bigger fish to fry if that does happen.

McDowell: Exactly.

Beckworth: This also goes back, I think, to the point I made earlier, the Federal Reserve, I believe, would step in that type of scenario. Just like it stepped in March 2020, to backstop Treasury. I believe it would do that. It's outlined some provisions. I'm not sure it would make that much difference. If it's catastrophic, the Fed may be pushing on a string, so to speak, in that kind of scenario. But the Fed would arguably be there. But, yeah, we want to avoid that. I guess I should also mention in the news we've seen recently that the president, or at least some in the White House, are talking about invoking the 14th Amendment if we come to that edge of the cliff. Hopefully, there's a lot of backup plans in play here so we can avoid this.

McDowell: What about the coin? You think they'll mint the coin?

Beckworth: I doubt it. I think its reputation has been tarnished enough. It's a political football. They'd probably avoid that. They would do something like invoke the 14th Amendment, maybe Treasury would issue some perpetual bond, some kind of other trick if you want to call it that, some other maneuvering to avoid outright default. But this has been a fascinating discussion, Daniel, and I thank you for coming on the show. Our guest today has been Dan McDowell. His book is Bucking the Buck: US Financial Sanctions and the International Backlash against the Dollar.

McDowell: Thanks David. This has been a lot of fun.

Photo by Kirill Kudryavtsev 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.