Had a nice week down in Miami (no, I wasn’t at the crypto conference). Did what I usually do, catch up on my reading, both Russian classics and topical work.
In the March 22 PoR I wrote a segment called “Rethinking The Big Picture” where I began to argue that the disconnect of Russia from the global financial system marked the signal event in the end of the globalization trend (or possibly even the start of deglobalization). Since then, there have been numerous other pundits to have addressed the idea (more thoroughly than I did). Blackrock’s Larry Fink wrote in his 2022 shareholder letter that “the Russian invasion of Ukraine has put an end to the globalization we have experienced over the last three decades.”1 Zoltan Poszar of UBS postulated on a possible Bretton Woods III framework (Money, Commodities, and Bretton Woods III) by extending the framework created by Perry Mehrling, and further expounded on his thinking in an Odd Lots podcast. The prolific Adam Tooze checked in with thoughts and expansions on Zoltan’s piece (The future of the dollar - Fin-Fi (finance fiction) and Putin's war, and Ukraine’s War Has Already Changed the World’s Economy). Adam Posen discusses what Russia's invasion of Ukraine means for the structure of the global economy in a talk titled Deglobalization Kicks Into High Gear. George Magnus had a few thoughts (China Is Facing a Big Contradiction Between its Politics and its Economics and Sinostan and the Sino-Russian axis), as did Michael Shuman at the Atlantic (The World Is Splitting in Two), Karen Petrou on Bloomberg (Financial Sanctions Call for a New Bretton Woods Framework) and Hugh Hendry (Odd Lots: Hugh Hendry On Why The World Still Can't Get Enough Dollar Assets). Foreign Policy had six perspectives on US Grand Strategy After Ukraine.
I want to summarize and integrate these for you. This may take more than one PoR. Abandon hope all ye who enter. There is a TL;DR at the bottom of the post if you don’t want to deal with my wall of text.
Where To Start
Perhaps the best place to start is with some historical perspective. Arslanalp, Eichengreen and Simpson-Bell provide a good review of the decline in the dollar share of international reserves since the turn of the century in an IMF Working Paper The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies. They document a modest recent decline in the dollar share of global reserves.
Since 2000 the share of the dollar in global reserves has fallen from 70 to 59 percent in 2021.
This decline reflects active portfolio diversification by central bank reserve managers; it is not a byproduct of changes in exchange rates and interest rates, of reserve accumulation by a small handful of central banks with large and distinctive balance sheets, or of changes in coverage of surveys of reserve composition.
[T]he shift out of dollars has been in two directions: a quarter into the Chinese renminbi, and three quarters into the currencies of smaller countries that have played a more limited role as reserve currencies. A characterization of the evolution of the international reserve system in the last 20 years is thus as ongoing movement away from the dollar, a recent if still modest rise in the role of the renminbi, and changes in market liquidity, relative returns and reserve management enhancing the attractions of nontraditional reserve currencies.
How Sovereign Nations Choose to Regulate Their External Affairs
Hugh Hendry takes the broadest framing of the issue on his Odd Lots podcast. Tracy Alloway provokes a discussion by asking:
You know, lots of people are talking about this as a turning point in world history and possibly in the economic order as Joe and I were discussing in the intro. What do you see?2
Excerpting and paraphrasing his answer:
I think we’re within the proximity of change. … There have been three previous changes, and as you say, I think we're close to a fourth. The changes and what I'm talking about are really how sovereign nations choose to regulate their external affairs, their commerce with each other, you know.
[U]p until the late 1920s, the affairs of major sovereigns were regulated by the transfer of gold and then gold acted as high power money. And it allowed for, it facilitated the private banking sector to create money or to take money away. …The frailties were exposed, its lack of kind of flexibility and response function to the bankruptcy of the U.S. banking system in the 1930s meant that it ceased to exist … it had created, a depression and therefore it was rejected by the many. It was then, and it takes a long time to replace the system.
[T]he system was ultimately replaced about 15 years later with Bretton Woods, which was essentially a kinda ledger reconciliation of the second world war. But of course it still had gold in its lexis. And it used the dollar as a kind of, as the the mechanism around gold.
And then unheralded and unnoticed by the many, around the mid 1960s, the Bretton Woods system came to pass and it came to be replaced by the eurodollar system. You know, around about 1965, British banks began to allow customers to borrow in dollars. When you get a loan from a bank, a bank is creating money. [B]anks outside the regulation and the domain of the Federal Reserve of America began to create U.S. dollars. … [W]hen we had the petrol crisis, the petrocurrency crisis, … that created a huge amount of deposits, which were put on the accounts of these overseas banks and deposits are a liability. And those banks needed an asset, which is a loan. And so they really took off in terms of dollar printing, making loans in U.S. dollars. … That is what the eurodollar system is. It's a dollar-based collateral. … [T]hat system has prevailed and it reached its apex in the years 2004 to 2006/2007, but it was mortally winded with the housing crash in the United States in 2008. I won’t say it died. And we've been operating ever since without a proper and certainly a well understood means of regulating the affairs of sovereigns.
Similarly, Karen Petrou summarizes the history as:
In 1919, the U.S. was forced to abandon much of the global decision-making consensus it sought as other powers balked. In 1945, the catastrophe partly caused by 1919’s reparations against Germany led the Allies, then including the Soviet Union, to craft a consensus-based, global financial order resting on a neutral reserve asset — gold — that all believed would ensure the balance of power stayed balanced. After 1971, the U.S. abandoned the gold standard and gained increasing clout as the dollar replaced gold as the world’s go-to reserve currency. The result was a long-lasting, if often uneasy, financial order empowering the increasingly globalized, financialized system that has come to advantage the U.S. at the growing cost of wealth inequality.
Some Theory
Now too this background we add Covid supply chain disruptions, the ongoing frictions with China and the recent sanctions against Russia that effectively are removing them from the dollar-centric financial system. This raises all sorts of questions about the future: will Russia and China align to form a block? Will there be the development of an alternative financial system? Wither trade and globalization? All of these questions are interconnected and path dependent.
Into this maelstrom weighs Zoltan Poszar of Credit Suisse with a somewhat provocative take Money, Commodities, and Bretton Woods III. Poszar succinctly summarizes the current financial regime as follows:
[B]anks create eurodollars and OPEC and China buy U.S. Treasuries with eurodollars.”
He continues to parse and articulate some of the challenges with the 3rd stage Eurodollar system articulated by Hendry:
The current environment is perhaps more complex than the crises of 1997, 2008, or 2020, for the problem is not only nominal (FX pegs, par, or the great overdraft, respectively), but also real: commodities are real resources (food, energy, metals), and resource inequality cannot be addressed by QE… …you can print money, but not oil to heat or wheat to eat. … Wars also upend the dominance of currencies and serve as a doula to the birth of new monetary systems.
What Deutsche Bank’s Bretton Woods II framework was to the first decade of the new century, and what QE and Basel III then were to the second (post-GFC) decade of the new century, we believe that our Bretton Woods III framework will be to the third decade of the new century…
A subtextual argument is that this Eurodollar denominated Breton Woods II framework blew up in 2008. There had been earlier stresses, such as the 1997 Asian debt crisis, but that was solved by increased foreign central bank accumulation of US Treasuries because:
we guarantee price stability, it's okay to accumulate your dollar reserves in Treasury securities3.
However, following the global financial crisis of 2008:
[A]ccumulation of U.S. Treasury securities stopped in certain parts of the world. And then the big central banks, like the Fed and the ECB started to buy the debt of their own governments
Zoltan proposes to expand upon Perry Mehrling’s noted “four prices of money” framework that is the backbone of most money and banking courses by introducing the equivalents in the “real domain of commodities.” He draws connections between the “real” world of commodity production and shipping to their financial equivalents in the Mehrling framework. I will not go into describing the Mehrling framework or the Poszar proposed extension, but highly recommend you read the piece and draw your own conclusions.4
Poszar argues, moderately persuasively to me, that (bolding is mine):
Central banks have it easy when it comes to policing the prices of money in the nominal domain, but not when it comes to policing prices in the real domain of commodities, especially when pressures come not from demand, but supply, or rather, a supply shock caused by a collapse in demand for specific commodities, like Russian commodities (the market self -policing for fear of future sanctions). Central banks are good at curbing demand, not at conjuring supply.
He extends this think to assert that the future will have more supply-side shocks than in the past, and that to mitigate these sovereigns will need to expand their store of commodity reserves. I’m not sure that this is as startling a revelation as it is being perceived; the US already has a Strategic Petroleum Reserve, a Strategic National Stockpile (originally called the National Pharmaceutical Stockpile), the Bill Emerson Humanitarian Trust (a strategic grain reserve), the Northeast Home Heating Oil Reserve, the Northeast Gasoline Supply Reserve, the National Helium Reserve, and the Defense National Stockpile Center.5
Linking to the Fink comments and the talk of deglobalization, he writes:
Central banks and banks always cooperate. Money has no enemies.
Sovereign states sometimes cooperate and sometimes they do not.
Sovereign states have no enemies during globalization…
…but turn into enemies during periods of de-globalization.
If Larry Fink is right about globalization, some sovereign states are now enemies.
Perhaps the most useful part of Zoltan’s framework is the triangles imbedded in the appendix. In the current Eurodollar-centric regime:
But faced with geopolitical tension we risk a world that looks more like the following:
Let’s Turn To The Criticism & Reactions
Adam Tooze challenges Zoltan’s and others belief in Chartbook 107 that we are about to enter a new financial and economic regime. He frames the debate as follows:
At the current moment, two lines of questions dominate these narratives.
One is the question of supply chains, which poses profound questions about the relationship between the monetary and the real economy.
The other is geopolitics and the power of the dollar.
He accepts Poszar’s framework:
The conceptual framework is clear. The sanctions imposed within the expanded euro-dollar system (dollar - eurodollar - euro) system clearly do create an incentive to form alternative systems of exchange - based around the ruble and the renminbi, with India and Saudi Arabia as possible partners.
But then goes on to ask:
Do we really expect a parallelism to emerge of the type that Pozsar suggests with this diagram?
And answers:
My bet is that the current system has huge inertia and is tied down by gigantic network economies.
And concludes:
Trade and finance are intimately associated and a disruption in one may be mirrored in a shock to the other. We are living through that reality right now.
There is a huge asymmetry in the world right now between the financial system that remains spectacularly euro-dollar centered and the new multipolarity of power, trade and economic activity.
[T]here is a positive desire to see the asymmetry overcome. There is a relish in the discomfiture of the West. The euro-dollar lock feels like the final frontier of Western power, long overdue for overthrow.
Summarizing So Far (TL;DR)
Since 2000 the share of the dollar in global reserves has fallen from 70 to 59 percent in 2021.
[T]he shift out of dollars has been in two directions: a quarter into the Chinese renminbi, and three quarters into the currencies of smaller countries that have played a more limited role as reserve currencies.
[L]ots of people are talking about this as a turning point in world history and possibly in the economic order.
The current regime is Eurodollar centric and is based on recycling: banks create eurodollars and OPEC and China buy U.S. Treasuries with eurodollars.
There is an asymmetry between the financial system that remains spectacularly euro-dollar centered and the new multipolarity of power, trade and economic activity.
Covid supply chain disruptions, the ongoing frictions with China and the recent sanctions against Russia are causing policymakers and pundits to question the existing regime to address the asymmetry.
This is ultimately a geopolitical issue.
More to come in Part 2.
Interestingly, the letter never mentions China.
Adam Tooze summarizes Mehrling fairly succinctly as follows:
For Mehrling, money can be thought of as being situated in four different relationships, each calibrated by a price.
Par price refers to the price that you pay to exchange different types of money into each other - regular bank deposits for reserve deposits at the central bank, for instance. Claims that in good times are “as good as money”, will, in a crisis be exchangeable into central bank money only at a signifiant discount to par.
The interest rate is the price you pay to exchange money today for money at some other point in the future.
Foreign exchange is the price you pay to swap one currency into another.
The price level is the rate at which money exchanges for actual commodities.
My personal favorite, the National Raisin Reserve, was found to be unconstitutional in 2015.