Economic Statecraft of International Banking Institutions

10th August 2016

-Tuneer Mukherjee

The global financial system that we have today is the result of the combination of international monetary cooperation, diverse economic ideologies and increasing financial innovation. The system is like an organism that has kept evolving over the years, repeatedly learnt from its mistakes and taken its current form through a process of natural selection. The political consequence of the 2007 crisis was the holdup that the United States (US) economy expected on the back of bailing out major banks, corporations and insurance companies. The well-designed US economic hegemony was beginning to be doubted and this had an effect on the standing of the US Dollar (USD). Logic would dictate that such a crisis would instigate the world economy to move away from the USD and look at alternatives. Political economists have been quick to suggest alternatives to the USD. While some have suggested the Euro, other have suggested the Chinese renminbi (RMB), “some Chinese authorities have even demanded a more responsible US economic policy to protect the value of their dollar-denominated assets and have proposed measures to encourage the use of the Special Drawing Rights (SDR) issued by the International Monetary Fund (IMF) as a partial substitute to the greenback).”[1] While such comments may augur well for the long-term future when such changes may be accommodated, for now the USD remains the de facto currency. This is largely associated to identity of the American economy which, “in narrow terms has a proven track record of successful macroeconomic management, a policy regime capable of sustaining relatively low inflation and inflation variability over time.”[2]

The People’s Republic of China (PRC) however, has taken upon itself to reform the international monetary order. It is difficult to ascertain whether these moves stem out of real concern for the global economy or if they are tools of Chinese economic statecraft. Zhou Xiaochuan’s paper for the People’s Bank of China titled Reform the International Monetary System, put forth a nuanced plan for the world to move away from the USD.[3] In 2016, the PRC finally followed up on this and published its foreign reserves total in SDRs. As the report from David Marsh mentions, “The world’s second-largest economy is embarking, pragmatically but steadily, toward enshrining a multicurrency reserve system at the heart of the world’s financial order.”[4] This move from the PRC is a follow up from its earlier efforts to create a parallel economic system via the Asian Infrastructure Investment Bank (AIIB) and the New Development Bank (NDB). As the Economist magazine posited back in 2014, “China will use the new bank to expand its influence at the expense of America and Japan, Asia's established powers. China’s decision to fund a new multilateral bank rather than give more to existing ones reflects its exasperation with the glacial pace of global economic governance reform. The same motivation lies behind the New Development Bank established by the BRICS (Brazil, Russia, India, China and South Africa).”[5] The art of economic diplomacy has for long been the most useful soft-power instrument in possessions of the US. When the US has failed to accomplish its national interest via hard power or through foreign policy, it has fallen back to its economic strength to further its objectives. This practice has also been referred to as economic statecraft.[6]

The relative political stability of the United States (US) places it on the top when it is compared to other capitalist economies. On the social indicators of trust and reliability, the US for more than half a century has proven itself as the master of financial capitalization. Institutions like the U.S. Securities and Exchange Commission (SEC), the Federal Reserve and the newly established Financial Stability Oversight Council (FSOC) make the US, the spearhead of worldwide regulatory reform. This along with the manner in which the US designed the global economy in the post-war era makes American economic institutions best suited to handle the global banking industry. Additionally, the International Monetary Fund(IMF), which monitors trade flows, and the World Bank, which helps provide financing for developing nations are headquartered in Washington, effectively making United States the de facto leader of the global economy.

On the other hand, the US Dollar is the primus inter pares of the international monetary system[7]. The US dollar since the inception of the Bretton Woods System had been held in high regard due to its convertibility to gold – a solid tangible asset.  In an era of uncertainty when the socialist regime of Russia was looming large on Europe, it was the US dollar that helped bring Europe’s economy back to its feet.  The economic hegemony that the US has sustained for the past half-century has got a lot to do with the acceptance of the USD around the world as the fiat currency of global finance. The hegemony of the USD has for a long time been criticized, and political analysts have time and again written articles on the need for an alternative. The financial tenacity of the USD is second to none and even though, “a number of voices have criticized the instability of the current flexible-dollar-standard (FDS) and alerted about the negative international externalities associated to the US current account deficits”[8], they also realize that, “The greenback remains the only truly global currency, the one major pole in the monetary system. Not even the crisis of 2008-2009 seemed able to topple the dollar from its perch at the peak of the currency hierarchy.”[9]

Conversely, it can be argued that the international financial system is designed in such a manner that the USD is the operating currency by default.  Furthermore, basic international economics is based on the principles of the Mundell-Fleming model, which shows that policymakers can choose only two out of three options: free capital flows, a fixed exchange rate and monetary policy autonomy.[10] While countries like Brazil have experimented with alternate avenues, these are untenable solutions to the entire global monetary system.[11]  The centrality of the USD has given the US the enormous monetary power in delaying its macroeconomic adjustment. Based on this monetary power, the US has been able to run skyrocketing current account deficits without any disciplinary constraints, and by doing so it has been the main source of global demand.[12] While the American economy recognizes the need for macroeconomic adjustment, especially after the crisis, it is also wary of ceding political space to surplus countries like China in this economic confrontation.

The US economy understands its standpoint better than the Chinese. “The feeling in America is that China has driven itself into a ‘dollar trap’. American scholars led by Krugman have seen Zhou’s article calling for a super-sovereign reserve currency to replace the dollar as a plea that someone rescue China from the consequences of its own investment mistakes”.[13] The Americans understand that in short-term, especially after the 2007 financial crisis, there are growing calls for an alternative fiat currency. It recognizes the fact that alternatives such as the Yuan and the Euro are relatively under-developed, and to bring economic prosperity back to its pre-crisis levels, it needs to engage in economic attrition on the issue of the greenback.

As Benjamin Cohen notes in his paper titled, ‘The Demise of the Dollar’,

“Nothing better illustrates the point than the global response to the bursting of the US real estate bubble in 2007 and the grinding financial crisis that ensued. America could be fairly blamed for a near-collapse of the global economy. Yet remarkably, as events unfolded, a tidal wave of capital flowed into US markets, not outward as might have been expected. In the last three months of 2008 alone, at the height of the crisis, net purchases of US assets topped half a trillion dollars – three times what had come in during the preceding nine months. The greenback appreciated rather than depreciated, and the T-bill market stood out as one of the few financial sectors anywhere to remain liquid and continue operating smoothly.”[14]

Even skeptics of the US economy like Li Xing note,

“With regard to the current scenario where the United States seems to be falling back economically... Neither China nor the BRICS coalition has, until the present moment, demonstrated having the capacity to transform themselves into an “indispensable” country or coalition as it is with the status of the United States. There is no alternative economic world order to the Bretton Woods-based order. This also means that there is no transition of the systemic order.”[15]

The 2007 crisis was caused by market securitization and financial innovation at a speed at which people creating these securities themselves did not understand completely. While blame can be put on the American regulators of the banking industry and poor judgement of politicians on Capitol Hill, the crisis precipitated largely to the world’s over dependence on America as the global economic spearhead. Any other country suffering from such negative publicity would still be reeling from the effects of such a crisis, but the lessons learned from the crisis portray the ability of the American economy to change and reform itself. The American Dream of meritocracy and liberal thought is tied to the view that people take of the economy. As such, it is hard to find a replacement for America, as an economic hegemon and a leader of socio-political thought in this age of information technology and innovation. Economic cycles everywhere are characteristic of drifts and crises, and the effects of economic crisis helps reform the system.

Sources

http://www.economist.com/blogs/economist-explains/2014/11/economist-explains-6

https://www.theguardian.com/commentisfree/2014/oct/26/guardian-view-asian-infrastructure-bank-united-states-work-not-oppose

http://news.xinhuanet.com/english/business/2014-10/24/c_133740149.htm

http://www.imf.org/external/np/exr/facts/sdr.htm

https://www.imf.org/External/spring/2016/imfc/statement/eng/chn.pdf

http://www.marketwatch.com/story/china-sdr-announcement-enshrines-move-away-from-its-dollar-focus-2016-04-11

http://www.scmp.com/news/china/economy/article/1935774/chinas-obsession-imfs-accounting-unit-and-forging-new-global/

https://www.washingtonpost.com/opinions/the-dollars-stubborn-challenges/2015/05/06/7a87b388-f405-11e4-bcc4-e8141e5eb0c9_story.html

http://www.pressreader.com/china/the-wall-street-journal-asia/20150505/281487864909172/TextView

http://www.marketplace.org/2016/07/06/world/post-brexit-why-us-bonds-are-safest-safe-haven

http://www.pbc.gov.cn/english/130724/2842945/index.html

http://www.chinastakes.com/BlogArticle.aspx?id=22&AID=1129

http://foreignpolicy.com/2016/07/22/chinas-currency-manipulation-actually-enhances-the-global-role-of-the-dollar-sdr-rmb-balance-of-payments/

http://www.polsci.ucsb.edu/faculty/cohen/recent/pdfs/Revue_de_la_regulation_2015.pdf

http://thediplomat.com/2016/07/indonesia-and-chinas-aiib/


[1] (Zhou 2009) (Otero-Iglesias: 310) (Cohen: 2).
[2] (Cohen :3)
[3] Zhou 2009
[4] http://www.marketwatch.com/story/china-sdr-announcement-enshrines-move-away-from-its-dollar-focus-2016-04-11
[5] http://www.economist.com/blogs/economist-explains/2014/11/economist-explains-6
[6] Berridge and James
[7] primus inter pares means ‘A first among equals’ in Latin according to the Oxford English Dictionary.
[8] Otero-Iglesias :310
[9]  Cohen: 1
[10] (Otero-Iglesias :318)
[11] (Otero-Iglesias :318)
[12] (Otero-Iglesias)
[13] Krugman 2009, Otero-Iglesias :326)
[14] (Cohen: 6).
[15] (Xing: 32).

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