This may be among the shortest of my posts, but it concerns an Iran-war-related development–one that’s ongoing–that hasn’t received the attention it deserves because the focus of most headlines has been on the drones and missiles that are landing on (mainly) Iran but also the Gulf monarchies and Israel. I decided, therefore, that a short, quickly-written post was in order.
I have in mind an important economic effect of this war. And no, I’m not talking about the soaring price of everything from oil and LNG to fertilizer inputs (urea and ammonia) and helium (essential for the manufacture of semiconductors). I’m talking about the effect that the war is already having on the (largely) dollar-based international system countries use for storing value, paying debts, and buying and selling.
The steps Donald Trump and Benjamin Netanyahu are taking to escalate the war with the view of forcing Tehran to make the concessions Trump has demanded, or in order to reduce Iran to anarchy, which seems to be Netanyahu’s objective, pose one of the biggest threats the dollar-based international financial system has faced in decades.
When a major war breaks out and things look like they are going to get far worse, investors–states, companies, and individuals–start worrying. They then take steps to protect their investments. The spiraling war in Iran is leading them to do precisely that, and with significant consequences for the dollar-based system of which, for reasons discussed below, the US is the biggest beneficiary.
Here’s what’s happening:
Big holders of US Treasury Bills (essentially IOU commitments by the US Federal Reserve Bank to those who buy them) have been offloading them at a pace not seen since 2012. That’s not all. French president Immanuel Macron directed that France’s gold reserves, which have been parked in the US Fed, be brought back to France. And they have been: around 129 tons worth ~$13 billion. (Charles De Gaulle, arguably the most famous of Macron’s predecessors, did the same in the early and mid-1960s.) If the war continues without let-up, other countries may reduce their financial risk by emulating France
Why does this, and the accompanying offloading of US T-Bills matter? Because the United States has a ~$38 trillion national debt, and foreign purchases of our T-Bills are critically important for paying the interest on that debt. Last year interest payments added up to $~970 billion. Part of our debt management and payment system also relies on oil exporting countries denominating oil prices in dollars, receiving payment in dollars, and reinvesting part of the proceeds in US T-Bills. Known as “petrodollar recycling,” this arrangement has been in place since the early 1970s oil shocks.
Now ask yourself this: If Trump and Israel continue escalating this war and the Strait of Hormuz remains closed will the flight from US T-Bills and the gold exodus get better or worse? I think you’d agree that the answer is obvious.
True, the US has a lot of firepower, but it’s a lot easier for Iran to make passage through the Strait hazardous by striking a tanker episodically than it is for the US to keep the Strait open—and keep it open. The latter task would require a continuous military presence—one that Iran will make far more hazardous using its drones, short-range missiles, mines, and its Ghadir-class mini-submarines, which can loiter underwater for extended periods.
The war is already escalating. In the last day alone, Israel has struck important Iranian energy installations. Iran responded–as part of its horizontal escalation strategy: widening the ambit of the war by attacking Gulf energy production, refining, and storage sites, as well as Qatar’s LNG complex at Ras Laffan–by targeting and setting ablaze a massive petrochemical complex in Saudi Arabia. It’s a safe bet that if the war doesn’t end in the next couple of weeks the (already high) price of oil and the other commodities I’ve mentioned will increase further, inflation will accelerate. Central banks will respond by raising interest rates, or at least deferring any plans they had to lower them. That, in turn, will increase borrowing and investment costs, and the negative effects will course through the global economy.
All of this will add to investors’ already mounting anxiety, and lead to even larger sell-offs of US T-Bills. The figure is already somewhere around $82 billion. If that happens and petrodollar recycling slows, it’s bad news for the US. But given the size of the US economy and the role of the dollar, it’s not good for the rest of the world either. Although the proportion had already been declining, ~56 percent of global currency reserves are held in dollars and around 89 percent of worldwide financial transactions are conducted in dollars. This provides the US with significant benefits.
Since everyone wants dollars and the confidence in the currency is high, countries are happy to buy T-Bills. And petrodollar recycling continues. Both processes help the US attract dollars–in the form of T-Bills-to cover its budget deficit specifically and its national deficit more generally. No other country has enjoyed this advantage, which is why De Gaulle famously referred to it as “an exorbitant privilege.” It’s the dollar’s dominance that gives American sanctions their bite. They have had devastating effects on Iran’s economy: that’s why Tehran wants sanctions removal to be part of any deal that ends the war permanently. The dollar’s unrivaled stature also helps explain the reach and size of US companies’ foreign direct investments and Washington’s ability to maintain a constellation of military bases overseas for projecting power.
Will a continuing and escalating war cause the arrangement I’ve sketched here to unravel. Probably not. Still, the war has certainly put it under pressure, and that pressure will increase. It’s natural to dwell on the bombs-and-rockets aspect of wars, and this one is no exception. But when you do turn your attention to its economic effects, don’t look merely at the price of gas at the pump. That’s important, of course, but it’s a symptom of something bigger.
