FINANCIAL STATECRAFT

Yale University Press

Chapter One

As long as the world remains divided into sovereign nations, there will always be a need for statecraft-the means by which governments pursue foreign policy. Harold Lasswell (1958), one of the scholarly giants in this field, suggested that statecraft was pursued through four primary instruments: information (words and propaganda), diplomacy (negotiations and deals), force (weapons and violence), and economics (goods and money). The scholarly literature on foreign policy is full of major treatises, articles, and other texts on the first three of these instruments. There remains, however, a single classic text on "economic statecraft." Though in his book by that title, David Baldwin (1985) provides no single, all-encompassing definition of the term, one can be spliced together from his discussions of both statecraft and economics: Economic statecraft encompasses efforts by governments to influence other actors in the international system, relying primarily on resources that have "a reasonable semblance of a market price in terms of money."Baldwin's reference to money prices is intended to distinguish economic statecraft from other types of statecraft, such as military statecraft, which utilize nonpecuniary means of persuasion or coercion, while at the same time accommodating the broadest possible range of measures that could usefully be called economic.

Economic statecraft has become increasingly important in the post-World War II era, as trade in goods and services has expanded robustly. The widened flow of trade has encouraged governments-notably, but not exclusively, the United States-to try to use their power over what can be imported into and exported from their countries as a lever, short of war, to influence the behavior of other governments.

Economic statecraft is not the same as foreign economic policy. Economic statecraft applies economic means to ends which may or may not be economic, whereas foreign economic policy encompasses means which may or may not be economic in the service of economic ends. Thus, trade sanctions imposed on a country in order to persuade it to halt a weapons program would qualify as economic statecraft, but not foreign economic policy, whereas suspending certain diplomatic contacts with a country-a noneconomic intervention-in order to protest its import barriers would qualify as foreign economic policy, but not economic statecraft. The distinction is important for us, as we focus here specifically on the use of economic means in the service of both economic and traditional foreign policy ends.

The most common and widely studied tool of economic statecraft is economic sanctions, particularly trade sanctions. Meghan O'Sullivan, in the New Testament of sanctions texts, Smart Sanctions (2003), defines sanctions as "the deliberate withdrawal of normal trade or financial relations for foreign policy purposes." The effectiveness of sanctions in terms of achieving foreign policy ends has been the subject of tremendous, and often heated, debate among both policymakers and scholars. Successful sanctions, as we will see in our own examination of capital markets sanctions in chapter 4, are often in the eye of the beholder, in the sense that the symbolic significance of sending nonviolent messages of political displeasure and, perhaps, of being willing to resort to more coercive forms of pressure in the future is often prized wholly irrespective of whether end-goals are actually achieved directly through their use. But if the achievement of such end-goals is to be the touchstone, O'Sullivan's assessment speaks for nearly two decades of scholarly literature. Her case studies "not only confirm the much-heralded conclusion that multilateral sanctions are the most effective form of economic pressure, but also suggest that even targeted or limited multilateral measures are preferable to comprehensive, unilateral ones." But trade is not the only way in which nations interact with each other economically. Whereas influencing international trade flows has long been and continues to be an important political objective and tool, another form of international economic exchange has risen to a level of much greater macroeconomic significance and political concern over the past two decades. This is the purchase and sale of financial assets-such as bonds, stocks, and derivative contracts-across borders, an activity whose growth has vastly outpaced that of traditional trade. Nearly $2 trillion worth of currency now moves cross-border everyday, roughly 90 percent of which is accounted for by financial flows unrelated to trade in goods and services-a stunning inversion of the figures in 1970, when 90 percent of international transactions were accounted for by trade. The relative importance of trade in goods and services, on the one hand, and trade in financial assets, on the other, is clearly illustrated in the U.S. balance of payments figures. If we chart the sum of American imports and exports (current account items) side by side with the sum of American foreign securities purchases and domestic securities sales to foreigners (capital account items), we see dramatically more rapid growth in the latter since the mid-1980s.

The answer to the question, "Why did Willie Sutton rob banks?"-because that's where the money is-captures precisely why governments have increasingly turned to banks and other financial institutions as objects and instruments of foreign policy. In the mid-1990s, after the customary lag required for politics to catch up with economics, the arsenal of economic statecraft began expanding in response to the growing importance of financial flows. Both the Clinton administration and its Republican opponents in Congress began to focus on how control of financial market institutions, instruments, and practices could be applied in the service of foreign policy-with the two sides often reaching very different conclusions.

The time is ripe, therefore, to ask some fundamental questions about the emergence of what we call here financial statecraft. We identify as financial statecraft those aspects of economic statecraft that are directed at influencing capital flows. These efforts have frequently involved harnessing financial institutions to achieve certain foreign policy objectives. But precisely how has the American government practiced financial statecraft? How effective have these efforts been? And how could they be made more effective? These are the central questions we tackle in this book.

To illustrate the nature of our task, and how economic statecraft differs from financial statecraft, we consider below some traditional forms of economic statecraft and their much more recent financial statecraft counterparts:

Economic Statecraft Financial Statecraft

Trade privileges, tariffs, and quotas Capital flow guarantees and restrictions Trade sanctions on states Financial sanctions on nonstate actors Foreign aid in drought or disaster Underwriting foreign debt in a currency crisis Regional trade agreements Currency unions or dollarization

The right-hand list is qualitatively different from the left-hand one in that each of the items on the right involves a manifestly greater degree of political sensitivity or "sovereign intrusion." To be specific:

Capital flows can have a vastly more immediate and dramatic influence than trade flows not only over movements in the relative value of national currencies but on the most basic economic and political conditions in a country. Threats of U.S. financial sanctions on foreign companies doing business with states subject to U.S. economic sanctions invariably provoke heated objections from foreign governments, which view them as overtly hostile acts and illegitimately extraterritorial in their reach. Bailouts of indebted foreign governments routinely provoke cries from around the world against the harshness of the conditionality applied, while at the same time calling forth condemnation of the moral hazard injected into international lending. The abolition of a national currency involves a major ceding of governmental control over national economic conditions to foreign bodies and is effectively irreversible without incurring significant economic and political turmoil.

In short, the stakes are higher and the foreign policy challenges are greater and more complex for financial statecraft than for traditional economic statecraft. Furthermore, policymakers frequently apply financial statecraft with a poor understanding of how financial markets actually work, leading to policy actions which are inadequate or which exacerbate the problems they are trying to remedy. Neither the phenomenon of financial statecraft nor its connection with the growth of financial flows, however, has received any systematic scholarly treatment.

This is a gap we hope to fill in the chapters that follow. Our objectives are both positive and normative. We aim to illuminate the relationship between financial flows and traditional foreign policy concerns, and the way in which the American government has attempted to harness financial markets and institutions in the service of foreign policy goals. We also aim to offer suggestions for change; sometimes very dramatic change. We believe that much of what is currently both integral to and absent from financial statecraft is based on dangerous but widespread misdiagnoses. Financial statecraft has a checkered past: some successes, and many more failures. There are also inherent limits to how successful financial statecraft can be in some settings. Where governments can usefully test those limits, we suggest how; and where they cannot, we suggest that the attempt not be made.

The first half of this book, chapters 2-4, examines the microeconomic aspects of financial statecraft, those focused on the specific institutions comprising the financial markets. The U.S. government has over the past 30 years attempted, sometimes alternatingly, sometimes simultaneously, to encourage as well as assist U.S. financial institutions in doing business overseas, on the one hand, and to restrain their ability to do so, on the other. Policy toward financial institutions has been driven in one direction by mercantilist motivations, in another by fears of risky global overstretch, and in yet another by a perceived need to enlist them in global wars, such as those on drugs and terror. The tremendous growth and internationalization of the U.S. markets for equity and bond finance in the 1990s has further led to increasingly vocal and influential calls to add denial of access to U.S. capital markets to America's arsenal of economic sanctions. All of these efforts, we argue, require significant recalibration to take better account of how financial markets work and how cost-effective these efforts are in achieving the foreign policy aims that motivate them.

The second half of this book, chapters 5-7, examines the macroeconomic aspects of financial statecraft, those focused more broadly on cross-border capital flows. As more and more countries around the world have chosen to enter the burgeoning global dollar-dominated marketplace for capital, national and regional financial crises have become more and more commonplace. As we demonstrate, these developments have raised significant new foreign policy challenges for the United States. New policy thinking is therefore needed. A new model must recognize that governments and companies around the world will continue to import capital prodigiously for the same sound economic reasons that U.S. regions import capital from other U.S. regions. Yet imports of capital by countries whose currencies are not, in turn, wanted abroad can lead to dangerous currency mismatch in their national balance sheets. Financial crises, therefore, will continue to occur in the absence of significant policy changes-particularly those related specifically to currency-in these countries as well as in the United States.

The workings of financial markets are frequently complex and growing increasingly important to the performance of national economies and political systems. This is why discussion and debate on the issues highlighted in this book are so important. Some of our analysis will be controversial; some will perhaps even appear counterintuitive. In particular, readers will discover as they proceed that tradeoffs are inherent in financial statecraft. Financial statecraft is also complicated in large part because money moves across jurisdictions so fast and in such large volumes that it, and the institutions that handle it, are difficult to redirect-it is frequently like trying to catch mercury. Moreover, steering financial markets in the service of foreign policy ends can have, and has at times had, economic costs both at home and abroad. For all these reasons, the wisdom of engaging in or forswearing financial statecraft is not determinable in the abstract.

Nonetheless, the cost-benefit calculus can and should be much more clearly illuminated in each particular case than it has been to date; both to improve it through a better political decision-making process where possible, and simply to improve the outcomes of the decision-making process where it is not. These are the aims of this book.

Chapter Two

Winning a war is the most monumental challenge any national leader can face. For Abraham Lincoln, one of the most vexing challenges posed by the American Civil War was figuring out how to pay for it. His Treasury secretary, Salmon Chase, initially followed the strategy used by European monarchs in the seventeenth and eighteenth centuries, issuing $150 million in bonds to domestic banks. But since these bonds were then sold to British banks, this strategy put the Union at the mercy of a foreign power sympathetic to the Confederacy. Lincoln therefore changed course, following a plan developed by Chase, and effectively drafted the banks into the war. In December 1861, Lincoln submitted to Congress a bill that would require nationally chartered banks to deposit with the Treasury government bonds equal to at least one-third of their capital. Congress adopted the plan in 1863. As we will see in this and the subsequent chapter, banks continue to this day to be used by governments as a tool to fight wars and pursue foreign policy. And in the 1980s and 1990s, as banking became a truly global business, banks became objects of foreign policy, through the development of international financial regulations to promote prudence in risk taking, vigilance in customer monitoring, and a semblance of parity in cross-border competition. At the same time, governments have frequently deferred to or sought to promote the narrow interests of banks (and other financial institutions) in international regulatory and trade initiatives. The results have been decidedly mixed.

Banks, OPEC, and Petrodollar Recycling: Beginnings of a New Financial Statecraft

There have been certain defining years in postwar economic history, and 1973 was undoubtedly one of them. That was the year the era of cheap energy ended. Angered by U.S. support for Israel during the October 1973 "Yom Kippur" war, the Arab members of the Organization of Petroleum Exporting Countries (OPEC) struck back, embargoing oil exports to the United States and enforcing that dramatic step by agreeing to cut production dramatically. The reduced supply led to much higher oil prices-from a prewar $3 per barrel to a postwar $12 per barrel. By one estimate at the time, the price increase added $37 billion to the cost of petroleum products in the United States, which in turn caused prices of other energy sources to jump as well. The result was a new phenomenon that afflicted the United States and oil-importing countries throughout the world: stagflation, the combination of slow growth or recession with sharply higher inflation.

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Excerpted from FINANCIAL STATECRAFT by Benn Steil Robert E. Litan Copyright © 2006 by The Council on Foreign Relations and The Brookings Institution. Excerpted by permission.
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