Weaponizing the Dollar
Featuring Luke Gromen and Brent Johnson
Published on: May 15th, 2019 • Duration: 12 minutesDo the U.S. government and the Federal Reserve have the stomach to break the global financial system with the dollar? Luke Gromen of Forest for the Trees and Brent Johnson of Santiago Capital join Real Vision co-founder Grant Williams to examine the knock-on effects of an escalating currency war. This video is excerpted from a piece published on Real Vision on February 4, 2019 entitled “The Great Dollar Debate.”
GRANT WILLIAMS: When you talk about weaponizing the dollar, are you just talking about them allowing it to strengthen? They're going to make it a more attractive currency through interest rates? They're just not allow it to strengthen without stepping in?
LUKE GROMEN: In this case, yes.
The biggest threat to my expected pathway is the weaponization of the dollar with extreme prejudice. In other words, the US government and/or Fed decide that it is a good thing to break the world with the dollar, which they can do, to Brent's point. It's absolutely doable. And that they are willing to take the collateral damage that would go along with that, which is to say you'd break the US bond market, you'd break the US equity market, you would break consumption in the US. You would drive a severe recession, if not depression. All of those. If the United States government at the Fed are willing to do those things for a period of time with their eye towards a goal, you know, ala Paul Volcker, with an eye with their eye towards a goal of setting the United States up in a better bargaining position vis a vis China, vis a vis Russia, other emerging markets. And to try to stem the tide of dedollarization of commodity markets that's been going on, then Brent is going to be 100% right. And the dollar is going to go to 120, or 160, or some really big number, and there's not going to be enough dollars.
GRANT WILLIAMS: When you talk about weaponizing the dollar, are you just talking about them and allowing it to strengthen? They're going to make it a more attractive currency through interest rates? They're just not allow it to strengthen without stepping in?
LUKE GROMEN: In this case, yes. I mean, I think we've weaponization of the dollar, you've probably heard us talk about it being used in sanctions, regimes, et cetera. In this case, the weaponization, I use that term purely as a we're going to strengthen it, and we're just going to use it to let everybody else break themselves on it.
GRANT WILLIAMS: So why is he an idiot? Because I've got to say, I listened to this, and I go backwards and forwards. Because the one thing is we will have to have an opinion on the dollar. And you have to build a trade process around that. And I've gone backwards and forwards. Right now, I lean towards Luke's camp. I've been in your camp, before but why are Luke and I idiots?
BRENT JOHNSON: Well, if you guys were idiots, I wouldn't be here. I should say that, too. Honestly, the only reason I even keep going back and forth with Luke is I actually respect his opinion. And I know how much work he's put into it, and how much time and thought he's put into it. I don't think he's out there selling something he doesn't believe in. I think he believes what he's saying. And if he didn't, I would delete the tweet, I'd block him, and whatever, right?
But you know, the reason I engage with him is number one, I disagree with him. But every now and then, he says something that makes me, god, now I've got to go look that up, right?
GRANT WILLIAMS: Right.
BRENT JOHNSON: It doesn't happen that often, but every now and then it does. And it kind of drives me crazy, right? And then I've got that little splinter in the brain that you've got to go figure that little angle out.
I guess I would say is a lot of people will use The Matrix to describe the market there were and now. It's a simulated world, it ain't real. And I guess I would go-- to answer this question, I'd go to a little subset of The Matrix-- I don't remember which film of the trilogy it was, but there was a guy called the Merovingian. And he talked about cause and effect, right?
And so I think a lot of the stuff that Luke talks about, that's the effect. The cause is going to be the dollar getting stronger.
GRANT WILLIAMS: Right.
BRENT JOHNSON: And to me, that's the main thing. Is like, won't swap lines be open? Yes, but what's going to cause the swap lines to be open is dollar pressure going higher. I don't think they're going to open swap lines if the dollar's already falling. The Fed, I think, is going to have a very hard time bailing out Italy, and Turkey, and China if we're not bailing out the US to begin with. Trump is going to say, make America great again. I don't want you open in swap lines to these guys without doing what I want you to do here at home first. I think there's a lot.
So to your point about the biggest risks, as you say, is the potential for the weaponization of the dollar-- I don't see how they don't weaponize the dollar. In my mind, of course they're going to weaponize the dollar. And I guess that would be the biggest threat to me is if they don't weaponize the dollar, right? I'm pretty sure they're going to.
GRANT WILLIAMS: But what would their aim be in weaponizing the dollar? Because the chaos that that would genuinely unleash across the world would be devastating.
BRENT JOHNSON: Yes. But I think-- and I think Trump knows this. Now maybe he doesn't, but if he ever figures out that the strong dollar helps him more than it hurts him, but heaven help the rest of the world, because he doesn't care. He doesn't care that his policies completely throw a wrench in the middle of Triffin's dilemma. You can't sit him down and explain to him that it isn't designed for that to happen, because he doesn't care. He's more likely to drive the truck faster into that if he figures that out than if you tell him that he can't do it.
And so I just don't see how we don't get into a situation where the dollar gets significantly stronger before all this stuff gets acted upon to weaken it. If the dollar just gets outright repudiated, then they don't need to do all this stuff, because everybody is selling the dollar, anyway.
GRANT WILLIAMS: Let's stick on that for a moment, because this is something you've written a lot about very, very eloquently-- about this dedollarization. And if you're paying attention, the signs are everywhere that there is not quite a stampede yet, but it's picking up pace. A number of people looking to try and insulate themselves from exactly what you are describing, by sorting out contracts in Yuan, or in gold, or in euros, to trade oil particularly directly with China, and try and bypass the US dollar. The Russians have singlehandedly sold all their treasuries, essentially, and loaded up on gold reserves. So talk a little bit about what's going on, why it's important, and how that might change what Brent is talking about.
LUKE GROMEN: So I think when you look at the dedollarization of the gold commodity markets, ultimately, I think there has been-- I think a real watershed moment was in 2012, when the United States weaponized the Swiss system or encouraged the Swiss system to be weaponized to be precise against Iran. And effectively, hyperinflated Iran's economy overnight.
GRANT WILLIAMS: Can you just talk about the mechanics of how that works? Because, as Ben Hung would call it, it's a $10 phrase. But people need to understand exactly what that means.
LUKE GROMEN: So basically, the United States encouraged SWIFT to disconnect Iranian banks from the dollar-centric system, from the eurodollar system. And so basically, Iran was completely disconnected from the global financial system, effectively. And the Iranian rial collapsed virtually overnight, hyperinflation, goods shortages. Sort of all of the worst things that can happen to an economy, just by virtue of having it.
And this is a one country extreme case of ultra strong dollar, ultra dollar shortage. And I think it was a penny wise pound foolish decision by the United States because it's a weapon you can only use once.
GRANT WILLIAMS: Yep.
LUKE GROMEN: They did it to Iran, and they caught Russia's attention, they caught China's attention. Anyone else in the world who figured they might be on the wrong side of the United States anytime in the next five, 10, ever years had to start thinking about the fact that the United States could within two weeks completely choke out your economy starve your people. Which is geopolitically completely unacceptable for any sovereign nation. Some nations can do something about it, some can't.
In the case of China and others, they can. And so what they started doing is working towards being or gaining the ability to print domestic currency and settle commodity imports, which is when you're in the case of China specifically, 60% of their import bill are raw commodities. And so it's really about gaining the sovereign flexibility to control your own current account, control your own balance of payments, get away from being choked out by the US within two weeks but with the dollar system.
Ironically, as they started to do this really in the third quarter '14, it drives exactly the phenomenon that Brent talked about and talks about, which is when China starts transacting in Yuan for oil or other commodities, they start increasing the supply of offshore Yuan. And there's very little demand for offshore Yuan. There's no Yuan denominated debt, et cetera. If there's capital controls, there's offshore, onshore-- it's not freely convertible.
So something that is in the long run, very, very bullish for the Yuan, and the flexibility, and the relative power of China and the Yuan, is actually in the near term very bearish, because you're increasing the supply of Yuan against virtually no demand. And then on the flip side, you're taking away just on the margin some supply of dollars, as oil and other commodities are coming out of the ground, against a very large and persistent bid for dollars from the large outstanding dollar denominated debt.
And so you can see it right in the third quarter of 2014, something really odd started to happen. You had a small series, a short period of time, you had Ecuador, Russia, and Venezuela all come out and say, we're having dollar shortages. And I thought it was odd because oil was still between $95 and $100 a barrel. All three of those countries were still running current account surpluses of roughly 2% to 3%, which means they're theoretically transacting entirely in dollars, and saving more than they're spending. And yet they're running short of dollar.
So there was really only two possible explanations for them running into dollar shortages with the oil price where it was. Either those three countries have become wildly more corrupt in the last three months to the extent that they were siphoning off. And while possible, you know, it strained credulity.
Or the flip side was-- hinted at actually, a year earlier in an article on Reuters about Ecuador, noting that China had extended a bunch of loans to Ecuador, and now controlled 88% or 83% of Ecuadorian oil production. And that they were starting to shift control of that or pricing settlement of that into non dollars. And as the amount of dollars for these countries energy exports was shrinking, while those countries dollar denominated debt obligations remained, you were creating a dollar squeeze. And I think that's exactly what started to happen.
And you know, the dollar went from 70 to 80 or 82 very quickly, beginning in the second half of '14. And it drove a number of other of the risk off effects that Brent talked about-- energy, et cetera. But that was sort of the start of that whole process. And I think some of the reason behind that process.