The Capital War
The two main capital war risks are being shut off from capital (which is a greater risk for China than it is for the
US) and losing one’s reserve currency status (which is a greater risk for the US than for China).
In Chapter 5 I reviewed classic capital war moves. They are all possibilities in the US-China conflict. The modern
term for these moves is “sanctions.” The goal is to cut the enemy off from the capital that the enemy needs
because no money = no power. Sanctions come in many forms with the broad categories being financial,
economic, diplomatic, and military. Under each of these categories there are many versions and applications. As of
2019, there were approximately 8,000 US sanctions in place targeted at individuals, companies, and governments.7
I’m not going to delve deeper into the various versions and targets because that would be too much of a digression.
The main thing to know is that the United States has by far the greatest arsenal of sanctions. Most
importantly the United States has the greatest influence over the global financial system and it has the
world’s leading reserve currency. That gives it the ability to cut most entities off from receiving money and
credit by preventing financial institutions from dealing with them by threatening those financial instructions that
deal with the targeted entity with being cut off from the global financial markets. These sanctions are by no means
perfect or all-encompassing, but they are generally damned effective.
Because financial market sanctions are so effective they naturally lead those countries that are most likely to
be harmed by them to work on approaches either to get around them (e.g., by developing an alternative
payment system) or to undermine the United States’ power to impose them. For example, Russia and China,
which both are encountering these sanctions and are at much greater risk of encountering more of them, are each
now developing and cooperating with the other to develop an alternative payment system. China’s central bank
will soon be the first major central bank to propose a digital currency, which will make it more attractive to use.
Whatever progress will be made to have China’s currency as a broadly accepted reserve currency at the
expense of the dollar will take time and should be viewed as part of the big decoupling phase of the
relationship that will take place over the next five years.
The United States’ greatest power comes from being able to print the world’s money (i.e., from having the
world’s leading reserve currency) and all the operational powers (e.g., influences on the clearing system)
that go along with that. The United States is at risk of losing some of this power while the Chinese are in the
position of gaining some of it. That is because the desirability of buying and holding US dollar debt is being
reduced because a) the amounts of dollar-denominated debt in foreigners’ portfolios (most importantly in
government-controlled portfolios such as central bank reserves and sovereign wealth funds) are disproportionately
large based on a number of good long-term measures of what the size of reserve currency holdings should be,8 b)
the US government and the US central bank are increasing the amounts of dollar-denominated debt and money at
extraordinarily fast paces that are scary and the amounts will be will be hard to find adequate demand for without
the Federal Reserve having to monetize a lot of it, c) the financial incentives to hold this debt are unattractive
because the US government is paying a negligible nominal yield and a negative real yield on it, and d) holding
debt as a medium of exchange or as a storehold of wealth during potential wartime is less desirable than during
peacetime. Further, the roughly $1 trillion of debt that China holds (which, by the way, equals only around 4% of
the roughly $27 trillion outstanding) is related risk. Also, because other countries realize that actions taken against
China could be taken against them, any actions taken against Chinese holdings of dollar assets would likely
increase the perceived risks of holding dollar debt assets by other holders of these assets, which would reduce the
demand for them. Also, the dollar’s role as a reserve currency largely depends on its being able to be freely
exchanged between and working well for most countries, so to the extent that the US puts controls on its flows
and/or runs monetary policy in ways that are contrary to the world’s interests in pursuit of its own interests, that
makes the dollar less desirable as the world’s leading reserve currency. As you can see these dollar-weakening
influences are adding up. At the same time the dollar is in a uniquely strong position because it is so extensively
used, which makes it more valuable and less easily replaced.
The United States is testing the limits of how much there can simultaneously be a) enormous amounts of
dollar-denominated money and debt created, b) falling and negative real returns, c) the dollar being used as
a weapon (e.g., the usage can be limited via capital controls), and d) a fiat monetary system. We won’t know
what the limit is and we can’t say it is here until it is reached. At that point it will be too late to fix. From both