The first casualty of economic warfare is the free market

To read remarks made by a string of treasury officials and central bankers in recent weeks, one thing becomes clear: It’s no longer an exaggeration to suggest the global economic system is heading toward a shift unlike anything since World War II. And what’s more, what’s emerging is war-like.

From European Central Bank President Christine Lagarde to U.S. Treasury Secretary Janet Yellen, the messaging has rarely been franker. For decades economic progress has been driven by free markets. But now, with national security and competition for natural resources increasingly top of the list of headaches for world leaders, the way our planet functions is entering a new era.

Consequences are likely to be varied and far-reaching. Expect a tech-focused arms race, the possible end of U.S. dollar supremacy, and isolation of China and its allies, similar to how the Soviet bloc was ostracized during the Cold War.   

“Even though these [national-security focused] policies may have economic impacts, they are driven by straightforward national security considerations,” Yellen told an audience at Johns Hopkins University last week. “We will not compromise on these concerns, even when they force trade-offs with our economic interests.”

As the world fractures into blocs, each one focused on its own values and national-security objectives — what top ECB officials have in the past few days repeatedly called global “fragmentation” — the free-market capitalist certainties taken for granted since the 1940s may give way to a more government-directed economy.

ECB board member Fabio Panetta added to the sentiment on Monday, noting in a speech in Brussels that the prevailing order focused on open trade and peace established after World War II would struggle to coexist within an antagonistic and politically competitive framework. The economic costs of the shift would likely be high, he added.

Military-civil fusion

So what’s happening? For a start, trade and investment between the different blocs will be constrained. Harald Malmgren, an international negotiator who served as senior aide to four former American presidents, believes a new buzz term — that of “military-civil fusion” — will come to define the security-oriented system that’s emerging. Yellen also referenced it in her speech.

The U.S. Department of Defense (DoD) already has a list of entities that meet that definition, he noted in a report earlier this year seen by POLITICO.

“From what we have heard to date, the investments that will not pass muster under legislation… will include any investment in companies linked to the PLA (the Chinese military), as well as chipmaking tools, advanced semiconductors, quantum computing and certain AI capabilities with military or surveillance applications,” he wrote.

Some are urging even greater limits on free markets. The U.S. might even need to ensure that “hedge funds, private equity firms and Wall Street are not investing in ways that hurt our economy or funding adversarial actions of the Chinese government,” according to Democrat Congresswoman Maxine Waters.

In Europe, too, there’s a real sense that the world is changing. For the ECB’s Panetta, a tighter relationship between technology and finance will be essential for maintaining financial and economic stability. “It offers an antidote to the effects of a possible reversal of globalization by making it possible to use scarcer resources more effectively and reduce dependencies,” he said on Monday.

China’s revenge

And that’s where the war analogy comes in. Because, as Malmgren warned, Chinese retaliation is almost guaranteed. That could be “perhaps in the form of confiscation of assets or worse,” he said. 

“Once the barrier to government involvement in foreign investments has been pierced, it should be expected that the scope of government restrictions will gradually widen,” he wrote. “A Pandora’s box has been opened.”

With President Joe Biden’s U.S. administration seeking to limit outbound and inbound China investments — or even reverse existing ones — some see parallels emerging with the controls on exports of products and technologies deemed strategically vital during the Cold War.

But there’s a new twist. The supply chains feeding products into a dislocated system don’t flow from the West outward but the other way.

And that could bring another consequence: The erosion of the dollar’s status as the trade and reserve currency of choice — especially if inflation in the West continues to bite and protectionism increases.

There’s “a risk when we use financial sanctions that are linked to the role of the dollar that over time it could undermine the hegemony of the dollar,” Yellen told CNN. 

Bretton Woods

After World War II, the U.S. dollar emerged as the global currency. That role was enshrined in the Bretton Woods Agreement of 1944, allowing countries to exchange dollars for gold at a fixed rate.

Even after the gold standard collapsed in 1971, the dollar’s dominance went unchallenged. This earned the U.S. exorbitant privilege status, and with that the ability to run ever larger trade deficits, paid for by the seemingly endless production of dollar-denominated assets.

Today’s shifts could see the euro, the renminbi (RMB), and even the rupee gain significant ground — first in their own spheres of influence, then further. A more multipolar financial system of this variety could, as the ECB’s Lagarde stressed last week, be highly inflationary, requiring rare “interdependence” between central banks and fiscal policies. 

However, China experts, like economist Michael Pettis at Guanghua School of Management at Peking University in Beijing, argue that this won’t happen overnight.

“For the world meaningfully to switch from dollars to RMB, exporters will have to want to hold their accumulated surpluses in RMB and, much more importantly, China will have to give up control of its monetary policy and abandon its surpluses for permanent deficits,’ Pettis tweeted earlier this month.

To date there’s little indication that’s the case. The dollar continues to account for 60 percent of global foreign reserves and of foreign debt, and around half of international trade keeps being invoiced in the greenback.

But a sizable shift by international reserve managers in recent months into gold shows the complexities of using dollar sanctions as a foreign policy tool.

Many foreign central banks and treasuries, which in theory benefit from sovereign immunity, responded with unease to Western moves to freeze Russian reserves. Calls to expropriate Russia’s sovereign reserves and redeploy them for Ukrainian reconstruction are seen as going even further — setting an even more dangerous confiscation precedent. 

Space race

“Expropriation would really be a change in the way we think about foreign reserves,” the Peterson Institute for International Economics’ Nicolas Véron told POLITICO. “I think [it] could be destabilizing for the global monetary order. I don’t think there’s any precedent for it, which is precisely what makes it so radical.”

This is the first time, Véron said, that such action has applied to states that have not suffered a regime change and where there is no question over who owns the assets.

One of the most prominent and influential U.S. defense contractors which also perfectly embodies the new era of military-civil fusion, SpaceX and Twitter boss Elon Musk, weighed in on the situation on Tuesday.  

“If you weaponize currency enough times, other countries will stop using it,” he tweeted to his 136 million followers.

Musk’s companies and those of his competitors, however, stand to benefit most from that weaponization. This is even more the case once the DoD’s Office of Strategic Capital — which was established last December with a specific mission to boost private investment in critical technologies like AI and quantum — gets into full swing influencing the 21st century’s very own Space Race.

Paola Tamma contributed reporting to this article.