Whenever we think of US monetary policy we usually think of the Fed. There’s another side to US monetary policy, and its probably just as significant.
Being part of the worldwide US dollar clearing & settlement system means having access to the world’s most liquid payments medium: the US dollar-denominated bank deposit. As long as a nation’s banks are connected to this network, goods that are produced in that nation will be infinitely more saleable. On the other hand, being cut off from it means that the same goods will be a lot tougher to move. The Iranian monetary blockade illustrates the US Treasury’s ability to use banishment from the USD network, or the threat thereof, to exert incredible influence over the world.
|Network view of cross-border banking, IMF, Minoiu and Reyes (2011) PDF|
To see how this works we’ve got to understand how the worldwide US dollar deposit clearing system functions. Let’s start at the periphery of the network. An Iranian bank (call it “Persian Bank”) lets Iranians keep USD deposits and transfer them amongst each other. These trades clear on the books of Persian Bank. The US Treasury is powerless to prevent Persian Bank from doing a local USD business.
What happens if an Iranian customer want to receive USD from a French company to pay for Iranian oil?
To facilitate this transaction, Persian Bank needs to set up a what is called a correspondent banking relationship with a non-Iranian bank at the centre of the network. A Persian Bank exec flies to London and opens a USD account at “London Bank”, a large multinational bank. As long as our French company’s bank –we’ll call it “Paris Bank” –also has a USD account at London Bank, then the entire transaction can be conducted on London Bank’s books. Paris Bank simply tells London Bank to transfer the appropriate quantity of USD deposits from its account to Persian Bank’s account. Back in Iran, Persian Bank credits the USD account of the Iranian customer. At the same time, Paris Bank debits the USD account of the French company. The oil can now be sent.
Here’s how the monetary blockade works. The US Treasury issues an ultimatum to London Bank. There’s nothing that we can do to stop you from clearing USD trades on your books for Iranian banks, the Treasury says, but if you do so, you’ll have to close your accounts at “New York Bank”, a large US institution.
London Bank is in a pickle. The reason it keeps an account at New York Bank is so that it can transact the US side of its business. Assume that US importers keep their accounts at New York Bank and debit these accounts to pay for imported goods. London Bank’s account at New York Bank allows it to settle trades between US importers and its European exporting clients. If London Bank is forced to close its New York Bank account, it can’t partipate in US trade anymore.
For London Bank, the choice is easy. It will cease dealing with Iranian banks altogether since the cost of losing US business is far larger than the cost of losing Iranian business. The upshot is that in threatening to banish London from the US, the US Treasury can force London to banish Iran from the worldwide USD network.*
The removal of Iranian banks from the international USD clearing system has meant that it’s infinitely tougher for Iranians to sell their crude. To get around the banking blockade, we here stories about Iran reverting to barter. But this has been insufficient to prevent Iran’s economy from entering what seems to be recessionary territory.
This certainly jives with monetary theories of the business cycle. Milton Friedman, for instance, wrote that the Great Depression was caused by the Fed providing insufficient liquidity to the banking system. Rather than conduct massive open marker operations, it tightened. As the Depression worsened, we saw the emergence of barter and alternative payment schemes. Even Irving Fisher became an advocate of these systems, publishing Stamp Scrip in 1933. Because it has been caused by a lack of liquidity, Iran’s recession is very much a monetary one. It will only get out of the recession if it is able to derive alternate payment schemes that make Iranian products as liquid as before, or if the US lets it back into the worldwide US dollar clearing & settlement network.
*the actual ultimatum given by the US Treasury is not an all-or-none ultimatum. As long as countries show some evidence of having reduced Iranian oil imports, the US Treasury grants a temporary waiver that allows banks in importing nations to continue to settle oil transactions made by Iranian banks. To date, all importers of Iranian oil have complied by reducing imports. This means that the Treasury hasn’t had to act on its threat of sanctioning banks that do business with Iranian banks.