Harvard Business School Working Knowledg e Archive

Financial Statecraft

3/20/2006

Following the attacks of September 11, 2001, as part of its War on Terror the American government announced a plan to battle money laundering schemes used to finance terrorism. The plan sounded good on the surface, but the $7 billion-per-year program has produced few if any meaningful results and has siphoned off Homeland Security money that arguably could be put to better use.

The increasing use of “financial statecraft” by American policymakers and the less-than-spectacular result is the subject of this new book from Benn Steil, Director of International Economics at the Council on Foreign Relations and Editor of International Finance, and Robert E. Litan, Vice President of Research and Policy at the Kauffman Foundation and a senior fellow at the Brookings Institution.

First, some definitions. The authors view financial statecraft as distinct from traditional economic statecraft such as trade tariffs, disaster foreign aid, and regional trade agreements. Financial statecraft includes capital flow guarantees and restrictions, financial sanctions on non-state actors, bailouts of indebted foreign countries, and currency unions or dollarization. Think of it as the purchase and sale of financial assets across borders. And it's a heavy club to wield. “Nearly $2 trillion worth of currency now move cross-border every day, 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 authors write.

The problems begin, however, with policymakers who don't understand the dynamics of world markets: Shutting off a source of income in one area opens up opportunities elsewhere, the authors explain. Worse, such lack of understanding can lead to policy actions “which are inadequate or which exacerbate the problems they are trying to remedy.” Capital market sanctions against China and other nations, for example, have often done little good and undercut both American foreign policy initiatives and the competitiveness of U.S. capital markets, according to Steil and Litan.

The missteps aren't party-specific—both the Clinton and Bush administrations are under fire in Financial Statecraft.

So what's to be done? Research is step one, the authors write. Scholarly treatment of financial statecraft has been meager, but this book is a major first step. For programs to stop the cross-national funding of drugs and terrorism, the task is more complex. It begins with greater cooperation between the U.S. and dozens of other countries whose financial institutions are being used. The book also calls for a ground-up rethinking of how we use capital market sanctions. As the authors write, “We have yet to see a case in which either companies or regimes were moved to behave in the way supporters of capital markets sanctions wished them to. . . .”

Policymakers, researchers, and global executives will come away from this book with a new perspective on the economics of foreign policy in the modern world.

- Sean Silverthorne

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