National Security

Choose Your Own Adventure for Policy Wonks

Gaming out a military strike on Iran.

Early this month, former U.S. Defense Secretary Robert Gates noted the folly of military action against Iran to prevent its nuclear ambitions. Speaking in Virginia, he said, "The results of an American or Israeli military strike on Iran could, in my view, prove catastrophic, haunting us for generations in that part of the world."

Yet many in Washington believe that military action is not only a potential option, but the desirable option. The Truman National Security Project has launched an online war game called Tell Me How This Ends, which allows players to assume the role of a president who has committed to war with Iran. It demonstrates why Gates is right, why those who would argue for preemptive military action (at this time) are wrong, and why the current policies of Barack Obama's administration are navigating through an incredibly complex and dynamic landscape of political, military, and diplomatic situations.

The scenario is laid out upfront: You are the president, and you are at a decision point. U.S. intelligence has indicated that the Iranians have crossed the 20 percent enrichment "red line." In other words, you're in the region that Israeli Prime Minister Benjamin Netanyahu displayed in his crude illustration of the pathway to an atomic bomb during the U.N. General Assembly meeting in September. The catch is, however, that there may yet still be time to dissuade the Iranians from weaponizing their assets. Indeed, in your advisors' view, it would still be months or years before the Iranians could build a weapon, and much longer before it could properly be mated with a delivery system such as a ballistic missile. The scenario does not -- for instructive purposes -- permit you to sit and wait. You must decide: Do you strike preemptively, or do you build a coalition before engaging in military action against Iran?

What follows is a well-thought-out explanation of the political tensions and military realities of preemptive strikes, walking the deterrence tightrope, and executing a range of less aggressive to more aggressive responses and counter-responses. For example, at one point you are provided advice from your secretary of state reminding you of the importance of coalitions. Your national security advisor notes that a coalition probably won't really provide much military benefit, and your politically savvy chief of staff observes that you might not want to delay in order to build a coalition, as Americans may think you're putting "America's security to a vote at the U.N."

Being able to rewrite and replay history (on my iPad, no less), I played the scenario several times, each time selecting different options and pathways -- a "Choose Your Own Adventure" for policy wonks, if you will.

I acted preemptively at times, cautiously at others, but in each I was faced with the challenge of escalating violence and a wider conflict. I found the Iranians reacting as they likely would in the real world and at times offering up a clumsy or unexpected response, reducing the effectiveness of my counters. As military theorist Carl von Clausewitz noted so adeptly, "In war more than anywhere else things do not turn out as we expect."

In other words, if there is one thing certain about war, it is uncertainty. Tell Me How This Ends reminds us that, even with the best understanding of an enemy's capabilities, intentions, and effectiveness, we may not know what is going on until events start to unfold. And, even if we guess right about its intentions, the enemy may come to seemingly illogical conclusions or be hampered by negligence, hastiness, disobedience, laziness, or pure exhaustion -- the human factor in war.

In the several scenarios I played, I noted some important similarities. Despite various approaches, I could do little to prevent or counter Iranian attacks on commercial shipping and the subsequent spike of oil prices to $100 -- and, in one less successful attempt, $200 -- per barrel. Likewise, gas prices skyrocketed to $6 and $7 a gallon. This sort of economic shock would be devastating to a U.S. economy that has begun to recover after a horrible recession.

Of more importance, there was the inevitable loss of life associated with military action -- the death of troops inevitable due to "hit-and-run" tactics by Iranian small boats against both commercial and coalition military vessels. Likewise, terrorist attacks, sponsored by the Iranians and perhaps Hezbollah surrogates, increased with each military move made by the United States. In some instances -- even when I chose to de-escalate -- these attacks were limited to Iraq, Israel, and the Persian Gulf region, but in others, the Iranians also increased the flow of advanced weaponry to insurgents in Afghanistan or supported terrorist actions against interests in Europe and the Americas. It was no surprise that the costs of this conflict with Iran began to skyrocket -- from $2 billion to $9 billion per month, depending on the level of U.S. military intervention.

In the end, Tell Me How This Ends illustrates the operational difficulties of enforcing naval blockades, launching airstrikes, and solving technical problems associated with destroying deeply buried targets. It shows that even a well-planned, accurately targeted, and proficiently executed strike against a broad set of Iranian nuclear targets will only postpone -- not halt -- the regime's program and will likely have a significant set of malicious side effects. As Colin Kahl, a former Pentagon official for Middle East policy, has suggested, this is also the blind spot in current Israeli thinking about preemptive military action: It would "be nearly impossible to prevent Iran from rebuilding its program. Iran's nuclear infrastructure is much more advanced, dispersed and protected, and is less reliant on foreign supplies of key technology, than was the case with Iraq's program in 1981."

Gates's and Kahl's warnings provide the intellectual framework for the answers that Tell Me How This Ends provides: The only true military solution requires massive intervention. Lesser options would merely postpone Iran's nascent nuclear program. If war broke out in the real world, this option would result in thousands of U.S. troops (and perhaps coalition forces) killed and perhaps a wider war -- which is not in the interests of the United States, Israel, or the tens of thousands of people who would likely be killed in such a conflagration. While Iran cannot be permitted to develop a nuclear weapon, the United States must make some very deliberate choices and exhaust a range of diplomatic and intelligence options before undertaking what will -- despite its best efforts -- become a very costly war with Iran.



To Renminbi Or Not to Renminbi?

Why China's currency isn't taking over the world.

As China moves up the economic pecking order, it has been trying to promote its currency, the renminbi (RMB), as an alternative to the U.S. dollar. The Chinese government has ambitious plans for establishing offshore centers where companies can raise RMB funds, internationalizing its currency, and possibly enabling the RMB to supplant the dollar as the global reserve currency. The U.S. dollar isn't the only global reserve currency -- countries also keep some of their foreign exchange reserves in euros and yen -- but it has been the dominant one since the 1944 Bretton Woods conference.

During Tuesday night's presidential debate, Republican nominee Mitt Romney repeated his promise to label China a "currency manipulator" on his first day in office. The heated rhetoric on China in the debate, and throughout the campaign, over which candidate would be tougher on China's currency manipulation and other unfair trade practices reflects Americans' anxieties about the relative standing of the U.S. and Chinese economies, and it suggests that a shift to the RMB would resonate deeply in U.S. domestic politics. However, despite the bluster, the dollar will remain dominant.

Americans benefit from the dollar's hegemony: Because the world needs dollars, the U.S. government and American consumers can borrow at a lower cost. By conducting transactions in their own currency, U.S. companies reduce the hassle and the risk of sudden shifts in exchange rates. Americans also hold their heads a bit higher knowing that even with a struggling economy, governments all over the world still view the United States as the most reliable country for protecting their foreign exchange reserves. As the title of economist Barry Eichengreen's 2011 book puts it, it is an "exorbitant privilege" that Americans have come to take for granted. If the RMB supplants the U.S. dollar as the global reserve currency, the world financial system will hum to the tunes of China, and U.S. fiscal and economic policies will become more constrained by international pressures, including the threat of a sharp currency depreciation.

There are three degrees of RMB internationalization. First, China and its major trading partners transact in RMB; this has been happening since 2009. The next step is widespread third-party usage of the RMB in financial and trade transactions. In other words, only when parties undertaking transactions unrelated to China regularly use the RMB will it truly be an international currency. For the RMB to take the final step and become a global reserve currency, central banks around the world would have to maintain sizable holdings of RMB to insure against their own financial risks. In other words, the RMB would become a so-called safe-haven currency the way that the dollar and the yen are today.

China's limited financial system and its lackluster global reputation -- not U.S. fears of China's rise -- are preventing the RMB from becoming a global reserve currency. The demand is there. Because U.S.-dollar financial markets seized up during the 2008-2009 global financial crisis, businesses in Asia and other emerging economies desire an alternative trade settlement and reserve currency. The U.S. Federal Reserve stimulated recovery in the United States through "quantitative easing" -- increasing the money supply by buying mortgage-backed securities and Treasury bonds, which lowered the value of these holdings to foreigners like the Chinese, weakened the U.S. dollar, and stimulated capital outflows to emerging economies that increased inflation. China and other holders of U.S. debt viewed the Fed's actions as a sign that it would always put its domestic-policy objectives ahead of global monetary and financial stability.

Since China began allowing its companies to settle payments for imports and exports in RMB outside mainland China in 2009, the RMB's international use has grown tremendously. As of this June, all mainland firms can invoice and settle their foreign-trade transactions in RMB. Foreign direct investment by Chinese firms abroad and by foreign firms in China can now be denominated in RMB. And brokerage firms in Hong Kong are now permitted to sell global investors RMB-denominated exchange-traded funds, which directly invest in mainland bond and stock markets. Bilateral currency-swap arrangements with countries including Japan, Russia, India, Brazil, and Chile, which provide those countries' central banks access to RMB outside China, encourage companies to use RMB when they do business with China. As of this year, China has made 18 bilateral swap agreements for a total of more than $250 billion.

According to the People's Bank of China (PBOC), China's central bank, 6.6 percent of China's merchandise trade in 2011 was settled in RMB, a rise from 2 percent in 2010. The RMB customer deposits of Hong Kong banks increased from the equivalent of $46.5 billion in 2010 to $91 billion in 2011. A senior PBOC official revealed this June that the central bank allows more than 60,000 firms worldwide to transact in RMB. Hong Kong alone handled the equivalent of roughly $300 billion in RMB trade transactions in 2011, nearly one-third of all of Hong Kong's trade. Chinese companies, as well as foreign companies that conduct a lot of business with China, like using RMB because it reduces their need to hedge against the volatility of the dollar. If Chinese exporters can be paid in RMB instead of dollars, they do not have to worry that a sharp depreciation of the dollar vis-à-vis the RMB would hurt their future income. Despite all this, international use has not expanded to transactions beyond those with China itself.

Since the fourth quarter of 2011, forward rates have shown that the expectation that the RMB would be revalued has reversed direction. Investors now predict that the Chinese government will allow the RMB to decline in value to make Chinese exports more competitive. Market participants in Hong Kong and China are now willing to pay a premium in RMB above the prevailing exchange rate to gain access to dollars one year from now, which implies a bet on RMB depreciation. Therefore, the number of RMB export invoices rose as firms brought cheap RMB from Hong Kong back to China to take advantage of the relatively higher official exchange rate.

The level of RMB deposits in Hong Kong, a more reliable sign of offshore willingness to adopt the RMB, has declined since late last year. Since both Chinese and foreign investors bank in the economically liberal Hong Kong, RMB deposits there are a bellwether of general confidence in the RMB. Enlarging the pool of RMB circulating outside mainland China, a prerequisite for it becoming a global currency, thus might prove more challenging than first imagined, especially as global economic woes reduce demand for Chinese exports and put downward pressure on the RMB.

So will the RMB ever truly go global? That depends on whether Chinese decision-makers are willing to accept the risks involved in allowing capital to flow more freely in and out of mainland China. One major risk of capital-account liberalization, as this process is called, is that it could engender financial instability. The upside is that capital-account liberalization in developing countries tends to lead to higher economic growth, lower inflation, and higher returns on equity within two to three years after the reform. In the short term, however, it can cause volatility in capital flows, which can lead to deflation or inflation and even economic crises. Chinese leaders might be worried that if they make it easier to take assets out of China, more and more wealthy Chinese will hedge their bets by moving their children's education, their home purchasing, and their savings abroad. Because wealth is very concentrated in China, such a stampede for the exits could drain a substantial amount of deposits from China's banking system.

To reduce the risks associated with capital-account liberalization, China would need to liberalize its interest rate. The Chinese banking system keeps interest rates low to provide cheap loans to businesses. This penalizes households, which earn very little from their savings -- and invest in real estate instead. As long as domestic interest rates are artificially low, allowing the free flow of money will lead to large capital flows across borders as money seeks to take advantage of the higher returns outside the country. Interest-rate liberalization won't be a popular move in some segments of China's economy -- it would raise the borrowing costs for thousands of heavily indebted state-owned enterprises, for instance -- but it would prevent a substantial outflow of savings once money can freely move offshore.

But the biggest hurdle to internationalizing the RMB is China's reputation. During the 2008-2009 financial crisis, there was significant downward pressure on the RMB, suggesting that the currency was still not considered a safe haven. It is striking that when panic struck the global economy in 2008 and late 2011, international investors still sought safety in the United States and Japan instead of China, the world's second-largest economy. The overarching reason is that China lacks fundamental institutions, such as the rule of law and democratic leadership selection, that provide what analysts call "credible commitments" to the financial market about the sanctity of debt and derivative instruments. As large as the Chinese financial system is today (with nearly $21 trillion in assets, according to global rating agency Fitch Ratings), state-owned entities such as state banks and insurance companies own most of the financial assets. The government has not been able to credibly demonstrate to private investors that it will keep its hands off their money. Because the counterparties in most international financial transactions will be state-owned entities, global investors are unsure whether these state actors will renege on agreements or whether the opaque Chinese legal system will fairly adjudicate claims against state-owned counterparties or even the government itself.

If China reforms its core institutions to overcome these doubts, its currency will become a major global reserve currency and China will have arrived as a genuine global power. Yet despite Beijing's hopes, the world seems to be a long way from RMB dominance.

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