Two pathways forward for Biden

Since the onset of Russia’s invasion of Ukraine, investors have been fixated on the impact of the conflict on global economies and markets. In the near-medium term, the outcome will mainly hinge on the duration of the conflict and the magnitude of energy price increases, as Europe is heavily dependent on Russia for natural gas and coal.

At this juncture, it is too early to tell because the situation is fluid. While the U.S. and its NATO partners have held off imposing sanctions on Russian energy, they announced new sanctions that are already taking a heavy toll on Russia’s currency and financial markets. The measures include cutting Russian banks off the SWIFT financial network and hindering its central bank from using its $630 billion arsenal of foreign exchange reserves.

Beyond this, Russia’s invasion carries significant long-term repercussions: It is the most important geopolitical event since the fall of the Berlin Wall in 1989.

At that time, both President George H.W. Bush and British Prime Minister Margaret Thatcher declared that the collapse of the Soviet Union would result in a “peace dividend.” They meant it would enable defense spending to be decreased in relative terms, which would allow more funds to be shifted to domestic priorities.  

This proved to be an accurate assessment: Defense outlays as a share of total federal spending declined from 27 percent in 1989 to 16 percent by 1999. The decade of the 1990s, in turn, was marked by above-average economic growth, low inflation and a federal budget surplus by the end of the decade.  

By comparison, the situation today is the opposite: The more the U.S. rebuilds defense capabilities, the more resources will be diverted from domestic priorities.

Until now, President Biden had not been inclined to increase military outlays materially.  In December, he signed a $768 billion defense policy bill that represented a 5 percent increase in military spending. But it was nearly $50 billion larger than his original request, as both Democrats and Republicans believed Biden’s proposal was insufficient to counter military advances by China and Russia.

Gary Schmitt of the American Enterprise Institute contends that Biden now faces a “Truman moment.” He reckons that for all of Biden’s desire to match FDR’s sweeping domestic agenda, he should instead follow the example of President Truman, who rebuilt the U.S. military after World War II and adopted a coherent foreign policy to counter communist expansion.

To do so, Biden will have to delineate clear policy priorities. In his State of the Union address, he praised the coordinated response of the U.S. and allies to counter Russian aggression. But he did not map out the need to boost defense spending or to curb spending on domestic programs.

With federal debt at record levels, inflation at four-decade highs and the Federal Reserve about to tighten monetary policy, spending must be brought under control.  Biden cannot follow President Johnson’s tack during the Vietnam War and increase both “guns and butter.” Nor does he have leeway to follow President Reagan’s strategy and substantially outspend Russia militarily.

Given these financial constraints, what options are left to consider?

My take is there are two avenues to pursue. The first is to rebuild alliances around the world after President Trump rejected multilateralism in favor of bilateral deals. The second is to use trade as an added lever. 

On the first, Biden deserves credit for bolstering America’s standing with its NATO partners over the past year. The dispute about Europe paying its fair share of the burden should lessen now that members realize what is at stake.

Germany recently upped its defense spending target above 2 percent of GDP, while also creating a strategic natural gas reserve. According to the Washington Post,  an official of the economy ministry stated: “We have to accept as Germans that we have to pay for our security in economic terms that we can no longer hope for Pax Americana.”

Also, neutral countries such as Switzerland and Sweden have lent support for Ukraine, while several of the Soviet Union’s former satellite states, including the Czech Republic, Hungary, Bulgaria and Romania, have condemned Russia’s action.

On trade, the goal should be to completely isolate Russia. In addition to financial sanctions, Russia’s status as a member of the World Trade Organization should be reviewed and possibly revoked. If so, Russia would face a return to Comecon, where its trade partners were confined to Soviet satellites and other communist states.

The Biden administration needs to eliminate tariffs that President Trump imposed on some of America’s closest allies, while also responding to China’s failure to purchase any of the additional $200 billion of exports that were pledged two years ago. This only reinforces China’s impression that the U.S. government lacks commitment to enforce agreements.

Meanwhile, Biden should revive U.S. membership in the Trans-Pacific Partnership (TPP) trade pact that Trump withdrew from in 2017. If the U.S. wants to regain its reputation as a global leader, it should make this a top priority.

The ultimate goal should be to preserve free trade with allies, while maintaining trade barriers with adversaries.

The open question is whether Biden can build a consensus within the ranks of Democrats and Republicans that Russia’s efforts to destabilize the Western alliance must be countered through military strength and multilateral commitments. By forging agreements with allies and using financial sanctions and trade as a lever over adversaries, the U.S. can lessen the burden of a new cold war on Americans.

Nicholas Sargen, Ph.D., is an economic consultant with Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business.  He has written three books, including “Global Shocks: An Investment Guide for Turbulent Markets.”