Warsh signaled at the hearing: The Federal Reserve will cooperate with Treasury Secretary Basant's "economic governance strategy," embracing geo-economics. Meanwhile, Basant is quietly seizing power from the Federal Reserve and plans to weaponize dollar swap lines. European financial officials have begun to worry.

Source: Jin Shi Data

This week, Kevin Warsh faced two and a half hours of intense questioning in Congress in his bid to become the next Federal Reserve Chair. Unsurprisingly, much of the debate at the hearing focused on monetary policy and whether Warsh would be President Trump's "puppet" — in other words, whether he would lower interest rates to please Trump. Warsh claimed he would not.

However, another brief exchange during Warsh's testimony was significant yet nearly ignored. When asked about the dollar issue, the prospective Fed chair stated, "The position of the United States in the world is at risk, including economic risks."

Roula Khalaf, editor of the Financial Times, stated in an opinion piece that this makes the "economic governance strategy" led by Treasury Secretary Basant and Secretary of State Rubio very important.

Therefore, Warsh added that "the Federal Reserve will play a supportive role to ensure the financial system is as safe as possible and will work with Basant and Rubio as this falls outside the realm of monetary policy operations."

Khalaf noted that simply put, under Warsh's leadership, the Fed will embrace geo-economics. This is particularly noteworthy — especially a day later when Basant revealed that the UAE and "numerous" other Gulf and Asian countries had requested the U.S. government to establish dollar swap lines.

Trump seems eager to cooperate. "If I can help them, I will," he said. This sent two important signals to the market.

The first signal is that some governments are concerned that a war with Iran could lead to real financial instability and that this risk is rising. Although the UAE ambassador to the U.S. insisted that "any suggestion that the UAE needs external financial support is a misreading of the facts," Gulf nations appear to be wisely bolstering their defenses.

But the second signal revolves around the Federal Reserve. Recall that during the 2008 global financial crisis, it was the New York Fed, led by Timothy Geithner, that took the lead in calming the markets. At that time, it utilized its own dollar swap lines because the Fed had permanent arrangements with five Western central banks to address short-term funding pressures and temporary arrangements with nine other central banks.

Since then, post-2008, the Federal Reserve has gained more bank regulatory powers and responsibilities for maintaining financial stability. By global standards, this may not seem significant, as the European Central Bank is also responsible for supervising financial stability, and the Bank of England has a Financial Policy Committee in addition to its Monetary Policy Committee.

However, last year, Basant vehemently criticized this arrangement. "Post-crisis reforms have significantly expanded the Fed's regulatory scope, but the results have been disappointing," he stated in an article. "The Fed now supervises, lends to, and sets the profitability calculations for the banks it regulates... this is an inevitable conflict that blurs accountability and jeopardizes the independence of monetary policy."

Basant is now quietly seizing more power from the Federal Reserve. For example, last year, the White House issued two executive orders that weakened the Fed's role in bank regulation. Recently, Basant has arranged meetings with insurance companies to discuss private credit risk, as well as meetings with bankers to discuss the Mythos AI model.

At the end of last year, the Treasury provided Argentina with a groundbreaking $20 billion swap line through the use of an exchange rate mechanism, without the Federal Reserve's involvement. Any dollar swap lines for the UAE are likely to repeat this model.

Is this a good thing? In some respects, yes. Basant is skilled at handling financial markets and has brought a market-savvy team to the Treasury. This is welcomed, especially since some financiers privately discuss that the New York Fed's market expertise seems to have declined since 2008.

The war with Iran could trigger new financial shocks (and Warsh is determined to prevent the Fed from devouring long-term bonds, even though Basant will be busy selling $10 trillion in U.S. Treasuries next year). Additionally, that $20 billion Argentina swap line was successfully implemented, despite many observers' initial skepticism.

However, Khalaf points out that one risk of this power shift is that domestic financial regulation will become more politicized and susceptible to White House intervention. Another risk is that dollar swap lines will increasingly be weaponized. Because even though the Fed has tried to downplay the role of geopolitics in its own swap lines, Basant has stated that he hopes to use swap lines to bolster U.S. dominance and reward allies, "locking in dollar hegemony."

Unsurprisingly, this has raised concerns among some European financial officials, who worry that if they challenge Trump, these swap lines might be rescinded.

Basant (and Warsh) might argue that this is simply the nature of geo-economics. But if that is the case, it raises another crucial question: Who will organize a global collective response if another financial crisis occurs? Washington was able to effectively do this at the end of 2008 because other Western central banks trusted the Fed and each other, and other governments respected Washington's leadership.

Fortunately, trust among central banks remains strong. But in the context of the rise of geo-economics and Trump's unpredictability, will other national governments heed Washington's directives in a financial crisis? This is uncertain and poses a danger.

Khalaf finally wrote that, in any case, Warsh should be questioned on this issue as well as on the "puppet" issue. Inflation is important, but global financial stability is now extremely critical. Just ask the UAE.