The U.S. dollar tale: entering the “PETRODOLLAR” system
In the previous article, we gave a brief connotation of the background of the modern petrodollar system and the introduction of a system in which dollars were “backed by gold” — an arrangement put in place by global leaders through the Bretton Woods conference in the final days of WWII.
As time went on, enormous government spending became deeply unsustainable; this narrative was greatly pushed by the huge costs of the so-called “welfare state”: a policy that, the U.S. in particular, adopted and justified with the necessity of “perpetual wars” in order to allow that system to continue.
But as we learnt, nations worldwide started to call the U.S. bluff and its impossibility to repay its enormous amount of debt. So the Nixon Shock officially signed the end of the Bretton Woods era and cast the world into a new chapter of the economic mechanism:
the ‘PETRODOLLAR SYSTEM’.
The Petrodollar system 101
We will start by defining what the Petrodollar by using the following statement:
“a petrodollar is every U.S. dollar deposited in Western Banks which derives from the sale of oil — which is priced in U.S. dollars”
Despite the simple affirmation of ‘dollars for oil,’ the petrodollar system has deep complexity, a feature that was very well designed to prevent the public to understand its mechanism.
“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
― Henry Ford
The rise of the Petrodollar
Approaching the end of the 1970s, it was clear that Bretton Woods was close to its end; in this climate of tension and concerns, Henry Kissinger — the U.S. Secretary of State under Nixon presidency — knew for a fact that a collapse of Bretton Woods agreement would have caused a DECLINE in the demand of U.S. dollars, causing the loss of Washington global trade and influence hegemony.
The Secretary held numerous meetings with the Saudi Arabia royal family, Kissinger then came up with a brilliant idea:
replacing the gold standard with a ‘promise’ of America ‘to back up, support and intervene in aid to the Saudis in exchange for their oil fields.’
The Saudi royals knew a good deal when they saw one: they were more than willing to accept weapons and basically the ‘guarantee’ that the giant U.S. military machine will restrain any attacks on the Kingdom, especially from the neighboring ISRAEL — an enemy with which the Kingdom has been at war since the late 1950s.
The Saudi Royals jumped at the opportunity, but they were not fools:
Naturally, they wondered how much all of this U.S. military muscle was going to cost…
What exactly did the United States want in exchange for their weapons and military protection?
The Americans laid out their terms, and they were rather simple at first glance:
- the Saudis must agree to price ALL of their oil sales in U.S. dollar ONLY (de facto refusing all other currencies except the dollar as payment);
- the Saudis would be open to investing their SURPLUS OIL PROCEEDS in U.S. DEBT SECURITIES.
A brilliantly executed plan by the American administration that would have been enough to propel them into the economic stratosphere in the coming decades.
The agreement was officialized on June 8th, 1974; the Americans did clever calculations, as the following years saw a multitude of other
oil-producing nations wanting in on the deal.
Fast-forward to 1975, ALL of the oil-producing nations of the OPEC (Organization of the Petroleum Exporting Countries) had agreed to price their oil in dollars and to hold their surplus oil proceeds in U.S. government debt securities in exchange for the generous offers by the U.S.
Nixon and Kissinger had successfully bridged the gap between the failed Bretton Woods arrangement and the new Petrodollar system. The global artificial demand for U.S. dollars would not only remain intact, but it would also soar due to the increasing demand for oil around the world as it was the commodity par excellence for economic & technological development.
Without the constraints imposed by a rigid gold standard, the U.S. monetary base could be grown at exponential rates.
It should come as no surprise that the United States maintains a major military presence in much of the Persian Gulf region, including the following countries: Bahrain, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates, Egypt, Israel, Jordan, and Yemen.
“I hereby find that the defense of Saudi Arabia is vital to the defense of the United States”
- President Franklin D. Roosevelt
A new era did began.
The benefits of the new Petrodollar system
The Petrodollar move can now be considered one of the most brilliant geopolitical and economic strategies in recent political memory.
Today, virtually all global oil transactions are settled in U.S. dollars.
When a country does not have a surplus of U.S. dollars, it must create a strategy to obtain them in order to buy oil.
One way to obtain U.S. dollars is through foreign exchange markets — by exchanging the country’s currency into U.S. dollars. This is not, however, a viable long-term solution as it is cost-prohibitive: many low-developed countries as well as emerging ones, present a seldom weaker and not competitive currency that is hardly matching the ‘power’ of the U.S. dollar.
Many countries have instead opted for an export-led strategy with the United States: exchange their goods and services for U.S. dollars in order to purchase oil on the market.
The petrodollar system, therefore, provides at least three immediate benefits to the United States:
1) it increases global demand for U.S. dollars: the more demand that exists for the currency, the better it is for the producer.
Like all modern developed economies, the United States has built most of its infrastructures around the use of petroleum-based energy supplies.
A major demand means major revenue for the producer: now, as the demand for oil rises and all the oil is priced in U.S. dollars, we can clearly see where it leads: exponential growth in demand for the dollar;
2) it gives the United States the ability to buy oil with a currency it can print at will — this point is of particular importance: deeply tied with the rise in demand for the dollar — this ‘artificial demand’ for the currency allows Washington to ‘PRINT DOLLARS AT WILL’, which are then used to buy real-world assets and services.
By the law of “supply and demand” applied to currency supply increase:
an increase in the supply of money causes the value of money to decrease over time
… a phenomenon called INFLATION, explained in greater detail in my previous article below:
The key takeaway:
“All other things been equal — if you print more money and the amount of goods doesn’t change in the relation of the money printed, households will have more cash and more money to spend on goods. If there is more money chasing the same amount of goods, firms will just put up prices”.
3. It increases global demand for U.S. debt securities: one of the most brilliant aspects of the petrodollar system was requesting that oil-producing nations take their excess oil profits and place them into U.S. debt securities in Western banks.
This system would later become known as “petrodollar recycling,” as coined by Henry Kissinger.
Through their exclusive use of dollars for oil transactions and then depositing their excess profits into American debt securities, the petrodollar system allowed the United States to go on a ‘shopping spree’ with virtually no limitation in their spending capability, a kind of an infinite money glitch.
Despite its obvious benefits, the petrodollar recycling process is both unusual and unsustainable. It has served to distort their true demand for government debt that has “permitted” the U.S. government to maintain artificially low-interest rates, de facto making all the players in the international market ‘addicted’ to these artificially low-interest rates.
The whole oil-backed system elevates the status of the US dollar but, as we saw, is also responsible for the downsides of petro-currency.
The petro-system results in a dilemma for the US dollar that has deteriorated the country’s status over the years due to:
- the U.S. needs to run account deficits to maintain liquidity in a continuously expanding global economy: stopping these deficits will slow down the global economy with potentially devastating drawbacks, especially for undeveloped nations and emerging economies;
- continuing the deficits may cause other countries to downgrade the value of the dollar.
This distortion has found its way into the markets, diluting the real purchasing power of the dollar over the past 40 years — an experiment in which we see the first signals of weakness and potential fall.
Foreign Policies: the slump of U.S. relationships with foreign countries
This is quite a politically sensitive topic, which, in my opinion, needs to be properly addressed to further clarify the effects of the petrodollar system in our history — both past, present, and future.
In the light of American interventionism in foreign countries, with the underlying motive of preserving the petrodollar system, we have seen the socio-political destabilization of entire regions, most notably the Middle East — an area where the U.S. involvement has been steady for the past 60 years.
A wearisome series of conflicts, culminating in millions of deaths and as many as displaced and forced to migrate.
We can see a pattern of how this energy-backed-by-warfare system is not working, and it is causing the majority of the problems our modern world faces today.
End of Part 2
For updates & the latest news and analysis — follow me on Twitter @FilandroMi
Link to Part 1 of “The Rise of the Petrodollar”:
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