2021/11: The Rise and Fall of the Petrodollar — Is the International Financial System Doomed?

The last years have been nothing less than packed with powerful and extremely disruptive set of events — from cryptocurrency to Brexit to the Robinhood GameStop stock scandal — the global economy is a hot topic.

It’s no surprise that in the face of economic uncertainty, many people are interested in learning about how the global economy actually works, and as we go through the process of erudition, learning about the petrodollar system is an essential step to improving our understanding.

THE ‘STAR & STRIPES’ DOMINANCE

The world relies on the U.S. dollar and U.S. treasuries, giving America unparalleled and outsized economic dominance. Nearly 90% of international currency transactions are in dollars, 60% of foreign exchange reserves are held in dollars, and almost 40% of the world’s debt is issued in dollars, even though the U.S. only accounts for around 20% of global GDP.

This special status that the dollar enjoys was born in the 1970s through a military pact between America and Saudi Arabia, leading the world to price oil in dollars and stockpile U.S. debt. As we emerge from the 2020 pandemic and financial crisis, American elites continue to enjoy the exorbitant privilege of issuing the ultimate monetary good and numéraire for energy and finance.

The past few decades have seen a vast global rise in economic activity, population, democratic progress, technological advancement, and living standards, but there are many flaws in this system that are rarely spoken about and that weigh heavily on billions of people across the globe, and yet we assisted to a dramatic increment of wealth into few ‘hands’ exacerbating inequality and all the related socio-economic issues derived from it, hence the stronger than ever need for a ‘decentralized’ and more fair system to address the needs of billions of people around the globe.

THE SUPREMACY OF THE DOLLAR

The British Empire was the unquestioned economic hegemon of the 19th century but began to lose steam early in the 20th century, especially after World War I. The United States emerged much healthier than war-torn Europe and as the country with by far the most gold. By the outbreak of World War II, the dollar had unquestionably eclipsed the pound as the world’s most influential national currency.

Governments still relied on gold as the underlying global reserve currency, but U.S. and U.K. policymakers were determined to create a more “flexible” system. In the waning months of World War II, leaders from 44 countries gathered in a hotel in Bretton Woods, New Hampshire, to choose a new financial bedrock. British economist John Maynard Keynes pushed the idea of the bancor, a global unit of account that many nations would manage.

But the U.S. preferred the idea of the dollar at the center, pegged to gold at $35 per ounce.

Since international trade deficits still had to be settled in gold, America’s substantial control of the world’s gold supply and favorable balance of payments position provided the leverage to get its way.

Over the coming decades, the world shifted to the Bretton Woods standard, with national currencies pegged to adjustable dollar amounts, where the U.S. was trusted to custody and hold enough gold to prop up the whole system. Up until the early 1960s, it did a reasonably good job. Dollars became the dominant medium of exchange for international settlement, backed by a promise to pay in gold. America became the largest creditor nation and an economic powerhouse. However, after the assassination of President Kennedy, the U.S. government chose a path of huge social and military spending. With President Johnson’s “great society” social programs and the invasion of Vietnam, U.S. debt skyrocketed. Unlike World War II or the Korean War, Vietnam was the first American war waged almost entirely on credit.

CAN YOU SAY “MIDDLEMAN”?

At this point, an appropriate question to be asking yourself is:

”Why would all of the nations be willing to allow the value of their currencies to be dependent upon the U.S. Dollar?”

The answer is quite simple.

The U.S. Dollar would be pegged at a fixed rate to gold. This made the U.S. dollar completely convertible into gold at a fixed rate of $35 per ounce within the global economic community. This international convertibility into gold allayed concerns about the fixed rate regime and created a sense of financial security among nations in pegging their currency’s value to the dollar. After all, the Bretton Woods arrangement provided an escape hatch: if a particular nation no longer felt comfortable with the dollar, they could easily convert their dollars holdings into gold. This arrangement helped restore much-needed stability in the financial system, but it also accomplished one other very important thing: the Bretton Woods agreement instantly created a strong global demand for U.S. dollars as the preferred medium of exchange…

… and along with this growing demand for U.S. Dollars came the need for a larger supply of dollars.

GOODBYE, YELLOW BRICK ROAD

Increasing financial spending fueled by demand for war-driven expenses (maintaining an enormous and expensive military infrastructure) quickly followed by an unrestful social environment — particularly worsen by the morality of the war — progressively put the U.S. in a highly indebted position with countries such as France and U.K. demining the return of their gold holdings amid the country uncertainty.

But all of that was about change.

It was August 15, 1971, that President Richard Nixon told the American people that the U.S. would no longer redeem dollars for gold as part of a plan that included wage and price freezes and an import surcharge in an attempt to save the economy: deeming it as ‘temporary’, the move named “Nixon Shock” caused the dollar to be devalued by more than 10%, ceasing the Bretton Woods system and initiating a worldwide financial crisis.

With this move, the U.S. de facto ‘rug pulled’ the world and for the first time in history and shifting the world in a pure fiat standard.

The dollars held by central banks across the globe lost their backing, and there was a geopolitical moment where U.S. dominance was called into question and where a multipolar financial world was a distinct possibility.

THE RISE OF THE PETRODOLLAR SYSTEM

The petrodollar system originated in the early 1970s in the wake of the Bretton Woods collapsed.

President Richard M. Nixon and his globalist sidekick, Secretary of State, Henry Kissinger, knew that their destruction of the international gold standard under the Bretton Woods arrangement would cause a decline in the artificial global demand for the U.S. dollar. Maintaining this “artificial dollar demand” was vital if the United States were to continue expanding its “welfare and warfare” spending policy.

Adding even more pressure, in 1973, the Arab petroleum exporters of OPEC decided to quadruple the price of world oil and embargo the U.S. in response to its support for Israel during the Yom Kippur War.

In just a few years, a barrel of oil rose from less than $2 to nearly $12. Faced with double-digit inflation and declining global faith in the dollar, Nixon and his Secretary of State and National Security Advisor Henry Kissinger came up with an idea that would allow them to keep “guns and butter” going in the post-gold standard era and irreversibley alter the fate of the world.

In a series of meetings, the United States — represented by then U.S. Secretary of State Henry Kissinger — and the Saudi royal family made a powerful agreement, then officialized on June 8, 1974.

According to the agreement, the United States would offer military protection for Saudi Arabia’s oil fields.

The U.S. also agreed to provide the Saudis with weapons, and perhaps most importantly, guaranteed protection from Israel.

The Saudi royal family knew a good deal when they saw one. They were more than happy to accept American weapons and a U.S. guarantee to restrain attacks from neighboring Israel, but 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. They were simple and two-fold.

1. The Saudis must agree to price all of their oil sales in U.S. dollars only. (In other words, the Saudis were to refuse all other currencies except the U.S. dollar as payment for their oil exports.);
2. The Saudis would be open to investing their surplus oil proceeds in U.S. debt securities.

Fast forward of one year: by 1975, all of the oil-producing nations of OPEC 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, it would soar due to the increasing demand for oil around the world as the key element to industrialization and technological advancement.

THE U.S. & THE PETRODOLLAR HEGEMONY

The petrodollar system has proven tremendously beneficial to the U.S. economy. In addition to creating a marketplace for affordable imported goods from countries who need U.S. dollars, there are more specific benefits.

First, oil consumers are required to purchase oil in U.S. dollars.

Second, the excess profits of the oil-producing nations are then placed into U.S. government debt securities held in Western banks.

The petrodollar system provides at least three immediate benefits to the United States:

• It increases global demand for U.S. dollars
• It increases global demand for U.S. debt securities
• It gives the United States the ability to buy oil with a currency it can print at will

In other words, if Washington can somehow create a growing global demand for its paper dollars, then it has given itself a “permission slip” to continually increase the supply of dollars.

That said, the artificial dollar demand created by the petrodollar system has “permitted” Washington to go on multiple spending sprees to further create their “welfare and warfare” state policy, and with so many dollars floating around the globe, America’s asset prices (including houses, stocks, etc.) naturally rose.

After all, prices are directly related to the available money supply.

THE IMPACT OF THE PETRODOLLAR AND ITS PROBLEMS

This system was created and held in place not by pure economics but by politics through the pact with Saudi Arabia and it brought U.S. treasuries into the spotlight by de facto replacing gold as the world’s reserve currency and ultimate store of value.

Since its creation in 1974, the petrodollar system has changed the world in many significant ways, including:

• The creation of a tight alliance between the United States and the Saudi Arabian dictatorship, as well as other tyrannies in the Gulf region.
• The steep rise of the “eurodollar” shadow global economy as petrodollars (created outside the control of the Federal Reserve) flooded banks in London and North America and were then recycled into U.S. treasuries or loaned back out to emerging markets.
• The financialization of the American economy as the artificially strong dollar made exports uncompetitive, hollowed out the middle class and shifted focus from manufacturing to finance, technology, defense and services, all while increasing the leverage in the system.
• Additional stress on the Soviet Union, which was now faced with an increasingly dollarized world market, where the U.S. could print money to buy oil, but it had to dig oil out of the ground.
• Painful issues for emerging market economies, which became mired in dollar-denominated debt that was difficult to pay back and stuck in a system that prioritized dollar accumulation over domestic investment, harming income and triggering debt crises everywhere, from Mexico to East Asia to Russia to Argentina.
• Steady growth of the oil and fossil fuels industries at the expense of nuclear power and regional energy independence.
• And, of course, the continuation of the U.S. as a military-financial hegemon and the ability of the U.S. to run humongous deficits to finance wars and social programs, all in part paid for by other countries.

The same elevated status for the US dollar is also responsible for the downsides of petro currency. The petro system results in a catch-22 for the US dollar that could cause it to lose its status:

• The US needs to run account deficits to maintain liquidity in a continuously expanding global economy.
• Stopping these deficits will slow down the global economy.
• Continuing the deficits may cause other countries to downgrade the value of the dollar.

There are petrodollar theory critics who say the phenomenon is largely a myth — while many say the dollar has been dominant simply because there has been no competition, others point the fact that the dollar was already the world reserve currency before 1973, and that the pricing of commodities in dollars is “just a convention,” and that “there would be no real difference if the euro, the yen, or even bushels of wheat were selected as the unit of account for the oil market.

A WEAKENED SYSTEM

The answer to “What is the petrodollar?” may continue to change as the global economic landscape shifts.

Many countries want to escape from U.S. financial control, and this desire is accelerating global de-dollarization and More and more countries are denominating oil trade in other currencies, like euros, yuan and rubles, because they fear the U.S. government continues to use the dollar as a weapon.

The American sanction system is incredibly powerful, as it can cut enemies off from the SWIFT payment network or from the World Bank or IMF.

By using American banks as a ‘baton’ against Russia, Joe Biden has shown a willingness to weaponize the U.S. financial system against foes, continuing a tactic honed during the Obama years and dramatically ramped up under Donald Trump.

For instance, Venezuela began selling its oil in other currencies, and the Saudi government has threatened to abandon petrodollars. There are several trends to consider when debating the future of the petrodollar.

First, continuing to run deficits has led to a loss in purchase power for the US dollar, leading some nations to begin losing faith in the system.

Second, concerns about global warming and technological advancements toward sustainable energy are reducing demand for oil — and the need for the petrodollar system.

Finally, strained international relations with major oil producers like Iran, Russia, and China are leading these countries to reconsider their dependence on the US dollar.

The CASE OF BITCOIN IN A MULTIPOLARIZED WORLD: A possible replacement as the world reserve currency?

In its growth from conceptual white paper to a trillion-dollar asset, Bitcoin has attracted an enormous amount of criticism. Detractors focus on its perceived negative externalities: energy consumption, carbon footprint, lack of centralized control, and inability to be regulated. Regardless of the validity of these arguments, few critics stop to think comparatively about the negative externalities of the world’s current financial system of dollar hegemony and one of the use-cases of Bitcoin is the fact that is a decentralized asset competing to be the new global reserve currency, aiming to inherit the role gold once had and the role the dollar holds today.

We are very possibly witnessing the birth of not just a new ultimate store of value but also a new global base money, neutral and decentralized like gold, but unlike gold, in that it is programmable, teleportable, easily verifiable, absolutely scarce, and resistant to centralized capture. Any citizen o any government can receive, store or send any amount of bitcoin simply with internet access, and no alliance or empire can debase that currency. It is, as some say, the currency of enemies: adversarial parties can use the system and benefit equally without detracting from each other.

The big fear, of course, is that America will not be able to finance its exorbitant social programs and military spending if there is less global demand for the dollar. If people prefer the euro or yuan or bonds from other countries, the U.S. in its current form would be in big trouble. Nixon and Kissinger designed the petrodollar so that the U.S. could benefit from global demand for dollars tied to oil.

The question is, why can’t there be a global demand for dollars tied to bitcoin?

Under the Bitcoin standard, everyone would play by the same rules. No government or alliance of governments can manipulate the monetary policy.

The world’s multipolar drift is inevitable. No one country can, in the near future, gain as much power as America had at the end of the 20th century. The U.S. will still be a powerhouse for a long time to come, but so will China, the EU, Russia, India, and other nations. And they may compete in a new monetary system that moves away from the petrodollar and all of its costly externalities: a neutral Bitcoin standard that plays to the strengths of open societies does not depend on dictators or fossil fuels and is ultimately run by citizens, not the entrenched elite.