End of an Era: The Rise and Fall of the Petrodollar System
The intricate relationship between energy markets and our global financial system, can be traced back to the emergence of the petrodollar system in the 1970s, which was mainly driven by the rise of the United States as an economic and political superpower. For almost twenty years, the U.S. was the world’s only exporter of petroleum. Its relative energy independence helped support its economy and its currency. Until around 1970, the U.S. enjoyed a positive trade balance. Oil expert and author of the book “The Trace of Oil”, Bertram Brökelmann, explains a dramatic change took place in the US economy, as it experienced several transitions: First, it transitioned from being an oil exporter to an oil importer, then a goods importer and finally a money importer. This disastrous downward spiral began gradually, but it ultimately affected the global economy.
A petrodollar is defined as a US Dollar that is received by an oil producer in exchange for selling oil. As is shown in the chart below, the gap between U.S. oil consumption and production began to expand in the late 1960s, making the U.S. dependent on oil imports. And while it led to the US Dollar being established as the world’s premier reserve currency, it also contributed to the country’s increase in debt. The oil embargo of 1973-74 was a major hit that exposed the vulnerability of the US economy. Nevertheless, under the banner of “national security” the future policy course was firmly set: in a 1973 National Security Council (NSC) paper, it was stated that “that U.S. leverage in energy matters resulted from its economic and political influence with Saudi Arabia and Iran, the two leading oil exporters”.
From a gold-based monetary system to a petrodollar system
Former U.S. Congressman Ron Paul explains that “understanding the Petrodollar system and the forces affecting it, is the best way to predict when the US Dollar will collapse.” The origins of the petrodollar system go back to the Bretton Woods system, the 1944 post-war agreement, which made the U.S. Dollar the sole reserve currency. From then on, only the U.S. Dollar would be convertible into gold at a fixed rate of USD35 per ounce. This also meant that only the U.S. was able to change the price of gold and, in turn, it committed to maintaining the value of the Dollar by buying and selling unlimited quantities of gold, at the agreed upon rate of USD35 per ounce. In 1945, the U.S. Treasury had 17’848 metric tons of fine gold, which at the time represented around 63% of the official gold reserves. The gold-backed Dollar offered the world a reliable and stable reserve currency. However, cracks in the Bretton Woods system began to emerge, as the export surpluses of the U.S. began to drop after 1960.
The Kennedy and Johnson administrations were rather big on money printing, be it to finance the space race, or to spend on domestic social programs, while a significant burden on the U.S. budget were the wars fought in Korea and Vietnam, which had to be paid for by resorting to the usual war funding mechanisms, i.e. through bonds and debts. Thus, the country began to live on credit and banks worldwide were being flooded with US Dollars. These same Dollars represented gold claims on the United States. In 1971, the U.S. temporarily suspended convertibility of the Dollar into gold, and agreed to devalue the Dollar to USD38.00 per ounce. A run on gold ensued nonetheless, as European states, particularly France and Germany, were still skeptical and wary of another devaluation; as a result, U.S. gold reserves shrunk to about 286 million ounces! Inevitably, Nixon closed the gold window in August 1971 and the Dollar was devalued for a second time by 10%, and like a shot, reached USD42.22 . This essentially meant that the U.S. Treasury defaulted on its promise to back the Dollar with gold and thus, the financial system as it was at the time was no longer sustainable.
1973 was an important year for oil: the oil embargo emerged as a reaction to the Yom Kippur war, but it also related to the closure of the gold window. The Dollar became nothing more than a fiat currency and the FED was free to pursue its monetary expansion completely unhindered. The only problem the U.S. faced was how to motivate countries to hold and use US Dollars. But not for long: the Americans had their eyes set on their target: Saudi Arabia.
According to leaked documents, there were other parties of interest that “orchestrated” these developments in 1973-74. Henry Kissinger held a meeting in Bilderberg in the Netherlands with an influential group of men: Lord Greenhill of BP, David Rockefeller of Chase Manhattan Bank, George Ball of Lehman Brothers and Zbigniew Brzezinski. Together they recognized that OPEC “could completely disorganize and undermine the world monetary system” and so, they decided to target the commodity they controlled. Oil was to save their banks and financial interests from the collapse of the Dollar. Shortly thereafter, Kissinger negotiated with the Saudi monarchy, acting as the middleman that helped steer the events in the direction that would lead to a tradeoff between Saudi Arabia and the United States. What was not known until recent disclosures, was another covert meeting between the Saudis and newly appointed U.S. Treasury secretary, William Simon. The objective was to find a way to convert the hostile Saudis to U.S allies and by doing so, to use that petrodollar to reanimate the ailing U.S. economy. Nixon would not take no for an answer – not only was it a matter of economic security, but he also wanted to block the Soviet Union from entering the region through that critical angle. Simon knew how to sell the idea: America was the safest place for the Saudis to invest their petrodollars and no one would know about it (Saudi investments were not disclosed separately, instead they were grouped with other oil exporting countries). As shown in the chart below, today, holding about USD117 billion, Saudi Arabia is the country’s largest foreign creditor compared to other oil exporting treasury securities holders.
And so, a partnership and a strategic alliance were formed: The U.S. agreed it would guarantee the survival of the House of Saud, provide military security for the Saudi oil fields, as well as provide military weapons and artillery to the Saudi government. In return, Saudi Arabia would use its leverage in OPEC to ensure all transactions would be in USD, invest its own Dollars generated from oil sales in U.S. investment vehicles, maintain influence over price levels and primarily prevent another oil embargo.
This alliance marked a paradigm shift, the transition to the petrodollar system. It enabled the U.S. to fill the vacuum that was left by the closure of the gold window. The oil conglomerates and finance oligarchs secured the flow of funds by creating a new wave of demand for US Dollars. Though artificial and baseless, it was backed by the increasing demand for oil worldwide. And this, also artificial, demand has successfully supported the continuation of the American expansionary monetary policy for decades – at least until the beginning of the global financial crisis and the point where we find ourselves now.
Is there another paradigm shift underway?
Similar to the paradigm shift that followed with the collapse of the Bretton Woods system, there is another major shift underway today. According to Ron Paul, we will know its consequences in full, the day oil-producing countries demand gold for their oil, instead of dollars. We have already been seeing changes in oil sale agreements made in recent years. In 2013, Russia’s Rosneft agreed to supply China USD270 billion worth of oil, the largest agreement to date. Additionally several OPEC nations are accepting oil transactions to be carried out in a currency other than the dollar. How so? In January 2016, India and Iran agreed to settle their oil sales in Indian Rupees. In 2014, Qatar agreed with China to be the first hub for clearing transactions in the Chinese Yuan. In December 2015, the United Arab Emirates (UAE) and China agreed on and created a new currency swap for the Yuan. Both steps strongly indicate, that the Gulf states are seeking measures to reduce their dependence and exposure to the US dollar.
It is therefore clear why all eyes are set on the geopolitical turbulences of the Middle East. Concerns are intensified after a failed military intervention by the U.S., the slowly weakening strategic position of Saudi Arabia in the region and the increasing strength of Iran after the removal of economic sanctions. In addition, U.S.-Saudi relations are currently on shaky ground. In April, Saudi Arabia warned it could proceed to sell off billions worth of U.S. bonds, if Congress passed a bill that would allow the kingdom to be held liable in U.S. courts for the Sept. 11 terrorist attacks. That bill indeed passed the Senate in May and is now in the House of Representatives, but the vote is yet to be scheduled. The Saudi threat has not yet materialized, but if it did, it would pull billions of Dollars out of the U.S. economy – the consequences of such a move would be as catastrophic as they are predictable.
Courtesy: Claudio Grass
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Chinese Yuan , Dollar into Gold , Gold Reserves , Indian Rupees , Monetary Policy , Oil Imports , Oil Sales , OPEC Nations , Petrodollar System , Petrodollars , Reserve Currency , Saudi Arabia , US Dollar , US Economy
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