The Petrodollar: How Much Longer?
In July 1944, at the Mount Washington Hotel in Bretton Woods, New Hampshire, delegates from all 44 Allied nations involved in World War II sought to define and regulate the international monetary and financial system.
In addition to the establishment of a number of global agreements (such as the General Agreement on Tariffs and Trade), the essential outcome involved an obligation for each country to maintain an exchange rate for its currency against the US dollar. The US dollar would in turn be backed by gold at an exchange rate of USD35 per ounce.
This was of course a great deal for the US. It created worldwide demand for the US dollar as a medium of exchange. The US obliged by increasing the supply of US dollars, while holding around 80% of the world’s gold.
However by the late 1960’s the US entered a period of very high deficits. The deficits arose from sharply increased spending on welfare and warfare (sound familiar?). Specifically: Lyndon Johnson’s “Great Society” (the introduction of Medicare, etc.); and the Vietnam War.
By 1971, with soaring US deficits and spending, foreign confidence in the US dollar declined rapidly. US gold reserves were perilously low as a result of foreigners exchanging US dollars for gold. It appeared that the Bretton Woods system would fail unless the US could dramatically reduce both consumption and debt. To do this would, of course, be political suicide.
In August 1971 President Richard Nixon “closed the gold window”. The US dollar was no longer backed by gold and was, for the moment, a true fiat currency. Further, it and many other of the world’s currencies became “floating currencies”.
A very serious side effect for the US was the decline in demand for the US dollar. Well aware of this declining demand, President Nixon needed to develop another mechanism to boost global demand for the US dollar. Cue the “petrodollar”.
President Nixon and then Secretary of State Henry Kissinger commenced negotiation with Saudi Arabia to price oil only in US dollars – the petrodollar. In addition, the Saudis would invest surplus income in US debt instruments. In return, the US would give military protection and weapons to Saudi Arabia.
The agreement was in place with Saudi Arabia in 1974 (at the time of the first “oil shock” and the Yom Kippur war), and with all of OPEC by 1975. While criticised at the time, it has proven to have been one of the most brilliant economic strategies ever devised.
It quickly led to three key benefits to the US:
- Increased global demand for the US dollar;
- Increased demand for US debt securities; and
- The ability for the US, alone, to print dollars to buy oil.
In time this agreement led to a huge increase in military expenditure, for self-evident reasons, and allowed increased welfare spending. It has worked well for the US for many years, but perhaps not so well for other nations.
After a successful 40 or so years the outlook for the petrodollar is not so promising. We now see both producers and consumers seeking alternatives to the petrodollar. Today China, Russia and others (such as Pakistan, Iran and India) are proposing to price oil in currencies other than the US dollar.
Now while the US military’s defence of the petrodollar has been somewhat successful to date:
“I’m saying taking Saddam out was essential,” for the purpose of “making certain that the existing system [of oil markets] continues to work”..
In an interview with Bob Woodward of the Washington Post in September 2007
it is certain that future defence of the petrodollar will become more difficult and more expensive. It is inevitable that the reign of the petrodollar will end, just as Bretton Woods did in 1971.
To the investor, it is what follows the petrodollar that is of most interest. Some questions to reflect upon:
- Will there be chaos and war, or will there be a more orderly transition to a new system?
- Will the replacement be a “world currency”?
- Will there be multiple oil exchanges trading in multiple currencies?
- What will happen to the price of oil?
- What will happen to the US dollar?
- Does the US have a Plan B?
Interesting times ahead.