(by Ryan McMaken | Mises Wire) – On January 17, Saudi Finance Minister Mohammed Al-Jadaan announced that the Saudi state is open to selling oil in currencies other than the dollar. “There are no problems discussing how we settle our trade deals, whether it’s in the U.S. dollar, whether it’s the euro, whether it’s the Saudi riyal,” Al-Jadaan said. he told Bloomberg TV.
If the Saudi regime actually accepts substantial trade in currencies other than the dollar as part of its oil export business, this would signal a shift away from the dollar as the dominant currency in global oil payments. Or measured another way, this would signal the end of the so-called petrodollar.
But how big is this change? With increasingly frequent Saudi comments about trading non-dollar currencies, we have also seen an increasing number of pundits announcing the “collapse” of the dollar, or the imminent implosion of the dollar’s currently outsized global power.
Will a displacement of the dollar in global oil trade really lead to a large relative decline in the dollar? Probably and eventually. But first other dominoes would have to fall, especially the domino we call “Eurodollars”.
On the other hand, it would be foolish to simply dismiss the potential end of the Saudi preference for the dollar with a wave of the hand. The end of the petrodollar would, in fact, weaken the dollar, even if that was not a death blow in itself. Moreover, it is especially reckless to ignore the status of the petrodollar because that status also has geopolitical implications. Saudi Arabia comments on dollar signal that Saudis no longer consider their alliance with the United States as important as it has been since the 1970s. What is not an immediate economic problem for the US regime or the dollar may nevertheless be an immediate geopolitical problem.
In context, probably the best way to look at the potential end of the petrodollar is to see it as a piece of the dollar-based part of the global economy. Since the 1950s, the dollar has experienced an immense amount of support in terms of global trade and investment and in terms of dollar reserves held by foreigners. This has greatly supported demand for US debt and dollars, and this has had huge disinflationary effects on the US domestic economy. That is, newly created dollars are absorbed by foreigners who want and need dollars to pay off dollar-denominated debt and cover bank reserves. But if the dollar’s global dominance is truly in decline, we could expect both higher domestic price inflation and higher interest rates than Americans have been accustomed to for the past thirty years. In other words, as the dollar falls, the US regime will no longer be able to monetize debt and run up huge new deficits without fear of high inflation or falling Treasury prices. The end of the petrodollar is not a reason to panic right now, but it is the latest sign that the US regime’s power through the dollar is being checked.
What is the Petrodollar?
The petrodollar is the result of U.S. efforts to secure access to Middle Eastern oil while stemming the decline of the dollar in the early 1970s.
In 1974, the US dollar was in a precarious position. By 1971, thanks to disproportionate spending on both war and domestic welfare programs, the United States could no longer maintain a fixed global price for gold under the Bretton Woods system established in 1944. The value of the dollar relative to gold fell as the supply of dollars increased as a byproduct of growing deficit spending. Foreign governments and investors began to lose faith in the dollar.
In response to these developments, Richard Nixon announced that the US would leave the Bretton Woods system. The dollar began to float against other currencies. Not surprisingly, this devaluation did not restore confidence in the dollar. Also, the US had made no effort to curb deficit spending. Therefore, the US had to continue to look for ways to sell public debt without raising interest rates. In other words, the US needed more buyers for its debt. The motivation to fix grew even stronger after 1973, when the first oil shock further exacerbated the deficit-fueled price inflation Americans were suffering.
But in 1974, the huge flood of US dollars into Saudi Arabia, the main oil exporter, suggested a solution. Nixon secured an agreement whereby the US would buy oil from Saudi Arabia and also provide aid and military equipment to the kingdom. In return, the Saudis would use their dollars to buy US Treasuries and help finance US budget deficits.
From a public finance point of view, this seemed to be a win-win. The Saudis would receive protection from geopolitical enemies, and the US would get a new place to unload huge amounts of public debt. In addition, the Saudis could park their dollars in relatively safe and reliable investments in the United States. This became known as “petrodollar recycling”. By spending on oil, the US was creating new demand for debt and US dollars.
Over time, thanks to Saudi Arabia’s dominance of the Organization of the Petroleum Exporting Countries (OPEC), the dollar’s dominance extended to OPEC as a whole, which meant that the dollar made it the currency of choice for oil purchases around the world.
This petrodollar arrangement proved particularly important in the 1970s and 1980s, when Saudi Arabia and OPEC countries controlled more of the oil trade than they do now. It also tied U.S. interests closely to Saudi interests, ensuring U.S. enmity toward the kingdom’s traditional rivals, such as Iran.
The petrodollar is a type of Eurodollar
In terms of its economic role, however, the petrodollar has always been a kind of Eurodollar.
What is a Eurodollar? According to Robert Murphy:
The term Eurodollar actually refers to any US dollar denominated deposit held at a financial institution outside the US, or even a USD deposit held by a foreign bank in the US. So it has nothing to do with the Euro and is not limited to dollars held in Europe; are dollar deposits that are not subject to the same regulations as US dollars held by US banks, nor are they guaranteed by the protection of the Federal Deposit Insurance Corporation (FDIC) (and therefore tend to get a higher rate of return).
Eurodollar trade is huge, although it’s hard to quantify exactly how big it is. One estimate places Eurodollar assets at around $12 trillion. For context, we can consider that all the assets of American banks add up to about 22 trillion dollars. Or to put it another way, “offshore dollar banking now accounts for roughly half of the US total.” Therefore, the Eurodollar economy is very large, and this “dollar zone” is also a key component of many of the world’s major economies, given that half or more of the world’s economy is located in this area
In contrast, in 2020, trade in petrodollars amounted to less than $3.5 trillion annually. That’s not insignificant, of course, but even a sizeable reduction in that amount won’t cause global demand for the dollar (relative to other currencies) to collapse on its own. With so many trillions of dollar-denominated loans floating around the global economy, the petrodollar remains only one piece of a larger pie.
However, we could also conclude that the end of the petrodollar is part of a larger and more important trend away from the dollar. The relative size of the Eurodollar market has declined since 2008, from a high of 87% of the size of the US banking system to less than 60%. Meanwhile, the US dollar share of foreign central bank reserves has fallen from 71% twenty years ago to 60% today. This is a minimum of twenty-five years. Russia, China and India have all shown interest in freeing the global economy from the dollar.
Even if this trend continues, demand for the dollar will certainly not disappear next week or next month or next year. There are still trillions of dollars of dollar-denominated debt in the global economy, and for now, at least, that means continued demand for dollars. Also, the dollar remains one of the safest currencies to hold, given that central banks in Japan, Europe, the UK and China are hardly accepting ‘hard money’. Since the US economy remains huge and US Treasuries are still at least as safe as bonds from other regimes, foreigners will still have plenty of dollars on hand to buy US assets. This is also true because—despite the myth that “America doesn’t do anything anymore”—foreigners also buy US products and services.
That doesn’t mean all is well for the dollar, however. A move away from the dollar, even in slow motion, will mean an increase in the cost of living for Americans. With fewer foreigners holding on to dollars, the current monetary inflation of the US regime will create more domestic price inflation. In other words, the move away from the dollar will mean that the US regime must engage in less monetization of the nation’s debt if it is to avoid runaway inflation. It will also likely lead to the need to pay higher interest rates on US government bonds, and that will mean the need for more taxpayer money to service the debt. It will mean that it will be more difficult for the US regime to finance all the new wars, programs and projects that Washington can imagine.
The geopolitics of the petrodollar
The most obvious short-term effects of moving away from the petrodollar will be in geopolitics rather than currency order. In addition to indicating that it is no longer wedded to the dollar, Saudi Arabia has also recently announced its openness to Russia and its willingness to join the nations of Brazil, Russia, India, the China and South Africa (BRICS). This shift in strategic interests for Saudi Arabia may pose an immediate threat to US strategic interests, as the US regime has become accustomed to dominating the entire Persian Gulf region through US Saudi ties . A Saudi spin on the petrodollar will add to that shift. This will be enough to further threaten the American standard of living, but not enough to wipe out the dollar. After all, the pound sterling did not cease to exist after its own fall from its coveted position as the preferred global reserve currency. But it became much less powerful. The dollar is going in the same direction.