Over the last few articles, I have explained the reality of peak oil. However, this is just one factor of America’s looming energy crisis. Another major component that is vital to understand is something known as the breakdown of the Petrodollar system. Today, I will begin explaining exactly what this system and why you should understand it.
In the early 1970’s, the international gold standard had collapsed, and America was beginning to live far beyond its means. And despite facing unemployment and inflation, America displayed few signs of the kind of fiscal discipline that could prevent future complications. But just like today, fixing the root of the problem was not the concern of Washington. Instead, the primary concern of those governing America was how to maintain its position of economic dominance on the global stage. In order to ensure continued hegemonic power and thereby preserve an increasing demand for the dollar, Washington needed a plan. That plan came in the form of the petrodollar system.
But what exactly is the petrodollar system? First, let’s begin by defining the “petrodollar.”
A petrodollar is a U.S. dollar that is received by an oil producer in exchange for selling oil. It’s really that simple: Money – in our case, U.S. dollars – received in exchange for oil.
Despite the seeming simplicity of this arrangement of “dollars for oil,” the petrodollar system is actually highly complex and one with many moving parts. It is this complexity that prevents the petrodollar system from being properly understood by the American public. Allow me to provide a very basic overview regarding the history and the mechanics of the petrodollar system. Once you understand this “dollars for oil” arrangement, I believe that it will provide you with a more accurate understanding of what motivates America’s foreign policy. Let’s take a closer look.
The petrodollar system originated in the early 1970’s in the wake of the Bretton Woods collapse. In a series of highly secret meetings, the U.S. – represented by then U.S. Secretary of State Henry Kissinger according to many commentators – and the Saudi Royal Family made a powerful agreement. According to the agreement, the U.S. offered military protection for Saudi Arabia’s oil fields. What did the U.S. want in exchange? For Saudi Arabia to agree to price all of their oil sales in U.S. dollars and to then invest their surplus oil proceeds into U.S. Treasury Bills. This system was later referred to as “petrodollar recycling” by Henry Kissinger. The Saudis agreed and the petrodollar system was born.
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 as well. Today, the U.S. 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.
Today, virtually all oil transactions are made in U.S. dollars. This means that if you want to buy a barrel of oil anywhere in this world, you must pay for it with U.S. dollars. If you do not have U.S. dollars, you must obtain them somehow. One way is to simply convert your currency for U.S. dollars on the exchange markets. Or, products can be exported to U.S. in exchange for U.S. dollars.
For example, if you are in Japan, you must first convert your yen into dollars to purchase oil. Mexico must convert its pesos to dollars to buy oil, and so on. This should help partially explain much of East Asia’s export-led strategy. Japan, for example, has very few natural resources, including oil. It must import large amounts of oil and to do this requires that they have U.S. dollars. So Japan manufactures a Honda and ships it to the U.S. and immediately receives payment in U.S. dollars.
The petrodollar system has proven very beneficial to the U.S. economy. In essence, America receives a double loan out of every oil transaction. First, oil consumers are required to purchase oil in U.S. dollars. Second, the excess profits from the oil-producing nations are often transferred to U.S. government debt securities. This arrangement provides two large benefits to the U.S. It increases global demand both for U.S. dollars and for U.S. debt securities.
Additionally, having oil priced in dollars means that the U.S. can, in essence, print money to buy oil and then have the oil producers hold the debt that was created by printing the money in the first place. What other nation, besides America, can print money to buy oil and then have the oil producers hold the debt for the printed money?
Obviously, the petrodollar system was a brilliant political and economic move on the part of U.S. strategists. Washington, knowing that the demand curve for oil would increase dramatically with time, positioned the dollar as the primary medium of exchange for all oil transactions. This single move created a growing international demand for both the U.S. dollar and U.S. debt – all at the expense of oil producing nations.
Tomorrow: The coming breakdown of the Petrodollar system and why it matters…
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