Part 1: Origins and Its Role in the global financial system
If you have never heard of the petrodollar system, it would not surprise me. It is certainly not a topic that makes its way out of the State Department or Wall Street and onto the broadcasting networks and our social media feeds too often.
Okay, I am getting slightly ahead of myself here (excuse the writer, for this is his first Praxarchy contribution). I am sure that many of you have heard of the petrodollar but all too often its true significance is often misunderstood or overlooked altogether.
In the simplest of terms, the petrodollar system is the practice of trading oil for U.S. dollars, and U.S. dollars only (rather than another currency). This means that no matter what country is buying the oil, they pay the oil-producing country in dollars. And this is the petrodollar system. The dollar is the world’s reserve currency, making it the medium of exchange for goods, services, trade, travel, investments, commodities and much more. The petrodollar has a central role in enabling all of this. Many feel that this arrangement gives the U.S. “exorbitant privilege” as oil is the most sought-after commodity in the world, and thus being priced and traded solely in dollars makes the U.S. dollar the most dominant currency. The petrodollar has had a considerable impact on shaping U.S. foreign policy, global trade and geopolitics for the last 50 years.
If you search Ben Shapiro, Joe Rogan, Prager University or Tim Pool’s respective YouTube channels you will not find anything about the petrodollar. The CNN website brings up three results with articles that have only brief, fleeting mentions of the arrangement and the Heritage Foundation’s website returns nothing. Many of the best books on this topic are either expensive and hard to find, have limited print runs or are discontinued altogether. This is all by design. The mechanics of the petrodollar system and the broader role it plays in geopolitics and international affairs is not something our elites want us talking about. Its origins, effects, and the enormous privileges it grants the United States has led some commentators to label the petrodollar system as the most brilliant economic and geopolitical strategy devised in recent history. It is arguably the most critical facet of U.S. power and it has been instrumental in dictating U.S. foreign policy in the Middle East since the 1970s.
A word of caution, it is essential to recognise that the petrodollar and the dollar as the world’s reserve currency are very much two sides of the same coin, as one enables the other. The dollar is the world’s reserve currency, in large part anyway, because of the petrodollar and the petrodollar wouldn’t be what it is without the dollar’s position as the world’s reserve currency. I don’t want to get preoccupied with semantics but the reader should allow for considerable overlap in this regard. I will be submitting separate articles on the broader role and significance of the U.S. dollar as the global reserve currency at a later date.
I should also point out that many of the points overlap as they all form part of a self-reinforcing cycle. Excuse the author in advance if he ends up revisiting the same ground in order to make sense of the oil for dollars arrangement.
The petrodollar is the name given to the oil for dollars bilateral relationship the United States originally had with the Kingdom of Saudi Arabia. When the 1973 oil embargo ended, Washington began a long diplomatic campaign with the Saudis in order to negotiate a bilateral trade relationship that would benefit all parties concerned. By 1975 this relationship would be extended to the other OPEC nations.
The removal of the international gold standard in 1971, by then-president Richard Nixon, caused a decline in the demand for the U.S. dollar worldwide. Maintaining this “artificial dollar demand” was vital if the United States were to continue heavy spending both abroad and at home. So in 1973, Nixon and the Secretary of State, Henry Kissinger, asked King Faisal of Saudi Arabia to accept only U.S. dollars as payment for oil as well as their personal assurances that there would never be another oil embargo again. In return, the U.S. would provide military support for Saudi oil fields and for the house of Saud generally (effectively guaranteeing their rule over the kingdom). Washington also agreed to sell weapons and other military-grade hardware to the Saudis.
By 1975 every OPEC member agreed to sell their oil exclusively in U.S. dollars. So in order for oil-importing nations to fund oil purchases, they first need to acquire dollars. This is highly significant because it meant that, from its inception, the nature of the petrodollar agreement had demand for the U.S. dollar built into the system, the same system we have today. There was no Congressional oversight or approval of the deal. The terms of the agreement also stated that Saudi Arabia and the other OPEC nations pledged to recycle excess dollars from oil exports by buying up U.S. debt securities and treasury bonds. This came to be known as “petrodollar recycling” and it is highly significant because it means that the United States receives a nominal sum of dollars on every oil transaction that takes place, thus creating a parallel revenue stream that runs alongside oil purchases.
The deal also stated that if other oil-producing countries threatened an embargo, Saudi Arabia would fill the shortage by increasing oil production or by drawing from its huge oil reserves. Under the agreement, oil prices were allowed to fluctuate but only to levels deemed suitable by Washington and in the best interests of the United States and its allies.
The U.S. made light of the highly unstable geopolitical climate of the region and the fact that Saudi Arabia had no real military capability.
In the wake of the 1973 oil crisis, British security cables at the time indicated that the U.S. would have launched a full-scale military invasion of Saudi Arabia had they not complied with the terms of the agreement. In one of modern history’s great “what if” scenarios, the U.S. would rather pursue military action than risk being held to ransom as they were during the 1973 oil embargo when Saudi Arabia slashed production sending prices skyrocketing. However, the invasion never materialised and under the terms and conditions laid out above both sides proceeded in an arrangement that was seen as mutually beneficial to all parties concerned.
Exorbitant Privilege: The role of the petrodollar in the global financial system
By tying the dollar to oil it created an immediate artificial demand for U.S. dollars around the globe. That is, as global oil demand increases, so does the demand for U.S. dollars (because dollars are required to purchase oil). This artificial demand is built-in to the system from the very beginning and is arguably the most important aspect to understand how the petrodollar system functions and how it is the foundation for U.S. power. It allows the United States to engage in monetary inflation, debt financing and deficit spending on an almost unprecedented scale; that is, print money to buy oil, even if it is in debt, safe in the knowledge there will always be demand for both U.S. dollars and U.S. debt securities which puts downward pressure on the dollar preventing hyperinflation from ever taking place and maintaining it as the most liquid currency in circulation. Keep in mind that before the advent of the petrodollar arrangement, demand for the dollar was falling as inflation spiralled out of control as countries scrambled to exchange their surplus dollars for gold, which led to Nixon eventually removing the gold peg in 1971. After years of running a balance of payments deficit (as dollars fled the U.S. to provide liquidity to the global economy) under the gold standard, the petrodollar system created inflows of capital into the U.S. thereby reversing that trend. Increased demand for dollars means increased capital flight into the United States.
Right now the U.S. has what has come to be termed as a ‘permission slip’ to print all the dollars it needs because the petrodollar ensures that demand is ever-present. A highly contentious point to all of this is that this artificial demand correspondingly allows for artificially low-interest rates both at home and abroad: banks can issue credit with low rates of interest domestically just as the federal government can issue government-backed securities and bonds to foreign suitors at low rates of interest to be paid by the U.S. to any nation that holds these treasuries notes.
The second point l would like to draw attention to is rather simple and obvious and that is that under the agreement the U.S. can purchase oil in its own currency. Literally, all they have to do is summon the Treasury to print the required amount of bills, take these to an OPEC member state and the deal is done. No other nation can do this because oil is traded in dollars only. Instead, other countries have to provide real goods and services in exchange for dollars (or enter the foreign exchange markets) to acquire dollars before being able to purchase oil.
Speaking of goods and services, this leads us nicely to my third point and that is that the oil for dollars system allows the U.S. to assume the upper hand in world trade. Simply put, the act of moving the dollar off gold and tying it to foreign oil forced every oil-importing nation in the world to create and maintain a consistent supply of federal reserve paper and in order to get that paper they would have to send real physical goods to America: this was the birth of the petrodollar. Furthermore, countries have to trade with the U.S. on favourable terms as such and would also need to keep ample foreign currency reserves of U.S. dollars to fund future oil purchases.
The result of all this is that the petrodollar system encouraged cheap exports to the United States as oil-importing nations restructured their trade policies in line with Washington’s requirements in order to bring in more dollars. U.S. dollars went out and everything America needed came in and came in on Washington’s terms no less and the U.S. got very, very rich as a result. Also, the U.S. is not forced to produce more or to reduce consumption in order to meet its energy requirements. Make no mistake about it, the petrodollar system is the very foundation of U.S. hegemony as it solidified the dollar as the world’s reserve currency.
For oil-importing nations the reality is that you must first purchase dollars to fund any oil transactions; no dollars, no oil, it really is that simple! There is no way around this. Oil is energy, you need energy to build industries, power economies and grow entire countries, and you can’t do this without oil. From the very inception of this arrangement, demand for the U.S. dollar was built into practically every layer of the system. In retrospect, it is quite some achievement that the Nixon administration, with Kissinger at its centre, was able to have the world’s most precious and sought-after commodity valued, priced and traded exclusively in dollars.
As l have alluded to several times already, one of the most fundamental components of the arrangement is that in essence, the U.S. receives a double loan out of every single barrel of oil that is sold worldwide, as every barrel of oil that is sold on the world market increases the demand for U.S. dollars and it also increases the demand for U.S. debt securities as well. That means that even if, say, Spain or Japan want to purchase oil the U.S. benefits from the transaction twofold because the terms of the petrodollar arrangement mean that 1) they must first acquire dollars to facilitate the transaction and 2) OPEC pledges to use a portion of the profits from the sale to purchases U.S. government bonds and securities. The act of using a portion of the profits from oil sales to buy U.S. debt would eventually be termed “petrodollar recycling”. Petrodollar recycling is a form of debt financing.
Debt financing is when a government monetises its debt, often abroad, in the form of government-backed bonds and securities with annual interest paid to whoever holds the debt. The point is that the U.S. can issue dollar-denominated debts at very low rates of interest because countries need to have an ample supply of dollars on hand to facilitate trade in oil and other commodities meaning that demand is permanently high. Every oil purchase increases the demand for U.S. dollars before the transaction and the demand for U.S. debt after the transaction. The U.S. gets the privilege of being allowed to monetise their existing debts almost ad infinitum on the back of this system. It is almost stating the blindingly obvious at this stage that the U.S. is the only country that can do all of this. Former President Barack Obama once said on the Bill Maher show when questioned about the huge level of Federal debt “we can afford to borrow as interest rates are low”, Obama was merely stating a truism as interest rates are permanently low when you have the privilege of having the global reserve currency.
In The Hidden Hand of American Hegemony, political economist David E. Spiro argues that excess profits from oil sales were “recycled” into U.S. treasuries to subsidise the “debt-happy policies of the U.S. government as well as the debt-happy consumption of its citizenry”. Petrodollar recycling over time pushed down interest rates and allowed the U.S. to issue debt very cheaply. Declassified documents later revealed that the U.S. government confidentially enabled the Saudis to purchase treasuries “outside regular auctions and at preferential rates.” The exact figures are highly confidential (as you might expect) but it has been estimated that hundreds of billions of dollars have been invested in U.S. debt since the inception of the petrodollar system.
It is essential to highlight how the petrodollar system allows for almost infinite deficit spending. Simply put, the U.S. can run up huge deficits regardless of its outstanding debt because demand for U.S. dollars and dollar-denominated debt securities is permanently high in this system. An important aspect of all this is that many of these deficits are used to fund Washington’s broader, strategic geopolitical interests abroad; especially in Asia, Central and Latin America, and the Middle East. It allows Washington to have approximately 600 military installations in 85 countries across the globe (for comparison, Britain, France and Russia have 30 overseas bases combined) as maintaining an empire built on the foundations of the oil for dollars arrangement is no cheap and easy task. The point here is that if the U.S. requires more aircraft carriers in the pacific, more munitions or further funding for research and development into military technology, the mechanics of the petrodollar system, and having the global reserve currency, allows them to do this. Whereas other countries would have to deal with the real inflationary effects of printing more units of currency the U.S. can monetise its debts abroad and with low-interest rates too. How the petrodollar system ties into U.S. foreign policy objectives will be explored in more detail in part of this series.
Lastly, now that oil was tied to the dollar the U.S. would be protected because in the event of an increase in the global price of oil there would be a corresponding increase in the demand for dollars along with it. Not only that, the U.S. has amassed large stockpiles of oil reserves that allows Washington to manipulate the market and keep domestic oil prices stable, for the short-term at least.
Under the petrodollar arrangement, the domain of the U.S. is without borders and boundaries. Having the world’s most sought-after commodity priced and traded exclusively in dollars allows Washington to dictate large segments of world trade and it allows for near-infinite deficit spending, debt financing and monetary inflation at the same time. The sum of all this means that the dollar is the most liquid and reliable currency in the world, firmly establishing it as the global reserve currency of choice. But more than that, it has solidified the United States’ position as the dominant power in a largely unipolar world. It is arguably the most critical component of the American empire as it enables everything from having a military presence in over 80 countries to possessing more aircraft carriers than all the other countries combined. It stands to reason that the U.S. will go to great lengths to preserve this system and I will go on to argue in part two of this series how the necessity to preserve the petrodollar has shaped U.S. foreign policy for decades.