the petrodollar wars

8/12/2019 The Petrodollar Wars

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But this was not the Gold Standard (Ill get to that in a moment).

Its also worth pointing out that the use of silver was actually more widespread before the gold from the

New World started arriving on European shores. In fact, silver was the first metal used as currency. And in

Ancient Greece, the silver Athenian tetradrachm was the first internationally accepted currency standard

(irony or grim warning?).

The Conversion from Silver to Gold

In the late 1700s, Britain experienced a massive shortage of silver which meant a massive shortage in

silver coinage. After two decades of this coinage drought, the UK embarked on a massive recoinage

program (in 1821), introducing gold sovereigns and copper farthings. Finally, in 1844, the Bank Charter

Act officially established the Bank of England as the Bank of England, confirmed that Bank of England

notes were fully backed by gold, and granted them sole legal tender status. At this point, Britain officially

went onto the Gold Standard.

Why am I focusing on Britain? Because British Empire was the world power at that point in time. And the

major trading partner to almost all countries. Soon after Britains adoption of the Gold Standard, the other

nations followed suit.

What exactly is the Gold Standard?

We all talk about the Gold Standard as though its obvious what it is people just used gold to pay for

stuff, or something. And as though the Pound Sterling, the US dollar and the Deutschemark were all

inventions that only happened after the, um, Gold Standard disappeared (?!). Which is not true at all.

The Gold Standard was (and is) a legal commitment imposed on a countrys Central Bank to convert a

single unit of the currency they issued for a certain amount of gold.

So, for example, in the UK the Pound Sterling was fixed at 113 grains of pure gold by Coinage Act of

1816. Another example: in the United States, the US dollar was defined as 23.22 grains of pure gold by

the Gold Standard Act of 1900. And because most major trading countries/empires agreed that gold had a

universal value, it gave us an implied exchange rate for trade (based on how much each currency was

worth in gold grains).

This is great in a perfect world where all things remain the same. But the world is not perfect, so the fixed

gold exchange caused problems. In particular, the gold standard meant that a countrys money supply

was fixed in relation to the countrys gold reserves (after all, these central banks were all committed to

exchanging every single issued pound and/or dollar notes for gold at a predetermined rate).


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So if there was a sudden need for more money to pay for stuff, like armaments in a time of war, there

was no quick way of borrowing money

World War I

As World War I began, the gold standard was practically abandoned. Countries printed money in order to

finance the war efforts, causing inflation and dramatic shifts in competitiveness.

As World War I ended, most countries then tried to return to the Gold Standard. And for Britain in

particular, this failed miserably. Let me try to explain why.

The Crisis of Competitiveness

Generally speaking, economic growth is determined by a countrys capital (resources and financing), its

labour force, and its labour forces productivity. Its a bit like a factory: in general, hiring more staff will

increase production. As will buying new machines that operate more efficiently. And incentivising staff to

work faster.

Lets say that the factory then has a major fire, where machines are burnt, people die, and the labour

force thats left is demoralised. What that sounds like, apart from disaster, is that production is about to

get really slow.

And what would happen to the factorys share price? It would plummet to the point where investors

consider the share fairly valued in relation to the new (and lower) production potential.

So if we apply that principle to Britain:

Britains resources had been heavily expended on the war effort. Britain had lost 2.19% of her population during World War I, with a further 3% wounded in action. Most of these losses were young men, meaning that a significant portion of the labour force had

been wiped out. And not only this: these would have been the young men producing the next

generation of young men.

And in addition, the labour force that remained still needed to be retrained in industry that was notwartime-related.

So each of the three factors (capital, labour force and labour productivity) had been significantlyaffected by the war.

Meaning that she was not going to be as competitive as she was before it.Today, if the same thing happened, the world market would echo with the thunder of a thousand million

investor feet fleeing from the Pound Sterling in every direction. And as the currency depreciated, Britains

exports would have become cheaper for everyone else. The currency would have eventually balanced out

when the lower productivity was matched by relative cheapness.


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In other words, if Britain wanted to return to the Gold Standard, then she should have done so at a

dramatically weaker exchange rate (like a pound for 50 grains of gold rather than 113 grains) to

compensate for her loss of competitiveness.

Only, they decided to do it at 113 grains.

Why, you might well ask? National honour, baby. The US whod suffered less relative to the chaos of

Europe (only 0.13% of the US population died in the Great War) had promptly announced a return to

their pre-War parity to gold in 1918. And the UK attempted to follow suit in order to patriotically defend

the Pound.

The Foolishness

Id like to go back to the factory and its share price. To recap the metaphor: the factory had a fire, so the

share price should be plummeting.

But lets say that instead, the company turns to you and says:

No no, theres nothing to worry about. Before the fire, each of our shares could buy you 100 grains of

gold. We believe that its our duty to you, our shareholders, to ensure that you still get 100 grains of gold

for every share that you hold regardless of what happens to the factory. Therefore, we are going to

keep the share price constant by committing to exchange any shares that you wish for 100 grains of gold

each, no questions asked

But before you all rush to change your shares for gold, wed like to ask for your loyalty in return by

imploring you not to exchange them, and remembering that if were committed to the exchange, and you

can exchange the shares at any time you like, then holding the share is exactly the same as holding the

gold!

What would you have done? Personally, Id have been rushing to the front of the line to get my gold. With

encouraging elbows.

So Britain started to experience speculative runs on the Pound (where pound holders would change them

for gold). And in 1931, she left the Gold Standard. The USA would follow in her footsteps two years later.

And any serious efforts to return to it again were put on hold by the arrival of World War II.

And its at the end of World War II where it really gets interesting.


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The Petrodollar Wars 102: The US Dollar Gold Standard

THE PETRODOLLAR WAR 102:

THE US DOLLAR GOLD

To recap from the last Petrodollar post, the big countries had been trying and failing to get back onto the

Gold Standard since the beginning of the First World War.

During the Interwar Period

There was a brief period of time when the various governments got together and established a Gold

Exchange Standard. The general idea was that the UK and the USA would hold all the gold reserves, andthe other countries would hold reserves in either pounds or dollars (because these were already backed by

the gold reserves of the UK and the USA).

But as a result of the competitiveness issue that I mentioned yesterday, most of Britains gold was being

shipped across the Atlantic as everyone preferred to hold dollars over pounds.


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At which point, the UK suspended the Gold Standard, which

made the American dollar the currency of reserve

Sound familiar?

But the US dollar hegemony only lasted two years. It ended when FDR took the USA off the

Gold Standard as well (more or less); when it was decided that the anchoring of the money

supply to gold was making it difficult for the USA to exit the Great Depression.

The apparent conclusions to be drawn from this little foray into a Gold Exchange Standard:

1. When a reserve currency country lose trade competitiveness, the Gold Exchange Standard fails.2. When a reserve currency country is in financial crisis, the Gold Exchange Standard can prolong it.Also, more to the point, the conclusion should have been that Gold Exchange Standards are not

sustainable because at some point, the world will be relying on the reserve country (or countries, in this

case) to jeopardise its domestic economy to the benefit of everyone else.

Enter and Exit World War II

Not long after this, the economic debate was interrupted by Hitler. And while World War II was still

ongoing, John Maynard Keynes began to devote his time to this issue of the Gold Standard and what to do

about it when the war was eventually over. And to put this in perspective: Keynes was making plans

around it as early as 1942 (talk about confidence in the Allies winning the war!).

By the time the Bretton Woods conference took place in 1944, Keynes had some very clear ideas about

what would not work. Included on that list was a return to a Gold Exchange Standard.

Keynes, Bretton Woods and Bancor

The Bretton Woods conference was arranged to discuss what would happen to the world (and trade) in the

aftermath of World War II. The general consensus among the Allies was that the treatment of the losers of

the previous war had somehow contributed to the Great Depression of the 1930s so there was real


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concern that a disconcerted array of monetary policies from the Allies would throw the world economy

back into a similar state.

If ever youve heard the phrase Beggar Thy Neighbour in reference to economic policies, this

is what the Bretton Woods economists were trying to avoid:

o The free-floating exchange rates that arose after both Britain and the United States suspended theGold Standard allowed countries freedom to devalue their currencies.

o It didnt take long before some of them realised that if they devalued outrageously, then theirneighbouring countries would find it cheaper to import that countrys products rather than make their

own.

o This was highly threatening, because the destruction of local industries (unable to compete withtheir cheap foreign rivals) meant economic collapse.

o In order to protect their domestic economies, these countries too would be forced to devalueoutrageously, which could cause internal inflation if those countries had become reliant on foreign

imports in the interim.o Which is the very definition of a currency war.So Keynes did not arrive at Bretton Woods encouraging a return to the Gold Standard. Instead,

he made the following observations (my interpretation thereof):

1. The real global problems with exchange rates arise when international trade and capital flows getout of control.

2. For example, countries that export a lot more than they import are creating debtors out of othernations (ie. other nations end up running trade deficits), and they themselves end up massive creditors

(ie. running corresponding trade surpluses).

3. The real global problems with exchange rates arise when international trade and capital flows getout of control.

4. For example, countries that export a lot more than they import are creating debtors out of othernations (ie. other nations end up running trade deficits), and they themselves end up massive creditors

(ie. running corresponding trade surpluses).

5. This is not sustainable.6. And neither is asking one country to carry all the responsibility of being the only country linked to

gold. After all being the global reserve currency AND having an internal monetary policy are a

significant conflict on interest.

7. So lets dispense with a global currency that sits in the hands of one nation.8. Rather, lets create an international trading unit (the bancor) that no country will control, and that

no one has the power to print.

9. Well establish an international settlement house, through which all international trade must settle.10. Well allow each trading nation to settle on a fixed exchange rate relative to the bancor, and well

grant them a trade allowance as an overdraft facility (being the amount by which their international

trade can be out of balance*).


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11. When they breach that allowance either way (ie. they exceed their surplus limitation, or theyexceed their deficit limitation on the other side), then well punish them with interest until they go back

to within their range.

12. So, for example, a nation in surplus, which normally exports more than it imports, would beincentivised to either import more, or devalue their currency relative to the bancor in order to make its

exports less attractive to other nations.

13. In this way, the global balance of trade would be maintained. 14. For a really great article on this, check this one out from the Guardian.15. This is not sustainable.16. And neither is asking one country to carry all the responsibility of being the only country linked to

gold. After all being the global reserve currency AND having an internal monetary policy are a

significant conflict on interest.

17. So lets dispense with a global currency that sits in the hands of one nation.18. Rather, lets create an international trading unit (the bancor) that no country will control, and that

no one has the power to print.

19. Well establish an international settlement house, through which all international trade must settle.20. Well allow each trading nation to settle on a fixed exchange rate relative to the bancor, and well

grant them a trade allowance as an overdraft facility (being the amount by which their international

trade can be out of balance*).

21. When they breach that allowance either way (ie. they exceed their surplus limitation, or theyexceed their deficit limitation on the other side), then well punish them with interest until they go back

to within their range.

22. So, for example, a nation in surplus, which normally exports more than it imports, would beincentivised to either import more, or devalue their currency relative to the bancor in order to make its

exports less attractive to other nations.

23. In this way, the global balance of trade would be maintained. 24. For a really great article on this, check this one out from the Guardian.

I mean Im not the biggest Keynes fan. But I think that his solution is a bit genius. Especially because it

keeps everyone in check; rather than forcing the debtor nations (those with heavy reliance on imports) to


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be the only ones with the issue of trying to correct their trade deficits while the creditor nations (the net

exporters) are allowed to continue flooding the debtor nations markets unchecked.

So what happened?

Well, the idea obviously appealed to the debtor nations. But the real objector was the largest creditor

nation at the time. Who wasyes, the United States.

The American representative at Bretton Woods, Harry Dexter White:

We have been perfectly adamant on that point. We have taken the position of absolutely no.

Instead, because America was the largest creditor nation at the time (and generally speaking, creditors

get their way), what the world got was this:

Again.

Oh and also the IMF and the World Bank to help the debtor nations to get out of their trade deficits by,

um, lending them more American money

The Petrodollar Wars 103: the collapse of Bretton Woods

THE PETRODOLLAR WAR 103:

THE COLLAPSE OF BRETTON WOODS

Thus far:

1. Petrodollar Wars 101: what was the Gold Standard? where I gave the briefest possible history ofcurrency, and the British Empire brought the world onto the Gold Standard.


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2. Petrodollar Wars 102: The US Dollar Gold Standard where I talked about the various failures ofthe interwar period, Keynes grand idea that never was, and how the Americans got their way in the

end.

At which point, the American Dollar was tied to gold (at $35 per ounce),and the World was

tied to the American Dollar. Even then, economists were aware of some problems that history

had shown with this particular approach:

1. if America wanted to maintain a fixed exchange rate of the dollar to gold, she would have tobalance on the edge of her trade;

2. if she didnt, someone would take advantage of the committed conversion of the dollar into gold;and

3. no funny business with monetary policy.Why Europe and Japan Got The Marshall Plan

Almost immediately, everyone realised that there was a problem. Some factors:

1. The United States of America was the country that everyone was importing products from, havingbeen left largely untouched (at least infrastructurally) by both of the World Wars.

2. This reliance on imports was not helping the economies of Europe and Asia to recover. Especiallywhen the newly-formed IMF told everyone that it was not permitted to make loans for capital and

reconstruction purposes its function was to cover short-term shortfalls.

3. Which resulted in a massive US dollar shortage in everywhere but America, because all the dollarswere being used by the rest of the World to pay for their American imports.

The situation was not good for the rest of the World. And it wasnt even good for America

(people that buy your goods on credit, but show no signs of getting a job, will one day go

bankrupt).

So US Secretary of State, Mr George Marshall, announced his plan to fix Europe. And the United

States forced itself into a position where it held a Balance of Trade Deficit. There were also Aid

programs put in place to Japan; and the Truman Doctrine meant that money flowed to anti-

communist causes.


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So to summarise:

1. The USA is looking ridiculously munificent.2. She is buying up raw materials from developing countries, processing them at home, then

exporting the finished goods at great profit.

3. She is then giving that money away in Aid Programs and under the Marshall Plan to rebuild theEuropean and Japanese economies, thereby expanding the market for American goods and creating

future destinations for American capital.

4. Would we call this global fiscal stimulus?The Trouble Begins

The problem with running grand balance of trade deficits (ie. youre exporting less than youre importing)

is that eventually, people begin to wonder whether it wouldnt safer to hold gold, actually. I mean how

can you say $35 will always buy you an ounce of gold when youre also saying were handing out more

dollars that we receive in. Which is almost the economic equivalent of saying: Ill always be a size 10.

Even though I eat ice-cream all day long and Ive stopped going to gym.

So here is the awkward dilemma that the United States found itself in (known as Triffins

Dilemma, after the economist that first noticed it):

1. The US had to run trade deficits in order to maintain the worlds liquidity (otherwise, the rest of theworld suffers dollar shortages like just after the war, and global trade grinds to a halt); but

2. Constant trade deficits were eroding faith in the dollar.At the same time, the United States had not monopolised the worlds gold markets. It only held

about 65% of the worlds gold reserves at the end of World War II, which meant that there

was still gold out there, people were still mining it, and all the young ladies were still adorning

themselves with it.Which meant that the gold market, like any other, was subject to fluctuations in price. In dollar terms.

And if, lets say, you could only get gold for a wedding ring at $42 per ounce: would you buy it, or would

you send a small note to the Federal Reserve asking them to hand you an ounce for $35? The higher the

free market price of gold, the higher the risk that people might take advantage of the arbitrage

opportunity.

A Short How-To Guide for Gold Arbitrage


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Lets say that gold was trading at $70 per ounce on the free market (it would never have been

this high but it makes my numbers easier). But because this was 1960, you could also

exchange $35 for an ounce of gold at the Federal Reserve. Heres a plan:

1. Exchange $35 for an ounce of gold at the Fed.2. Sell the ounce of gold for $70 on the free market.3. Take the $70 back to the Fed and exchange it for two ounces of gold.4. Sell the two ounces of gold for $140 on the free market.5. Take the $140 back to the Fed and exchange it for four ounces of gold.6. Sell the four ounces of gold for $280 on the free market.7. And so on.Now obviously, if everyone is doing this, it should drive the free market price of gold down. But in those

short periods where these trades are ongoing, you can expect some decimation of the Feds gold

reserves

The Speculative RunsSo the speculators started gathering. And some of them were large-scale. I mean France was a

primary protagonist. Those French

And at this stage, the banking world had expanded across borders, forming international banking

consortia that allowed for huge capital flows between countries.

Which made the 1960s a decade of increasing measures to try and maintain the price of the dollar relative

to gold. There were restrictions on imports into the USA, and restrictions on trade outflows. There was talk

of export subsidies. Basically: anything to strengthen the value of the dollar.

But then the Vietnam War happened.

The Johnson administration refused to fund the war effort from taxes, so American monetary policy

became expansionary. Borrowed dollars flooded out of the United States to pay for the war effort, causing

the dollar to depreciate significantly.

In order to borrow from the Federal Reserve, Congress had to repeal the requirement that the

Fed maintain a 25% reserve of gold backing to the dollar. Which meant that at least 75% of

the worlds gold was now floating around in private markets, leading to a sharp diversion

between the free market gold price and the dollar-gold fixed exchange rate.

Taking full advantage of this opportunity, France and a few other nations began to build their gold

reserves, swapping out their dollars. Far from a dollar shortage there was now a dollar glut.

By 1970, the US was in reserve deficit.

Mr Nixon


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On 15 August 1971, President Nixon issued an executive order (number 11615) and closed

the gold window. That is: he declared that the dollar would no longer be directly convertible to

gold. The only way to exchange it would be on the open free market.

And the world bid the Gold Standard farewell.

But the real problem: how would the American Dollar continue to maintain its reserve currency status now

that it was just as free-floating as any other currency?

The Petrodollar Wars 104: Welcome the Fiat

Currency

To briefly recap:

1. Petrodollar Wars 101: What was the Gold Standard?- where I gave the briefest possible history ofcurrency, and how the British Empire brought the world onto the Gold Standard.

2. Petrodollar Wars 102: The US Dollar Gold Standard- where I talked about the various failures ofthe interwar period, Keynes grand idea that never was, and how the Americans got their way in the

end.

3. Petrodollar Wars 103: the Collapse of Bretton Woods- where I listed the various ways to arbitragegold, how the gold standard forced America into the Triffin Dilemma, and how Mr Nixon suddenly

and unilaterally told the French (and everyone else) to sod off.

Nixons decision to take gold convertibility away from the US dollar was game-changing. Today, were 40

years on, and weve gotten used to a world of fiat currencies. But then they were new. And terrifying,

Id say. Especially after everyone had had 30 odd years of the security of gold.

To put this into perspective, its almost like your government suddenly declaring that the right of privacy

no longer applies, and that all information will now be public. Your bank records, medical records, private

emails and phone conversations, online dating profiles Everything. Prior to that, youd been going along,

glibly assuming that you could keep most things to yourself, and then suddenly: theres your laundry in

public, all steaming and soiled.


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In the same way, you might have been quietly accumulating money for your future, saving and looking

forward to that happy day when youd be Scrooge McDuck in a mansion with a safe the size of a dungeon

and a diving board. Then Mr Nixon announces that the cash in your mattress and your bank balance are

now just pieces of paper and numerals in a creditors ledger next to your initials.

The White House Concern

If I was in the White House midnight emergency meetings at the time, I think I would have been properly

panicked about public outcries, inflation, market crashes, bank runs, and losing the next election. And

theres some good evidence of that concern: the announcement of the Bretton Woods dissolution was

accompanied by a 90 day wage and price freeze, and a blanket 10% tariff on imports.

Effectively, Nixon was saying to the American people: For at least the next 90 days, we wont guarantee

that your dollars will be exchangeable for gold but we will guarantee that theyll be exchangeable for

everything else. And were going to stop the outside world from interfering with that by making it

unprofitable for them to export to America.

Also, because its quite entertaining, heres what Nixon actually said:

Let me lay to rest the bugaboo of what is called devaluation. If you want to buy a foreign car or take a

trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the

overwhelming majority of Americans who buy American-made products in America, your dollar will be

worth just as much tomorrow as it is today. The effect of this action, in other words, will be to stabilize the

dollar.

Bugaboo?! Either Nixon was folksy, or he was attempting to infantilise the response of those who werepanicking. Which must have worked because the decision was generally seen as a political triumph!

Regardless of the politics, you could almost view that 90-day freeze as the creation of a Commodity-

Basket Standard, rather than a Single-Commodity (ie. Gold) Standard. Which should give some indication

of the direction that the currency was going

How Fiat Currencies Work

Fiat Currency: a currency that is not linked or backed to any type of commodity (eg. gold).

Fiat currencies are free-floating in the sense that the currency no longer has its own fixed intrinsic value

relative to some specified good/item. Rather, a fiat currency derives its value from a government

regulation/law. So, for example, the American Government declares that the US dollar is the sole legal

tender, and that the Federal Reserve has the sole authority to manage the supply of US dollars, and

therefore, the US dollar is the US currency.

The term fiat derives from the latin word for let it be done and a government is usually said to

declare a currency as legal tender by fiat.


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Its usually at this point that people begin to feel a bit panicked as though theyre Wil. E Coyote and

theyve just looked down to discover that they stopped walking on land three paces ago. Because how can

money be money if it doesnt have its own intrinsic value?

Which brings us to an even more existential question:

What is Money anyway?

In its simplest form, money allows us the freedom to trade our goods and services for other peoples

goods and services. Before money, we had to barter: Let me give you these eggs in exchange for that

rather comely set of animal skins.

But the barter system is wildly inefficient, because it means that:

I have to have something to trade; You have to have something to trade; I have to want what you have to trade; You have to want what I have to trade; and We have to be able to agree that what I have is worth what you have.

Which is a lot of admin.

So money comes into play as something that all of us will accept in exchange for our goods and services

(a generally-accepted medium of exchange), because it will allow us to buy something at a later date

(a store of value). Its also particularly useful if we can break it down and build it up relatively easily

(a unit of account), because one egg is generally worth less than a set of new clothes.

Traditionally, whatever was the most widely used commodity became money. So you might have traded in

bushels of wheat if you were a farming community; or you might have traded in dried fish if you lived on a

river. But when you think about it, thats really just being practical with whatever is close to hand.

The whole thing could just as easily have worked if wed all been trading in IOU notes with each other

provided that we were all men of our word. And even then, if you suddenly became aware that one guy

was being a bit liberal with his IOU notes, youd stop accepting his word for it.

If you carried that process to its logical conclusion, youd probably find that theres one guy in the village

whose word is particularly trustworthy; and if anyone tries to fake one of his IOU notes, hell find the

culprit and quarter him publicly.

Pretty soon, his are the only IOU notes that everyone will accept. And presto: you have a currency.


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And fiat currencies are exactly that:

you have a Central Bank that is the only issuer of a currency; they are men of their word because they commit to a given certain set of policies around the

printing and protection of their IOU notes;

they have the backing and support of the governing authorities; so we all accept their notes as good-for-value.

Also, when a Central Bank starts playing excessively by its own rules, the rest of us react by losing

complete faith in the currency, which is the very definition of hyperinflation.

So as it turns out fiat currencies arent really so different from a Gold Standard, provided that the

Central Bank doesnt give in to the temptation to play the fool.

But in the American Case

At the time of Nixon, the Federal Reserve wasnt just the Central Bank of America, it was also the Central

Bank of the world. And while Nixon may have been doing good things for his American voters, his decision

to remove gold exchangeability was a complete violation for the voters from the rest of the world.

Why voters?

Because when you initiate a free market for your currency suddenly, everyone that uses that money is a

voter. And if they dont like you and/or your policies, maybe theyll try to stop using it.

In the next post, Ill be talking about what it actually means to be the Global Currency of Reserve


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What Is A Global Reserve Currency?

Officially speaking, a global reserve currency is what governments choose to store their foreign exchange

reserves in which is a wordy way of saying this is the currency in which we will trade.

For example, lets say that a Liberian company wants to import diamonds from Sierra Leone.

Unfortunately, the Liberians only have the Liberian dollar to pay with. And the Sierra Leoneans would

probably like to get paid in Sierra Leonean leone, because thats what they use to pay the diamond

miners.

So a lack of exchangeable

money would leave things at a bit of a standstill.

If that were actually the status quo, someone would eventually stand up and say:

what would be really helpful is some kind of global currency that the world could use forinternational trade.

And, like, a government could keep some of it in reserve So that when their people want it to trade, then they could bring their Liberian dollars and exchange them for the international currency, take that and give it to their trading partner across the border, who could then take it to their own government and change it for Sierra Leonean leones.


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So as it turns out, every country that engages in trade (ie. every country) needs to keep a supply of

foreign reserves. And those foreign reserves are going to be denominated in the global reserve currency.

But Who Decides Which Currency Gets To Be The Reserve Currency?

Its a good question and the answer, generally, is the same as the answer to the what is money

anyway section of Petrodollar Wars 104: whichever currency is the most trusted and most widely used

gets chosen by the market.

For example, when the British Empire was around, every second country to be traded with was a British

Colony. Meaning that the Pound Sterling was usable the world over, which in turn meant that every

country had a stock of pounds on hand. So even if you werent trading with a British colony you could be

pretty sure that the government of your trading partner would be happy to swap their local currency for

British pounds so that you could pay your supplier. After all those governments would always need

British pounds to trade with.

So if a country wants to its currency to be a global reserve currency, then there are three things that it

needs:

1. There needs to be a high global demand for the countrys exports (because these need to be paidfor in the home currency, this means a corresponding high demand for the countrys currency);

2. There must be somewhere to store the currency while the trading partners are waiting to spend it(they must be able to invest it somewhere which strongly implies that the country must have large

developed financial markets); and

3. The trading partners must be able to get their hands on the currency in the first place.And back in 1944, when Bretton Woods was just concluded:


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1. America was the largest exporter in the world (requirement 1 tick),2. America had relatively developed financial markets (requirement 2 tick); and3. America was dishing out dollars everywhere, and was also happy to exchange gold for dollars

(requirement 3 tick).

So it made the US dollar an obvious choice for a global reserve currency. Besides, all the Allies agreed

that it would be so.

But Why Would a Country even want their currency to be a Global Currency of Reserve?

This is a surprisingly debated question, in the sense that there are some quite obvious advantages to

being a Global Reserve Currency. But I guess its not that surprising when you look at those three

requirements and realise that some things have changed since 1944

In pure economic terms, here are the advantages for America:

1. Seigniorage Revenue:seigniorage revenue is the return offered to the Federal Reserve byinflation. Money is an effective IOU note printed by the Federal Reserve for us to use in circulation.

If this were an IOU note between friends, maybe wed say Im taking $100, so heres an IOU note

for $102 which Ill give back next week meaning that thered be an interest component. But in

this case, the Fed borrows $100 from you by issuing you an IOU note, and pays back $100 when

it retrieves it making that bank note an interest free loan. And then inflation takes place so $100

today will buy you more than $100 in a years time. And its that difference that gets recorded by

the Fed as seigniorage revenue.

2.

Low borrowing costs:because countries will need somewhere to invest their foreign exchangereserves (US dollars), theyre probably going to put it into the Americas bond markets meaning

that the American Government can borrow really cheaply. Its part of the reason why Americas debt

is so high theyve used the cheap borrowing component to fund their Social Welfare programs.

But no advantage comes without cost:

1. A strong/overvalued currency:because there is constant demand for dollars for internationaltrade, and because countries are ploughing their reserves into American bond markets, it means

that the dollar is going to be stronger than it should be otherwise. This negatively impacts American

exporting firms, as well as American firms that compete with imported products (so almost everyone

really). On the other hand, American consumers benefit from cheap imported products.

And thats generally where the debate stops, or concludes, as though were saying:

Well there we are then. Being a global reserve currency isnt really that great or that bad its only a

small benefit and China will never accept those costs so the dollar will reign forever.

Rubbish.


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The geo-political advantage of being the global currency of reserve is the realbenefit. And once the

inertia sets in its very difficult to displace. Today, the dollar denominates world trade, and therefore the

bulk of each countrys exchange reserves, as well as the largest part of the worlds derivative markets in

swaps and international financing. There is global vested interest in the US dollar maintaining its

hegemony.

Which means that the American government can almost borrow unpunished to fund its internal policies. Of

course America may be approaching that limit (because there must be a limit) but look at how far

theyve come!

But more than this, it means that the United States wields dramatic economic power on the world stage

(just look at what Obama has done to Iran). It brings security and access to resources and the ability to

dictate from a distance. How do you put an economic price on that?

And the truth is that the decisions around the US dollar status are not made by economists or any of the

McKinsey consultants that prepare these economic assessments. The decisions are made by politicians.

Politicians who will make ridiculous economic choices if it appeals to their voting base.

Which brings me rather neatly back round to the politics of 1971, when Nixon had just suspended the

Gold Standard to rapturous voter applause.

The Petrodollar Wars 106: The Petrodollar

Conspiracy

Right this is the post that Ive been building up to on the back of five previous ones:


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1. Petrodollar Wars 101: What was the Gold Standard? where I gave the briefest possible history ofcurrency, and how the British Empire brought the world onto the Gold Standard.

2. Petrodollar Wars 102: The US Dollar Gold Standard where I talked about the various failures ofthe interwar period, Keynes grand idea that never was, and how the Americans got their way in the

end.

3. Petrodollar Wars 103: the Collapse of Bretton Woods where I listed the various ways to arbitragegold, how the gold standard forced America into the Triffin Dilemma, and how Mr Nixon suddenly

and unilaterally told the French (and everyone else) to sod off.

4. Petrodollar Wars 104: Welcome The Fiat Currency where I explained that theres really not muchof a difference between gold-backed paper money and unbacked paper money provided that the

Central Bank behaves itself.

5. Petrodollar Wars 105: The Global Currency of Reserve where I discussed the function of a globalreserve currency, how the global reserve currency gets chosen, and why a country might want to

have their currency be the global kingpin.

The Historical Timeline

And seeing as Ive already started with the lists, heres the summarised historical timeline of events

leading up to the Nixon Shock of 1971:

1. The British Empire goes onto the Gold Standard in the 1800s, bringing the rest of the world with it.2. As World War I breaks out in 1914, the Gold Standard is abandoned because who really cares

about gold shiny stuff in a wartime situation (Ive long argued this).

3. Immediately after the war, the United States announces that she will be returning to the GoldStandard at the exact same exchange rate as before the War.

4. Britain tries to do the same. Stupidly. In a froth of nationalistic gung-ho.5. For a few years, the world attempts to run a Gold Exchange Standard, where the USA and the UK

back their currencies with gold, and the rest of the world backs their currencies with US dollars and

UK pounds.

6. The Great Stock Market Crash of 1929 happens, followed by the Great Depression.7. In 1931, after various speculative runs on the pound, and the annoying transportation of their gold

reserves across the Atlantic, the UK takes the pound off the Gold Standard.

8. Two years later, FDR does the same thing with the dollar, after people suspect that a money supplylimited by a mined commodity just might be prolonging the Great Depression.

9. World War II happens. Conversation suspends.10. In 1944, the Allies meet at Bretton Woods to decide on what to do after the War is over.11. John Maynard Keynes, Britain, and the rest of the debtor nations, try to argue for an international

monetary system that penalises both the spenders for overspending and the suppliers for

oversupplying. And that, in order to do this, there be an international unit of trade that is not

printable by any government.


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12. Harry Dexter White and the rest of the American delegation, being the major (if not only) creditornation at the table, decide that theyd rather not be penalised for oversupplying, thanks. And seeing

as theyre the seller and the creditor at the table, everyone that owes them money is actually going

to be using US dollars; and the Americans will make sure that there is enough gold to back them.

Understood.

13. Everyone concedes, and the world goes onto the US Dollar Gold Exchange Standard. Because thatworked so flawlessly during the Interwar Period.

14. Almost immediately, America realises that the debtor nations cant pay with dollars if they donthave the dollars to start with. So they implement the Marshall Plan and start pumping the

recovering European economies with aid. They do the same with Japan (in particular) and other

countries (to a lesser extent).

15. By the 1960s, things have begun to turn. The recovering economies of Europe and Asia are nowrecovered; and the American consumer has recently discovered the delight of the cheap foreign

import.

16. Mr Triffin discovers the Triffin Dilemma when he realises that the US needs to give out more moneythan it gets back (ie. run a trade deficit) in order to maintain the flow of international trade, but that

this ironically makes the dollar seem weaker in the eyes of the rest of the world.

17. In 1968, President Johnson declares that the Vietnam War will not be funded by taxes. No word onwhether he actually declared the logical conclusion to this: that it would have to be funded by

borrowing plenty of dollars and flooding them directly into South-East Asia.

18. At around this time, France, that opportunistic nation of American-despisers, decides that it wouldlike to take advantage of the whole I give you your dollars, you give me your gold clause in the

Bretton Woods agreement.

19. The physical gold proceeds to wend its way back across the Atlantic.20. In 1971, realising that the United States is perilously close to losing all its gold reserves, Mr Nixon

unilaterally announces that the US dollar will no longer be convertible to gold at anything other than

open-market prices.

The Ramifications and Concerns

I think that we tend to forget that Americas abandonment of the Gold Standard was a decision forced by

necessity. And this seems almost inevitable in retrospect, because of two things:

1. One of the primary requirements for global reserve currency status is that American exports bedemanded the world over (which was the case in 1944); but

2. Maintaining global reserve currency status means having a strong dollar and running a tradedeficit, which would eventually run the American exporters into crisis thoroughly negating the

above primary requirement.

So the dollar goes off the Gold Standard because there was not enough gold for it to remain on it. But Im

pretty sure that America didnt want to lose all those great geo-political advantages of being the Worlds

Central Banker.


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What I Would Have Suggested If This Were An Academic Exercise in Strategy

If I were looking at that particular requirement about the importance of American exports, I hope that I

(or someone) would have pointed out that the real issue is not so much that the exports be American, but

that the sale of the exports take place in dollars. After all thats what creates the demand for dollars:

the fact that the rest of the world needs them to pay for American goods.

But if the problem is maintaining the demand for dollars Surely, then, one solution is to find a product

that the whole world demands, and make sure that the sale of this product is denominated in dollars? In

need not necessarily be an American product, per se.

At this point: a humble pie moment. In one of my first posts on Gold (Why Buy Gold? Buy Oil!), I kept

presenting the argument that oil is a much better bet than gold. After all gold is just pretty. Oil, on the

other hand, makes the world go round:

1. Need to eat? You need an oil-product to transport the food from the farm to the store you buy itfrom.

2. Need healthcare? You need an oil-product to transport you to the hospital, and an oil-product totransport everyone else there as well.

3. Need anything? Youll need an oil-product.And the humble-pie is that I kept presenting that idea as though its somehow new and I was the only one

to realise it. It seems that Mr Nixon and his Secretary of State (Henry Kissinger) beat me to it.

The Denomination of World Oil Trade Into Dollars

In 1973, Henry Kissinger approached the Saudi Royal Family and offered them the following:

The Americans would offer military protection to the Saudi Arabian oil fields, as well as providingthem with weapons and protection from Israel.

In exchange, all the Saudis had to do was agree to denominate all of their oil sales in US dollars(ie. a dollar monopoly on Saudi oil), and consider investing their surplus oil proceeds in US debt

securities.

The Saudis were, like, sweet costs us nothing to tell everyone that well only accept US dollars thats

what theyre paying in anyway!

By 1975, every single country in OPEC had made the same commitment. And the worldwide trade in oil

was denominated in the US dollar. Lets call it: the Oil Standard.

The Fun Conspiracy Part


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Heres where it creeps in (everything up and until this point has been factual, not speculative). It seems

that every time an oil-producing nation attempts to re-denominate its oil sales into another currency,

America is suddenly threatened by a weapon of mass destruction.

Iraq:In 2000, Iraq re-denominated all its oil sales into euros under its Oil For Food program. In2003, post their invasion, the United States returned Iraqi oil sales back to dollars.

Iran:In 2008, Iran started an Iranian Oil Bourse which would sell oil in gold and multiplecurrencies. In March 2012, it announced that it would no longer be settling trades in US dollars. At

which point, Iran got hit with US sanctions over its nuclear capabilities. I feel like we should watch

this space

Either way, I think that there is good reason to continue to have faith in the dollar.

The Petrodollar Wars 107: The Petrodollar

Collapse

I thought that I was done with this series of posts. However, Ive since been told that Ive missed out the

last part of the story. That is: what happens if/when the Petrodollar System collapses?


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So, if this is the first time youre reading this, heres the backstory*:

*although you probably only need to read Petrodollar Wars 106for the summarised historical timeline.

1. Petrodollar Wars 101: What was the Gold Standard? including the briefest possible history ofcurrency, and how the British Empire brought the world onto the Gold Standard.

2. Petrodollar Wars 102: The US Dollar Gold Standard including the various failures of the interwarperiod, Keynes grand idea that never was, and how the Americans got their way in the end.

3. Petrodollar Wars 103: the Collapse of Bretton Woods including a list of the various ways toarbitrage gold, how the gold standard forced America into the Triffin Dilemma, and how Mr Nixon

suddenly and unilaterally told the French (and everyone else) to sod off.

4. Petrodollar Wars 104: Welcome The Fiat Currency including an explanation of how theres reallynot much of a difference between gold-backed paper money and unbacked paper money provided

that the Central Bank behaves itself.

5. Petrodollar Wars 105: The Global Currency of Reserve including the function of a global reservecurrency, how the global reserve currency gets chosen, and why a country might want to have their

currency be the global kingpin.

6. Petrodollar Wars 106: The Petrodollar Conspiracy including a deal with the Saudi government,and the reason why the Americans go to war over oil.

A summary of where we stand today:

1. The primary global currency of reserve (the American Dollar) operates off a Petrodollar (Oil)Standard.

2. Because oil trade is denominated in dollars, you can be pretty sure that the dollar will maintain itsvalue as long as:

A. The world needs oil; andB. The oil trade continues to be denominated in dollars.

3. And thats not just a demand-for-oil story. Its the other side as well:A. As the oil-producing countries get paid in dollars, so they need to invest the dollars

somewhere.

B. That place is American Financial Markets, because those markets are the only ones bigenough to take those levels of investment.

C. So the Oil Trade ensures a steady and constant demand for American (financial) products.4. Because the Oil Trade has created a status quo for dollar trade, and because most countries will

keep their Foreign Reserves denominated in US dollars (in order to pay for oil imports), the natural

tendency is then to denominate most international trade in dollars.

5. And the American people, by consuming plenty of imports, are actually helping to reinforce thedollars global dominance.


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So, now, what happens if:

1. The Oil-Producing Countries decide that American Markets are too risky; and/or2. We run out of oil, maybe?

Actually, maybe we should start by asking: how likely are either of those scenarios? Because, to my

mind, the answer is not very.

The Oil-Producing Countries may well dislike the risk of American Markets but they dont exactly have a

long list of alternatives. 40 years of investing oil surplus into the American financial markets have left

them giant. A little googlinggets to an answer of around 25% of the worlds capital being held in

Americas financial markets. The other (less but still) big markets: Japan, Europe, China. One of those

seems poised on the hyperinflation brink (thanks, Abenomics, thanks), another beset by general political

and economic crisis, and the last closeted and running out of water. And (breathable) air. None of those

sound especially appealing.

And more than that if any of said countries attempted to break with the US dollar on oil, or any of the

rules around it Well just look at Iraq.

And as for Peak Oil and Oil Reserves

Peak Oil? Well die from Climate Change long before that happens. Or well run out of water and food.

Also, theres the small fact that proven oil reserves (the figure that gets thrown around when someone

from Forbes decides to be alarmist) actually refers to oil that companies are actually drilling for in existing

fields.


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Let me repeat that: oil that companies are actually drilling for in existing fields.

So when this graph gets thrown about:

[and you'll notice the USA looking all depressed about its small allocation]

What you must remember is this:

That said, is there anything to suggest that the other big Oil Reserve players dont face a similar outlook?

Well there is an economic aspect to this. If you pay attention, you may notice that oil reserves go down

when the oil price is low and they go up as the oil price increases And thats because the market price of


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oil determines how recoverable a particular well of oil is. At a higher oil price, the more difficult-to-

access reserves might be extracted, meaning that those will count toward oil reserves. At a lower oil price,

they wont.

And in the United States, oil and gas law puts limits on what can be extracted from an oil well. In the rest

of the world, those limits are either non-existent, or much higher. What does that mean? It means that

significant US oil reserves are not economically feasible to extract, so they get excluded from proven oil

reserve statistics*.

*the more oil you can pump out of a well per day or per year or whatever, the more oil revenue you have

to cover the costs of extraction After all, the big costs are capital investment and fixed salaries. Those

costs wont change with the volume of oil extracted!

As a long-term strategy, that does seem to suggest that the United States is setting itself up to be a

future dominant player in energy. You know, after shes consumed most of what the other big players can

extract.

But lets assume that the Petrodollar System collapses anyway

What would happen?

Nothing.

At least not for a while:

As a result of inertia, pre-planning, and general custom, most global trade would already beplanned to take place in US dollars, with multiple forward and futures contracts already in place.

There are no real alternatives for large-scale financial investment, so the world would have to waitfor a secondary market to develop and become accepted.

The oil-producting nations, China and Japan would be holding large amounts of dollar reserves, sothose countries would have a vested interest in the petrodollar system perpetuating, or at least

emerging in an alternative form.

Whatever nay-saying might be out there, I think that the important point to remember is that this is what

people would have expected when the US dollar left the Gold Standard.

But when the dollar left gold, the dollar stayed the global currency of reserve for years in the interim while

the Petrodollar system was developing

So I think that we should all be more concerned by the threat of Climate Change. And/or the crisis of the

worlds impending water shortage.


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Seriously.

the petrodollar wars

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