Understanding the Petrodollar System

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Podcast Transcript

On August 15, 1971, US President Richard Nixon ended the gold convertibility of the US Dollar and simultaneously ended the Bretton Woods System, which had governed international monetary policy since the end of the Second World War.

The system which replaced Bretton Woods wasn’t built on formal treaties and conferences. It was a highly informal system that, for the most part, still exists today.

Learn more about the petrodollar system, how it came to be, and how it works on this episode of Everything Everywhere Daily.

This episode is part four in a series on the international monetary system. If you haven’t yet listened, you can go back to listen to the first three episodes, which were the history of money, the gold standard, and the Bretton Woods system. 

When we last left our international monetary system, Richard Nixon had ended the Bretton Woods system in 1971 by ending the convertibility of dollars for gold. 

The entire Bretton Woods system was built on everyone pegging their currency to the US dollar and the US dollar being pegged to gold at $35 per ounce. 

The reason why Nixon did this was that the US Dollar had become overvalued, and the United States didn’t have enough gold reserves to cover the dollars which were in circulation. 

Here I want to take a detour and talk about the economics of one currency being the global reserve currency. 

The potential problem with this was identified as early as 1959 by the Yale economist Robert Triffin.

Triffin figured out that if one currency were to be the world’s reserve currency like the US Dollar was after Bretton Woods, the system would eventually implode. 

Whatever the reserve currency was would be in demand all over the world. Countries would need to have the reserve currency, and the country whose currency was used would have to supply tremendous amounts of it.

The only way to do that would be by consistently running trade deficits. Dollars would have to find a way to get out to the rest of the world. Also, as the reserve currency, it will have to be overvalued, making goods from the issuing country relatively more expensive. 

In the case of the United States in the 1960s, the dollar became overvalued relative to other currencies. Still, all of the pegs were in place, so the outlet for this overvaluation was countries exchanging their dollars for gold because the gold became a relative deal. 

Holding the world’s reserve currency is a very mixed bag. This is known as the Triffin Dilemma or the Reserve Currency Paradox. On the one hand, selling currencies to other countries basically costs nothing. The United States can produce an almost infinite number of dollars at no cost. Remember that most dollars are electronic, not physical paper currency.

On the other hand, by overvaluing your currency, you make everything you produce relatively more expensive to the rest of the world. 

Up until the end of Bretton Woods in 1971, the United States wasn’t running serious trade deficits, mostly because of their gold peg. They were exporting gold and dollars. 

Once Nixon ended this, everything changed. 

The world went from a very managed, orderly system of money to one with no central order. This is known as a managed float. National currencies can float in value in an open market, but individual central banks can still take steps to protect their currency. Hence, a managed float. 

Once Nixon closed the gold window, there was no longer any need for countries to hold large amounts of US dollars. This resulted in a new agreement in December of 1971 known as the Smithsonian Agreement. 

The Smithsonian Agreement pledged the G10 group of industrialized nations to peg their currency to the US Dollar again, and the dollar would now be converted at $38 per ounce. 

This new agreement lasted about 14 months when the open market price of gold diverged from the dollar convertibility rate, and in February 1973, all the currencies went back to floating again. 

The United States still wanted to have a strong dollar, and they still wanted everyone to have to use its currency. The problem was if they couldn’t use currency pegs and gold convertibility to make that happen, how could they do it? 

In 1973 the dollar was sinking in value, coming down from its overvaluation. There were also other really big things happening in 1973. 

In October, several Arab countries invaded Israel in what is now known as the 1973 War, the Yom Kippur War, or the Fourth Arab-Israeli War. 

The United States supported Israel via arms sales, and in response, the Arab members of OPEC, the Organization of Oil Exporting States, issued an oil embargo against the United States and other western countries.

This caused the price of oil to skyrocket, and long lines for gasoline began appearing everywhere. 

The US National Security Advisor Henry Kissinger saw a way out of all this mess. With a single stroke, it was possible to end the oil embargo and return the US Dollar to its palace at the center of the world monetary system. 

Kissinger and US Treasury Secretary William Simon began working on a plan whereby the Kingdom of Saudi Arabia would agree to price all of its oil sales in US Dollars. 

In July 1974, Simon went on what was called an economic goodwill tour. However, unbeknownst to anyone, the real purpose of the trip was actually what was scheduled as a four-day layover in Jedda, Saudi Arabia. 

There Simon and the Saudi King Faisal came to an agreement that has been one of the most defining moments of the last fifty years. 

King Faisal agreed to price all oil sales in US dollars, and they would then invest much of their dollar surplus in US Treasury bonds. 

In exchange, the United States agreed to buy Saudi oil in dollars, to sell weapons to Saudi Arabia in dollars, and also agreed to use the US military to protect Saudi Arabia and keep the House of Saud in power

This was a great deal for Saudi Arabia. They had their security ensured, and it didn’t have to cost them a dime. They were able to price their primary export in a high-priced, stable currency and invest their proceeds in a stable, safe way.

This agreement turned out to be one of the most important international agreements of the latter half of the 20th century, and no one knew about it for over 40 years. 

This agreement was kept secret until 2016, when the story was broken by Bloomberg News which filed Freedom of Information Act requests to break the story. 

Neither side had any incentive for the story to go public, and it was basically kept a secret for the entire time. 

Within a year, all OPEC members had agreed to price their oil in dollars, following the lead of the biggest oil producer, Saudi Arabia. 

Now, suddenly, everyone in the world needed US dollars once again to buy and sell the world’s most important commodity: oil. 

Oil-producing states needed to do something with their surplus of dollars, and US Treasuries provided an easy way to absorb almost all of this money. 

Henry Kissinger dubbed it “petrodollar recycling.” For the most part, it is still in place today. 

Many people are confused by what petrodollars are. Petrodollars are just regular US dollars used to buy and sell oil. They aren’t a special or different currency from the US Dollar. 

This increased global demand for the US dollar has also led to increased use of what are known as Eurodollars. Eurodollars are also sort of a misnomer. A Eurodollar is any bank account that is denominated in US Dollars overseas. It doesn’t necessarily have anything to do with Europe. 

As far as establishing demand for US Dollars, the petrodollar system has worked far better than the Bretton Woods system did. 

Today, 90% of all foreign exchange trades involve the US Dollar, 60% of all foreign exchange reserves are in US Dollars, as is 40% of all global debt.

There are certainly benefits to having a reserve currency. One of the biggest exports of the United States over the last fifty years has been…..dollars. It isn’t something people usually consider an export, but it is. 

However, as I mentioned before, having a reserve currency is a double-edged sword.  The predictions of Robert Triffin have pretty much come true. 

What was the last year that the United States had a trade surplus? 1975, the same year that all the OPEC countries came on board and started pricing oil in dollars.  

The petrodollar system has survived since the mid-1970s, but there have been constant attempts over the years by oil producers to skirt the system. Iraq, Libya, Venezuela, and other countries at various times have threatened to stop pricing oil in dollars. 

Talk of ending the petrodollar system has accelerated in the last few months. The problem is, there isn’t really a viable replacement. 

The Chinese Yuan is often floated as being a replacement. However, it isn’t necessarily something that China wants. The Chinese Yuan has been one of the world’s most managed currencies over the last several decades, so it would remain undervalued to encourage Chinese exports. 

If the Yuan became the world’s reserve currency, the Reserve Currency Paradox could undo their entire export-based economy. 

One possible replacement for the petrodollar system would be to create a single currency for the whole world, which would benefit no one country. In particular, a currency that wasn’t controlled by any one country. 

In my fifth and final episode in the series, I’ll be explaining one possible future for money, how it was developed, and how it works: Bitcoin.

Everything Everywhere Daily is an Airwave Media Podcast. 

The executive producer is Darcy Adams.

The associate producers are Thor Thomsen and Peter Bennett.

Today’s review comes from listener Jake over on Instagram. He writes:

Hey Gary,

Just wanted to say thank you for the podcast, I’ve listened to every single episode and they are great. They keep me entertained every morning on my drive into work and I look forward to them every day. Keep up the good work!

Thanks, Jake. Congratulations on your membership in the completion club. You’ll find the keys to the clubhouse in your locker. Just make sure to lock everything up when you are done. 

Remember, if you leave a review or send me a boostagram, you too can have it read the show.