By Bill Wilson — As part of the resolution to the 1973 oil shock, the petrodollar was born when Richard Nixon convinced Saudi Arabia to only accept dollars for payment of oil in return for protecting their oil fields and a guaranteed return on investments in U.S. treasuries.
It was a move that cemented the dollar as the world’s reserve currency, since ample dollars were needed on hand by nations in order to transact in the most essential of commodities in the global economy.
For the U.S., such a system was generally seen as a boon. Having fully come off the gold standard, in theory it gave the dollar staying power as a dominant currency that retained value. And with such a high demand for dollars and therefore dollar-denominated assets, particularly U.S. treasuries, the nation could borrow more cheaply overseas to fund its deficits.
In turn, the high demand for dollars would keep the currency’s value high and oil prices low. This got off to a rocky start, with prices rising throughout the 1970’s, and then peaking in the 1979 oil shock born out of the Iranian hostage crisis.
But after that, prices declined and pretty much remained relatively cheap — until the mid-2000’s.
Now, nearly 40 years later, the cracks are beginning to be seen in the petrodollar’s foundations. No longer burdened by the gold standard, the financial crisis of 2007-08 was made entirely possible by the massive accumulation of debt in both the public and private sectors over several decades.
It had fueled inflation in the housing sector and throughout the economy, but as the credit bubble popped, investors fled into hedges like treasuries, gold, and oil — the prices of which soared.
After that the economy crashed, along with commodities prices temporarily. The value of treasuries kept rising until 2009, when rates stabilized. But it was not long before the sovereign debt crisis then reared its head and the flight to perceived safety began anew.
Now, interest rates have never been lower, and gold and oil appear to once again be testing their highs. If past performance is any indication, investors are therefore again hedging against overall risks in the economy and a weak dollar.
That is certainly a more thorough explanation than one will get from the Obama Administration for the current state of affairs. Recently, Obama said that “as the economy strengthens, global demand for oil increases” to explain the recent jump in oil prices.
On Feb. 21, the Wall Street Journal reported that the White House says it “anticipated the current spike in gas prices, which they attribute to increased demand around the world, particularly from China.”
While demand did rise globally from 88.3 million barrels a day in 2010 to 89 million in 2011 according the Energy Information Agency, so too has global production increased to 90 million a day in Dec. 2011. So, there is no supply shortage at present. Tell us another one.
But the debate over oil and gas prices not only tends to obfuscate the weak dollar causes of our collective economic woes, it hides the fragility of the entire petrodollar system.
It will not take much for this house of cards to fall given its dependence on 80-year old monarchs in Saudi Arabia and elsewhere to continue transacting oil in dollars. When that is no longer the case, in an instant, the incentive to stockpile dollars and dollar-denominated assets like treasuries will be wiped out — along with our prosperity as a nation.
The negative impact of the weak-dollar policy is roaring inflation in other parts of the world, including Saudi Arabia, where inflation hit 5.3 percent in Dec. 2011. And we have to wonder how long the rest of the world will accept a now near-zero return on money held in treasuries — in short, a U.S. fueled inflation — just to prop up a monetary system pieced together by Richard Nixon and Henry Kissinger 40 years ago. My bet is not much longer.
Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.