This was a comment made by Dr Gavin R. Putland for a post I wrote on a political forum on 4 Nov 2003. It remains significant today: From 1944 to 1971, the U.S. dollar was backed by gold, meaning that the government agreed to buy and sell gold for a fixed price in dollars. Other governments did likewise, leading to fixed exchange rates between their currencies.
In 1971, when US President Nixon abandoned gold backing, the exchange rate system began to unravel. Domestically, the U.S. dollar became a fiat currency, i.e. a currency whose only backing is the legal obligation to accept it as final payment of debts. Internationally, however, there is no such thing as a fiat currency, and no currency will be accepted as payment unless it is guaranteed to buy some valuable commodity.
In 1973, the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of oil but continued to accept only U.S. dollars in payment, so that the demand for dollars soared. From then on, the dollar was effectively backed by oil instead of gold — and the U.S. government didn’t even have to own the oil!
Because dollars can buy OPEC oil, countries that need to import oil — i.e. most developed countries — will accept dollars as payment for their exports. Hence everyone who needs to buy from those exporters will accept dollars as payment for other things, and so on, so that the dollar is the preferred global currency.
To pay their bills, importers must have reserves of dollars. To prop up their currencies against speculative attacks, the central banks of all countries must have reserves of dollars. To get capital, poor countries must borrow dollars, and to service these debts they must export goods to obtain more dollars.
About 2/3 of all currency reserves, more than 4/5 of all currency transactions, more than half of the world’s exports, and all loans from the International Monetary Fund (IMF) are denominated in dollars. As these things create demand for the dollar and shore up its value, OPEC is the more willing to accept payment in dollars. So the system is self-reinforcing.
The result is that America can export dollars, which cost nothing to produce, and receive real goods and services in return. As long as those dollars are spent outside America, they don’t cause domestic inflation. And when they eventually find their way into foreign reserves, they can only be invested in American assets.
This continuous flow of foreign investment (on the capital account props up the American real-estate market and stock market, and allows America to run a mammoth trade deficit (on the current account without devaluing the dollar. America’s imports now exceed its exports by almost 50% (or 5% of GDP) and its foreign debt is 60% of annual GDP.
If OPEC were to abandon the dollar for some other currency, the whole process would slam into reverse. America could no longer export paper dollars for real goods and services. Corporations and central banks would sell their dollar reserves, causing the value of the dollar to plummet.
The redemption of dollar reserves would force sales of the assets in which those dollars are invested, so that the American property and stock markets would crash. Other investors who have bought American property and stocks with borrowed money would declare themselves bankrupt, causing some American banks to collapse under the weight of bad debts.
The newly liberated dollars could only be spent on American goods and services, which would begin to flow out of the country (reducing living standards), while the glut of dollars chasing these same goods and services would cause rampant domestic inflation. The flow of foreign investment would dry up, so that America could no longer run a trade deficit, but would have to export yet more goods and services to pay for its imports, and to service its massive foreign debt, and to accumulate reserves of the new global currency — whatever that currency might be…
In 1999, eleven member states of the European Union (EU) adopted the euro as a common accounting currency. Greece joined the Euro Zone a year later. On January 1, 2002, the twelve countries withdrew their old money from circulation, completing the biggest currency reform in history.
The Euro Zone already has a bigger share of world trade than the USA. In particular, it imports more oil than the USA and is the main trading partner of the Middle East. It offers higher interest rates than the USA, but does not have a huge foreign debt or trade deficit. These things inspire confidence in the euro.
It was perhaps for that reason that in 2002, China started converting some of its currency reserves from dollars to euros, while North Korea abandoned the dollar and started using euros for trade. The strength of the euro also encourages expansion of the EU and puts pressure on current members Denmark, Sweden and the U.K. to join the Euro Zone. In December 2002, ten new countries were accepted for EU membership with effect from May 2004. This will create a common market of 450 million people, which will buy more than half of OPEC’s oil.
In summary, the only argument for preferring dollars to euros is that dollars can buy oil. As that argument does not affect OPEC, it would make sense for OPEC to convert its reserves to euros by mid 2004. If OPEC were then to price its oil in euros, it would increase demand for the euro, causing a huge increase in the value of its new euro reserves. These possibilities are not discussed in the U.S. media.
The first OPEC member to show serious disloyalty to the dollar was Iran. Since 1999, Iran has been talking about pricing oil in euros. In January 2002, George W. Bush named Iran in his axis of evil although the country is experimenting with democracy — something that the USA, if true to its professed values, would want to reward and encourage. Undeterred, Iran converted most of its currency reserves to euros during 2002, and a proposal to price Iran’s oil in euros is being considered by the central bank and the parliament.
Let us see whether the Americans find an excuse to topple Iran’s fledgling democracy and to replace it with a dictatorship that just happens to prefer dollars to euros.
The second offender was Venezuela. In 2000, Venezuela’s president Hugo Chavez called a conference on the future of fossil fuels and renewable energy. The report of the conference, delivered by Chavez to the OPEC summit in September 2000, recommended that OPEC set up a high-tech electronic barter system, so that members could trade oil for goods and services without the use of dollars or any other currency. The chief beneficiaries would be OPEC’s poorer customers, who did not have large currency reserves. Chavez made 13 barter deals. In one of them, Cuba provided health services in Venezuelan villages.
In April 2002 there was a coup against the twice elected Chavez. The coup was welcomed by the Bush administration and by editorials in numerous American newspapers, but collapsed after two days, leaving evidence that the U.S. administration was behind it.
The third and most blatant offender was Iraq. In October 2000, Saddam decreed that Iraqi oil would be sold for euros instead of dollars, with effect from November 6. Soon afterwards, Saddam converted Iraq’s entire $10 billion oil reserve fund from dollars to euros. These facts went unreported in the U.S. media.
George W. Bush assures us that Iraq’s oil belongs to the Iraqi people. But any asset priced in dollars is at least partly an American asset because it adds to the demand for dollars, allowing America to export more dollars and receive more goods and services in return. So the test of America’s sincerity will be whether its new regime in Iraq continues to accept euros for oil.
For more information on the oil currency war, see:
Oil, Currency and the war on Iraq and the links on that page. On the fortunes of the U.S. dollar, see: Fortunes of the US Dollar. For more reflections on the economic significance of natural resources, see: The economic significance of natural resources.