🔋Not Your Average Dollar

The petrodollar agreement sits atop shaky ground today as it holds together the US dollar as global reserve currency.

Oct 26, 2022

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Petrodollars

The petrodollar was an agreement between the US and Saudi Arabia that priced oil internationally in US dollars. There have been moments where the relationship has been questioned, but ultimately it remains intact to this day. The context and backdrop was discussed in more detail in my earlier post, found here. Since oil was and remains the most important energy input globally, it gave the US an exorbitant privilege by maintaining the global currency hegemony it established post world war two. This article is a deeper dive on one of the more important consequences of the early 1970s and end of the oil embargo of 1973.

The dollar profits from oil producing countries were then “recycled” back into US treasuries, which contributed to the ability to continuously lower interest rates and issue cheap debt. This allowed the US to essentially "print” oil through issuing debt to purchase real goods like oil. This is a function of the deal with the Saudis and not a mere market phenomena as the value of the dollar debt is likely depreciating faster than the value being supplied on the other end. As you can see below, interest rates have been mostly rangebound in a clear descending channel which has been breaking in recent years.

The problem today is that with lower and lower interest rates, the trend cannot continue on its path and go below zero. In that environment you are getting paid to take on credit which doesn’t make much sense. The problem however with breaking the channel to the upside is that with the higher debt, it becomes harder for government and private debt-holders to service that debt or more expensive to take on new debt. This runs the risk of less growth, bankruptcies, or even another financial crisis. When bonds are not attractive, the bonds demand a higher yield to attract buyers. If there was less foreign interest in buying US treasuries moving forward, it gives the US government less ability to fund its spending programs and other expenditures which it has become reliant.

According Alex Gradstein in BTC magazine, further consequences of the petrodollar agreement are: a strong alliance between the US and the Saudi Arabian dictatorship, financialization of the US economy shifting away from exports/manufacturing, the Eurodollar issue, stress on Russia/other resource exporting countries, emerging market debt issues, a focus on fossil fuels rather than other technologies, and the ability of the US to fund wars and social programs unrivaled by other nations.

Reserve Currency

With the world reserve currency for trade, a problem with liquidity arises. If Japan wishes to buy oil from Venezuela for example, they need dollars in order to do so. This means that Japan will have to take out credit for or exchange domestic currency for dollars in order to buy the oil. If Venezuela wishes to earn yield on their dollar reserves, they may buy treasuries or other US assets with the profits. This is seemingly a win-win for the US who can issue debt at whim and there will always be buyers. The US has to issue enough dollars to satisfy global demand for trade which they have a stranglehold on because of the reserve currency and petrodollar agreement.

One consequence of this is foreign banks that accumulate dollars also start issuing dollar denominated loans. Since foreign entities cannot be regulated by the US, there becomes a whole world of new dollars in the world in which the supply and reserve quantity are unknown. This is known as the Eurodollar system and is a beast in itself that the US cannot control. It is more or less okay as long as the banks do not blow up, in which case causing problems to the dollar funding machine.

Enter the Triffin Dilemma: to remain the world’s reserve currency, the U.S. must provide global liquidity by running increasingly large deficits, which one day must undermine faith in the dollar.

Running up the supply of an asset depreciates its value. This is true for currency, and as the US “prints” more money, the value of all outstanding dollars goes down in consequence. This is the reason gold and other hard assets tend to appreciate over time vs fiat currencies. The US (and the unregulated Eurodollar system) must issue enough currency to satisfy global demand for trade. This very process undermines the underlying value of the dollar which is a dilemma.

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This is true as long as foreign trade is done in US dollars. Around the world we are have seen and continue to see countries try and break free from trading in dollars. For some nations it has not gone well, for others they are slowly or forcibly weening themselves off. This is a negative for the US as they need demand for dollars to keep their power and influence globally. Countries have typically been very hurt by straying from the dollar, and the US has used it as a weapon in many occasions. Most recently, the US confiscated Russian reserves of US dollars because they invaded Ukraine. This was a warning and attempt to hurt Russian currency and government, but at the same time undermines the system they are so desperate to protect to keep their own power.

Russia, Saudi Arabia, China, and others have been moving away from dollars. BRICS is trying to develop a new reserve currency, Russia has decided to sell natural resources in their currency, and some OPEC countries are considering trading in other currencies as well. Ironically, the reason many resource producing want to move away from the dollar is precisely because the value has been depreciating. Triffin dilemma full circle.

Bifurcated World

It has gotten to the point that dollars (US treasuries) are the largest export of the US. This has eroded the middle class over time, consolidated wealth with the top earners, and favored financial and tech sectors over manufacturing and hard assets. Debt and financial assets exploded while interest rates declined. Technology is the other large export of the US, which was also just raised as a weapon with semiconductors.

Eventually dollar hegemony will deteriorate, especially with the debt/GDP ratio so high and other resource producing countries already veering away from dollars. Many speculate that the debt issues will come home to roost and that more nations today will look to continue to sever their ties to the US dollar and its reserve currency hegemony. How exactly this may play out is extremely complicated and could go many different ways so we can only speculate.

One thing is for sure is that the US has defended the US dollar reserve currency at every step and those who question it almost immediately run into problems. Russia, OPEC, and China are all examples of countries that have been met with sanctions in varying degrees for trying to trade outside dollars.

The federal reserve is currently tightening financial conditions more aggressively than any other time in its fight against inflation. The problem is that inflation>interest rates, meaning negative real rates is necessary and helpful to reduce the government debt. It is important for the fed to maintain control over inflation expectations, which can cause the price spiral and issues similar to the 1970s. I believe however that raising interest rates and thus a strong dollar right now is also being used as a weapon in a sense. Many countries are not happy with the depreciation of the dollar and are moving away. Right not the dollar is soaring and perhaps they are trying to convince conflicted countries of how important the dollar is. In a similar vein, it could be a weapon in the sense of trying to hurt the respective currency/economy of countries that the US is in conflict with. The ultimate test is whether/and at what cost the US can hold together its reserve currency status or it will continue to lose market share in global trade and power over the world. Correlation or causation aside — the more the US dollar gets challenged, the more conflict that arises around the world. Until next time,

-Grayson

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