27 February 2006

MAD Petrodollars

The impending ribbon-cutting ceremony for the opening of the Iranian Oil Bourse is receiving scant attention - but should be front and center for every one. If the Bourse opens as anticipated in March 2006, it is likely to shake up the global order significantly.

Here is the background. In 1971, the US took the dollar off of the gold standard, essentially turning currency trading in the dollar into a confidence game. To reassure investors, the US made a (not so secret) deal with Saudi Arabia to insure that Saudi oil would be denominated in dollars; the quid pro quo was a series of security assurances. Ever since then, essentially the entire world has been buying oil on the international market for dollars. For the world at large, this means that they need to find a way to get their hands on US dollars so that they can purchase oil, and in the normal course of events this is accomplished by trading goods for dollars. On the other hand, the US can buy oil with dollars that they print themselves.

As pointed out recently in Z Magazine, this essentially allows the US to purchase oil with fiat money - bills that have value only because the issuing country says they do - as opposed to commodity money, which the rest of the world must use to purchase oil. The interesting and compelling observation is that this situation has allowed the US to run up deficits ($725 billion in 2005!!!) that would be otherwise unsustainable, especially in a world where money can move so easily.

Of course, this is the nub of the matter. So long as oil is denominated in dollars, the US economy retains its ability to dominate. But what happens if this situation changes and oil becomes denominated in another currency, Euros for example? Several people (here and here and here) have speculated that this represents the underlying reason for the invasion of Iraq, and with the looming threat of the Iranian Oil Bourse, tongues are wagging at the relationship between the threat to petrodollars and the level of rhetoric about Iran's nuclear program.

In a world awash in misinformation, it is always difficult to know what is true (and there are contrary views). However, one observation that supports this line of argument is that the US dollar has not cratered in the face of astoundingly poor financial performance. In a sense, the scenario that has developed is analogous to that which arose in the Cold War. All of the players need to keep the US dollar propped up lest their holdings of US dollars lose their value. If countries (Japan and China come to mind) stops buying oil in dollars, the entire house of cards comes crashing down and everyone loses. When the Russians were on the other end of the 'hot line', there was reason to expect that Robert McNamara's notion of Mutually Assured Destruction would stay their hand. It is worth pondering whether the Iranians will be equally prudent.

Beware the ides of March.

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1 comment:

NeonTetra said...

Not every nation prefers to trade in dollars. Europe, obviously would benefit, and the advantage would increase as oil rises and the dollar falls (which amont to much the same thing). Russia has made no secret of its desire to trade in Euros.

China, a key player in this Great Game, is being cagey, but it is becoming clear that they will do whatever it takes to secure their energy supplies. Eventually they will come into direct conflict with the US.