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(Credit goes to Luke Gromen, Lynn Alden and Peter Zeihan for most of the ideas in this piece.  Any misstatements or inaccuracies are my own)

Prior to World War II, the US dollar was redeemable for a certain amount of gold.  This gold backing, combined with the fact that the US economy was by far the strongest in the world after the war, lead representatives from all the major powers to agree in 1944 (at a meeting in Breton Woods) that the US dollar (rather than a neutral asset like gold itself) would thereafter function as the world’s major reserve asset and currency.  (A “reserve currency” is a common currency used to settle debts among countries and to settle transactions in international trade.)  

The US had over 20,000 metric tons of gold immediately after World War II but only about 8,000 metric tons of it remained by 1971. At that pace, and left unchecked, US gold would eventually be entirely depleted.

The Gold Window Closes

Concerned that fully or nearly depleted gold reserves would undermine the US’s wealth and strategic positioning in future decades, and desperately wanting to print more money to fund the Vietnam War (something not really possible while on the gold standard), Nixon closed the gold window in 1971.  This meant that, despite the implicit promises made at Breton Woods, foreign countries would no longer be permitted to redeem their dollars for US gold.  In other words, the US government defaulted (in a manner of speaking) on its obligations, and the dollar became an unbacked currency.   

The world was unsurprisingly alarmed.  Without gold backing and with the US now printing money like mad to fund the Vietnam War and other social programs, countries that had accumulated large dollar reserves due to trade surpluses felt understandably insecure.  Might their dollar denominated wealth be inflated away by the US?    Would the US continue to exploit the exorbitant privilege of its reserve currency status by exporting much its inflation (the cost of its money printing) to the rest of the world?

Inflation Goes Wild  

Understandably the nations of the world began to look for opportunities to dispose of their US dollars, or at least to accumulate them less rapidly.  They began accumulating hard assets with those reserves instead, especially gold.  Though the US no longer permitted these countries to redeem their dollars for a fixed quantity of gold from the US treasury, nothing could stop them from buying gold with their surplus dollars on the open market.  

Less worldwide demand for dollars, more worldwide demand for gold and a greater supply of dollars (due to all the money-printing) led to a rapid depreciation in the dollar’s purchasing power in the 1970’s.   

The Origins of the Petrodollar

The faster the dollar’s purchasing power declined, the less other countries wanted to hold dollars and the more they wanted to acquire hard assets like gold instead.  By 1974, the US became alarmed that confidence in the dollar might collapse completely.  Not yet prepared to abandon the exorbitant privilege of issuing the world’s reserve currency to a neutral asset like gold, the US needed to do something to prop up demand for (and confidence in) the American dollar, and fast.          

Henry Kissinger and others then realized that if the rise of the price of gold could be artificially suppressed, the price of oil could be inflated and the US could convince the Saudis and others to accept only dollars for their oil, demand for dollars would soar once again. And that demand could be maintained at levels sufficient to sustain the dollar’s purchasing power indefinitely, even in the face of moderate money printing.  Reserve currency status could thereby be maintained even though the US had closed the gold window.  

In accordance with this plan and over ensuing decades, the US and some allies sought to foster a massive expansion of the “paper gold” market and likewise took other steps to suppress the price of gold (the primary competitor to the dollar for reserve currency status).  By expanding the availability of “paper gold”—that is, by allowing multiple individual parties to have claims to each ounce of gold, with each party more or less assuming he/she owned the whole thing—the “supply” (or the illusion of supply) could be artificially increased.  All else being equal, an increase in apparent gold supply would lead to lower-than-otherwise gold prices, at least for so long as people didn’t demand physical delivery of their gold in great numbers.  

With gold (the dollar’s main competitor) being suppressed, oil being made more expensive, and essentially all international trading in oil requiring dollars, the now famous (or infamous) petrodollar system was born.  To paraphrase Luke Gromen, from 1974 forward the dollar was no longer as good as gold, but it was then better than gold for purchasing oil.  And with oil now so expensive, demand for oil ever-growing and prices propped up by the the occasional artificially-induced supply shock (as and when needed), the dollar’s reserve currency status was thus assured indefinitely.

Trade Imbalances 

This sustained worldwide demand for dollars kept the dollar’s purchasing power artificially high versus other currencies, higher than the performance of the US economy alone justified. This was especially true after 1971 (when the dollar could no longer be redeemed for gold). 

When a nation’s currency is persistently “stronger” than its own economy justifies, it becomes cheaper for its companies to manufacture overseas rather than at home.  A country’s normal response in such situations is to implement capital controls designed to legally prevent that investment and those jobs from moving overseas. However, the issuer of the reserve currency does not have the luxury of implementing capital controls.  To retain reserve currency status, its capital (and the property, plant, equipment and jobs tied to it) must be permitted to flow freely across the world.      

As Lynn Alden has puts, “From 1944 to 1971, the US drew down its gold reserves in order to maintain the Breton Woods dollar system, whereas from 1974 to the present, the US instead drew down its industrial base to maintain the petrodollar system.” 

It’s important to understand that these were intentional and knowing decisions designed to preserve the US dollar as the world reserve currency. Policymakers at the time knew the consequences of these decisions. They understood well the trade-offs.  They deemed them to be worth it at the time.

The “Success” of the Petrodollar

As a result of the new petrodollar system, the world continued to trade almost exclusively in dollars, and the Age of Globalism dawned.  From 1974 until about 2014, countries resumed storing their foreign currency reserves (their savings) in dollars and dollar-denominated assets (like US treasury bonds), and they placed far less emphasis (than they had from 1971 to 1974) on accumulating gold and other hard assets.   

In exchange, the US, as promised, policed the world (in part to ensure its own supply lines as manufacturing would undoubtedly move overseas), tolerated the hollowing out of its industry (a natural consequence of an artificially strong dollar thanks to foreign demand), and defended the dollar’s purchasing power by (a) not printing too much money and (b) by tightening monetary policy whenever inflation started getting out of control. 

The system worked well until about 2008 because the US did what it said it would.  For example, in the early 1980s Chairman of the Federal Reserve Paul Volker raised interest rates to historic extremes, forcing the US into two quick but very painful recessions in a row, all to tame growing inflation, preserve the dollar’s purchasing power and thereby preserve the legitimacy of the new petrodollar system.  Under Volker, the US did exactly what it promised to do in 1974.

The Petrodollar System Weakens

However subsequent US politicians and and Fed Chairmen were not nearly as devoted to those promises as Volker.  The US eventually began to cheat on the deal.  

The cheats were small and could be rationalized away at first, allowing the US to plausibly deny that it was doing anything truly inconsistent with the 1974 understanding.  But eventually the cheats became so significant that the world could no longer safely ignore them.  

For a world reserve currency to be widely adopted and fully functional, it must be politically neutral.  Without a politically neutral form of money greasing the skids of international trade, countries are forced to either abandon foreign trade (not good for anyone), to sacrifice their own sovereignty to the issuer of the politicized currency (which is not something most are willing to do) or to find (or create) and use a different and truly apolitical form of money instead.    

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Under Volker and Greenspan, the US could be relied on to operate the dollar in a mostly politically neutral way.  But starting with President Obama and Ben Bernanke, the US became increasingly willing to use the dollar system as leverage to force other nations to bend to its political will, and   to punish them for perceived misconducts.   

Because the transition from an apolitical currency to a political one was gradual at first, it’s hard to pick a firm date upon which it occurred.  But 2008 is probably as good a marker as any.  In that year Russia invaded Georgia, and the US and much of the rest of the world responded with very tough sanctions.  

Recognizing how much its dollar dependency made it vulnerable to US political manipulation and thereby jeopardized it own sovereignty, Russia worked relentlessly over the ensuing decade to divest itself of dollar denominated assets and instead to use gold and other currencies as much as possible for its foreign reserves.  Over the entirely of its existence Russia had by 2008 managed to accumulate only about 450 metric tons of gold.  But today, in 2002, it has over 2,300 metric tons, a nearly 6X increase in only a couple decades!  

During those years Russia also negotiated agreements with various other countries, including China, to conduct much foreign trade in currencies other than dollars.  

Alas, Russia was not the only country to intentionally reducing its dependency on the US dollar over the last few decades. Since 2014, the world’s central banks purchased (on a net basis) three times (!!!) as much gold as they did US treasuries, reversing a decades old trend going back to 1974 and returning to the policies of the 1971-1974 period (shortly after Nixon closed the gold window).  So by 2014, the petrodollar was already looking wobbly.    

The Final Nail in Petrodollar’s Coffin

Believing itself to be much more insulated from US pressure as a result of the measures it took since 2008 to be less dependent upon dollars, Russia boldly invaded Ukraine in 2022 (the likely reasons for this invasion will be discussed in another post).  

The US thus had two options:  (1) Do nothing and set a horrible precedent (effectively handing over much of Eastern Europe to Russia), or (2) take (in conjunction with its allies) the historically unprecedented step of booting key Russian banks off of SWIFT (thus depriving them of access to the world’s dollar denominated trade settlement system) and subsequently “freezing” much of the non-gold portion of Russia’s foreign currency reserves, reserves that by practical necessity had been stored in banks under the control of the NATO allies.  

The US knew that both of these steps would be truly devastating to Russia, but it also knew that these steps would effectively end the 1974-based petrodollar system once and for all.  

Why?

Because after seeing how easily and quickly the US and it allies could abuse the US’s exorbitant privilege by taking the unprecedented step of depriving a sovereign nation of its foreign currency reserves (something previously considered impossible due to the doctrine of sovereign immunity), no country (certainly not Saudi Arabia nor other oil exporters) would ever again feel safe conducting trade exclusively or primarily in dollars.  Nor would they they feel safe storing their foreign currency reserves largely in dollar-denominated assets.  Nor would they ever again want to be entirely dependent upon the US-controlled SWIFT settlement system for international trade. 

Abandoning the Petrodollar Benefits the US

In order to avoid war, the US chose to run a play that it knew would devastate Russia but that it could only effectively run once.   It chose to break the petrodollar bat over Russia’s head.  

And it chose this play mostly because the petrodollar system no longer served its interests anyway.  

In the past the US would have policed the world to preserve the dollar’s status, as it had explicitly or implicitly promised to do since 1974.  In other words, it would have gone to war, or at least fought a proxy war, to contain Russia and protect the integrity of the petrodollar system.  It would not have flushed the whole system in order to punish a single enemy for misconduct.     

However, with its own debts already at unsustainable levels (and higher than even at the end of World War II), its manufacturing base hollowed out, its increased energy independence and its Asia-centric supply lines being very vulnerable to disruptions from pandemics or geopolitical events—all as a consequence of the petrodollar system and the globalization it inspired—the US decided now was the time to throw in the towel. 

The US had to know that booting Russia from SWIFT and seizing its foreign currency reserves would accelerate the US dollar’s downfall as the primary world reserve asset (by incentivizing countries to store their reserves in assets not so easily frozen by the US on a whim), but it also knew that it could likely avoid a shooting war, bring Russia to its knees and reshore American industry at a faster pace by simply accelerating its inevitable decline.  

And…so it did.  When it froze Russia’s reserves, it sacrificed the petrodollar once and for all and signaled to the rest of the world that that Age of Globalization was ending.  The world could no longer count on the US to operate a nonpolitical reserve currency nor to fight foreign wars to preserve the petrodollar system.  

For example, when the US real estate bubble burst in 2008, the Fed flooded the system with freshly printed dollars.  This had two primary effects.  One was to provide sufficient liquidity to “rescue” the US (and to some degree the world) from economic catastrophe. The other was to export much of the resulting inflationary pressure to our friends and foes overseas.  

This was, of course, a breach of the 1974 international understanding backing the petrodollar.   But, given the state of emergency, it could be rationalized to some degree.  The nations of the world begrudgingly accepted the inflation as a necessary evil while at the same time hedging their bets by diversifying more out of dollars into gold, other hard assets and other currencies in future years. 

With the arrival of COVID in 2019, the US abandoned all pretext of monetary discipline and therefore of honoring the 1974 accord.  When it became clear that COVID was affecting the US stock market and might badly damage the US economy, the US Fed launched the greatest money printing operation in world history, and it did so even before any real economic emergency existed.  And then it continued for the next two years to print at unprecedented levels even in the face of rapidly rising inflation!  

Thus, the world was already moving quickly away from the dollar by the time the US hyper-weaponized it against Russia in 2022. As noted before, the world’s central banks have since 2014 purchased 3 times more gold (on net) than US treasury bills, reversing a multi-decade trend and reverting to their post-1971 and pre-1974 ways.  And countries increasingly negotiated trade deals that called or settlement in local currencies rather than dollars.  

Conclusion

By 2022, the dollar’s reserve status was from the US’s perspective already a wasting asset that no longer served it well.  Maintaining the petrodollar was no longer consistent with long term US interests and was economically unsustainable even if that were not the case.  

What does a world without the petrodollar as the primary reserve asset look like?  What can we expect over the next decade as the dollar looses its peg to oil and the world accelerates its transition away from holding US treasuries in reserve?  I have some thoughts on those subjects, and I’ll explore them in future posts.