Why the end of the Petrodollar is bad news for the US government

'If the Saudi regime does indeed embrace substantial trade in currencies other than the dollar as part of its oil-export business, this would signal a shift away from the dollar as the dominant currency in global oil payments. Or measured another way, this would signal the end of the so-called petrodollar.'

On January 17, Mohammed Al-Jadaan, the Saudi minister of finance, said that the Saudi government is willing to sell oil in currencies other than the dollar. "There are no problems with talking about how we pay for our trade deals, whether it's in US dollars, euros, or Saudi riyals," Al-Jadaan told Bloomberg TV.

If the Saudi government does start doing a lot of business in currencies other than the dollar as part of its oil export business, this would mean that the dollar is no longer the main currency used to pay for oil around the world. Or, to look at it another way, this would mean the end of the "petrodollar."

But how big is this change? With Saudi Arabia talking more and more about trading in currencies other than the dollar, more and more experts are talking about the "collapse" of the dollar or the coming implosion of the dollar's huge global power.

Will moving away from the dollar in the global oil trade really cause the dollar to drop a lot? Probably, and in the end. But a number of other dominoes would have to fall first, and the one we call "Eurodollars" would be the most important.

On the other hand, it would be silly to just wave your hands and say that the Saudis might stop preferring the dollar. The end of the petrodollar would make the dollar weaker, but it wouldn't be the end of the dollar by itself. Also, it is especially stupid to ignore the status of the petrodollar because that status has geopolitical effects. The Saudis' comments on the dollar show that they don't think their alliance with the U.S. is as important as they have since the 1970s. Even if something isn't a problem for the US economy or the dollar right now, it could be a problem for US foreign policy right now.

In this case, the best way to think about the possible end of the petrodollar is as a part of the dollar-based part of the world economy. Since the 1950s, the dollar has gotten a lot of help from international trade and investment, as well as from foreigners' dollar reserves. This has kept the demand for US debt and dollars very high, and it has had a huge effect on lowering inflation in the US economy. That is, when new dollars are made, they are quickly bought up by foreigners who both want and need dollars to pay off debts in dollars and add to their bank reserves. But if the dollar really is losing its power around the world, we could see both higher inflation and higher interest rates at home than what Americans have been used to for the past thirty years. In other words, as the dollar falls, the US government will no longer be able to "monetize" debt and run up huge new deficits without worrying about high price inflation or falling Treasury prices. The end of the petrodollar is not a reason to panic right now, but it is another sign that the dollar is no longer giving the US government as much power as it used to.

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What Is the Petrodollar?

The petrodollar came about when the US tried to get oil from the Middle East and stop the dollar from falling in the early 1970s.

By 1974, the US dollar was in a bad place. The Bretton Woods system, which set a fixed price for gold around the world in 1944, could no longer be followed by the United States in 1971. This was because the country was spending too much on both the war and social programs at home. As the amount of money in circulation grew due to growing deficit spending, the value of the dollar fell in comparison to gold. The dollar started to lose the trust of foreign governments and investors.

Richard Nixon said that the US would leave the Bretton Woods system because of what had happened. When compared to other currencies, the dollar started to change. Not surprisingly, this drop in the value of the dollar did not restore faith in it. Also, the US had not done anything to stop deficit spending. So, the US had to keep looking for ways to sell government debt without causing interest rates to go up. That is, the US needed to sell its debt to more people. After 1973, when the first oil shock made the price inflation caused by the deficit even worse, people wanted to find a solution even more.

But by 1974, the huge flow of dollars from the US into Saudi Arabia, which was the biggest oil exporter, showed that there was a way out. Nixon got Saudi Arabia and the US to agree that the US would buy oil from Saudi Arabia and give the kingdom military aid and equipment. In exchange, the Saudis would buy US Treasury bonds with their dollars, which would help the US pay for its budget deficits.

From the point of view of public money, this seemed like a good deal for everyone. The Saudis would be safe from geopolitical enemies, and the US would have a new place to dump large amounts of government debt. Also, the Saudis could put their dollars in investments that were pretty safe and reliable in the United States. This came to be known as "recycling petrodollars." When the US spent money on oil, it made more people want to buy US debt and dollars.

Over time, Saudi Arabia's leadership in the Organization of the Petroleum Exporting Countries (OPEC) made the dollar the most important currency in OPEC as a whole. This made the dollar the preferred currency for buying oil around the world.

In the 1970s and 1980s, when Saudi Arabia and other OPEC countries controlled more of the oil trade than they do now, this petrodollar deal was especially important. It also tied US interests closely to Saudi ones, making sure that the US would be against the kingdom's traditional rivals, like Iran.

The Petrodollar Is a Type of Eurodollar

In terms of its economic role, however, the petrodollar has always just been a type of Eurodollar.
What is a Eurodollar? According to Robert Murphy:
The term Eurodollar actually refers to any US dollar-denominated deposit held at a financial institution outside of the United States, or even a USD deposit held by a foreign bank within the US. It thus has nothing to do with the euro currency, and is not restricted to dollars held in Europe; they are dollar deposits that are not subject to the same regulations as US dollars held by American banks, nor are they guaranteed by FDIC (Federal Deposit Insurance Corporation) protection (and hence they tend to earn a higher rate of return).
The trade in Eurodollars is very big, but it's hard to say just how big. According to one estimate, Eurodollar assets are worth about $12 trillion. For example, all of the assets in US banks add up to about $22 trillion. Or, to put it another way, "about half of all US dollar banking is now done outside the US." So, the Eurodollar economy is very big, and this "dollar zone" is also a key part of many of the world's leading economies, since half or more of the world economy is in that zone.

In 2020, on the other hand, the petrodollar trade was less than $3.5 trillion per year. That's not a small amount, but even a big drop in this amount won't cause the global demand for the dollar to drop compared to other currencies. With trillions of dollars worth of loans floating around the world economy, the petrodollar is still just a small part of a much bigger picture.

Still, we could also say that the end of the petrodollar is part of a larger and more important trend away from the dollar. Since 2008, the relative size of the Eurodollar market has gone down. At its peak, it was worth 87 percent of the size of the US banking system, but now it is worth less than 60 percent. The amount of US dollars in the reserves of foreign central banks has also gone down, from 71% twenty years ago to 60% today. This is the lowest since 1995. Russia, China, and India have all said they want to get the world economy off of the dollar.

Even if this trend keeps going, there will still be a lot of demand for the dollar next week, next month, or next year. In the global economy, there are still trillions of dollars worth of debt that is denominated in dollars. For now, at least, this means that there will still be a need for dollars. Also, the dollar is still one of the safest currencies to keep on hand, since the central banks in Japan, Europe, the UK, and China aren't doing much to support "hard money." Foreigners will still keep a lot of dollars on hand to buy US assets because the US economy is still very big and US Treasury bonds are still at least as safe as bonds from other regimes. This is also true because foreigners buy US products and services, despite the myth that "America doesn't make anything anymore."

This doesn't mean, though, that everything is good for a dollar. Even a slow move away from the dollar will cause the cost of living in the United States to go up. With fewer foreigners holding dollars, the US government's current out-of-control monetary inflation will lead to more price inflation at home. In other words, if the world moves away from the dollar, the US government will have to stop "monetizing" the country's debt as much if it wants to stop inflation from getting out of hand. It will also probably mean that US government bonds will have to pay higher interest rates, which will mean that more money from taxpayers will be needed to pay off the debt. It will make it harder for the US government to pay for every new war, program, or pet project that Washington comes up with.

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The Geopolitics of the Petrodollar

The move away from the petrodollar will have more obvious short-term effects on geopolitics than on the currency order. Saudi Arabia has recently made it clear that it is no longer tied to the dollar. It has also said that it is willing to work with Russia and join the Brazil, Russia, India, China, and South Africa (BRICS) group of countries. This change in Saudi Arabia's strategic goals could pose an immediate threat to US strategic goals, since the US government has grown used to controlling the whole Persian Gulf area through its ties with Saudi Arabia. If Saudi Arabia turns away from the petrodollar, this shift will get even bigger. That will be enough to hurt the American standard of living even more, but it won't be enough to kill the dollar on its own. Even though it lost its position as the preferred global reserve currency, the pound sterling did not disappear. But it did lose a lot of its power. The same thing is happening to the dollar.