For years, much has been written about excessive debt and money creation causing debasement of the U.S dollar and undermining its position as the world’s reserve currency. The essence of the counterargument is that the U.S. can and should expand its debt and currency beyond normal or prudent levels, with little fear of worrisome inflation or dire consequences, precisely because so much of the world’s trade–particularly in oil and commodities–settles in U.S. dollars. In other words excess dollars won’t be inflationary at home if they slosh around abroad.
Even though there has been a temporary strengthening of the dollar in the last eight months, the dollar trades lower today against the Euro than it did in the first few years of conversion to the Eurocurrency. And against some currencies, like the Swiss Franc, the long-term dollar trend remains down, with the dollar losing 70% of its value in 40 years.
Understanding how the dollar became the world’s reserve currency is essential in order to grasp currency risk today. When Nixon suspended the convertibility of the dollar into gold in August 1971, there were immediate negative repercussions in the currency markets. Nixon’s move effectively ended the relative stability of the gold-backed Bretton Woods international currency regime and ushered in the instability of fiat currencies and floating exchange rates. This, combined with the inflationary effects of the oil embargo, caused precipitous weakness in the dollar.
In an effort to restore stability, in 1973 Nixon sent secretary of state Henry Kissinger to negotiate with the House of Saud. A deal was struck and the Saudis agreed to price oil in dollars in exchange for a U.S. commitment to defend Saudi oil fields. This led other OPEC countries to follow suit, which is how the petrodollar trading regime came into being and was then further expanded to other commodity pricing and trading. This ultimately resulted in the U.S. dollar becoming the world’s reserve currency —providing a key support for the dollar’s position in the global economy for the last four decades.
But quietly, with little news coverage, in the last five years everything has been changing due to a whole host of international currency and trade agreements that exclude the dollar. Not only has the stature of the U.S. been declining in the world, but rivalry and distrust have been rising, with a number of traditional allies no longer viewing the U.S. as a reliable ally. Economic growth in China has prompted its leaders to create and muscle in on non-dollar trade agreements with not only our rivals such as Russia, but also with friends, such as Germany, Brazil, Australia, India, Japan, Chile, South Africa, Saudi Arabia and the United Arab Emirates. It is well-known that Iran has evaded international trade sanctions — imposed to curb its nuclear weapons development — with countries like India by trading oil for gold and rupees.
Today, Middle Eastern countries are not only faced with growing regional instability and security threats, but many U.S. allies among Sunni Arab states, such as Saudi Arabia, Egypt, Jordan and the U.A.E. are considering going it alone because of lost trust ensuing from President Obama’s pursuit of a temporary and feckless nuclear deal that facilitates acquiescence to Iranian Shia hegemony.
If these countries and particularly Saudi Arabia feel abandoned by the U.S. and decide to pursue their own nuclear capabilities, they may also decide to trade oil in non-dollar currencies. The fracking revolution has made the U.S. nearly energy independent, while Saudi Arabia’s top trading partner for oil is now China. And if other countries follow suit, the dollar would likely get sold off, with central banks world-wide no longer needing high dollar reserves. The defacto demise of the reserve currency status of the dollar could precipitate a new financial crisis — one with potentially more serious implications than the 2008 collapse.
President Obama stated clearly on the eve of his election in 2008 that he intended to transform America. That change has already been seen in burdens put on the domestic economy from signature legislation in the Affordable Care Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act, and a slew of executive orders and regulatory mandates. But it turns out that transformation also meant radically changing America’s foreign policy and its position in the world — the financial consequences of which need to be better understood before being implemented.