It’s been rightly said that “he who holds the gold makes the rules.”
After World War 2, the US had the largest gold reserves in the world, by far. Along with winning the war, this let the US reconstruct the global monetary system around the dollar.
The new system, created at the Bretton Woods Conference in 1944, tied the currencies of virtually every country in the world to the US dollar through a fixed exchange rate. It also tied the US dollar to gold at a fixed rate of $35 per ounce.
The dollar was said to be “as good as gold.”
The Bretton Woods system made the US dollar the world’s premier reserve currency. It forced other countries to store dollars for international trade or to exchange with the US government for gold.
However, it was doomed to fail.
Runaway spending on warfare and welfare caused the US government to print more dollars than it could back with gold at the promised price.
By the late 1960s, the number of dollars circulating had drastically increased relative to the amount of gold backing them. This encouraged foreign countries to exchange their dollars for gold, draining the US gold supply at an alarming rate.
To plug the drain, President Nixon “temporarily” suspended the dollar’s convertibility into gold in 1971. This ended the Bretton Woods system and severed the dollar’s last tie to gold.
The “temporary” suspension is still in effect today. And it’s had profound geopolitical consequences.
Most critically, it eliminated the main reason foreign countries stored large amounts of US dollars and used the US dollar for international trade. As a result, oil-producing countries began to demand payment in gold instead of rapidly depreciating dollars.
It was clear the US would have to create a new monetary system to stabilize the dollar. So it concocted a new scheme… and chose Saudi Arabia as its ally. This agreement came to be known as the “petrodollar system.”
The US handpicked Saudi Arabia because of the kingdom’s vast petroleum reserves and its dominant position in the global oil market.
In essence, the petrodollar system was an agreement that the US would guarantee the House of Saud’s survival. In exchange, Saudi Arabia would do three things.
First, it would use its dominant position in OPEC to ensure that all oil transactions would only happen in US dollars.
Second, it would recycle hundreds of billions of US dollars from annual oil revenue into US Treasuries. This lets the US issue more debt and finance previously unimaginable budget deficits.
Third, it would guarantee the price of oil within limits acceptable to the US and prevent another oil embargo.
The petrodollar system gave foreign countries another compelling reason to hold and use the dollar. And it preserved the dollar’s unique status as the world’s top reserve currency.
But… why oil?
Unmatched Geopolitical Power
Oil is the largest and most strategic commodity market in the world.
As you can see in the chart below, it dwarfs all other major commodity markets combined. The annual production value of the oil market is ten times bigger than the gold market for example.
Global Commodity Markets (Billions)
Every country needs oil. And if foreign countries need US dollars to buy oil, they have a compelling reason to hold US dollars.
Think about it… If Italy wants to buy oil from Kuwait, it must purchase US dollars on the foreign exchange market to pay for the oil first.
This creates a huge artificial market for US dollars.
This is what differentiates the US dollar from a purely local currency, like the Mexican peso.
The dollar is just a middleman. It’s used in countless transactions, amounting to trillions of dollars that have nothing to do with US products or services.
Since the oil market is enormous, it acts as a benchmark for international trade. If foreign countries are already using dollars for oil, it’s just easier to use the dollar for other international trade.
In addition to nearly all oil sales, the US dollar is used for about 80% of all international transactions.
This gives the US unmatched geopolitical power.
The US can sanction or exclude virtually any country from the US dollar-based financial system at the flip of a switch.
By extension, it can also cut off any country from most international trade. And that would be a financial kiss of death. This creates a powerful incentive for governments to stay in Washington’s good graces.
The petrodollar system is why people and businesses worldwide take US dollars. They have had little choice but to accept this.
Today, the biggest US exports are dollars and government debt. The US government can create unlimited quantities of both… from nothing.
It requires no effort to create US dollars, which can then be exchanged for real things like French wine, Italian cars, electronics from Korea, or Chinese manufactured goods.
Ultimately, the petrodollar boosts the US dollar’s purchasing power. This is because it entices foreigners to soak up many of the new currency units the Fed creates.
The system has helped create a deeper, more liquid market for the dollar and US Treasuries. It also helps the US keep interest rates artificially low. This allows the US government to finance enormous deficits it otherwise would be unable to.
This kind of spending would otherwise be impossible without destroying the currency through money printing.
It’s hard to overstate how much the petrodollar system benefits the US. It’s the bedrock of the US financial system.
China, the Saudis, and a Paradigm Shift
For nearly 50 years, the Saudis had always insisted anyone wanting their oil would need to pay with US dollars, upholding their end of the petrodollar system.
But that could all change soon…
China is the world’s largest importer of oil and Saudi Arabia’s top customer. Beijing buys over 25% of Saudi oil exports.
The Wall Street Journal recently reported that the Chinese and the Saudis had entered into serious discussions to price Saudi oil exports to China in yuan instead of dollars.
The WSJ article claims the Saudis are angry at the US for not supporting it enough in its war against Yemen. They were further dismayed by the US withdrawal from Afghanistan and the nuclear negotiations with Iran.
In short, the Saudis don’t think the US is holding up its end of the deal. So they don’t feel like they should hold up their part. In this context, the Saudis have entered serious talks with China to sell oil in yuan.
Even the WSJ admits such a move would be disastrous for the US dollar.
“The Saudi move could chip away at the supremacy of the US dollar in the international financial system, which Washington has relied on for decades to print Treasury bills it uses to finance its budget deficit.”
Here’s the bottom line.
Saudi Arabia is flirting in the open with China about pricing oil in yuan. It signals an imminent and enormous change for anyone holding US dollars. It would be incredibly foolish to ignore this giant red warning sign.
We are likely on the cusp of a historic financial earthquake…
One that could alter that direction of the US forever and mark the biggest economic event of our lifetimes.
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Putsky is gaining control of the gold price, which means gold could be in the neighborhood of 3k per oz if the Ruble gets down to XRate of 50 to the USD. I say HA!
The plot thickens……
$3k per oz will be a blip on the radar when this is over, in 10 years or so…
Great article and a cogent explanation including historical context.
Not included, however, is India–Lavrov paid them a visit just now and the ramifications of that will prove to be interessting. This petro dollar debacle is just too nuts to be a mistake; it’s all going according to Schlob’s great reset.
This is going to be Mr. Toad’s Wild Ride for the masses.