March 7, 2023
by J.R. MacLeod | Mises Institute
In 1971 Richard Nixon took the US off the last feeble vestiges of the gold standard, otherwise known as the Bretton Woods Agreement. That system had been a bizarre gold-dollar hybrid where the dollar was the world reserve currency but the US agreed to keep the dollar backed by gold. Henry Hazlitt’s book From Bretton Woods to World Inflation explains the consequences of this situation well.
The end of this system left a vacuum at the heart of world financial affairs, one that needed to be filled quickly.
The dollar, now unmoored by gold, remained the default currency for international trade, but without the confidence derived from its former gold backing, the US needed to bolster its credibility lest other more enticing options appeared to displace the dollar’s hegemony.
During the 1973 Arab-Israeli war, Organization of the Petroleum Exporting Countries (OPEC) had gained leverage by imposing an oil embargo, which caused serious disruptions in the global economy. In 1974 Henry Kissinger brokered a deal: Israel would back off its territorial ambitions, the Arab states would end the embargo, and oil would be traded in dollars. Thus, the petrodollar was born.
Every economy needs energy, and Saudi Arabia supplies plenty of oil, meaning that the dollar was backed up by a valuable commodity that would always be the recipient of demand. Everyone wants oil, and the Saudis would only trade it for dollars, so the dollar became unavoidable in international trade, reaffirming its status as the world reserve currency.
Even if others would have preferred a neutral, market-based currency not subject to manipulation, the opportunity cost of foregoing oil was far higher than the cost of having to use the dollar. A global medium of exchange selected by the market would have been more economically efficient, but given that the US and the Saudis possessed the ability to impose a politically motivated system, nobody was willing to bear the costs to create an alternative as long as the dollar was managed fairly sensibly.
Washington and the Gulf States benefit enormously from this situation. The petrodollar gives the Fed extreme license to print currency and export its inflation. If other countries are forced to use your currency, that gives you a lot more room to debase it. Imports are made cheaper with the high purchasing power of the dollar, and exports are propped up because the easiest way to spend dollars is to buy American products.
All this amounts to Washington essentially taxing world trade. The Gulf States benefit in the same ways by having enhanced access to the world reserve currency. Their oil is given priority in world markets compared to competitors opposed by Washington, such as Iran. They are also just simply given financial aid by Washington for participating in this scheme.
However, there are consequences for the countries involved. Even if the US has largely avoided extreme domestic consumer price inflation by circulating dollars around the world, the business cycle consequences of inflation are unavoidable. For example, the 2008 recession was severe yet unaccompanied by extreme inflation before or after. Holding the world reserve currency has also given the US a free ride with far less need to produce valuable goods and services. The dollar holds its value because there has always been global demand for it, so it has been possible to print money to prop up the US economy by consumer spending without an extreme loss of value in the dollar. But there is now very little worth in the underlying US economy.
The dollar is backed up as the world reserve currency by a series of secondary institutions: the International Monetary Fund, the World Bank, etc. On top of this, though unspoken, there exists a military and intelligence enforcement mechanism. Oppose the dollar and either Washington will invade you, or agents from the Central Intelligence Agency will appear and ask domestic radicals what color they would like their revolution.
Iraq persistently attempted to abandon the dollar, making a particularly assertive move in October 2000. Then they were invaded in 2003 without having attacked America or any other country. Libya’s Muammar Gaddafi attempted to create an Africa-wide gold-backed dinar and was assassinated in 2011. Of course, US involvement in these countries is not monocausal, and other factors like security guarantees for Israel and progressive crusading play a role. But securing the hegemony of the dollar is a critical issue in Washington’s foreign policy.
The corollary of the power granted by possession of the world reserve currency is the ability to break the rules of your self-proclaimed rules-based order. Saudi Arabia funds radical mosques around the world, and we have already mentioned the recent American invasions. Other states must acquiesce to this behavior because ending up on the wrong side of the dollar would be disastrous for their economies, and it could potentially mark them as a target for invasion or subterfuge.
But it seems like recent actions have been too extreme for other world powers to accept. The printing of more dollars in 2020–21 than in the entirety of the currency’s history up to that point destabilized the global financial system by creating mass inflation. And the sanctions imposed on Russia exacerbated the situation even further.
In the past thirty years there have been many post-Communist wars involving many deaths and frequently involving Russia (not that I am necessarily blaming Russia for these wars). Think of Chechnya and Georgia: nothing like the current sanctions were imposed on Russia for what were essentially parallel conflicts to the current stramash in Ukraine. The West’s reaction against Russia in 2022 was unprecedented.
The fact the West has turned a regional conflict into a proxy war and destabilized the world economy, seemingly due to ideological frenzy and a desire for one world government, has disturbed many other powers. They have suffered from the economic chaos and may encounter similar regional conflicts in their own future. They are concerned the West could leap into these disputes in the same way they have attempted to crush the Russians.
Thus, in the long run, the dollar is doomed as other world powers realize that Washington has abrogated its responsibilities, and the second and third world cannot ever allow what has transpired with the covid inflation and the Russia sanctions to happen again.
Russia has already linked the ruble to a semi–gold standard. China has also made moves regarding gold and is far ahead of the US in the race for an all-important central bank digital currency. Previous solid allies like India are backing away from the increasingly deranged Washington establishment. As countries refuse to go along with the bizarre social agenda and utopian eschatology of Washington, they will also have to seek alternative economic arrangements.
For Washington both the political and economic systems are nonnegotiable. It has hardly been trumpeted by the Western press, but if you have been paying attention this past year, you will have noticed stories of major countries agreeing to trade in currencies other than the dollar.
Decoupling is a tricky proposition as these countries’ economies have been tied up with the dollar for decades.
There is also the risk of Washington violently lashing out to maintain its hegemonic status. Thus, the transition away from the dollar is likely a medium- to long-term trend. But the first decisive moves have occurred, and there is no turning back short of serious self-reflection on the part of Washington (which I would bet against).
However, much hinges on Saudi Arabia’s actions. As we discussed earlier, they made the petrodollar, and they will be the ones to break it if that is what transpires. Since it is their oil that underpins the value of the dollar, the more they trade oil in other currencies, the less value the dollar possesses. And in a momentous story, the Saudi minister of finance stated that they are open to trading oil in currencies other than the dollar. The Chinese and Saudi leadership have discussed this issue, and securing bilateral trade without the involvement of the dollar appears to be a top Chinese priority.
A failing dollar will have disastrous consequences for the US as there are not enough manufacturing or nonfinancial services in its economy. Imports will suddenly be expensive, and the quality of life will drop. Much of the establishment isn’t as hardheaded as those who came before and doesn’t conceive of the possibility of Washington losing.
How could they? Russia is mildly antigay, and they don’t believe in climate change. They’re the bad guys, and the bad guys always lose. Other quarters of the establishment seem to have retained a dose of realism and appear to be looting the government and the economy while the dollar still has value (think Biden’s gigantic crony-laden spending bills).
The good news is that Washington’s plans for world domination are bound to fail as China and Russia have a revived alliance, which also appeals to and is open to other powers. The bad news is that this will lead to the drawn-out collapse of the dollar, which Washington will attempt to parlay into a new central bank digital currency to accompany an increased crackdown on opposition within the dwindling empire. But ultimately, with visibly successful alternative systems elsewhere and less material comfort at home, more people will begin to question the first principles, foreign policy, and economic doctrines of the post–World War II order.