The Demise of the Petrodollar
January 24, 2012


Marin Katusa

Chief Energy Investment Strategist
Casey Research

Tehran Pushes to Ditch the US Dollar

The official line from the United States and the European Union is that Tehran must be punished for continuing its efforts to develop a nuclear weapon. The punishment: sanctions on Iran's oil exports, which are meant to isolate Iran and depress the value of its currency to such a point that the country crumbles.

But that line doesn't make sense, and the sanctions will not achieve their goals. Iran is far from isolated and its friends – like India – will stand by the oil-producing nation until the US either backs down or acknowledges the real matter at hand. That matter is the American dollar and its role as the global reserve currency.

The short version of the story is that a 1970s deal cemented the US dollar as the only currency to buy and sell crude oil, and from that monopoly on the all-important oil trade the US dollar slowly but surely became the reserve currency for global trades in most commodities and goods. Massive demand for US dollars ensued, pushing the dollar's value up, up, and away. In addition, countries stored their excess US dollars savings in US Treasuries, giving the US government a vast pool of credit from which to draw.

We know where that situation led – to a US government suffocating in debt while its citizens face stubbornly high unemployment (due in part to the high value of the dollar); a failed real estate market; record personal-debt burdens; a bloated banking system; and a teetering economy. That is not the picture of a world superpower worthy of the privileges gained from having its currency back global trade. Other countries are starting to see that and are slowly but surely moving away from US dollars in their transactions, starting with oil.

If the US dollar loses its position as the global reserve currency, the consequences for America are dire. A major portion of the dollar's valuation stems from its lock on the oil industry – if that monopoly fades, so too will the value of the dollar. Such a major transition in global fiat currency relationships will bode well for some currencies and not so well for others, and the outcomes will be challenging to predict. But there is one outcome that we foresee with certainty: Gold will rise.

Uncertainty around paper money always bodes well for gold, and these are uncertain days indeed.

The Petrodollar System

To explain this situation properly, we have to start in 1973. That's when President Nixon asked King Faisal of Saudi Arabia to accept only US dollars as payment for oil and to invest any excess profits in US Treasury bonds, notes, and bills. In exchange, Nixon pledged to protect Saudi Arabian oil fields from the Soviet Union and other interested nations, such as Iran and Iraq. It was the start of something great for the US, even if the outcome was as artificial as the US real-estate bubble and yet constitutes the foundation for the valuation of the US dollar.

By 1975 all of the members of OPEC agreed to sell their oil only in US dollars. Every oil-importing nation in the world started saving their surplus in US dollars so as to be able to buy oil; with such high demand for dollars the currency strengthened. On top of that, many oil-exporting nations like Saudi Arabia spent their US dollar surpluses on Treasury securities, providing a new, deep pool of lenders to support US government spending.

The "petrodollar" system was a brilliant political and economic move. It forced the world's oil money to flow through the US Federal Reserve, creating ever-growing international demand for both US dollars and US debt, while essentially letting the US pretty much own the world's oil for free, since oil's value is denominated in a currency that America controls and prints. The petrodollar system spread beyond oil: the majority of international trade is done in US dollars. That means that from Russia to China, Brazil to South Korea, every country aims to maximize the US-dollar surplus garnered from its export trade to buy oil.

The US has reaped many rewards. As oil usage increased in the 1980s, demand for the US dollar rose with it, lifting the US economy to new heights. But even without economic success at home the US dollar would have soared, because the petrodollar system created consistent international demand for US dollars, which in turn gained in value. A strong US dollar allowed Americans to buy imported goods at a massive discount – the petrodollar system essentially creating a subsidy for US consumers at the expense of the rest of the world. Here, finally, the US hit on a downside: The availability of cheap imports hit the US manufacturing industry hard, and the disappearance of manufacturing jobs remains one of the biggest challenges in resurrecting the US economy today.

There is another downside, a potential threat now lurking in the shadows. The value of the US dollar is determined in large part by the fact that oil is sold in US dollars. If that trade shifts to a different currency, countries around the world won't need all their US money. The resulting sell-off of US dollars would weaken the currency dramatically.

So here's an interesting thought experiment. Everybody says the US goes to war to protect its oil supplies, but doesn't it really go to war to ensure the continuation of the petrodollar system?

The Iraq war provides a good example. Until November 2000, no OPEC country had dared to violate the US dollar-pricing rule, and while the US dollar remained the strongest currency in the world there was also little reason to challenge the system. But in late 2000, France and a few other EU members convinced Saddam Hussein to defy the petrodollar process and sell Iraq's oil for food in euros, not dollars. In the time between then and the March 2003 American invasion of Iraq, several other nations hinted at their interest in non-US dollar oil trading, including Russia, Iran, Indonesia, and even Venezuela. In April 2002, Iranian OPEC representative Javad Yarjani was invited to Spain by the EU to deliver a detailed analysis of how OPEC might at some point sell its oil to the EU for euros, not dollars.

This movement, founded in Iraq, was starting to threaten the dominance of the US dollar as the global reserve currency and petro currency. In March 2003, the US invaded Iraq, ending the oil-for-food program and its euro payment program.

There are many other historic examples of the US stepping in to halt a movement away from the petrodollar system, often in covert ways. In February 2011 Dominique Strauss-Kahn, managing director of the International Monetary Fund (IMF), called for a new world currency to challenge the dominance of the US dollar.

Three months later a maid at the Sofitel New York Hotel alleged that Strauss-Kahn sexually assaulted her. Strauss-Kahn was forced out of his role at the IMF within weeks; he has since been cleared of any wrongdoing.

War and insidious interventions of this sort may be costly, but the costs of not protecting the petrodollar system would be far higher. If euros, yen, renminbi, rubles, or for that matter straight gold, were generally accepted for oil, the US dollar would quickly become irrelevant, rendering the currency almost worthless. As the rest of the world realizes that there are other options besides the US dollar for global transactions, the US is facing a very significant – and very messytransition in the global oil machine.

The Iranian Dilemma

Iran may be isolated from the United States and Western Europe, but Tehran still has some pretty staunch allies. Iran and Venezuela are advancing $4 billion worth of joint projects, including a bank.

India has pledged to continue buying Iranian oil because Tehran has been a great business partner for New Delhi, which struggles to make its payments. Greece opposed the EU sanctions because Iran was one of very few suppliers that had been letting the bankrupt Greeks buy oil on credit. South Korea and Japan are pleading for exemptions from the coming embargoes because they rely on Iranian oil. Economic ties between Russia and Iran are getting stronger every year.

Then there's China. Iran's energy resources are a matter of national security for China, as Iran already supplies no less than 15% of China's oil and natural gas.

That makes Iran more important to China than Saudi Arabia is to the United States. Don't expect China to heed the US and EU sanctions muchChina will find a way around the sanctions in order to protect two-way trade between the nations, which currently stands at $30 billion and is expected to hit $50 billion in 2015. In fact, China will probably gain from the US and EU sanctions on Iran, as it will be able to buy oil and gas from Iran at depressed prices.

So Iran will continue to have friends, and those friends will continue to buy its oil. More importantly, you can bet they won't be paying for that oil with US dollars. Rumors are swirling that India and Iran are at the negotiating table right now, hammering out a deal to trade oil for gold, supported by a few rupees and some yen. Iran is already dumping the dollar in its trade with Russia in favor of rials and rubles. India is already using the yuan with China; China and Russia have been trading in rubles and yuan for more than a year; Japan and China are moving towards transactions in yen and yuan.

And all those energy trades between Iran and China? That will be settled in gold, yuan, and rial. With the Europeans out of the mix, in short order none of Iran's 2.4 million barrels of oil a day will be traded in petrodollars.

With all this knowledge in hand, it starts to seem pretty reasonable that the real reason tensions are mounting in the Persian Gulf is because the United States is desperate to torpedo this movement away from petrodollars. The shift is being spearheaded by Iran and backed by India, China, and Russia. That is undoubtedly enough to make Washington anxious enough to seek out an excuse to topple the regime in Iran.

Speaking of that search for an excuse, this is interesting. A team of International Atomic Energy Agency (IAEA) inspectors just visited Iran. The IAEA is supervising all things nuclear in Iran, and it was an IAEA report in November warning that the country was progressing in its ability to make weapons that sparked this latest round of international condemnation against the supposedly near-nuclear state. But after their latest visit, the IAEA's inspectors reported no signs of bomb making. Oh, and if keeping the world safe from rogue states with nuclear capabilities were the sole motive, why have North Korea and Pakistan been given a pass?

There is another consideration to keep in mind, one that is very important when it comes to making some investment decisions based on this situation: Russia, India, and Chinathree members of the rising economic powerhouse group known as the BRICs (which also includes Brazil) – are allied with Iran and are major gold producers. If petrodollars go out of vogue and trading in other currencies gets too complicated, they will tap their gold storehouses to keep the crude flowing. Gold always has and always will be the fallback currency and, as mentioned before, when currency relationships start to change and valuations become hard to predict, trading in gold is a tried and true failsafe.

2012 might end up being most famous as the year in which the world defected from the US dollar as the global currency of choice. Imagine the rest of the world doing the math and, little by little, beginning to do business in their own currencies and investing ever less of their surpluses in US Treasuries. It constitutes nothing less than a slow but sure decimation of the dollar.

That may not be a bad thing for the United States. The country's gargantuan debts can never be repaid as long as the dollar maintains anything close to its current valuation. Given the state of the country, all that's really left supporting the value in the dollar is its global reserve currency status. If that goes and the dollar slides, maybe the US will be able to repay its debts and start fresh. That new start would come without the privileges and ingrained subsidies to which Americans are so accustomed, but it's amazing that the petrodollar system has lasted this long. It was only a matter of time before something would break it down.

Finally, the big question: How can one profit from this evolving situation? Playing with currencies is always very risky and, with the global game set to shift to significantly, it would require a lot of analysis and a fair bit of luck. The much more reliable way to play the game is through gold.
Gold is the only currency backed by a physical commodity; and it is always where investors hide from a currency storm.

The basic conclusion is that a slow demise of the petrodollar system is bullish for gold and very bearish for the US dollar.

January 25, 2012 7:47 pm

Meddle with the market at your peril

Pinn illustration

Controlled experiments are not feasible in economics. But we came close in the competition between East and West Germany after the second world war. Both countries started with the same culture, the same language, the same history and the same value systems. Then for 40 years they competed on opposite sides of a line. The only major difference was their political and economic systems: central planning vs market capitalism.

The experiment came to an abrupt close in 1989 with the fall of the Berlin Wall, exposing the economic ruin of decades of Soviet-bloc economics. Centrally planned East Germany had exhibited productivity levels little better than one-third those of market-oriented West Germany. Much of the then third world, absorbing the tutorial, converted quietly to market capitalism.

China, especially, replicated the successful export-orientated economic model of the so-called Asian tigers: fairly well-educated, low-cost workforces, joined with developed-world technology. Functioning in newly opened competitive markets, China and much of the developing world unleashed explosive economic growth. Between 2000 and 2007 the growth rate of real gross domestic product in the developing world was almost double that of the developed world. The International Monetary Fund estimated that in 2005 more than 800m members of the world’s labour force were engaged in export-orientated and therefore competitive markets, an increase of 500m since the fall of the Wall. Additional millions became subject to domestic competitive forces, especially in the former Soviet Union.

Capitalism, since it was spawned in the Enlightenment, has achieved one success after another. Standards and quality of living, following millennia of near stagnation, have risen at an unprecedented rate over large parts of the globe. Poverty has been dramatically reduced and life expectancy has more than doubled. The rise in material well-being – a tenfold increase in global real per capita income over two centuries – has enabled the earth to support a sixfold increase in population.

While central planning may no longer be a credible form of economic organisation, the intellectual battle for its rival – free-market capitalism – is far from won. At issue, the dynamic that defines capitalism, that of unforgiving market competition, clashes with the inbred human desire for stability and, for some, civility. A prominent European politician several years ago best expressed the widely held anti-capitalist ethos when he asked: “What is the market? It is the law of the jungle, the law of nature. And what is civilisation?
It is the struggle against nature.” While acknowledging the ability of competition to promote growth, many such observers nonetheless remain concerned that economic actors, to achieve that growth, are required to behave in a manner governed by the law of the jungle. These observers accordingly choose lesser growth for more civility.

But is there a simple trade-off between civil conduct, as defined by those who find raw competitive behaviour deplorable, and the material life most people nonetheless seek? From a longer-term perspective, does such a trade-off exist? During the past century, for example, competitive-market-driven economic growth created resources far in excess of those required to maintain subsistence. That surplus, even in the most aggressively competitive economies such as America’s, has been mainly employed to improve the quality of life: advances in health, greater longevity and pension systems that go with it, a universal system of education and vastly improved conditions of work. We have used much of the substantial increases in wealth generated by our market-driven economies to purchase what most would view as greater civility.

Anti-capitalist virulence appears strongest from those who confusecrony capitalism” with free markets. Crony capitalism abounds when government leaders, usually in exchange for political support, routinely bestow favours on private-sector individuals or businesses. That is not capitalism. It is called corruption.

The often-assailed greed and avarice associated with capitalism are in fact characteristics of human nature, not of market capitalism, and affect all economic regimes. The legitimate concern of increasing inequality of incomes reflects globalisation and innovation, not capitalism.

But an additional contributor to inequality in America is our immigration law, which “protectsmany high earners from skilled migrant competitors. The American H1B programme is in effect a subsidy for the wealthy, a policy that is anathema to the supporters of capitalism.

Whatever the imperfections of free-market capitalism, no regime that has been tried as a replacement, from Fabian socialism to Soviet-style communism, has succeeded in meeting the needs of its people.

Capitalist practice needs adjustment. I was particularly distressed by the extent to which bankers, previously pillars of capitalist prudence, had allowed their equity buffers to dwindle dangerously as the financial crisis approached. Regulatory capital needs to be increased.

Yet I fear that, in response to the crisis, innumerableimprovements” to the capitalist model will be enacted. I am very doubtful those “improvements”, in retrospect, will appear to have been wise.

The writer is former chairman of the US Federal Reserve

Copyright The Financial Times Limited 2012.

Economic and Social Turmoil Risk Reversing the Gains of Globalization, Report Warns

  • Economic imbalances and social inequality risk reversing the gains of globalization

  • A dystopian world, unsafe safeguards and the dark side of connectivity are this year’s major risk cases

  • Key crisis management lessons from Japan’s earthquake, tsunami and nuclear disasters are highlighted

LONDON--()-- The world’s vulnerability to further economic shocks and social upheaval risk undermining the progress that globalization has brought, warns the World Economic Forum in its Global Risks 2012 report, the seventh edition, published today.

Chronic fiscal imbalances and severe income disparity are the risks seen as most prevalent over the next 10 years. These risks in tandem threaten global growth as they are drivers of nationalism, populism and protectionism at a time when the world remains vulnerable to systemic financial shocks, as well as possible food and water crises. These are the findings of a survey of 469 experts and industry leaders, indicating a shift of concern from environmental risks to socioeconomic risks compared to a year ago.

“For the first time in generations, many people no longer believe that their children will grow up to enjoy a higher standard of living than theirs,” said Lee Howell, the World Economic Forum Managing Director responsible for the report. “This new malaise is particularly acute in the industrialized countries that historically have been a source of great confidence and bold ideas.” Global Risks 2012 analyses three major risk cases of concern globally:

1. Seeds of Dystopia

Bulging populations of young people with few prospects, growing numbers of retirees depending on debt-saddled states (stoking fiscal imbalances) and the expanding gap between rich and poor are all fuelling resentment worldwide. Collectively, these trends risk undoing the progress that globalization has brought.

Individuals are increasingly being asked to bear risks previously assumed by governments and companies to obtain a secure retirement and access to quality healthcare. This report is a wake-up call to both the public and private sectors to come up with constructive ways to realign the expectations of an increasingly anxious global community,” said John Drzik, Chief Executive Officer of Oliver Wyman Group (Marsh & McLennan Companies).

2. Unsafe Safeguards

Policies, norms and institutions from the 20th century may no longer protect us in a more complex and interdependent world. The weakness of existing safeguards is exposed by risks related to emerging technologies, financial interdependence, resource depletion and climate change, leaving society vulnerable.

“We’ve seen examples of over-regulation, like the response to the Icelandic volcanic eruptions, or under-regulation, such as the subprime or Eurozone crises. We need to get the balance right with regulations and, to that end, our safeguards must be anticipatory rather than reactive. It’s equally important that regulations be made more flexible to effectively respond to change,” said David Cole, Chief Risk Officer at Swiss Re.

3. The Dark Side of Connectivity

Our daily lives are almost entirely dependent on connected online systems, making us susceptible to malicious individuals, institutions and nations that increasingly have the ability to unleash devastating cyberattacks remotely and anonymously.

“The Arab Spring demonstrated the power of interconnected communications services to drive personal freedom, yet the same technology facilitated riots in London. Governments, societies and businesses need to better understand the interconnectivity of risk in today’s technologies if we are truly to reap the benefits they offer,” said Steve Wilson, Chief Risk Officer for General Insurance at Zurich.

Natural disasters also remind us of the devastating power of nature and the limits of technology, as witnessed by last year’s Great East Japan Earthquake and subsequent crisis at the Fukushima nuclear plant. In a special chapter on key lessons to be gleaned from the disaster, the report stresses that organizations are far more resilient to major shocks if they have clear lines of communication and employees across the organization are empowered to take decisions.

The report describes 50 global risks and groups them into economic, environmental, geopolitical, societal and technological categories. Within each category, the most significant systemic risk is singled out. The report also highlightsX Factors” – emerging concerns with still unknown consequences that warrant more research. These include a volcanic winter, cyber neotribalism and epigenetics.

Global Risks 2012 indicates that global governance is closely intertwined with all other global risks. The report argues for rethinking private and public responsibilities to foster greater trust. It provides the basis for a dialogue on the adverse impacts of myopic thinking and the importance of designing implementable and well-received, long-term strategies,” said Howard Kunreuther, James G. Dinan Professor and Professor of Decision Sciences and Public Policy at the University of Pennsylvania’s Wharton School.

The three risk cases, Japan and X Factors are the focus of special sessions at the World Economic Forum Annual Meeting 2012 in Davos-Klosters, Switzerland, taking place on 25-29 January.

Published in cooperation with Marsh & McLennan Companies, Swiss Re, The Wharton Center for Risk Management and Zurich, Global Risks 2012 is the flagship initiative of the World Economic Forum’s Risk Response Network. The Risk Response Network provides private and public sector leadership with an independent platform to better map, monitor, manage and mitigate global risks.

Obama is tinkering with a tax system that needs fundamental reform

Bruce Bartlett

January 25, 2012

One of the few potential areas for bipartisan cooperation in Congress this year is tax reform. There is broad agreement on both the right and left that the US tax system is a mess. Since the last major tax overhaul in 1986, the tax code has become cluttered with far too many special tax breaks that cost a great deal of revenue and show little proof of effectiveness.

Meanwhile, American corporations are hobbled by one of the highest statutory tax rates and grave uncertainty about what tax regime will be in effect in 2013, as many tax provisions are scheduled to expire under current law at the end of this year. Unfortunately, Barack Obama effectively threw cold water on any tax reform effort in his State of the Union Address on Tuesday.

There is a consensus between Republicans and Democrats, at least among the tax experts, that the current situation is highly undesirable and in dire need of a permanent fix. They agree that the tax base needs to be broadened and tax rates reduced and that perpetually expiring provisions such as the research and development tax credit should either be made permanent or scrapped. Others, such as the alternative minimum tax, need be updated to better target those it was originally intended to cover and not those with modest incomes.

Since there are so many elements of the tax code that require rethinking and review, it would be best to do so in a comprehensive way, rather than in an ad hoc fashion. There is enough general agreement on what needs to be done that it is realistic to believe that something meaningful might be accomplished and enacted into law in the not too distant future.

But rather than proposing a cleaning-up of the tax code, Mr Obama is proposing several new tax preferences. He wants a special deduction available only to companies engaged in manufacturing to be doubled, but most tax specialists think this should just be abolished. He’s in favour of extending a tuition tax credit, which mostly gets capitalised into higher tuition fees and does little to improve access to higher education for middle class families. There’s also special tax relief for small businesses “that are raising wages and creating good jobs” that he wants to introduce even though no one knows how to target such incentives and past efforts have failed. Finally, he would like a new tax credit for “clean energy” and tax credits for companies hiring military veterans.

At the same time, Mr Obama proposes a variety of gimmicky new tax penalties, to punish companies that move jobs overseas for example. He wants to force every US-based multinational corporation to pay a minimum tax, and made individuals earning at least $1m per year to pay at least 30 per cent of their income in tax.

Whatever the merits of these specific tax proposals, they do not move towards tax reform. They move in the opposite direction, by cluttering up the tax code with still more special tax breaks for activities in current political favour and penalties for individuals and businesses in disfavor. This is exactly the sort of thing that created America’s current tax mess.

At a minimum, Mr Obama should have directed the Treasury Department to begin a study of tax reform as Ronald Reagan did in his 1984 State of the Union Address, which paved the way for the Tax Reform Act. Mr Obama’s decision to move away from reforming the tax code this year is both a substantive and political error that I believe he will come to regret.

The writer a former senior economist at the White House, US Congress and Treasury. He is author of ‘The Benefit and the Burden: Tax Reform—Why We Need It and What It Will Take’