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Everyone's Dollar

As the carnage of World War II was winding down, two things had become clear: The Allies were going to win, and after the war the United States would be the economic strongman. It had all the best cards to play.

For three weeks in July 1944, with the end of hostilities in Europe still nine months away, 730 delegates from all 44 allied governments gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, for the United Nations Monetary and Financial Conference—now simply referred to as the Bretton Woods Conference. They came to design the financial structure of the postwar world. At the end of the conference, all present signed an agreement with two key monetary provisions.

To promote ease of international trade and to help fund postwar reconstruction, each member state agreed to maintain a fixed exchange rate for its currency versus the U.S. dollar (and by implication, fixed exchange rates versus all other participating currencies). To that end, each signatory pledged to buy and sell U.S. dollars as needed to keep its currency within 1 percent of its agreed-upon exchange rate.

The United States, for its part, assured the solidity of the arrangement by pledging to deliver gold, at a price of $35 per ounce, to any foreigner who chose to tender its dollars (although this was later modified to honor redemptions only by foreign central banks). Because at the time the U.S. Treasury had an abundance of gold (a result of the deflationary Great Depression and then wartime trade surpluses and capital flight), it was an easy promise to make.

The Bretton Woods Agreement placed the United States at the center of international finance. Its allies may not have liked the new way of things, but in truth, they had little choice in the matter if they wanted to rebuild their countries. In signing, they ushered in the dollar's golden age. The dollar had become the world's reserve currency.

The promise of gold redeemability was honored for 27 years. It ended when U .S. trade deficits and creeping price inflation undermined confidence that the U.S. government would be able to live up to its promise much longer. To keep the open-market price of gold from rising more than pennies above $35, the United States and its partners in the London Gold Pool had to sell larger and larger quantities of the metal. That couldn't go on forever. In 1967, France withdrew from the effort and added the insult of repatriating the gold it had been storing with the Federal Reserve Bank of New York. Yellow bars flew to Paris.

The U.S. government continued to sell gold, in increasing quantities, to keep the open-market price near $35. Then, on August 15, 1971, President Richard Nixon "closed the gold window," ending the convertibility of dollars into gold by anyone and eliminating the need for further sales to suppress the open-market price. He referred to the default on America's pledge as a measure to stop "international money speculators."

The dollar was still the world's reserve currency, but it had become fiat money. And since other major currencies were convertible only into dollars, they too became fiat money. With narrow exceptions, all the world's currencies were untethered from gold.

The new regime allowed governments to pull unlimited currency units from thin air. Inflation became a fact of life everywhere, including in the United States. Since 1971, money creation by an unfettered Federal Reserve has cost the dollar nearly 80 percent of its purchasing power.

Thank you, Mr. Nixon

With gold no longer part of the system, something had to be done to maintain the dollar's preeminence as the world's reserve currency.

Washington might have sought to ease the country's trade deficit (the counterpart of which is a buildup of dollars in foreign hands), but that would have required a slowdown in the printing of new dollars. So, of course, it didn't take that approach. Quite the opposite. It sought a way to gain a grip on the global financial system that would be so strong it would protect the dollar's status as the world's reserve currency even as the flood of new fiat dollars continued.

The power to pass off ever more units of the world's reserve currency made everything produced outside the United States both cheap and plentiful for U.S. consumers. A failure to keep that system running would mean a drop in Americans' living standards and political death for whoever got the blame.

Conveniently, an opportunity for protecting the dollar's status was ready and waiting. It came from a commodity far more important to the world economy than gold: oil. Though rightly disdained for much of what he did, Richard Nixon underwrote his country's dominance for decades to come by devising the petrodollar system.

After closing the gold window, Nixon dispatched Secretary of State Henry Kissinger to Saudi Arabia to offer the ruling House of Saud a four-part deal. The U.S. government would provide military protection for Saudi Arabia and its oil fields. It would sell the Saudis any weapons they needed. It would guarantee protection from Israel and any other Middle Eastern state, such as Iran, that might attempt to destabilize the kingdom. And it would secure the Saud family's place as rulers of the country in perpetuity.

That last point was the clincher.

In return, the Saudis would do two things. They would make oil sales in U.S. dollars only. And they would invest their surplus oil proceeds in U.S. Treasuries.

Saudi Arabia was (and remains) a sparsely populated country with enormous riches. It is stuck in a historical twilight zone between the Dark Ages and the modern world. It sits in a bad neighborhood, where religious imperatives readily evolve into imperatives for slaughter. It faces a pair of much larger and inherently stronger neighbors that are waiting for a chance to eat it. No surprise that its rulers felt vulnerable and welcomed a powerful protector.

To the ruling family, Kissinger's proposition was a sweet deal.

Saudi Arabia signed on in 1974, and as Nixon and Kissinger had calculated, the other members of OPEC quickly fell in line. By 1975, all of them had embraced the petrodollar system.

It was a brilliant maneuver. The world's demand for U.S. dollars would soar with the world's increasing demand for oil. For the United States, the new "dollars for oil" system was even better than the Bretton Woods "dollars for gold" system. There was no pesky redemption promise, so it imposed no constraint on the creation of more and more dollars to pay for imports.

It was quite a feat, and with knock-on effects. Everyone needed oil. Since it could be purchased only in dollars, countries needed to stockpile them, which meant more demand for currency units that the Federal Reserve could produce at zero cost.

Nixon's petrodollar system kept the United States at the top of the global economic heap for decades. But the Great Game wasn't over. At the beginning of the twenty-first century, on the eastern fringe of Europe, a master player was at work, rebuilding his shattered country and preparing it to return to the playing field.

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