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Twilight of the Petrodollar

In Chapter 3, I explained how the petrodollar system began and how it now reinforces the dollar's status as the world's reserve currency. Then we looked at Vladimir Putin's grand strategy for waging the Colder War and unseating the dollar.

Now we come to the present and to the signs that the dollar's position is vulnerable.

What we're watching is a remake of an old movie: The Rise and Fall of the British Pound. So, for some useful perspective, let's hit the replay button and watch that epic production again.

Before World War I, the British pound sterling was the world's premier currency—not quite like the dollar today, but close.

It was the success of British entrepreneurs that gave the pound the inside track. The system of manufacturing they developed was vastly more efficient than the small craft shops it was replacing, which gave British products a big competitive advantage in export markets. Other countries sold raw materials to Britain, and value-adding Britain turned them into manufactured products, notably textiles and metal goods.

Britain became "the workshop of the world," turning out relatively low-cost products by the boatload. The world wanted them, but to buy British products, you needed British pounds, so everyone wanted them, too.

Britain also maintained a strong military, particularly its navy, and it accumulated so many colonial possessions that, as they used to say, "the sun never sets on the British Empire." The colonies, some a source of great riches, helped reinforce the pound's dominance. If you wanted to buy from a British colony, you needed pounds. And if you wanted to sell to a British colony, you could expect to be paid in pounds, probably through a bank in London, which was becoming the world's undisputed financial center.

It was a sweet deal while it lasted. But one by one, other countries entered the age of industry, and they brought competition to markets that the British had virtually owned. And as administration of the colonies passed from the early financial adventurers who had made them profitable into the hands of government functionaries, many became costly to maintain. They were a burden and a drag on the economy rather than a boost.

Then came World War I. It ended with Britain mired in debt, which did terrible damage to the pound's brand name. The United States, in contrast, came out of the war with huge holdings of gold from exporting food and other goods to countries at war. The war also served as a bloody, four-year advertisement for the United States as a safe place to store wealth. In the eyes of the world, the dollar began to emerge as a reserve currency, first as simply a serviceable alternative to the pound, and then, at least for some, as a superior one.

Britain's physical damage and added debt from World War II finished off the pound as an international currency. The empire disintegrated, and Britain reverted to being a small but prosperous country with some prominence in world affairs, but nothing like dominance.

The United States picked up the position that Britain had lost. World War II added to the U.S. Treasury's already impressive gold holdings (more exports to a war-torn world) and served as a follow-on ad campaign for the United States as the safest place in the world to store wealth. The dollar had become unambiguously the world's reserve currency— almost everyone's first choice for international trade and for diversifying out of the risks of holding the local currency.

As noted earlier, in 1973 a deal between the United States and Saudi Arabia cemented the dollar in place as the most practical currency for buying and selling crude oil. This allowed the United States to import the world's oil essentially for free, since its central bank, the Federal Reserve, could create from thin air all the money needed to buy all the oil its citizens wanted. It allowed the United States to do much else as well.

The currency monopoly on the oil trade put the dollar laps ahead of any possible competitor for status as the world's reserve currency. Everyone needed oil, so everyone needed dollars. If you had anything to sell in an export market, you were happy to be paid in dollars, because you knew you were going to need them for oil. If there was something you wanted to buy from another country, you knew that the seller would gladly accept dollars because the seller could use them to buy oil—or almost anything else. If you were participating in the world economy, it was dollars in, dollars out. Your own local currency was useful only locally.

From Russia to China, from Brazil to South Korea, every country fell under the dollar's hegemony.

Demand for U.S. dollars grew, pushing up the greenback's value. The strong dollar allowed Americans to buy imported goods on the cheap, which is to say that the petrodollar system was subsidizing U.S. consumers at the expense of consumers in the rest of the world. Of course, there was a downside to that: cheap imports hammered the U.S. manufacturing sector. In 1970, manufacturing was 23 percent of the total economy. Today it's just 12 percent.

By putting the dollar so far ahead of any possible competing currency, the petrodollar system allowed the United States to exploit (critics might say abuse) the dollar's status as the world's reserve currency. It could run a perpetual balance of payments deficit; that is, it could spend more dollars in other countries than outsiders were spending in the United States—and not just by small amounts, but by billions each day.

The dollar's position as first among the currencies of the world gave the same status to debt instruments (IOUs) denominated in dollars. Among the countries that were accumulating the dollars Americans were spending—like Saudi Arabia, China, and Japan— the first choice for storing the money was in U.S. Treasury bills and bonds. That provided a new, deep pool of lenders to accommodate U.S. government deficits, which, rather predictably, skyrocketed. There's nothing a politician enjoys more than spending money that no one has to pay in taxes.

Today the U.S. government borrows from practically the entire world without preparing for the day it will have to repay the money— because it can always print it.

If you suspect there is something unsustainable about this arrangement, you're right. It can't go on forever, but the petrodollar system has allowed it to go on for so long that it seems normal and natural. It isn't. Here's where living on the petrodollar for 40 years has taken the United States:

• Government debt now exceeds 100 percent of what the country produces every year—its gross domestic product (GDP). That puts the U.S. economy in what historically has been the danger zone for ruinous trouble of one kind or another—economic stagnation, default, or runaway inflation.

• Most manufacturing industries are languishing.

• The economy has been left with little capacity for recovering from shocks. Despite the unprecedented money printing and deficit spending evoked by the recent recession, recovery has been pitifully slow. Unemployment has been declining, but the pace has been a tease.

• To keep the economy from slipping back into recession, the Federal Reserve has depressed interest rates to levels that mock savers.

• Investment markets can't go anywhere without creating a bubble that eventually bursts, as happened with dot-com stocks and real estate, and is happening now with bonds.

Is this the picture of a healthy superpower? Or is it the picture of a vulnerable giant close to exhausting its advantage?

The world is moving toward sloughing off the U.S. dollar. As it proceeds in that direction, the U.S. currency will lose its position as the global reserve asset. Holders of trillions in dollar-denominated assets will become sellers, and the value of the dollar will plummet.

This is another way of saying the dreaded word inflation. If we're lucky, inflation will merely be nasty. If luck deserts us, we get massive inflation; double-digit interest rates; crippling increases in the cost of food, clothing, and gasoline; and bad, bad news for the stock market.

The 2008-2009 recession, in retrospect, will look like a bump in the road.

The consequences for Americans, who have been living well on a dollar that the world wants and needs, are that dire. The eventual outcome for the world—which currency winds up as top dog, or whether any currency does—is unknowable.

What is utterly predictable is that the U.S. government will use any means available to try to counter threats to dollar hegemony. In an earlier chapter, I advanced the notion that the 2003 invasion of Iraq was driven by, as much as anything else, the threat to the petrodollar that came from Saddam Hussein redirecting the Oil for Food program from dollars to euros.

Something similar could be said of the uprising in Libya. Muammar Qaddafi's regime was fragile, but the timing of its end is instructive. Qaddafi began encouraging Arab and African nations to abandon both the dollar and the euro and instead use a new currency, the gold dinar. Not long after, Qaddafi was history, pushed out by rebels with assistance from the United States and NATO.

It's also telling that the conflict gave Washington legal cover for freezing $30 billion of troublesome Libyan assets. The money had been earmarked as Libya's contribution to three key components of an African economic federation: the African Investment Bank in Libya; the African Monetary Fund, to be based in Cameroon; and the African Central Bank in Nigeria, which was about to start printing the new, dollar-displacing African currency.

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