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How Long Until We End the Petrodollar?

Saudi Arabia, the world’s largest producer of oil, only sells its lucrative substance in U.S. dollars. The country puts many of its excess oil proceeds into billion-dollar Treasury Securities & other American investments. Because of Saudi Arabia’s giant status in the international oil industry, many other oil producers do the same.

Before this system was introduced in the 1970s, the U.S. dollar was tied to the gold standard, where dollars could be directly exchanged for a fixed amount of gold. The U.S. abandoned the gold standard in 1971 during the Nixon shock, replacing it with a free-floating currency which quickly became pegged to the price of oil. The petrodollar, therefore, isn’t all that old. But how did it even come to fruition?

The system was developed because it helped ensure financial stability. After a series of oil shortages (largely caused by instability in the Middle East) during the 1970s paralyzed the world economy, the U.S. agreed to protect Saudi Arabia and its large oil fields, in order to prevent another energy crisis.

The Saudis could also stabilize oil prices by raising and lowering their production levels. Furthermore, by agreeing to sell their oil exclusively in U.S. dollars, global demand for the currency would remain steady. The U.S. Treasury could therefore keep printing money, to help pay for a growing welfare state and the U.S. war in Vietnam.

It was a crazy idea, and it worked for a while, but several important things have happened since the 1970s that undermine the wisdom behind the petrodollar. First, green energy is becoming cheaper and more widely used. Sooner or later, oil won’t be as valuable as it is today. Keeping the U.S. dollar tied to oil means that it is also linked to its decline as a useful commodity.

We are also at a time in American politics where the next debt ceiling crisis could instigate major chaos. Debt to GDP ratio has climbed significantly since the 1970s, and being able to easily borrow money hasn’t always resulted in the best decisions. Instead of looking at ways to ensure cheap credit, most Americans want to explore methods that will help reduce the national debt. Politicians can either heed their call, or risk being run out of office.

Finally, the U.S. has successfully diversified its oil imports, meaning its economy is no longer reliant on Saudi oil to function. The U.S. has therefore lost one of its major reasons for being in the Middle East; ensuring a steady flow of Saudi oil. Saudi Arabia still has a disproportionate ability to influence oil prices, but they can no longer hold the U.S. hostage by withholding their currently-precious commodity.

Were the U.S. free of its military commitments in the Middle East, it could save a lot of money. Instead, by unilaterally protecting the Saudis, we have emboldened them into promoting their own conflicts, without them having to suffer from the repercussions. The Saudis have used their vast oil wealth to help fund terrorist groups like ISIS (which I’ve written about here) in order to advance their own interests. The U.S. and its allies often deal with the consequences.

Furthermore, no one really knows just how much America’s debt is owned by Saudi Arabia. The Saudis threaten to sell U.S. Treasury Securities and their other assets, whenever complications in the relationship arise. Why should the U.S. allow them to continuously increase their leverage over American government policies?

If you’ve read this far and still think I am typing this with a tin-foil hat, a more simple explanation for the creation of the petrodollar (and the status of the U.S. dollar as the world’s reserve currency) reads as follows: “The fact that most world trade is designated in dollars does not make the U.S. strong. Rather, the strength of the U.S. economy leads people to designate trade in dollars. The very humdrum aim is to reduce the risks of currency fluctuations. No conspiracy theory is needed to explain this.”

The U.S. dollar is popular because of faith in the American economy, while the petrodollar has helped underpin this notion. But because the system is based on the value of oil (which will eventually be worthless), the U.S. dollar must find a different source of stability. Until then, Saudi Arabia will continue to reap the most benefits from the decades-old agreement.

The next question is what can replace the petrodollar? We could go back to the gold standard, but a quick Google search tells us that not everyone is sold on that idea. Even though many countries still keep significant gold reserves, I don’t believe the U.S. will be returning to the gold standard anytime soon.

There are other alternatives, like digital currencies, which are gaining attention in media and financial circles. Bitcoin, the most famous digital currency, went public in 2009. It is a crypto-currency that operates outside the jurisdiction of central banks, using cryptography to secure the exchange of digital information (unique to each transaction) and control the creation of new units. Digital information is valued by the market and can be used to purchase goods and services.

Already, Japan accepts Bitcoin as legal payment, while China recently became the first country in the world to test a national crypto-currency. On a corporate level, “companies such as Toyota and Microsoft are throwing their weight behind crypto-currency” as well. Because the petrodollar cannot last forever, a time will come when the U.S. abandons it, much like it did the gold standard less than half a century ago. If digital currencies continue their journey into the mainstream, don’t be surprised if the term crypto-dollar comes into circulation.