The Oil And Petrodollar Connection to the Recent Military Conflict

1 January 2017

The Future of the Dollar as a Petrodollar. In this paper, I intend to assess the validity of claims that there is a definite connection between the petrodollar and recent military conflicts. I will also look at why the United States needs to keep the dollar as the global reserve currency to secure their global hegemony for the future and what other contenders for the role of reserve currency are emerging. The Petrodollar Connection with the Recent Military Conflict in Iraq There is a history of violence related to oil.

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A major example of this is World War Two. In 1945, Albert Speer, the German Armaments minister told his Allied forces captors that “the need for oil was certainly a prime motive” for Hitler to invade Russia even though Hitler had told the German people that the motive was to “save the western world” from barbaric and godless communists (Black, 2007). Now with the trade of oil linked so closely to the hegemony of the US, this history of violence is set to continue. After World War Two, world leaders met at Bretton Woods to negotiate a new international monetary system.

The front runners in the negotiations were the United States and the United Kingdom. John Maynard Keynes, the UK’s leading economist, called for more realist policies and believed that no national currency would be strong enough to be the global reserve currency. He suggested that a new currency would be created (which he called ‘bancor’) and that it would be administered by a world central bank. This did not fit in with the policies of the US and their leading economist Harry Dexter. The World War had left many countries in debt and the UK was no exception.

The UK had borrowed money from the US in order to fund their participation in the war. Therefore, the US was able to get their way when it came to the matter of negotiating the future of the global currency at Bretton Woods. The US dollar became the global reserve currency at a price linked to gold. While the US did compromise on some matters, this was one thing they did not. This shows how important having the dollar as the leading currency in the international monetary system is to the US (O’Brien & Williams, 2010).

While the US dollar is no longer linked to gold due to President Nixon breaking the link when a problem called the ‘Triffin Dilemma’ was uncovered, where there would not be enough gold to cover the amount of dollars there were outside of the US, the US dollar still remains as the global reserve currency to this day and the US have shown that they are prepared to use extreme measures in order for it to stay this way. From the 1970s when the link to gold was cut, the US dollar became an oil-backed currency.

Many argue that this provides reason for the US to use extreme measures such as military intervention in oil producing countries (Clark, 2005). One of the key factors keeping the dollar as the global reserve currency is its unique position as ‘petrodollar’. This means that transactions for oil are made using the dollar. Through the process of petrodollar recycling, the US is able to sustain yearly current account deficits and fund its military supremacy amongst other things. So it is therefore important to the US to keep the dollar as the currency used to trade oil.

After the cold war, Europe became more united and eventually a single monetary zone was created along with the euro currency. Before this, there was not another currency that could challenge the dollar to its throne of global reserve currency. On the 24th September 2000, Saddam Hussein announced after a meeting of his government that Iraq would begin the transition from using the dollar for its oil transactions to using the euro currency. This caused the US to make plans to ensure that this did not happen and to keep the dollar as the currency Iraq, one of the biggest oil producing countries in the world, used to sell oil (Clark, 2005).

In 2003, the US military invaded Iraq under the pretence of them stockpiling Weapons of Mass Destruction (WMDs). As a UN report later concluded, there were no such WMDs present in Iraq (BBC News, 2005). William R. Clark argues that the real reason the US invaded Iraq was to secure the dollar’s global dominance (2005). It is of vital importance to the US economy to keep the dollar in its dominant position within the international monetary system. While countries keep large reserves of dollars, this effectively provides the US with free imported goods and services.

Without this input, the US economy will struggle. Their central bank will have to start building up foreign currency reserves such as the euro which would mean trouble for their attempts at monetary management. The US would lose their subsidy of effectively free goods and services and the value of the dollar will come down dramatically (Gokay, 2004). This means that there is much more at stake in the Iraq war than publicised by the US government. It’s not just a fight against terrorism, or a fight to keep the US supplied with the oil it needs to continue its lavish lifestyle.

It is a fight to keep the US in the position to have its debts denominated in its own currency that it has enjoyed for around 40 years. It is a war against Europe as well as it is a war against Iraq to try and see off the euro’s challenge to the dollar (Gokay, 2004). While it may have been the principal objective behind the Iraq war, securing the dollar’s position is not the only advantage the US gains from controlling the oil in Iraq. Firstly, it would mean they would control the oil supplied to Europe. This will ensure Europe’s loyalty to the US.

Zbigniew Brzezinski warns in his book The Grand Chessboard (1997) of how a truly united Eurasia would be a major threat to US hegemony. This is because Eurasia is one of the biggest land masses, and is where much of the world’s supply of oil either comes from, or goes through. The economy of Eurasia would soon surpass that of the US and in turn, the military power will as well. If the US controls the oil to Europe then they will be able to control political decisions in Europe especially regarding relationships with countries in the Middle-East and the Far-East.

Also, China is emerging as a potential major competitor with the US. At the moment China is going through what could be described as their ‘Industrial Revolution’ and are demanding large supplies of oil to power it. If the US controls the supply of oil to China at this stage, they could at least profit from their excessive use of oil, if not slow their growth down to stop China’s economy catching up with theirs. In December 2007, Iran – the Organisation of the Petroleum Exporting Countries (OPEC’s) second largest member, had ceased trading its oil for US dollars.

Instead it now trades its oil for most other major currencies with the euro being the predominant currency (Reuters, 2007). If we assume for now that the US did in fact invade Iraq to ensure they continue trading oil in dollars, you have to wonder what the US will do now Iran has stopped trading oil in dollars. It was a lot easier in the case of Iraq because they did not have the capability to strike the US with a WMD such as a nuclear weapon. The US could invade Iraq and only risk the lives of a very small minority of its citizens. Things are completely different in the case of Iran.

This is because Iran has a much stronger military and could inflict a lot more damage to the US. Also, experts believe that it would only take a few months for them to build a nuclear weapon (BBC News, 2011a). This leaves the US in a difficult position as an attack on Iran to secure its oil would be too risky. The heart of Eurasia, the Caspian – Caucasus region, is geopolitically a very tense region. This is where the different social, political and economic traditions of Russia, Turkey, Iran and the Shiite and Sunni of the Islamic world all meet.

However, this is the region which will be vital to the future of oil production due to its vast unexploited oil potential and the decreasing production of the North Sea and Alaska’s North Slope regions (Gokay, 1999). If the US can control the oil in this region, then this should secure the dollar’s position as the leading international currency for the foreseeable future. The geopolitics of this region is one of the main reasons for Iran to ask buyers of their oil for payment in euros instead of dollars.

There is ongoing tension between Iran and Israel and with the US being the main source of Israel’s financial and political support, Iran wants to punish the US. Switching their oil trade to euros is a much more effective punishment for the US than an oil embargo (Gokay, 2004). Other Contenders to the Dollar’s Throne Paul Krugman (1995) speaks of the six roles of the dollar (See ‘Table 1’ below). They are based on Cohen’s 1971 model. Firstly the dollar is a medium of exchange or ‘vehicle’ in private transactions or an ‘intervention’ currency in official use as it is brought and sold by central banks.

It is also a unit of account with many trade contracts being denominated in dollars making it an ‘invoice’ currency or a ‘peg’ as the par values for exchange rates are often stated in terms of the dollar. Finally, it is a store of value. For private agents it has a ‘banking’ role as they hold liquid dollar-denominated assets and for central banks it is a ‘reserve’ (Krugman, 1995). Table 1: Roles of an International Currency (Krugman, 1995) For a currency to take over from the dollar as the leading international currency, it will need to be able to fulfil all of the above roles.

Looking at the first role, a medium of exchange for private actors, we can see that there is currently increased, yet still distant competition from other currencies. To fulfil this role a currency needs to have economies of scale. Back in 1978, Kubarych said “Since the dollar is the main currency for international trade and investment the dollar market for each currency is much more active than between any pair of foreign currencies. By going through the dollar, large amounts can be traded more easily” (Kubarych, 1978). At its peak, 95% of international trade was conducted in dollars.

However, now this has fallen to around 55%. Even though there has been a rather dramatic decline in the denomination of international trade conducted using dollars, the euro is still a rather distant second and other currencies such as the British Pound, Japanese Yen & Chinese Yuan are even further behind in the field (Turk, 2011). One of the other most important roles for an international currency is it’s store of value as a ‘reserve’ held by foreign central banks. Table 2: Share of national currencies in total identified official holdings of foreign exchange, end of year (In percent)(IMF, 2010)

As you can see from ‘Table 2’ on the previous page, accessed from the IMF Annual Report 2010, the percentage of dollars being held by other countries is slowly falling while that of the euro is increasing, meaning the dollar is starting to see competition from the euro in the role of ‘reserve’ as well as its role of a medium of exchange. Although, as you can see from ‘Table 2’, the euro still has a long way to go to overtake the dollar. There have been previous occasions when there was a scare that the dollar would be overtaken by a rival currency, once in the late 1970s and again in the early 1990s.

However these scares were premature. However, this time around things could be different because of the existence of the euro as a plausible rival. Menzie Chinn & Jeffery Frankel state in their 2005 study that the euro could overtake the dollar as the top reserve currency by as early as 2020. They say in order for this to happen the countries within the EU who are not currently using the euro (including the UK) need to adopt the euro as their currency. Or even if not all of these countries adopt the euro, the dollar could still be overtaken if the US government continues to depreciate its value (Chinn & Frankel, 2005).

Special Drawing Rights (SDRs) are another contender to the throne of the dollar. SDRs are allocated to member states of the International Monetary Fund (IMF) at a low cost. They do not represent a currency, but can be exchanged for the currencies of the IMF members. China has been the main driving force behind the push for SDRs to replace the dollar as the international reserve currency. While Chinn & Frankel (2008) argue that the euro is the main contender to the throne of the dollar, China believes that a reserve currency that is not connected to economic conditions and sovereign interests of any single country is needed.

Also, accumulating a foreign-exchange exposure is another cost to countries of having a national currency as the leading international currency (Humpage, 2009). Conclusion I believe the best way forward for the world economy would be to switch to using a basket of currencies or something along the lines of SDRs instead of having the dollar as the leading international currency. We have seen the troubles of having the dollar as the reserve currency in the recent global financial crisis. It is a classic example of the saying “when America sneezes, the whole world catches a cold”.

America’s economy was in trouble and this rippled through most of the globe. This was partly down to the vast amount of dollars the rest of the world has to keep in reserve in order to keep their economies stable. If we were using a non-national currency as a global reserve currency then I believe the recent global financial crisis would not have been as hard hitting. This, I believe, is because the monetary policies the US had to put into place to stabilise their economy made the dollars that countries held in their reserves worth less.

However, I do not believe that the US will allow any other currency, be it another national currency or a non-national currency, take the dollars throne. This is because it would not be long after the dollar loosing its position as the leading international currency that the US would loose their hegemonic position. While having something like SDRs or Adam Smith’s ‘bancor’ as the global reserve currency would probably be better for the world economy, if the US was ever in a position where it was going to loose it’s hegemonic position, with the destructive power that it possesses, I don’t think it would go without a fight.

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