The US $ and the World's Reserve Currency
One of the reasons the U.S. dominates the world's economy is that the U.S. dollar is the world's reserve currency. The U.S. dollar gained status as the world's reserve currency consequent to a meeting of forty-four allied nations at Bretton Woods, New Hampshire in 1944. That meeting had several long term consequences, such as the establishment of stable currency exchange rates and the creation of the International Monetary Fund, but perhaps most importantly, it established the U.S. dollar as the world's reserve currency. Before Bretton Woods most nations were on the gold standard meaning that a holder of their currency could demand gold in exchange for the currency. Bretton Woods changed that so that currencies could be exchanged for U.S. dollars.
The US dollar was a natural replacement for what had been the world's reserve currency - the British Pound. Like most of Europe, Great Britain was damaged and debt-ridden as a result of the war. The U.S. was essentially untouched and in a position to be the world's most stable and pioneering economy. At that time the US dollar was still backed by tangible gold. Nations could tap the U.S. gold reserve by exchanging U.S. dollars for gold.
In the late 1960's the amount of U.S. dollars increased making the ratio of dollars to gold reserves smaller. Gold reserves dropped from 574 million troy ounces at the end of World War II to around 261 million troy ounces in 1971. Nations, perhaps, taking a cue from Goldfinger, started draining the Fort Knox gold reserve. On August 21, 1971 President Nixon suspended the convertibility of U.S. dollars to gold. Nixon blamed this on International speculators and stated that the conversion ban was temporary but those were ruses. In any case, unfettered by the gold tie the Federal Reserve was subsequently able to create as much money as it liked.
This had a serious negative consequence for the US dollar. Once ties were severed between the dollar and gold, nations had less motivation to secure and hold dollars. This could negatively and seriously impact the value of the US dollar. In September 1971, OPEC issued a joint communiqué stating that, from then on, they would price oil in terms of a fixed amount of gold.
Petrodollars
In 1973 OPEC's Arab members decided not to sell oil to the U.S. in retaliation for the U.S. having supported Israel in what is usually known in the U.S. as the Yom Kippur War. Those of us old enough to be drivers at the time remember long gas lines and being only able to buy gas every other day depending of the last number of our license plate.
Nixon responded to this with a rather clever strategy. He chose Saudi Arabia because of its vast oil reserves and rather odd political structure of being essentially a family business with little internal opposition and vast need of external military support. Nixon agreed to support the House of Saud in exchange for using its position as the leading player in OPEC to agree that all OPEC oil had to be purchased in US dollars. This is where the term "petrodollar" came from.
The size of the foreign exchange (FOREX) market is enormous - over $5 trillion per day. About 85% of the Forex transactions involve U.S. dollars on one side. This enormous liquidity machine is a significant part of what the Federal Reserve can increase money supply with little consequence. To sidetrack briefly about the enormous Forex volume - most (about 90%) of it is intraday trading by speculators.
The petrodollar system is one of the most important things which has enabled the US dollar to remain strong even with the enormous increase in money supply after the Great Recession. Zerohedge speculated last week that Saudi support of the petrodollar system may have been the reason Saudi Arabia was not on the Trump immigration ban list despite the fact that 9/11 was essentially an operation by Saudis.
An end to the petrodollar system would be a disaster for the U.S. dollar and the U.S. economy. My belief is that the real problem is that this could come "out of the blue."
The only recent threat to the U.S. dollar's reign has been the Euro but that has been mitigated by concerns about Brexit, Le Pen, and weakness of the economies of Greece, Italy, and Spain. China would like to take over the role but China is cursed by lack of believability of its macroeconomic data and near total lack of transparency in general.
The risk of the end to petrodollars also provides justification for increasing domestic oil production, alternative energy sources, and things such as CAFE (Corporate Average Fuel Economy) so that we seriously reduce the outflow of U.S. dollars used to purchase imported oil from the mid-East.
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