An Alternative Reason Why “Dollar May Be Dropped In Oil Trade”
The econoblogs are buzzing over an article in The Independent about talks between the Gulf States and key consumers to reprice oil away from the dollar, as highlighted by Guest Voice John Wells. The implication is that this occurring because of our massive debts, will severely weaken the dollar, and is a large first step towards the dollar losing its reserve status. John was rather measured, which can’t be said about all sources.
On the other hand, other commentators think it’s all just hyperventilation. As Mish points out, the unit that oil is priced in doesn’t matter, because anyone can (and does) just use the Forex markets to instantly convert to and from dollars. Mish overlooks the factor of currency risk in the oil contracts, since the pricing is set months in advance, but a weakening dollar would help the consumer countries in that situation, whereas pricing in their own currencies would hurt them.
The whole thing is really murky. It’d benefit the Gulf States the most to switch pricing, but on the other hand they have trillions in US bonds that would be severely damaged by a move away from the dollar. China wouldn’t be helped from either the currency or bond situation, while Russia, well Russia is a bit of a basket case in its current economy. The whole thing just doesn’t make a lot of sense, except as an entirely political maneuver.
Of course it’s entirely plausible it’s all about politics but I have another theory: they aren’t worried about there being too many dollars (and thus a weak dollar) they are worried about there being too few. I am part of a (rather small) group that views the primary dynamics of the global economy in terms of trade flows. I’ve always been interested in this because if you look at historical economic crises, about 80% of them follow the same pattern: a powerful nation has the ability to borrow extremely cheaply and loads up on debt by importing much more than it produces; the countries that benefit from this boom are the developing countries of the day and have a rapid inflow of money that at first raises their standard of living, but quickly leads to massive corruption, malinvestment, wealth inequity and large amounts of inflation; at some point the borrowing countries get overburdened and trade plummets, causing massive deflation that wipes out most of the developing countries’ new “wealth.” The formerly powerful nation either suffers from decades or centuries of stagnation, or occasionally has tried to print their way out of the debt leading to massive hyperinflation and partial or total government collapse. This pattern seems doomed to repeat itself, and some historians have said that most historical events can be explained in terms of whether global trade was rising, plateaued or collapsing.
Sometimes Empires have showed characteristics of both roles. As they expanded, they quickly amassed much of the wealth of the globe and showed characteristics of booming developing countries. This is in part what caused the Spanish collapse, where they brought over so much gold that they suffered massive inflation. Rome too acted like a developing country, where its expansion papered over malinvestment for several centuries. However, Empires also were traditionally in positions to borrow cheaply even as their expansions slowed, and often exercised this ability to fund unnecessary wars and occupations until the debts vastly outweighed the benefits, leading to the same problems that only super powers can have.
So how’s this have anything to do with oil being priced in dollars? Well as Michael Pettis has repeatedly harped, the primary global economic problem is due to trade imbalances. A few countries (e.g. Japan, Germany and China) are massive creditor countries, with a few other countries (primarily the UK and US) massive debtor countries. There are also other first world countries that are debtors, and primarily emerging markets that (were) creditors. The last 20-30 years of globalization has been dependent on this dynamic, but the US, UK and other first world debtor countries have built up so much debt that their domestic demand has collapsed and led to increased savings rate. This has not only led to recessions, but a huge drop in global trade. Due to some maneuvering, China’s trade imbalance hasn’t changed, but their neighbors have felt it and in some cases gone from high trade surpluses to deficits. Prof. Pettis sees this as the worst outcome imaginable, and one that will lead to increasing trade friction.
Here is the kicker: these dynamics will lead to less dollars available externally, because the amount of dollars is dependent on how much of a trade deficit we run. This could lead to a big problem for other countries trying to do trade in dollar denominated assets. Indeed, last year the global trade network completely seized up because dollars were in such short supply that it was causing other currencies to plummet and only the Fed agreeing to trillions of dollars in currency swaps ended the crisis. While Mish is right that the unit of pricing *shouldn’t* matter, it does when it is difficult to convert currencies due to supply/demand imbalances. With the US running smaller external deficits and the Fed constrained, this situation could easily arise again.
At present, the Fed is by far the most powerful entity in the global economy and any misstep will lead to severe repercussions throughout the globe. It’s no wonder that countries want to start moving away from the dollar, especially because the correct moves for our domestic economy will not necessarily align with the world as a whole.
To me it’s unclear what this means for the value of the dollar. On one hand, if dollars are drying up externally it should make the currency stronger, but on the other hand there are already more dollars out there than can be supported by our economy, so even partial loss as a global reserve currency could lead to it plummeting. In general the dollar will probably oscillate wildly based on small changes in demand. As Prof. Pettis has repeatedly said, the US $ is not the reserve currency in spite of our massive debts, it’s become the reserve currency because of them.
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While I was working in Dubia our sister company employees would always harp about how they hated that their currency was linked to the value of the dollar. I believe the middle east is becoming more and more Euro friendly by the year.
Aside from our currrent mismanagement at home, there is envy and resentment among other nations, and of course the alternative explanation that is perfectly plausible as well as obviously current is that Obama once again is being tested (and the US challenged thereby). That the USA can be neglected or ignored is obviously not true; note the negative reaction when other nations are asked effectively to help shoulder the economic load faced by the world during this current slump, rather than rely on the USA.
Pegging their currencies to the dollar has been very hard for people in the Gulf and (much of) China, because it makes it so we export our inflation to them. The last 10 years especially has seen a humongous rise in US dollar creation, but instead of having domestic inflation like would be seen if we didn't run massive trade deficits, that money has flowed into those areas and their governments just keep buying more and more to keep their own currencies down (and implicitly causing inflation there).
Mish's (correct) point is that it has little to do with what oil is priced in, and more to do with their decision to sock all their reserves in US assets. As China and the gulf diversify into other assets, it'll put pressure on the dollar, but to me it's unclear whether that will be able ot counteract the decrease in dollars flowing abroad due to our declining trade deficit.
I don't really see how changing the denomination would benefit the Gulf States in any significant way, particularly because “they have trillions in US bonds that would be severely damaged by a move away from the dollar.”
Also, I believe the US is still the number one consumer of oil, making our currency the most efficient choice out there. Even if the Eurozone were close, there would still be significant costs to changing the denomination that would be borne by all consumers, without any particular near term benefits to balance out those costs.
At some point in the near term, China, or maybe India, may overtake us as the world's leading consumer of oil. Even then, I doubt the governments of either China or India would want their country's economy exposed by denominating oil in their native currency. I doubt that either country would be able, economically or politically, to suffer the slings and arrows of such outrageous fortune as price shocks would inevitably deliver. Even the potential for price variation ought to give pause to any serious consideration of switching the denomination.
I recognize that these have the ring of famous last words, but I just don't see it in any kind of near term. And in the long run we're all dead anyway.
Uncle Sam is still the only sensible choice.
Hey, but while we're talking about the denomination of globally traded commodities, how about illegal drugs. It's a cash only business.
It used to be that drug dealers liked the US hundred dollar bill, but there is now a two hundred euro bill, worth twice as much. This means drug dealers can now pack twice the full-faith-and-credit into the same suitcase, to the benefit of Brussels and the detriment of Uncle Sam. The euro is way more useful than the dollar.
I sometimes think the most meaningful economic reform would be the introduction of a two hundred dollar bill. Intuitively, it seems that the costs would be vanishingly small–not much beyond the design. I'm sure John Adams would be happy to have his portrait on it, and no one could be politically more acceptable that a Founding Father.
That this will never even be considered is just one more folly brought to you by the war on drugs.
George, that comment was only talking about currency risk involving new contracts and if they were worried about dollar fluctuations. I agree it's a net negative for them.
I see no reason why they would switch except for liquidity (as opposed to valuation) concerns. The IMF has said that moving to a basket of currencies would make global trade more stable, but eh who knows.
Isn't this just another example of yet another move to obtain one world currency?
The libs in Congress have already put that gem out there. I don't think it's a coincidence that the oil market is magically and simultaneously thinking the same thing.