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.