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Karen Bespalov
Karen Bespalov

Lyn Alden On Why The Dollar System No Longer Se... ##BEST##



In 1971, however, the US defaulted on this system, rendering the dollar no longer redeemable for or fixed against gold. After that, all currencies rapidly fell vs gold, and along with oil embargoes, this played a role in a big commodity boom and period of high global inflation that persisted through the 1970s.




Lyn Alden on Why the Dollar System No Longer Se...


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In the aftermath of this default, the United States created the petrodollar system from the mid-1970s and onwards to keep the dollar in the center of the global financial system, which contributed to the formation of structural US trade deficits in exchange for maintaining global power projection:


This strengthening dollar, however, became such a problem for the global system, including the US industrial/export sector, that major countries got together and agreed on the Plaza Accord in 1985. The purpose of the accord was to sharply devalue the US dollar vs other major currencies, and the Japanese yen in particular, in order to make American exports a bit more competitive and, more broadly, to try to bring balance back to the Force.


By 1985, however, thanks to accumulating trade deficits under the petrodollar system, our NIIP crossed under zero, meaning we shifted to being a net debtor nation. Foreigners now owned more of our assets than we owned of their assets.


This article explores some of those concepts, ranging from the fraying of the existing petrodollar system (for all of its stakeholders, both for US interests and foreign interests), to central bank digital currencies, to a total restructuring of the global monetary system.


This article places an emphasis on where the bottlenecks and problems have been forming in the system, explains why a continued weak dollar over a 3-5 year period remains my base case, and shows why some of these growing pains seem to be leading to a new re-ordering of the global monetary system over this decade.


Over the past century, for example, the world went from a gold standard system, to the Bretton Woods system, to the petrodollar system. Each system mostly unraveled from within rather than being brought down externally, and each time one system transitioned to another, a significant and widespread currency devaluation occurred.


However, after only a decade, the Bretton Woods system began to fray. The United States began running large fiscal deficits and experiencing mildly rising inflation levels, first for the late 1960s domestic programs, and then for the Vietnam War. The United States began to see its gold reserves shrink, as other countries began to doubt the backing of the dollar and therefore redeem dollars for gold instead of comfortably holding dollars.


Eventually in 1971, math came back with a vengeance on the Bretton Woods system, and Richard Nixon ended the convertibility of dollars to gold, and thus ended the Bretton Woods system. The closing of gold convertibility was proposed to be temporary at the time, but it ultimately became permanent. Rather than shifting to another country, though, the United States was able to re-order the global monetary system with itself still in the center, in the next system.


With the petrodollar system, Saudi Arabia (and other countries in OPEC) sell their oil exclusively in dollars in exchange for US protection and cooperation. Even if France wants to buy oil from Saudi Arabia, for example, they do so in dollars. Any country that wants oil, needs to be able to get dollars to pay for it, either by earning them or exchanging their currency for them. So, non oil-producing countries also sell many of their exports in dollars, even though the dollar is completely fiat foreign paper, so that they can get dollars for which to buy oil from oil-producing countries. And, all of these countries store excess dollars as foreign-exchange reserves, which they mostly put into US Treasuries to earn some interest.


The petrodollar system is creative, because it was one of the few ways to make everyone in the world accept foreign paper for tangible goods and services. Oil producers get protection and order in exchange for pricing their oil in dollars and putting their reserves into Treasuries, and non-oil producers need oil, and thus need dollars so they can get that oil.


This leads to a disproportionate amount of global trade occurring in dollars relative to the size of the US economy, and in some ways, means that the dollar is backed by oil, without being explicitly pegged to oil at a defined ratio. The system gives the dollar a persistent global demand from around the world, while other fiat currencies are mostly just used internally in their own countries.


When most other countries run trade deficits, they eventually have a big enough currency devaluation so that their exports become more competitive and importing becomes more expensive, which usually prevents multi-decade extremes from building up. However, because the petrodollar system creates persistent international demand for the dollar, it means the US trade deficit never is allowed to correct and balance itself out. The trade deficit is held open persistently by the structure of the global monetary system, which creates a permanent imbalance, and is the flaw that eventually, after a long enough timeline, brings the system down.


Because exchange rates are free-floating since 1971 within the petrodollar system, the dollar can strengthen or weaken against other currencies significantly, and other currency pairs can strengthen or weaken relative to each other.


We need to treat those concepts separately. The dollar indeed has had two huge bear market drawdowns of 40%+ vs a basket of other major currencies within this existing monetary system, without losing global reserve currency status. Being a dollar bear within the existing petrodollar system (and having no opinion about the petrodollar system ending), is not identical to someone who thinks the petrodollar system as currently structured is coming to an end.


The dollar cycle is based on major shifts in monetary and fiscal policy, as well as the resulting capital flows for global money that wants to chase whatever area of the world is doing well. Underlying all of this is the global monetary system as currently structured, i.e. the petrodollar system.


During a weak dollar period, there is often a global economic boom, and nations around the world including the United States have a period of growth and prosperity. If nations are smart, they start building up big foreign exchange reserves with their dollar inflows. Within this petrodollar system, that has meant buying US Treasury securities. Countries also often use that period to take out dollar-based loans, which comes back to bite them later.


This chart shows the trade-weighted dollar index in blue (with a newer index in red spliced onto it, due to the fact that the longer-running index discontinued at the start of 2020), and the percent of US federal debt held by the foreign sector in green:


For the Bretton Woods system, the flaw was the persistent reduction in US gold reserves against a growing amount of external liabilities, leading to an eventual inability to maintain the convertibility of dollars into gold.


For the petrodollar system, the flaw is the persistent trade deficits that the US has to run with the rest of the world in order to supply the world with dollars that they must use for energy pricing. The US ends up outsourcing large portions of its industrial base, and in the process builds up a massive deficit in its net international investment position as the foreign sector owns an increasing share of US assets.


In addition, as macro analyst Luke Gromen, who in recent years has specialized in analyzing the petrodollar system and the US fiscal situation, has pointed out that the first two decades of the petrodollar system overlapped with the Cold War. So, the system helped strengthen US hegemonic power in a divided world. Love it or hate it, the geopolitical intentions of the system architects were clear.


In the aftermath of World War II, the United States represented over 40% of global GDP. By the time the Bretton woods system ended and the petrodollar system began, the United States still represented 35% of global GDP. It has since fallen to only 20-25% of global GDP:


Europe created INSTEX in 2019, a special purpose vehicle to avoid US sanctions on Iran. The vehicle facilitates trade outside of the SWIFT system and outside of the dollar system more broadly. It has been successfully tested, but barely used. Similarly, India has long had constructive trade with Iran, despite religious/cultural differences that often cause issues between India and its neighbor Pakistan and territorial disputes in Kashmir, but the Iran-India trade partnership has been constrained in 2020 due to a combination of US sanctions and COVID-19. China has a number of strategic energy partnerships and trade agreements with Iran as well, but US sanctions along with COVID-19 also threw a curveball into their trade situation.


For the past seven years, China has been using the petrodollar system against the United States. The petrodollar system encourages mercantilist nations to run trade surpluses with the United States and recycle those dollars into buying US Treasuries, but after a while of doing this, China started taking their dollar surpluses and investing in other foreign assets instead. This topic has been reported on by petrodollar experts like Luke Gromen and others for quite some time, but is not widely followed in the broad sense.


All was well, except for the Americans who wanted to make things, or any folks, American or foreign, who were on the wrong side of military adventurism. The wheels of the petrodollar system kept functioning.


But then, China broke the wheels. Back in 2013, China declared that it was no longer in their interest to keep accumulating Treasuries. They kept running huge trade surpluses with the United States, and had dollars still coming in, but they would no longer recycle those to fund US fiscal deficits by buying Treasuries. As per the linked Bloomberg article: 041b061a72


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