The Petrodollar System

Many of us are familiar with the idea that the dollar is the global reserve currency. This means that when other countries conduct trade, goods are often priced and paid in US dollars, even when the US is not involved in the transaction.

This gives the US tremendous power both globally and at home. Internationally, having the global reserve currency gives us immense policy influence—for example, financial sanctions. When we impose sanctions on Iran, we can basically cut them off from the global banking system entirely by cutting off their ability to use the dollar  and the SWIFT system in international trade. By essentially being able to ban them from using the dollar, they are cut off from the global economy, which is overwhelmingly priced in dollars.

But why is the dollar the global reserve currency? Well – one huge reason is because of oil. Oil is priced globally in dollars. If Russia wants to buy oil from Saudi Arabia, they do it in dollars. Why though?

In the mid-1970s, the US agreed to provide military protection to Saudi Arabia in exchange for the global pricing of oil in dollars. This is the backbone for the dollar’s international strength and provides a global demand for dollars that no other country or region can compete with.

Understanding this is where things start to get complicated and morally grey. In exchange for the power we receive in return – oil priced in dollars globally – we are protecting the regime of a country with longstanding problems and human rights abuses (https://www.hrw.org/world-report/2021/country-chapters/saudi-arabia#). Furthermore, we are also supporting the global oil trade.

In a way, the US is reliant on oil. We need other countries to keep demanding oil because, without that, $USD would not be as needed globally, and we would lose significant international power.

It is almost hypocritical for our leaders to talk about green energy in the US when not only are we protecting the Saudi oil trade, but we need it to continue, to enforce the global dollar hegemony that has been present since the end of WWII. Hypocritical isn’t really the right word though, since most politicians don’t understand the dynamic at play here any more than the average person does. 

Can we just stop protecting Saudi oil? It’s not so simple.

The global soft power we would lose is considerable. Sanctions against Iran don’t do nearly as much if they can just buy whatever they want in Russian rubles instead of dollars.

And it’s not just international either. Global demand for dollars sucks USD out of the country, which is good since we print a ton of new dollars. If global demand for USD falls, yet we keep increasing the money supply, those dollars will stay in the country, and price inflation would likely rise. If you want more deficit spending, more social programs, more stimulus, etc., you need global demand for the dollar to stay high. This is why the US can create much more new money than, for example, Nicaragua can.

To summarize – it’s complicated. We’re protecting a corrupt Saudi oil regime and we’re protecting the global use of oil itself. We need countries to keep buying oil priced in dollars to maintain the dollar’s dominance, even though it’s at odds with the green future that we want. And if we stop that protection, it causes a ton of other problems for the US.

While the dollar may not be ‘backed’ by anything, the backbone of its strength is oil.

If you have time, check out this piece by Lyn Alden https://www.lynalden.com/fraying-petrodollar-system/. It’s like a 45-minute read, so you might want to break it into chunks.