Oil for Yen: the first grain of sand

A grain of sand drops out of place on a steep hillside, hitting two other grains of sand and knocking them out of place. A little slump in the sand evolves, which displaces a pebble. Do I need to elaborate? Eventually the whole hillside comes rumbling down, from sand to boulders.

I think I just saw that grain of sand make its move. The slightly ungrammatical headline in Business Week read, “Japan refiners pay for Iran oil with yen.” Iran wants to lower its holdings of U.S. dollars and so it arranged a deal with the Japanese refiners to pay for the oil in their own currency.

You might well ask, “Why should the Japanese pay for oil in dollars anyway?” The yen is a perfectly convertible internationally traded currency. There is some history involved. (Oversimplification alert – people have written entire books on this bit of history)

Back in 1971, the U.S. government had a big problem. The U.S. was bleeding cash and borrowing to finance the war in Viet Nam and to buy foreign oil. The dollar was backed by gold, pegged at $35 an ounce. Foreign governments started showing up, demanding real gold for their dollars. Of course, there was not 1/35th of an ounce of gold for each and every dollar out in the world, so we had a gold reserve crisis. President Nixon solved this by detaching the dollar from gold and letting it float on the world market. The dollar devalued, and inflation resulted. To counteract this, in the early 1970’s, the U.S. cut a deal with Saudi Arabia, the biggest oil producer in OPEC, to provide military support for the Saudi monarchy in return for the Saudis selling oil only for dollars. Later this agreement was extended to all of OPEC. These agreements established the so-called petrodollar.

Robert Newman explained the petrodollar with a story about the artist Salvador Dali. In his later years, the story goes, Dali never paid a dime when eating out. He would entertain his friends all evening, and when the bill came he would write a check. Then, just before handing it to the proprietor, he would do an original sketch on the back. This made the check more valuable as an artwork than the cost of dinner, and it would never get cashed. So it goes with the dollar. Everybody needs dollars to buy oil, so they keep circulating and seldom come home to the U.S. to buy goods. But what if people started to decide that Dali’s check sketches were worth less than the cost of dinner? His account would be overdrawn almost instantly. If the dollar was no longer necessary to buy oil then dollars would start coming back to the U.S. Our currency would tank, driving oil prices (for us) that much higher.

Some observers have said that Saddam Hussein sealed his fate when he started selling oil for Euros through the oil for food program in 2000. It might help explain our current animosity against Iran. Iran has been taking Euros in payment for oil and is planning to establish its own oil bourse for a few years now, with oil sold for Euros. President Chavez of Venezuela, another non-favorite of this administration, came out in support of this move, and even transferred some of Venezuela's cash reserves out of the dollar.

Of course, Iran can’t sink the dollar all by itself. As long as Saudi Arabia and other major exporters keep demanding dollars, we are relatively safe. However, it is not comforting to think that our financial future depends on the petrodollar. First, it gives OPEC an enormous amount of leverage over us. Second, we are reliant on OPEC maintaining internal discipline, which has already cracked with Iran’s oil for yen move. Third, there is the possibility of an escalating series of opportunistic side deals between non-OPEC exporters and importers in various internationally traded currencies as the dollar declines. This could become a vicious circle, as the declining dollar would drive more oil-exporting countries away. After all, where is it written in stone that there should be only one currency for buying oil? Other commodities sell for an array of currencies in various domestic and international markets.

What I fear is a case of the Prisoner’s Dilemma. No oil-producing country wants to upset the political and financial structure that keeps the whole scheme going, but none of them wants to be the last one holding large reserves of devalued ex-petrodollars. As the dollar declines due to our foreign trade and account deficits, and as countries like Iran move away from the dollar for political reasons, others will feel compelled to hedge their bets with other currencies. From the grain of sand to the house-sized boulders, the whole hillside could come thundering down.

(For more resources on the petrodollar warfare debate, try this Wikipedia entry.)