Huge Debt Got Us Hooked on Petrodollars — and on Saudi Arabia
The Iranian regime and the Saudi Arabian regime are longtime enemies, both vying for control of the Persian Gulf region. Part of the conflict stems from religious differences — differences between Shia and Sunni Muslim groups. But much of it stems from mundane desires to establish regional dominance.
For more than forty years, however, Saudi Arabia has had one important ace in the hole in terms of its battle with Iran: the US's continued support for the Saudi regime.
But why should the US continue to so robustly support this dictatorial regime? Certainly, these close relations can't be due to any American support for democracy and human rights. The Saudi regime is one of the world's most illiberal and antidemocratic regimes. Its ruling class has repeatedly been connected to Islamist terrorist groups, with Foreign Policy magazine last year calling Saudi Arabia "the beating heart of Wahhabism — the harsh, absolutist religious creed that helped seed the worldviews of al Qaeda and the Islamic State."
Saudis behind the Petrodollar
The answer lies in the fact that the Saudi state is at the center of US efforts to maintain the dollar as the world's reserve currency, and to ensure global demand for US debt. The origins of this system go back decades.
By 1974, the US dollar was in a precarious position. In 1971, thanks to profligate spending on both war and domestic welfare programs, the US could no longer maintain a set global price for gold in line with the Bretton Woods system established in 1944. The value of the dollar in relation to gold fell as the supply of dollars increased as a byproduct of growing deficit spending. Foreign governments and investors began to lose faith in the dollar, and both Switzerland and France demanded gold in exchange for their dollars, as stipulated by Bretton Woods. If such demands continued, though, US gold holdings would soon be depleted. Moreover, the dollar was losing value against other currencies. In May of 1971, Germany left the Bretton Woods system and the dollar fell against the Deutsche mark.
In response to these developments, Nixon announced the US would abandon the Bretton Woods system. The dollar began to float against other currencies.
Not surprisingly, devaluing the dollar did not restore confidence in the dollar. Moreover, the US had made no effort to rein in deficit spending. So the US needed to continue to find ways to sell government debt without driving up interest rates. That is, the US needed more buyers for its debt. Motivation for a fix grew even more after 1973, when the first oil shock further exacerbated the deficit-fueled price inflation Americans were enduring.
But by 1974, the enormous flood of dollars from the US into top-oil-exporter Saudi Arabia suggested a solution.
That year, Nixon sent new US Treasury secretary William Simon to Saudi Arabia with a mission. As recounted by Andrea Wong at Bloomberg the goal was to
neutralize crude oil as an economic weapon [against the US] and find a way to persuade a hostile kingdom to finance America’s widening deficit with its newfound petrodollar wealth. …
The basic framework was strikingly simple. The U.S. would buy oil from Saudi Arabia and provide the kingdom military aid and equipment. In return, the Saudis would plow billions of their petrodollar revenue back into Treasuries and finance America’s spending.
From a public finance point of view, this appeared to be a win-win. The Saudis would receive protection from geopolitical enemies, and the US would get a new place to unload large amounts of government debt. Moreover, the Saudis could park their dollars in relatively safe and reliable investments in the United States. This became known as "petrodollar recycling." By spending on oil, the US — and other oil importers, who were now required to use dollars — was creating new demand for US debt and US dollars.
This dollar agreement wasn't limited to Saudi Arabia, either. Since Saudi Arabia dominated the Organization of the Petroleum Exporting Countries (OPEC), the dollar deal was extended to OPEC overall, which meant that the dollar became the preferred currency for oil purchases worldwide.
This scheme assured the dollar's place as a currency of immense global importance. This was especially important during the 1970s and early 1980s. After all, up until the early 1980s, OPEC enjoyed a 50 percent market share in the oil trade. Thanks to the second oil shock, however, much of the world began searching for a wide variety of ways to decrease dependency on oil. By the mid 1980s, OPEC's share had fallen to less than one-third.
Today, Saudi Arabia ranks behind both Russia and the United States in terms of oil production. As of 2019, OPEC's share remains around 30 percent. This has lessened the role of the petrodollar compared to the heady days of the 1970s. But the importance of the petrodollar is certainly not destroyed.
We can see the ongoing importance of the petrodollar in US foreign policy, which has continued to antagonize and threaten any major oil-exporting state that moves toward ending its reliance on dollars.
As noted by Matthew Hatfield in the Harvard Political Review, it is likely not a mere coincidence that an especially belligerent US foreign policy has been applied to the Iraqi, Libyan, and Iranian regimes. Hatfield writes:
In 2000, Saddam Hussein, then-president of Iraq, announced that Iraq was moving to sell its oil in euros instead of dollars.
Following 9/11, the United States invaded Iraq, deposed Saddam Hussein, and converted Iraqi oil sales back to the U.S. dollar.
This exact pattern was repeated with Muammar Gaddafi when he attempted to create a unified African currency backed by Libyan gold reserves to to sell African oil. Shortly after his announcement, rebels armed by the US government and allies overthrew the dictator and his regime. After his death, the idea that African oil would be sold on something other than the dollar quickly died out.
Other regimes that have called for abandoning the petrodollar include Iran and Venezuela. The US has called for regime change in both these countries.
Oil Exporters Control US Assets
Threats can be leveled in both directions, however. Last year, for example, Saudi Arabia threatened "to sell its oil in currencies other than the dollar" if Washington "passes a bill exposing OPEC members to U.S. antitrust lawsuits." That is, the Saudi regime is aware that it has at least some leverage with the US because of the Saudi position at the center of the petrodollar system.
Saudi Arabia is one of few states that can even feign to call the US's bluff on matters such as these. As has been made abundantly clear by US policy in recent decades, the US is more than willing to invade foreign countries that run afoul of the petrodollar system.
In the case of Saudi Arabia, however, the kingdom's position as an Iran antagonist — and as the world's third-largest oil exporter — means that the US is likely to avoid unnecessary conflict.
Moreover, it is likely that Saudi holdings of US debt and other assets are significant. When the Saudis make threats, this implicitly also "include[s] liquidating the kingdom’s holdings in the United States." As Bloomberg reported, Saudi Arabia has also
warned it would start selling as much as $750 billion in Treasuries and other assets if Congress passes a bill allowing the kingdom to be held liable in U.S. courts for the Sept. 11 terrorist attacks.
We often hear about how China and Japan hold a lot of US debt, and therefore hold some leverage over the US because of this. (The problem here is that were foreigners to dump US assets, they would drop in price. If US debt drops in price, then the the debt must increase in yield, which means the US must then pay more interest on its debt.) But there is good reason to believe that Saudi Arabia is a major holder as well. It is difficult, however, to keep track of how large these holdings are because the Saudi regime has worked closely with the US regime to keep Saudi purchases of American assets secret. When the US Treasury reports on foreign holders of US debt, Saudi Arabia is folded in with several other nations to hide the precise nature of Saudi purchases. Nevertheless, as Wong contends, the Saudi regime is "one of America’s largest foreign creditors."
The Problem Grows as US Debt Grows
All else being equal, the US should be growing less dependent on foreign holders of debt. This should especially be true of Saudi and OPEC-held debt since the global role of OPEC and the Saudis has been diminishing in terms of global market share.
But all else isn't equal, and the US has been piling on ever-larger amounts of debt in recent years. In 2019, for example, the annual deficit topped one trillion. In a past, less profligate age, this sort of debt creation would have been reserved only for wartime or a period of economic depression. Today, however, this immense growth in debt levels makes the US regime more sensitive to changes in demand for US debt, and this has made the US regime ever more reliant on foreign demand for both US debt and US dollars. That is, in order to avoid a crisis, the US must ensure that interest rates remain low and that foreigners want to acquire both US dollars and US debt.
Were petrodollars and petrodollar recycling to disappear, it would have a twofold effect on US government finances: a sizable decline in petrodollar recycling would put significant upward pressure on interest rates. The result would be a budget crisis for the US government, as it would have to devote ever-larger amounts of the federal budget to payments on the debt. (The other option would be to have the US central bank monetize the debt by purchasing ever-larger amounts of it to make up for a lack of foreign demand. This would lead to growing price inflation.)
Further, if participants began to exit the petrodollar system (and, say, sell oil in euros instead) demand for dollars would drop, exacerbating any scenarios in which the central bank is monetizing the debt. This would also generally contribute to greater price inflation, as fewer dollars will be sucked out of the US by foreign holders.
The result could be ongoing declines in government spending on services, and growing price inflation. The US regime's ability to finance its debt would decline significantly, and the US would need to pull back on military commitments, pensions, and more. Either that, or keep spending at the same rate and face an inflationary spiral.