Iraq, Iran and the end of petrodollar: The waning influence of the USA in the Asian century

The United States runs a balance of payments deficit by spending more money in other countries (buying their products, investing in them, or giving them dollars) than they spend in the United States . - The extra dollars are held by the countries' central banks. The banks do not ask the United States to redeem them for gold or another currency. As long as foreign banks accept and hold dollars as if they were gold, the dollars act as reserves.

The US economy began to dominate the world economy in the early 20th century. The US dollar was then tied to gold, so that the value of the dollar neither increased nor decreased, but remained the same amount of gold. Most money was paper, as it is now, but governments were required, if requested, to redeem that paper for gold. This 'convertibility' put an upper limit on the amount of paper currency governments could print in order to prevent inflation. This link between paper money and gold was a product of law as well as custom. The Federal Reserve, which was established in 1913, had to ensure that every dollar of paper money was backed by at least forty cents of gold. There was no tradition (as there is today) of continuous inflation. The large levels of inflation and astronomic levels of government deficits during the Great Depression, 1929-1931, rendered the support of US dollars by gold impossible. By the early 1930s, this led the US President Roosevelt to adjust the dollar/ gold ratio as he saw fit. Until this point, the US may well have been a dominant power in the world economy, but from an economics point of view, it was not an empire. The fixed value of the dollar did not allow the US government to extract economic benefits from other countries by supplying them with dollars convertible to gold.

The American Empire was born, in a real economics sense of the term, with Bretton Woods in 1945. After 1945, the dollar was not fully convertible to gold, but was made convertible to gold only to foreign governments. As a result of this, the dollar established itself as the global reserve currency. No one planned this development. It came directly from the fact that the US was the dominant world power: well over half of all international money transactions were financed in terms of dollar; the US produced more than half the world output; the US also owned a large section of the gold reserves in the world. This became possible because during the Second World War, the US had supplied its allies with provisions, demanding gold as payment, thus accumulating significant portions of the world's gold reserves. By 1945, the US had accumulated 80 percent of the world's gold, and 40 percent of the world's production.

The aggressive policies of the 1960s, however, put an increasing pressure on the US dollar. The US economy experienced a cumulative reserve deficit. In particular, the dollar supply was relentlessly increased to finance America's war in Vietnam. Financially the Vietnam War was a real mess. The US printed and spent more money than their gold reserves allowed. By 1963, the US gold reserve at Manhattan had fallen to alarmingly low levels -- it barely covered liabilities to foreign central banks. By 1970 the gold coverage had fallen to 55%, by 1971 22%. Before the Vietnam War, the US had $30 billion in gold reserves, but it spent more than $500 billion on the war alone. By this time, the post-war reconstruction period had come to an end, and the European and Japanese economies had improved their economic position relative to the US, which had increased pressure on the US dollar. The strain on the US financial system became evident in 1965, when French President de Gaulle demanded gold from the US in exchange for $300 million in debt.

The situation reached a crisis point in 1970-71 when more foreign central banks tried to convert their dollar reserves into gold. In response to a massive flight from the dollar, the US government defaulted on its payment on 15 August 1971 by cutting the link between the dollar and gold. This was because it seems that there was no other choice - the US government would not be able to buy back its dollars in gold. If governments and foreign central banks tried to convert even a quarter of their holdings at one time, the United States would not be able to honour its obligations. Hence the Bretton Woods system was ended. This was a serious crisis inspired by a significant loss of confidence in dollar. As a result, the dollar was left 'floated' in the international monetary market, which weakened the position of the dollar as the hegemonic currency. Now the dollar had no firm backing other than the 'full faith and credit' of the US government. From that point on, the US had to find a way convincing the rest of the world to continue to accept every devalued dollars in exchange for economic goods and services the US needed to get from others. It had to find an economic reason for the rest of the world to hold US dollars: oil provided that reason, and the term petrodollar became the crucial link in this.

Bulent Gokay
To be continued

Dr. Bulent Gokay is a Reader in International Relations, School of Politics, International Relations and philosophy, Keele University, United Kingdom. He can be contacted by e-mail at b.gokay@intr.keele.ac.uk

Discuss this article on Pravda.Ru English Forum