Petrodollar Diplomacy and Iran’s Hegemony

After the Yom Kippur War, when the price of oil shot upward due to the oil boycott, the Shah of Iran went on a military buying spree. The boycott had triggered a geopolitical signal; the security of oil-rich yet militarily-feeble Saudi Arabia, vis-a-vis its Iranian neighbor, had been placed in serious doubt. It was at this point that the US was forced to choose between the two royal houses. It was a difficult choice, because Iran was situated next to the Soviet Union but Saudi Arabia possessed the world’s largest reserves of oil. Not only did the US fear Soviet expansion southward into Iran, but the excessive inflationary bias of the oil price rise exacerbated grave financial tensions that had already built up since the US had gone off the gold standard in 1971. The vital future confidence in the US dollar had been put in jeopardy, while inflation threatened to upset the US dollar as the reserve currency of the world.

Victory in the Cold War depended not only on the US geopolitical position, but also on the enormous benefit that reserve currency status endowed upon the treasury. It meant that the US could run a permanent current-account deficit and pay its bills in its own currency. In other words, unlike “normal” countries who would be forced to pay for their imports by earning US dollars (the international reserve currency), the US could simply issue IOU’s (treasuries) that the rest of the world would buy with the dollars they earned through export. These same countries would hold the US treasuries as reserve, while at the same time the global nature of the buying power would drive US interest rates lower as the bond prices rose.

But a generation of vast military and domestic spending (called guns and butter) had depreciated the US dollar and had caused prices to skyrocket. The vast sums of money spent on the Viet Nam War and NATO, along with increased expenditures for the American domestic welfare state, had distributed a large dollar overhang across the face of global central banks. With the erosion of its value, confidence in the dollar became shaky; the oil boycott had made matters worse. As the dollar dropped in value, so too did the value of the treasuries.

At that time, the Saudi royal court determined that Iran was a greater threat to its security than little Israel, hundreds of miles away. So instead of maintaining the oil boycott against the West, Saudi Arabia embarked on a new policy, petrodollar diplomacy. In exchange for the promise of US military protection, the Saudis decided to use a large portion of their oil profits to buy US treasuries. They also agreed to trade their oil only for US dollars. Although the deal did not curb the rampant inflation, it did put a strong new structure under the reserve status of the US currency. It also hurt the Iranian economy, once the price of oil stabilized. Within a few years, the Shah of Iran was deposed.

The US and Europe were in a deep economic crisis. In fact, it was the worst economic crisis since the Great Depression of the 1930’s. The only way to curb inflation, and restore some modicum of confidence in the US dollar, was to raise interest rates and allow the economy to cool. But even this recessionary policy bias was without sufficient result. An entire new paradigm had taken over the global economic scene. It was called “stagflation”, the most unusual combination of recession and inflation at the same time. It lasted from 1973-1982 and eroded savings and earnings across the seven major North American and European economies. The last thing Washington needed was a further loss of confidence in the US dollar. After all, the US was engaged in a global proxy war with the Soviets, and reserve currency status was essential for victory. If another currency (like the Swiss Franc) or gold became the international currency of the world, the US advantage of permanent deficits would be extinguished. In 1974, with petrodollar diplomacy, finance trumped geopolitics, Iran isolated and the tacit US-Saudi alliance was firmly established.

In the long run, the permanent deficits and the soaring inflation were conquered through the globalization of cheap labor. The US dominance as an industrial power was replaced by cheap Chinese imports. For the last twenty-five years, finance, insurance and real estate (FIRE) have eclipsed production as the dominant categories of US GDP. Since 1987, one bubble after another has burst as the US Federal Reserve has maintained a policy of wildly printing money to offset the deflationary bias of cheap labor. Since the near financial meltdown of 2008, the world has been in its most severe crisis since the 1970’s. But unlike then, the globalization of cheap labor has not meant recession or stagflation. On the contrary, it has meant depression. The world is in a depression, and the US Federal Reserve is printing trillions of dollars in order to once again inflate another bubble. The last thing Washington needs is a geopolitical imbroglio which could work to undermine the reserve currency status of the US dollar.

Enter the presidency of Barack H. Obama. Obama wants to cut a nuclear deal with Iran without a parallel regional tract. This policy has alienated the Sunni Gulf states, Jordan, Israel, Turkey and Egypt. Of all these countries, the most important is Saudi Arabia. It is important because it possesses vast amounts of US treasuries, and it sells huge amounts of oil to China in US dollars. Oil is the most prevalent, and therefore the most important, commodity on the planet. If it were ever sold for a currency other than the US dollar, America’s privileged international financial position would be put into jeopardy. The Federal Reserve printing presses would come to a grinding halt if Saudi Arabia decided to sell US treasuries and price oil in gold or some other currency.

With Iranian generals poised on the Golan Heights, Israel (like Saudi Arabia) is finding US policy in the Middle East more and more difficult to understand. Without a regional dimension, any prospective deal with Iran will not be considered a success by America’s traditional Arab allies nor by its best Middle East ally, Israel. But the geopolitical confusion of the Obama administration is without precedent. Obama has mortgaged his legacy in the vain hope that revolutionary Iran is somehow amenable to a nuclear deal. That is, a less-than-perfect nuclear deal which would leave Iran free to pursue its regional interests as it sees fit. Meanwhile, Obama has also mortgaged his domestic legacy on the thin reed of the US Federal Reserve’s ability to overcome global cheap labor by printing mountains upon mountains of dollars. With the world awash in debt, something has to give. Could the trigger of the next financial meltdown become the erosion of petrodollar diplomacy?

Why not? Saudi Arabia’s biggest trading partner is China. The Chinese have been absorbing US treasuries, and with them, US inflationary bias for years. All the world’s emerging markets have been on a roller-coaster ride with the US dollar. Sooner or later, big players like China and the Saudis will most certainly grow tired of the ride. The Russians are already there. Geopolitical events in eastern Europe over the past twenty years have proven to the Kremlin that the promises made by Secretary of State Baker to Premier Gorbachev have become nothing but a tissue of lies. In fact, if Obama continues on his reckless path of Russian sanctions, prospective NATO expansion into the Ukraine, and a Middle East tilt toward Iran, Hezbollah and Assad, the US might find itself at an inflection point with regard to all its traditional allies.

US global financial and economic leadership is on the ropes, and Saudi Arabia, China and Russia hold great assets in finance, oil and gold. The danger of geopolitics can work in more than one direction. Asymmetric financial war can bring any military giant to its knees, especially if the giant is in hock up to its eyeballs. US vulnerability was distinctly on display in the 1970’s. Then, the crisis of inflation with fiat money (unconnected to gold) was solved on the backs of the working classes. It has now morphed into a global depression (the demise of organized labor) whose true nature has been masked by oceans of debt and extreme central bank financial manipulation. The entire project has become a house of cards dwarfing even the events of 2008. Economics is never separate from geopolitics, and as economics becomes more and more disturbed, geopolitical tensions intensify. Without a just solution to the Saudi-Iranian rivalry, economics could bring the whole house tumbling down.