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Petrodollar Recycling And The Gold Switch

Commodities / Gold and Silver 2013 Jul 16, 2013 - 03:12 PM GMT

By: Andrew_McKillop


President Nixon's head of the Federal Reserve, Arthur Burns vigorously opposed the Nixon plan to “close the gold window”, decided at Camp David through 13-15 August 1971 because Burns saw it as admitting defeat in the struggle against inflation. He said the policy mix including a “free float for the dollar” would not stimulate jobs, or prevent wage demands. The dollar would be weakened further driving up inflation - to the delight of the Soviets.“What the boys around the White House fail to see,” Burns scribbled in his diary, “is that the country now faces an entirely new problem—sizable inflation in the midst of recession.”  He was overruled by Nixon.

Nixon was not interested in what Pravda might say. The reason was simple. Nixon had publicly declared himself to have seen the light, becoming a “Keynesian” committed to “expansive monetary policy” earlier the same year.

To him, this promised easy ways out of the problem. Gold was one of them – too little gold left in Fort Knox as foreign holders of dollars hurried to exchange 35 of them for 1 ounce of American gold – the “gold peg or window”. Through money-printing or “expansive monetary policy” gold's price in dollars might of course take off like a rocket, but the avalanche of chaff dollars would sweep the barbarous relic out of any future role in the monetary, financial and economic arena.

His August 1971 Camp David conclave produced the Soviet-sounding New Economic Policy. Apart from “temporarily suspending the convertibility of gold”, it also temporarily -- for 90-days -- froze wages and the prices of food, energy and certain services, in the hope this would check inflation. Nixon said he believed the policy would restore growth, create jobs, and allow his administration to pursue its “classic Keynesian” expansive fiscal policy. Since 2008 we call it Quantitative Easing.

Nixon in fact triggered massive inflation and further recession for the US economy. The sole difference of the current global economic context – of massive fiscal easing - with the US in 1971 is that Nixon's failure to “turn around the economy” was a surprise at the time.

Most of the NEP (New Economic Policy) system was abolished in April 1974, 17 months after Nixon's reelection and 4 months before he was forced to resign as president. Only one segment of the wage-and-price control system was not abolished -- price controls over oil and natural gas – which were maintained for more than 3 years and left an enduring legacy. Through a near-obsessional system of energy production and price controls, now including environmental regulations decided by the EPA (Environmental Protection Agency), an agency which Nixon created, the NEPs purported or claimed overall goal of holding down energy prices was a disastrous failure. Domestic producers produced less oil and gas, increased subsidies were needed to import more oil, and the USA's dependence on imported oil increased at a rapid rate. The supply and price of oil became a constant major theme of American economic policy.

What we can call the Petrodollar Window was established at the same time as the Gold Window was closed. The only difference between the two “windows” was that Nixon kept his new oil policy secret.

From 1945 until almost the end of the “gold window” in 1971 gold was pegged at $35 per Troy ounce and oil was priced at around $1.50 per barrel.

After abandoning the gold standard, monetary inflation / dollar devaluation roared. In 1975, gold averaged $161 an ounce, rising about 400% in 4 years. Oil prices rose by 395% through 1973-74.

How the “Oil Window” was created is of course clouded in secrecy. Some sources claim that Henry Kissinger himself made prior visits to Saudi Arabia before 1974, but it is officially known that in early 1974 Kissinger sent Secretary of the Treasury, William Simon, to Saudi Arabia to try formalizing the exclusive use of dollars for oil transactions by the Arab OPEC (OAPEC) member states. At the time, the Shah of Iran although described by Henry Kissinger in flowing terms “that rarest of leaders, an unconditional ally, and one whose understanding of the world enhanced our own”, had stepped out of line on oil prices. The Shah was the leading price hawk inside the OPEC cartel.

Several scholars believe the Kissinger deal cut with Saudi leaders through the year of 1974 also included shutting out Iranian oil, with its counterparty of a precipitous drop of Iranian oil sales and revenues, triggered by Saudi Arabia undercutting Iran to oppose further price rises proposed by Iran at the 1976 Doha meeting of OPEC (see for example “Showdown at Doha: The Secret Oil Deal That Helped Sink the Shah of Iran”,  Andrew Scott Cooper, The Middle East Institute 2000). One direct result of this for Iran, from late 1976, was a sudden fiscal crisis due to reduced government revenues – helping seal the fate of the Shah's regime at the hands of Ayatollah Khomenei.

Sources differ on exactly how the Kissinger deal set the roles of Saudi oil and Saudi oil dollars, when proposed and discussed by Kissinger, Simon and Saudi deciders including Cheikh Yamani. What is certain is that from 1974 Saudi influence in the cartel maintained the exclusive use of the dollar for oil transactions. At several key moments such as the 1978 de facto devaluation of the dollar against the Yen and Mark, Saudi Arabia acted decisively to encourage OPEC to drop all debate about widening the number of currencies accepted for oil sales.

Saudi surplus petrodollars and those of other Gulf states allied with KSA were “recycled” to purchasing US Treasuries through a special facility at the Federal Reserve Bank of New York, and other Federal Reserve banks. By at latest December 1974, the nature of US-Saudi monetary cooperation was formal and published. The first known formal agreement was signed in Riyadh with the Saudi Treasury (SAMA) for buying US Treasury securities, starting with a $2.5 billion purchase (about $11.5 billion in dollars of 2013).

On top of the political benefits for the Saudi side, whose role inside the IMF had been massively strengthened by Kissinger (moving KSA up from 38th by voting power to 8th), the United States agreed to maintain Nixon-era “energy price controls”, and applied new environmental controls on the energy sector, set by the Environmental Protection Agency, also created under Nixon. The direct result was to cap thousands of wells across the US and to heavily limit drilling activity. This resulted in rapidly increasing oil import dependence of the US and not by coincidence, imports of oil from Saudi Arabia rose rapidly, as well as oil from other OPEC states.

Above all for the USA, money-printing could be continued and increased.

Many writers attribute the invention of the term “petrodollar recycling” to Henry Kissinger himself, but we can be sure this system, created and established through at most 5 years – from 1971 to 1976 – transferred the fiduciary support or value-backing for the US dollar from Gold to Black Gold. As we can also be sure, oil prices are renowned for price manipulation and volatility, posing the question as to how the Nixon-era US politicians who set up the system, and those who followed them for the next four decades, could have believed that petrodollar recycling could protect and support the dollar?

Most important, as already noted, the policy was never openly announced or admitted, and remains to this day a so-called “secret policy”.

The theory was delightfully simple – too simple. By either conniving with, or forcing OPEC to sell oil exclusively in dollars a “permanent” high level of international demand for dollars – to buy oil – will be engineered. Dollars which cannot be spent by the few “capital surplus oil exporters”, which in the 1970s included Iran and Venezuela as well as the Arab Gulf states, would be channeled back to the US to buy US Treasuries, enabling more and further money-printing through “fractional reserve central banking”. Surplus dollar would not “leak out” causing inflation in the US. Oil exporter countries would become active partners with the US – more especially when oil prices were high!

Above all, the first claim or hope – that petrodollar recycling was able to create strong and hoped-for permanent world demand for dollars enabling further US money printing – has not stood the test of time. The main problem, in fact, was that none of the hopes, beliefs or claims were true.

In the 1970s, apart from enriching OPEC producers led by KSA – but excluding Iran – the new system mainly enriched the Big 7 Western oil corporations of the period, mostly US and UK owned: British Petroleum, Mobil, Exxon, Royal Dutch Shell, Texaco, Gulf and Chevron. The inflow of petrodollars, sterilized as Treasuries, however certainly did not maintain the world value of the dollar, which from as early as 1978 was repeatedly attacked by speculators, culminating in the extreme rise of US interest rates from 1980. Any claim that petrodollar recycling may or might have stabilized oil prices can be dismissed – while its role in creating constant de facto US-Saudi manipulation of world oil prices from the late 1970s is stark and clear.

Above all, the start of petrodollar recycling was part of a process whereby the USA was set to become the most indebted nation on earth - - after being the world's largest creditor nation in 1970.

As noted above, in exchange for a special role, Saudi Arabia had its position at the IMF drastically improved. With almost no possible doubt KSA was promised that whenever the value of the US dollar might temporarily fall, it would soon dramatically rebound against the other currencies which had been considered as alternatives to the dollar in oil trading. The first test ensued following the 1979 collapse of the Shah's regime in Iran – and the USA's “rather cynical” abandonment of the Shah. Sharp falls in the value of the dollar against other moneys were soon reacted and responded to, in 1980, through the most extreme use of “neoliberal monetarist” policies by then Treasury secretary Volker – racking US interest rates to 20%. To be sure, the value of the dollar rose considerably. Saudi players were with almost no possible doubt given insider information of pending changes in the dollar's value.

Certainly since the period of 1971-1976 in which petrodollar recycling was mooted, honed and then launched as a long term US-Saudi “secret” strategy, oil prices have remained at all times subject to heavy manipulation, usually unrelated to supply-demand fundamentals. One example is the US-Saudi decision to collapse oil prices (cutting prices by 67%) in 1986, during the Iran-Iraq war. If we took the so-called “Middle East geopolitical risk premium” seriously, an all-out war between two of the region's, and the world's biggest oil exporters should have caused or maintained very high oil prices.
In fact they collapsed. As the following chart shows for 1986-88, this was a simultaneous devaluation of oil or reevaluation of gold

Simply due to this, if today we take talk about the “Syrian and-or Egyptian risk premium on oil” seriously, we can rather easily be disappointed. Expecting oil prices to respond to supply-demand fundamentals is a losers' strategy (See my article 'Syria, Egypt and the Middle East Oil Risk Premium').

At any time and for totally different reasons, due to US-Saudi collusion, oil prices can be increased or collapsed, that is changed by huge amounts in a few days trading.

In current conditions – oil expensive, gold cheap - the only way that gold can climb significantly against oil is if oil prices fall. Continuing with this reasoning, if oil recovered its absolute peak price of 2008 at $147 a barrel, and maintained it, gold could theoretically rise to about $2250 an ounce. On the other side of the ledger, if gold can fall to say $875 an ounce, oil should fall to around $57.50 a barrel.

This however ignores the basic role of petrodollar recycling. Each time the price of oil goes up, so does the demand for US dollars. The first and most important policy goal of petrodollar recycling was to create and maintain a high level of international demand for dollars – to buy oil. When oil prices fall, less dollars are needed and more dollars will be “repatriated”, posing an almost certain inflation risk inside the US. Conversely, gold has been savagely debased as a “money metal”, since the late 1970s but especially since the start of 2013, probably for the same convergent goal – of strengthening the US dollar and enabling more and further money-printing.

The price-demand relationship believed to exist for oil - demand for oil is fairly inelastic and hardly changes due to price – in fact applies much more to gold, with the additional factor, as proven today, that gold buying goes into overdrive when gold prices fall. When oil prices fall, however, demand also remains fairly inelastic, but frequent extreme high prices for oil, and extreme price volatility, over the decades since the 1970s has resulted in oil saving and oil substituting energy policies, worldwide.

As we know, gold prices are also heavily manipulated making the interpretation of gold-oil ratio not an exact science, but this ratio will always send telltale signs for upcoming change. At present, this is likely to feature falling oil prices and rising gold prices, causing major US-Saudi manipulative action in so-called “transparent” markets.

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2013 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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