The United States of America is currently one of the richest and strongest economies in the world.  The U.S. dollar is considered one of the most  “stable” currencies in the world and is often held by those outside the U.S. simply because it is a “safe haven”.  But at this very moment there are several U.S. dollar-related dynamics in play around the world that are likely to have an adverse affect on our economy and our personal pocketbooks in the future.

How the Dollar Became “Almighty”

After World War II, the U.S. was the only major economy left in the world that was not destroyed. The 50's and the 60's saw U.S. industry grow big and strong.  Everyone in America and around the world wanted American goods from cars to washing machines.  The middle-class expanded and grew and with it the might of the U.S. economy.  During this period the U.S. dollar got strong and very quickly became the de-facto currency for international trade.

In the latter part of the 20th century, one of the most important things that helped elevate the U.S. Dollar to the Almighty Dollar was the Middle-Eastern countries agreeing to price and sell their oil in US dollars.  During the surge in oil prices in the late 70’s, whole new financial instruments were created because of the flood of dollars (or petrodollars) into Europe from the OPEC countries looking to invest their immense wealth.  Grain, gold and other commodities also became most commonly valued in dollars as the strength of the U.S. economy grew.  This arrangement benefited the U.S. economy immensely, because now any country or corporation in the world who wanted to buy necessary commodities would first have to buy US Dollars.  The jump in oil prices during the 70’s led many central banks around the world to convert a significant portion of their national cash reserves into US Dollars.  This also led to foreign corporations doing the same and investing in US Dollar assets like US Treasuries, U.S.-based Real Estate and so on.

Because oil was valued in dollars, and because many parties outside the U.S. began holding assets in dollars in anticipation of needing them for future oil purchases, the US Dollar started commanding a premium.  This premium gave it an inherent value over and above its true worth because of the perceived safety and necessity of the US Dollar.  Hence the “almighty-ness” of the Dollar.  In the 1970's the US Government decided to stop backing the US Dollar with gold, but this did not have the adverse consequences for the US Dollar that many expected.  Another advantage obtained by the U.S. economy because of this dollar pricing was having much of their foreign imports valued in dollars protecting the economy from any currency fluctuations.  It also makes the country’s debt more valuable than other investments because most foreign corporations and governments realize that they will need US Dollars for future imports of their own whether it may be jeans, grain or oil.  The US Government debt is considered risk free.  This contributes to the perception that the dollar is the safest currency in the world.  Throughout the last half of the 20th century whenever there has been a world-crisis the value of the U.S. dollar has spiked up in price.  Thus the perception has become reality that the U.S. dollar is the safe-haven currency and this is how it earned its “Almighty” status.

Even today the U.S. continues to benefit from the inherent value of the world preference for dollars.  The U.S. economy still grows in spite of the fact we now buy huge amounts of consumer goods from China, South Korea, or Japan.  Is it imaginable that any other currency would give the U.S. a run for “their money”?

Birth of The Euros

On January 1, 1999 the Euro became an official currency.  In that moment that single currency created the largest single economy in the world with a larger share of global trade and with 456 million people, a greater number of consumers than the U.S.  This was done to counter the strong economic position of the US and the US Dollar.  The introduction of the Euro has effectively reduced the cost of doing business among all countries in the European Union (EU).  It has helped them stabilize inflation by having one single European Central Bank.  In terms of business it has made many corporations more efficient and profitable.

These countries still trade in US Dollars when they import oil or other commodities like gold or food, but their strong currency has made some of their imports cheaper.  Now any country trading with Europe needs Euros and not US Dollars.  The perception of most Americans is that everyone buys from the U.S., but this is not true.  Reports indicate that the trade imbalance between the U.S. and China in 2005 was on track for a $200 billion deficit.  While China is selling an ever increasing amount of goods to the U.S., they are starting to buy an increasing amount from the EU especially in the form of airline or military equipment.  (According to EU trade statistics, in the first three quarters of 2005 sales of aircraft and their parts by Germany to China rose by 86.5% over the same period for 2004, while those by France increased by 38.5%.)  The birth and subsequent strength of the Euros has forced all countries trading with Europe to think about switching a part of their foreign reserves to Euros.  This is not a good trend for the “almighty” stature of the dollar.

Pricing of Oil in Euros

Some historical facts: In October 2000, the U.N. gave approval for Iraq to sell their oil in Euros and not US Dollars.  According to UPI, Iran, the 2nd largest oil producer in OPEC after Saudi Arabia, has declared that it intends to start selling oil valued in Euros in March 2006.  Venezuela has announced that it is willing to barter oil in exchange for machinery and cattle in order to offset a portion of their oil reserve conversion to into dollars.

I will leave it to the political experts to determine whether or not our foreign policy is pushing oil-producing countries to move to non-US dollar based pricing or whether their move to non-dollar pricing is pushing the U.S. to be more aggressive with these nations.  But there is a common element between all these nations and the U.S.  We do not get along with them politically.  This is where politics intersects with economics.  The decline of the U.S. reputation in the world opinion is impacting the appetite of the rest of the world for dollars.

Is it a coincidence that the price of oil and the value of the Euro are both climbing without real fundamental reasons such as a surge in demand behind this price change?  What I do know is that any exchange in the world that trades oil exclusively in Euros will give birth to a new world of PetroEuros and the US Dollar is going to start losing it value very fast.  Another big nation: Russia, does a lot of business with Europe and also needs Euros.  They also have a lot of oil, how do you think they will greet this news about trading oil in a strong currency like the Euros?  In the last couple of years Russia started talks with Germany over the creation of an exchange to sell oil futures denominated in Euros.  Russia, which on some measures is the world's # 1 oil producer at the moment, is awash with petrodollars, but trades mainly with Europe.  In the past few years Russia has decreased their US Dollar holdings, but as of  2004 still held about 65% in US Dollars.  The EU is Russia's main trading partner, accounting for above 50% of its overall trade.  As of 2003 trade between Russia and the EU amounted to Euro 92 billion.  The EU welcomed President Putin's statement (October 9, 2003) that Russia was considering pricing its crude in Euros (PetroEuros) rather than dollars.

Right now countries like China, Japan and India are buying vast quantities of oil.  In fact the demand for it in China and India has grown considerably in the last few years.  Both countries have been on a shopping spree lately buying oil companies and partnerships around the world.  They are all trying to secure their supply of fossil fuel for the future as their demand increases.

Since countries like India and China are already converting a lot of their money to Euros for trade, they are likely to be equally happy buying their oil in Euros and not have to keep large reserves of US Dollars.  As this scenario plays out imagine that even the United States having to pay in Euros if they continue to import oil.

So How Will All This Effect You and I?

I believe that the trading of oil in Euros is inevitable and is not a matter of “if” but “when”.  Which country or group of countries will bring about this change is still to be seen.

When oil starts trading in Euros the first thing that will happen is that the demand for US Dollars will start to fall hard and fast and will soon not be as important to the world as it has been in the past.  It will lose its dominance as the de-facto world currency.  The world’s perception of the Almighty Dollar will change.

One of the first and most important consequences of oil valued in Euros would be that foreign nations and foreign corporations that have invested in US Dollars denominated assets will start to liquidate some their vast holdings, switching into euro-based assets.  This will be enough to drive the value of the US Dollar down.  When that happens even US corporations and big trading houses (while not un-patriotic) will also sell the dollar short for a profit.  It is simple demand and supply economics.  The demand will surely drop, and there will be a glut of US Dollars in the world markets.  The Federal Reserve will have to start buying back our own cheap dollars to support it, or else it will fall very hard.  They may even convince some of our allies to do the same through their central banks.

The next likely thing to happen will be the pricing of other commodities such as gold in Euros.  That too will add more downward pressure on the US Dollar.  The Federal Reserve will have no choice but to raise interest rates and tighten the supply of US Dollars.  Otherwise they run the risk of rampant inflation or even deflation domestically.

While this is happening real estate in the US will drop too as foreigners divest themselves of U.S.-based real estate.  Even US corporation may reduce their real estate holdings to avoid large losses.  Think of all the individual people and families who have bought million dollar homes in the last few years based on the extra equity they accumulated, while putting down only 5-10%.  When the price of their homes fall, it will reduce their family net worth.  In many cases it will put added presure on their monthly budget.  There will be layoffs at many major corporations that have been adversely effected by the weak dollar.  If any of these people lose their high paying jobs, they will not be able to meet their financial obligations.  This will lead to many individuals and families defaulting on home mortgages and credit card debt.  Banks will not fare too well.  A spiral effect among some if not many of the U.S. corporations that are in the business of real estate, lending, and financial services, will serve to further devalue the U.S. stock market.

Wrap It Up

If the world was not dependent on oil, none of the above would matter too much.  However, the reality is different and I do not see any alternative source of energy right now that will completely replace fossil fuel.  Just solving the problem of electricity with nuclear power is only part of the equation.  What about cars, planes and the manufacturing of goods and food.

I do not think that the US will just stand by and let all this happen.  Our Government is very aware of the consequences of all the above.  The question is how will we go about solving this issue?  Will we continue to rely almost exclusively on our military might to force things our way or will we use our intellect to solve this?  We have an abundant supply of smart people in this country.  I am sure we could come up with other realistic solutions that will work.  But just having the solution may not be enough.  We need the political will to make it so.

One radical solution to the decline of the U.S. Dollar is for the US to create a “euro” of its own.  Start talking with China, India, Russia and other countries out of the EU to create a common currency.  This would require us to forgo the US Dollar and adopt a new currency and lose some of the autonomy of our central bank.  But a common currency among the countries I mentioned would create a formidable economic force to counter the EU.  It would also strengthen the economies of all the countries in this group.  Together we would be buying more oil and other commodities than all of the EU.  It would give us a position of strength in all import negotiations. 

A milder solution may be to put more efforts into our diplomatic efforts with those countries that control much of the oil.  The world perception is starting to be that the USA gives more financial aid and help to the rest of the world than any other country, yet we are disliked more than any other country in the world.  Is this our foreign policy or lack thereof?  Given our current relationship with the rest of the world, it is really no big surprise that some countries in the world would like to topple the apple cart and change the status-quo of the Almighty Dollar!  We need to decide if we are going to continue to aid them in that effort with our aggressive military efforts or thwart their efforts by changing our approach.

So many Americans may be thinking that our foreign policy has nothing to do with them at home.  However, world pressures are mounting against "us" in the U.S. and while foreign governments may not have issues with individual Americans they are taking increasing issue with American policy.  One economic way they can "fight back" is to change how our basic world commodities are priced so that there is no longer a U.S. advantage built in.  One small change to how oil is priced around the world may have a huge avalanche affect on how we prosper here at home.