Oil Dollar Era Ends: Dollar Hegemony Risky?

In the annals of global finance, few events have had as profound an impact as the 1974 agreement between the United States and Saudi Arabia concerning the pricing of oil in US dollars. On June 8, 1974, US Secretary of State Henry Kissinger and Saudi Prince Ibn Abdulaziz signed a pivotal pact, fundamentally intertwining the destinies of these two nations. This landmark accord committed the US to provide unequivocal support for the Saudi royal family's grip on power amidst rising threats from nations like Iran, Iraq, and Egypt. In return, Saudi Arabia agreed to sell its oil exclusively in dollars, thereby entrenching the currency's dominance in international trade and finance.

However, many analysts point out that while the 1974 agreement may have initially bolstered the dollar's prestige following the collapse of the gold standard in 1973, the reality is more complex. Data reveals that from 1975 to 1980, the dollar's reserve status experienced a stark decline rather than a meteoric rise, followed by a slight recovery, only to slowly falter again until 1990. The so-called oil dollar did not significantly enhance the dollar's foothold in the global reserve market, challenging the interpretation that such agreements facilitate a currency's rise to supremacy.

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Fast forward to the present day, and the relationship between the US and Saudi Arabia seems strained, often characterized by a simmering tension that lacks any official acknowledgment. No longer is the US viewed as the unassailable beacon of leadership; the Saudi Crown Prince Mohammed bin Salman notably skipped a G7 summit, hinting at a discord regarding the renewal of their longstanding oil agreement. Speculation is rife that the revised security treaty negotiations have not progressed as smoothly as hoped. This absence at such a critical diplomatic gathering starkly serves as a signal regarding the underlying complexities of their partnership.

Even with enticing offers from the Biden administration, the kingdom may be hesitant to commit solely to dollar-denominated transactions. With China's role in brokering a reconciliation between Saudi Arabia and Iran, the reduced security anxieties provide the Kingdom with greater autonomy in its economic dealings. Trade between Saudi Arabia and China has been soaring, eclipsing its exchange with the United States. The notion that countries should tether themselves closely to Washington seems increasingly antiquated, especially when considering America's track record of freezing foreign assets indiscriminately. Few nations, aside from staunch allies like the UK, are willing to bind themselves tightly to US economic whims.

Nevertheless, it would be erroneous to suggest that the end of dollar-denominated oil transactions would shake the currency's established dominance overnight. The United States remains the world's leading oil producer, and its position as a top crude exporter further solidifies the dollar's significance in global oil markets. Despite the growing chatter around alternatives, predictions of an immediate transition to non-dollar settlements seem overly optimistic.

The dollar's current supremacy stems not solely from its association with oil but is also a byproduct of historical circumstances and its versatile nature as a currency. Its multifaceted role—spanning reserve currency status, pricing mechanism, and trade settlements—has contributed to a self-reinforcing cycle that continues today.

However, this doesn't imply that the dollar's supremacy is destined to endure without challenge. Over the past two decades, growing competition from other currencies has gradually eroded the dollar's dominion. The phenomenon of "America First" policies under the Trump administration and the ensuing consequences have exacerbated vulnerabilities in the dollar's standing. Such trends can shift from a positive feedback loop to a detrimental cycle, raising concerns about the future health of the currency.

When discussing dollar hegemony, common misconceptions arise. A prevalent assumption is the steady decline of the dollar following the dissolution of the gold standard up until 1990, with its resurgence post-1990 defying economic forecasts. Notably, the financial crises of 2000 and 2008 failed to dent its standing fundamentally, largely due to the simultaneous international demand for “safe assets,” coupled with an environment of excessive global savings driving demand for US Treasury securities.

Moreover, the US capitalizes on its currency’s unique status to reap excess returns on global investments, which are estimated to be 2-3% annually. This seemingly disproportionate privilege manifests notably during periods of floating interest rates, where the US assumes the roles of both global banker and venture capitalist. Yet the flip side emerges during economic downturns or financial crises, where the dollar can also be subjected to runs, where the US then assumes the mantle of a global insurer.

Another reinforcing element of dollar supremacy is America's provision of security for its allies, enabling it to function as a global public goods provider. In technology, for example, the US continues to lead in theoretical innovation, technological diffusion, and knowledge dissemination. This dominance is mirrored in the exceptional performance of the US stock market post-2008, contrasting dramatically with the stagnation of markets in other nations.

While the "weaponization" of the dollar has raised eyebrows, detractors note that it may paradoxically enhance the dollar's value as collateral, attracting foreign investments while assuring foreign entity investors, further entrenching the dollar in the international financial system.

Some theorists posit that maritime nations exhibit better prospects than their continental counterparts, suggesting that the dollar’s position is intrinsically linked to US naval supremacy. This perspective contends that China's ascent need not immediately target dollar hegemony. It is recognized that despite China's strides toward trade liberalization, barriers remain with an unconvertible capital account, trailing behind nations such as Indonesia, Brazil, and South Africa. While this strategy may guard against capital flight and financial crisis, it has produced problems domestically, including inflated real estate and stock market bubbles.

In summary, the path to the internationalization of the renminbi is arduous, characterized by numerous challenges and hurdles. Regardless of the dollar's dysfunctionality or complaints surrounding its monetary policy, its supremacy is likely to remain intact in the foreseeable mid to long-term landscape. Perspectives from the Harvard School, represented by economists such as Paul Krugman, propose that, due to the mutually reinforcing functions of the dollar, a future currency system may remain firmly in the dollar's domain.

Contrarily, the California School, led by Barry Eichengreen, predicts a multipolar world where two or three currencies coexist rather than the hegemony of the dollar. This projection aligns with historical observations that the dominance of a single currency is the exception, not the rule.

Three significant dilemmas, known collectively as the Triffin Dilemma, pose tangible threats to dollar supremacy. The original Triffin Conundrum highlighted the contradictions arising from US trade deficits, which could trigger an outsized demand for gold and instability but did not predict the circumstances that ultimately dismantled the gold standard. Today, as the dollar attracts capital flows due to its 'safe asset' status, there remains the risk of prolonged trade deficits, which would devalue the dollar in the long run.

Moreover, the second Triffin Dilemma surfaces as the US may increasingly struggle to sustain its financial credibility relative to global economic growth, leading to potential unrecoverable public debts, further undermining dollar dominance. Thirdly, a scenario might emerge where if the US becomes the sole provider of safe assets, it risks driving yields too low, pushing the global economy toward the zero lower bound and stagnation, creating a feedback loop of diminished growth prospects. Past empirical evidence underscores this cyclical phenomenon across the last 500 years of monetary history.

The British pound, for instance, saw its share of national debt reach a staggering 130% of GDP post-World War I, requiring a choice between economic contraction to maintain currency value or risk plummeting into obsolescence. Ultimately, the UK was forced to devalue its currency in 1949 as it confronted untenable trade and employment pressures. Although geopolitically the dollar supplanted the pound in political respects post-1956, economically, that transition traces back to the aftermath of the war.

As we evaluate the trajectory of the dollar’s ascendancy within this historical context, it seems plausible that the prevalence of dollar dominance might be regarded as an abnormality rather than the norm. In the future, we may witness the crystallization of two predominant systems, one sustaining the dollar, the other potentially harnessing the renminbi or digital currencies as alternatives. To safeguard its rise, China must tread carefully, drawing insights from the successes and pitfalls encountered in the US experience.

Lastly, a diverse currency milieu presents its risks, potentially spawning financial instability and crises. As China aims to elevate the status of its currency, it must remain vigilant against the potential consequences that accompany such ascendancy.

(This article reflects the author's personal viewpoints.)