Michal Lerner

The name Petrodollar is used to designate dollars that are used to buy oil.

So if country X buys 1 million barrels of oil at $70 dollars per barrel from an oil exporter and pays for that oil in dollars, then an account at some US bank will be marked up by £70 million.

The $70 million in that account are called petrodollars even though they are just dollars.  They are called petrodollars because they have been used to buy oil.  Usually an oil exporter will pay its earnings from oil sales into an account that is only used for oil transactions.

When an oil exporter sells oil, it will typically want to be paid in dollars.  This means that an oil buyer must get its hands on dollars if it wants to buy oil.  European countries are able to buy dollars on the foreign exchange markets which will happily accept euros or British pounds in exchange for dollars.  

However poor countries will struggle to buy dollars with their currency since the foreign exchange markets would not want to hold their currency.  This often means that poor countries have to go, cap in hand, to institutions like the IMF and the World Bank to get the dollars that they need.  These institutions are essentially controlled by the US and can impose political and economic conditions on the poor countries.  

An oil exporter will want to be paid in dollars because it knows that there will be no sudden changes in the value of that currency.  The dollar is a good currency in which to park money that you don’t immediately want to spend.  Hence the dollar is called a reserve currency.

In 1960 an American worker, earning $100 a week, might only spend $10 on oil.  The other $90 would be spent on other, mainly American, produced goods and services.  (These figures are illustrative rather than accurate.)

In the 1970s the oil exporting countries hugely increased the price of oil.  

After 1973 the American worker found he was spending $40 per week buying oil imported from Saudi Arabia.  The Saudis were now receiving $30 per worker per week more than they had previously received in payment.  If the Saudis did not spend their newly acquired wealth buying American goods and services this would have reduced demand in the US economy and resulted in massive unemployment.

There is a basic accounting identity in economics:  (S-I) = (G-T) + (X-M)

Where S is private sector savings, I is private sector investment, G is government spending, T is tax revenue, X is exports and M is imports.  This accounting identity is not disputed by neoliberals or Marxists.

Let’s suppose the American economy was close to full employment in 1973.  The huge increase in the oil price led to a huge increase in M as money flowed to the Saudis.  To retain full employment, the value of the other variables in the equation had to change to counter the increase in M.  

For instance, suppose the Saudis had spent all their new found wealth buying American goods, the value of X (exports) would have increased and cancelled out the increase in M (imports).  However, there was no way the Saudis could have consumed all the extra products and services they could now afford to buy.  So the value of X was not going to increase significantly.  What other variables could change?  

Consider S (savings): The American worker could have used savings to continue with his current level of consumption.  But that’s not a long term solution.  Savings eventually run out.  

Consider I (investment):  The private sector could have increased investment to match the drain of demand caused by increased imports.  But in an uncertain world, investment activity will more likely decline.

Consider (G-T):  This is the government deficit.  If the government increases the deficit to match the increased cost of Saudi oil imports then there is no significant reduction in employment.  

Where will the money come from to finance the increased deficit?  It’s simple in theory.  The government creates the money and uses the newly created money to hire the workers made unemployed by the increased spending on oil imports.  However, there are many practical issues that have to be resolved in moving the newly unemployed from old industries to new industries.  

Many people believe that the government must borrow the money from the private sector to finance its deficit.  In fact they are encouraged to believe that, since it implies that the government is dependent on the private sector to fund its policy decisions and that the private sector can veto government spending that it does not like.  It’s a false belief.

A currency creating government has no need for private sector money.  The US officially became a currency creating government in 1971 when it moved off the gold standard.  So the US had no need to borrow from the Saudis the money it needed to spend to stop unemployment rising because of the reduction in demand caused by the increased cost of oil imports.

However, the Saudis wanted somewhere safe to put their new found wealth.  The US and the Saudis appear to have done some sort of deal in 1972 that if the Saudis only accepted payment in US $ for oil exports then the US would guarantee to create sufficient interest paying US bonds that the Saudis could buy.  That would be a great deal for the Saudis.  They were allowed to exchange their dollars for a riskless interest earning asset.

Why did the US enter into such an agreement?  Most certainly not because it ‘needed the dollars’.  Since the US state is the monopoly issuer of dollars, it does not need to borrow dollars from another state.  It promised to issue US bonds that would allow the Saudis to put their surplus income in riskless interest earning assets so that it could bind the Saudis tightly into the US financial system.  

Being bound into the US financial system has huge advantages.  You can use the system to buy and sell things anywhere in the world.  In the remotest regions of the world, you can use your debit or credit card to buy things.

However, if the US chooses to sanction a country then the financial system becomes a choke point to prevent and discourage other countries from trading with the sanctioned country.  The US has been sanctioning Venezuela for over 10 years.  That meant that no company that normally used the US financial system could use that system to engage in trade with Venezuela.  No such company could use the system to buy oil from Venezuela or help in the production of Venezuelan oil.  However in recent years China has been engaged in buying oil from Venezuela with Chinese Yuan.  And Venezuela has been buying products from any country that would accept Yuan in payment. 

Trump decided that a clear message needed to be sent out that no such undermining of American sanctions could be tolerated particularly if that undermining was being carried out by China, its peer competitor.  That was the main reason for his recent intervention in Venezuela.  That could not of course be openly stated so it was sold as a venture to end drug smuggling into the US and to gain access to Venezuela’s large but uneconomic, at today’s prices, oil reserves.  It is unclear how it will play out.

What’s important about the petrodollar system is not the actual amount of dollars.  What is important is the fact that it binds oil exporting countries into the US financial system.  

By insisting that oil—the most important traded commodity in the world—is priced and settled in dollars, the US ensures that virtually every country must interact with the dollar-based financial system simply to meet its basic energy needs. This creates a constant global demand for dollars and, more importantly, for access to US-regulated payment, clearing, and settlement infrastructure. The key point is not the currency itself, but the plumbing through which dollar transactions flow.

In this way the petrodollar system significantly enhances the ability of the United States to undermine political regimes it dislikes through sanctions, because it concentrates global trade, finance, and liquidity management within institutions that the US controls or heavily influences.