Wednesday, December 15

Faustian Bargain

"Dear Pundita:
I didn't know Saddam Hussein started a currency war against this country until I read your Fool's Gold post. I'm confused. If the petrocurrency war was quixotic at best, as you wrote, why did he launch the war? Was it just because he's crazy?"

Dear Confused:
It was not so much a war against the US as against the Saudi retrogrades at OPEC. They're called the retrogrades because by 1999, just about every other OPEC country wanted to abandon the petrodollar and replace it with the petroeuro. A powerful faction among the Saudi rulers was the holdout and the faction held sway at OPEC.

At first glance the push at OPEC to switch to euros seems premature. So I need to review some history. Certain members of the EU (notably Germany and France) wanted the euro to replace the dollar as the world's reserve currency. For this to happen, OPEC would have to officially agree to demand payment in euros, instead of dollars.

The impetus for such an agreement began to build even before 1991 but it snowballed after the EBRD was formed in 1991. The EBRD (European Bank for Reconstruction and Development) was formed by West European governments to write project loans exclusively to NIS (newly independent states of the Soviet Union, now called FSU -- former Soviet Union countries).

Meanwhile, every Western commercial bank on the planet had petroleum drilling engineers in West African nations. And NIS countries were set on modernizing and expanding oil production and exploration.

OPEC looked at the writing on the wall, which appeared a few years before the EBRD was official. The Middle East, and particularly Saudi Arabia, would remain king of oil supplies, but competition from other places meant that OPEC would be greatly weakened. If OPEC was to survive the new millennium, and survive as the price-setter for petroleum, this meant persuading the US or the EU to subsidize OPEC's continued existence.

However, the US government liked the idea of more competition between oil-producing countries. The Germany-France-Belgium club liked the idea of the euro as the world's reserve currency; for that to happen, OPEC oil would need to be re-priced in euros.

There were two obstacles. One was the British populace, who were still watching reruns of those bastions of British post-WW2 xenophobia, Fawlty Towers, Monty Python, and Are You Being Served? There was a growing segment among the populace that didn't like being greatly integrated with the EU. That segment wanted to keep the British pound instead of adopting the euro.

The other snag was the Saudi retrogrades who held sway at OPEC. The retrogrades pointed out that petroleum is not soybeans. So, if you switch to accepting euro payments, that means you're expecting the Eurozone army and their navy of rubber duckies to come to your rescue, if someone tries to walk off with your oil wells or overthrow your government.

The Saudis were aware of the petrodollar downsides, which had become increasingly evident over the decades. However, they questioned whether simply replacing the dollar with the euro was the best way to overhaul The Casino (the international monetary system). Perhaps a basket of currencies, to include the EU and US dollar (USD), was the way to go. This idea could not go forward until all the nations in the EU trading bloc agreed to adopt the euro. So, the Saudis argued for a wait-and-see approach.

Not everyone could afford to be patient, and least of all the large building contractors in the Islamic world. They knew that if OPEC tanked, they would have a hard time keeping their companies big enough to win big contracts in the New Europe and NIS. Those contractors had already built up every square inch of the Islamic countries with mosques. They didn't want to see mosques stamped "Made in Germany" going up in former Soviet countries.

So those building contractors were hyperfocused on the threat of competition from EU contractors, who would make a mint from EBRD project loans. The Islamic contractors knew they could still cut deals on World Bank project loans that would be made to NIS (as soon as the Soviet Union dissolved), but they feared they'd be shut out of bidding for EBRD projects. No amount of words can convey the import of this fear unless you are steeped in the world of building contractors.

To summarize to this point, by the late 1980s, building contractors in the Islamic countries were staring at the prospect of going belly up if OPEC didn't put its weight behind the euro. But the retrograde camp among the Saudis, who ruled at OPEC, stubbornly refused to give up on the US dollar.

By interesting coincidence, just around that time the guardians of Wahabism in Saudi Arabia took a very strident turn. The clerics began biting the hands of those Saudi princes who fed them, and who just happened to be among the retrograde camp.

And as coincidence would have it, the Global Islamic Terrorist Bogeyman also materialized around the same time. The Bogeyman declared a jihad against Christianity, the modern world, the West, America, and too much starch in shirts.

Thus, consensus began to build in West Europe that all things considered, it might be wise to subsidize the continued existence of OPEC and hurry up and get the euro adopted as the EU currency. But a large segment of the British populace still hung tough against adopting the euro. And the Saudi retrogrades refused to budge.

So, the ante needed to be upped. Thus, Saddam Hussein's petrocurrency war. By amazing coincidence, the euro climbed 17% against the dollar not long after Saddam began demanding euro payments for his oil. This meant Saddam made a killing on his oil deals in euros. This caused Iran and all the other OPEC members to say to the Saudi retrogrades, 'See? See?' Kim Jong-il chimed in, 'See? See?' but he was thrown out of the OPEC lunch meeting after his waiter's disguise was unmasked.

All this is why cynics who have been following the petrocurrency war believe the real Bush national security doctrine reads, 'Nobody re-prices oil in euros, nobody gets bombed.'

The cynics overlook that Bush was raised as a member of the ruling class. That means he understands how the world works without having to study books on the subject or read newspapers. Bush knew that Saddam's petrocurrency war risked pumping up the euro too soon against the dollar; that would backfire on EU zone exporters. Thus, the quixotic aspect of Saddam's petrocurrency war.

Also, Bush knew that the pressure to re-price oil in euros was just another sign that a sea change was building. The Casino needs overhaul. The international monetary system is the linchpin of global trade, not to mention the keystone of modern civilization. Despite the fact that the dollar is the key ingredient, the US will have limited say in how the new monetary system, whenever it gets off the ground, will work out in practice. The best any US president can do is blow on the dice and steer this country through another hairy night at The Casino.

If the Lords of the Craps Table don't screw up terribly, many of the world's current economic problems will vanish after The Casino is renovated. However, macroeconomics being what is, we must steel ourselves for screw-ups.

I should stop at this point and identify for Confused reader The Lords of the Craps Table. They are World Bank and IMF governors, the Bank for International Settlements (central bankers acting in concert to manage The Casino), central bankers in the G club (major trading nations), heads of major transnational commercial banks (Citibank and various Swiss banks, for example) and currency traders and economists who labor for major OPEC producers.

Which lord has the greatest power? The Federal Reserve board, of course. We are the world's lone superpower nation, after all. Americans need to remember this when reading headlines that scream, 'X country set to dump US debt instruments!'

Saddam Hussein and his buddies at the EU didn't exactly overlook America's clout. However, they assumed that another hayseed would be elected US president. When they discovered that a member of the ruling class had been ushered into the White House they knew the plan to make the euro the world's reserve currency had hit a snag.

Just to rub it in, Bush asked Chirac to hold his bag of pretzels when he elbowed his way to the craps table to blow on the dice. Gossip has it that's the real reason Chirac dislikes the 43rd President of the United States.

How will the craps game play out? As of last year, the consensus was leaning toward a 'trading band' composed of the euro and the USD and maybe the SDR thrown in. What would that band do to OPEC? Hard to predict; too many variables and unknowns to consider.

However, one thing that's certain is that change always causes dislocations until a new system shakes out. Change in this case would mean a rough patch for the USA. This is because ever since Japan and South Korea walked off with much of the US manufacturing sector, the biggest US export industry has been US dollars, although much of the exporting is in the form of electronic transfers. Americans are not clearly aware of the dollar export industry, unless they remember the front-page stories of the late 60s and early 70s. So let's do a quick review:

The US government went broke funding domestic programs in combination with fighting the Cold War, which included the Vietnam campaign. Instead of cutting back on the mega-spending, the US began printing dollars in massive amounts. That created an international run on the US gold supply, which backed up the dollar.

So, the US government faced a choice: start practicing fiscal responsibility, or de-link the dollar from gold. The government chose the latter. That left the dollar with no backing except the productivity of the American worker. Thus, Americans learned the hard way that the sweat of our brows was not enough to persuade the world's central bankers outside the US to keep the dollar as their reserve currency. The bankers wanted to see the dollar backed by something more tangible; if not, they were going to dump the greenback in favor of the Swiss franc or something.

So, to prevent the US government and international financial system from collapsing, the US struck a Faustian bargain with Saudi Arabia. Although OPEC oil was already priced in USD, the Saudis agreed to hold the line against all challenges from within OPEC to the payment system.

Once it was official that OPEC would only accept payment in USD, this calmed those worked in The Casino, who were alarmed after Nixon ended the Bretton Woods agreement that currency floats would inject too much uncertainty into global financial markets.

The stabilization of the oil pricing mechanism gave assurance that despite America's profligate defict spending the US dollar would continue as the world's reserve currency. Thus, stability returned to financial markets and gave rise to what's been termed the petrodollar.

The 'new' international monetary system meant that central bank currency traders could use the price of OPEC oil as their benchmark. So one needs to see the bright side of an oil cartel. The fact that OPEC is a cartel, and can fix the price for a critically important commodity, brings a stable component to the international monetary system -- indeed, it is the linchpin of the system.

The downside is that the system artificially controls the price of oil instead of allowing the market to hold sway. Another downside is that the system set the developing world on a dollar chase that their governments could not afford.

The "world's reserve currency" means that virtually all major imports, not only petroleum, are priced in USD. Second and third-tier countries can't use their funny money to pay companies such Bechtel to build a city or subway system for them. First they have to buy tons of US dollars -- or to be more precise, their currency payments are much higher, when converted to USD.

That's why Gorbachev had no choice but to dissolve the Soviet Union. As early as 1989, the Bundesbank was running a pool at The Casino on whether Gorbachev would have to read the dissolution speech by candlelight. Russia needed huge infusions of USD because the government couldn't buy much-needed materials without first buying or bartering for dollars. The only way Gorbachev could get the infusions was by dissolving the union so that the World Bank would start writing project loans to Russia to beat the band. World Bank loans are made in USD, of course.

The World Bank's dollar loans would be a drop in the bucket against what Gorbachev needed, but the Bank was (still is) the lead ship for the big international commercial banks. This returns me to the subject of building projects.

Once the commercial banks see the World Bank commit to a country, this is a sign that the country has reached a certain level of political stability. (Translation: The country's military won't cart off all the heavy equipment from the project sites and resell it along the Silk Route.) So then it's worthwhile for the commercial banks to underwrite projects in that country. All of which are denominated in US dollars.

Do not ask whether Islamic terrorists understand how the World Bank works. Everyone on earth except Americans understands how the Bank works. But if you must ask, the EBRD is a RDB (regional development bank), as versus an MDB (multilateral development bank) such as the World Bank. The word on the EBRD, years before it was formed, was that bin Laden and his crowd -- here I'm speaking of Islamic building contractors -- would be shut out of the building projects gold rush in the NIS.

Before you feel sorry for Islamic building contractors, they have their own RDB -- the Islamic Development Bank, which makes project loans exclusively to Islamic countries. During the Soviet Union era, the Muslim-country contractors had a steady infusion of projects generated by Islamic commercial banks that follow in the wake of the IDB. But the Muslim building contractors were running out of space to put up mosques, unless they moved into NIS countries.

I interject that someday, a building materials procurement specialist will write a history of the world. Then innumerable mysteries will be solved. While we're waiting for illumination, and if you want to know what's really going on in the world, don't watch the news feeds or the financial pages. Watch the bids on large-scale building contracts.

If you see a certain group of contractors consistently shut out the bidding, you can set your clock by what happens next. On goes the war paint. Welcome to The Revolution. The contractors hire The Natives to stage a revolution that will beat the war drums until development and commercial banks roll over and dole out more building contracts.

To return to The Casino, the dollar chase put governments and building contractors on a merry-go-round that kept going faster and faster. This was a recipe for disaster in Asia, where the banks lived to make bad loans to businesses. The contraption finally exploded with the Asian banking crisis. That's when the Lords of the Craps Table knew they had to renovate The Casino. They've been piddling around ever since with the project.

But even before the Asian crisis, governments in the developing world were driven to or near ruin in their chase to buy USD so they could purchase OPEC oil. This created a big black market in OPEC oil. The official oil price became a Disneyland figure, as individual OPEC members cut deals on the side. For example, Venezuela began accepting payment for their oil in barter when a government purchaser was too broke to cough up USD. Also, if the currency could be traded up, OPEC members started accepting any currency in payment from the poorer nations.

Of course all this discounting and barter is unofficial. OPEC can't mess too much with the official price of oil, if they don't want to crash the price of the dollar and thus, bring down The Casino.

At first glance, all this seems a good deal for the United States because we have a captive market for dollars. It is a good deal, but it's not called a Faustian bargain for nothing.

The problem with petrodollars is that the USD became a critical commodity. So, the US had to create large quantities of dollars. Again, this was so countries could purchase dollars to purchase petroleum and other big-ticket imports. If other US commodity exports are strong, and the manufacturing export sector is strong, large amounts of dollars sloshing around The Casino is not a problem. But after the US manufacturing sector became weak, the US became increasingly dependent on the dollar export industry. This meant the US became increasingly vulnerable.

Now you know why President Bush remains on speaking terms with some Saudis despite many questions about Saudi funding of Islamic terrorist organizations. The Saudis Bush has on speed-dial are the retrogrades, who aren't really retrogrades; they are realists.

The realists know the only way to return stability to the international monetary system would be if governments returned to the gold standard. That will happen when the cows come home because gold-backed currency would mean that all national governments would have to practice fiscal responsibility. This is unless they wanted to see a run on their gold supply by other governments. Realists know that governments and fiscal responsibility rarely mix. However, the petrodollar is hideously expensive. Yet switching from petrodollars to petroeuros would not solve the underlying problem.

So the question is, what do you replace the USD with, if not gold? And if you want a trading band of the euro/dollar, what backs up that band? Would it be your faith that the American and EU economies won't suffer severe downturns?

There are many other vexing questions when considering how to renovate The Casino. It's all very well to say, 'Dismantle OPEC and get rid of petrodollars.' Replace them with what? Trying to find the answer is the work of macroeconomists who labor for large universities, The Lords of the Craps Table, and cabinets in major trading nations. But it's also a dice game because the mathematical models can't predict every surprise. So maybe the Saudi retrogrades are right. If you don't know for certain what you're doing, just leave the dang thing alone if you don't want to crash The Casino. But then, maybe The Casino will crash if it isn't renovated.

In short, it's all very complex, and even the experts have no idea how a renovation will pan out. Big-ticket building contractors don't like that much complexity and uncertainty. They just want to survive and unlike companies that pump petroleum, they have to be very adaptable.

As to how long we've got before The Casino might collapse if it's not renovated -- I don't know and I don't think anyone knows; too many variables to consider. I do know that within 72 hours of the 9/11 attack, the EU pumped $40 billion into the US financial markets. That's all that prevented the US stock market from going into freefall. The rescue was a cooperative effort between the Bank of London and the European Central Bank. The rescue was a reminder of the strength of the NATO alliance. Yet it also served as a demonstration of the growing power and integration of the EU and America's growing economic vulnerability.

The USA has been skating on the edge for a long time; the dotcom bubble did nothing to skate us back from the edge. The 9/11 attack, the US response and the Enron-type scandals continued to divert our attention from the reality that time is running out on our Faustian bargain.

I'm not sure whether all the above does anything to resolve Confused reader's confusion. But Confused should consider that behind all the charts, graphs, mathematical models and supercomputers, The Casino is just a bunch of people. The bunch recognizes that global trade has gotten too interconnected to let the whole shebang crash.

We'll struggle through the sea change somehow. However, we would be wise to struggle through while we have a member of the ruling class in the White House because when it comes to any game at The Casino it's hard to catch Bush napping. But Bush also has the war on the terror to oversee, so the Lords of the Craps Table might just have to rely on duct tape and prayer a while longer.

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