Note in response to questions arising from the ‘Disorder Afterwards’ Listener Column of 19 April, 2003
Keywords: Globalisation & Trade; Macroeconomics & Money;
In the past few weeks I have been asked by a number of people about published opinions that argue the US is invading Iraq in order to get access to its oil, and to strengthen the role of the US dollar, it being noted that a few years ago Iraq decided to settle its oil deals would be transacted in euros.
While such articles appear convincing, I have read other equally compelling articles which argue that the US has invaded Iraq for quite different reasons: it is tied up with Israel; it is a fundamentalist Christian attack on Moslems; confused US domestic political pressures are blindly lashing out at terrorism; the US military wants to demonstrate its might; US business wants the contracts for reconstruction; George W. Bush is settling the humiliation that his father received in 1991 by not successfully conquering Iraq; and so on. Strangely, none argues the invasion has anything to do with Iraq’s alleged cache of weapons of mass destruction.
The fact of the matter is that the US government has not made it clear why it is invading Iraq, and I shall not be surprised if future historians conclude it did not have a clear objective. Perhaps the answer is ‘all of the above’.
So how important is the oil-dollar dimension? As I argued in Rhetoric and Iraq, Iraq’s oil – they have the second largest reserves in the world – is important to world prosperity, but it is a high risk gamble to unlock via an invasion, because it is likely to destabilise the Arab World, and hence the whole of the Middle East supply. At the time of writing, in mid-April 2003, the danger of destabilisation remains real. Even so, it is possible that a significant factor in US thinking has been Iraq oil. Only time will tell if they have got it right.
But what about the US dollar? That is the point of my Listenercolumn of 19 April, written three weeks earlier. The US dollar is the currency of international preference, so it is not surprising that oil – which makes up a quarter of the world’s exports – are traded in it, especially as the US is the world’s largest importer. (As I write this, it occurs to me the countries of European Monetary Union may be – or may soon be – a larger importer. We tend to collect data by individual European countries, so the comparison is not readily available. If this conjecture is true, than it reinforces what I say below.)
There are three functions of money, each of which may – or may not – have a role in the oil market. The first and simplest is that money is a standard of account. This functions occurs when the price of oil is set in US dollars. It may add to the prestige of the US, but it is little advantage to the US economy, since the trade price could be in US dollars, but the settlement could be in Euros.
The second function of money is the medium of exchange, which occurs when the oil is exchanged for currency. US dollars are the most common international medium because the dollar is the currency of international preference. This may result in a small gain of ‘seigniorage’ to the US government, as when a traveller holds US dollar notes, is in effect lending purchasing power to the US Treasury without it paying any interest. It is not in the interests of oil traders to forgo interest, so any cash they hold is quickly turned into interest paying assets (e.g. Treasury bills), so the seigniorage benefits to the US government from using US dollars to trade in oil are likely to be small.
The third function is a ‘store of value’, which includes holding dollar notes because they are valuable (the holder may think the alternative currency is going to depreciate in value), but the notion might be extended to a preference to hold dollar denominated financial assets (some of which will be liquid enough to, in effect, be a medium of exchange). There has been a tendency for the world to hold a high proportion of dollar denominated assets in its balance sheet. As a result it seems likely that US interest rates are slightly lower, and this may be of considerable value to the US Treasury. (Even so, the column argues that the US government interest rate will rise as its debt increases, in order to attract more holders of it bonds.)
When an international actor chooses to settle in US dollars, or hold its balances and investment funds in US dollar denominated currencies, it does so because the US economy is, and for over fifty years has been, the most powerful in the world. It is an advantage to the US to have its dollar used as the international trading and investing currency, but that is not the main reason why it is a strong economy.
The column argues that there may be along term movement towards also using the euro as an currency of international preference, reflecting the growing strength of the European Monetary Union. That might mean that more prices being set in euros, more trading deals using euros in the excahnge, and more euro denominated assets in balance sheets (especially if US fiscal management is seen as incautious).
On the whole, the column discounts that the Iraq war will influence this trend much – one way or another (although, on reflection, it occurs to me that it may speed up the Arab countries’ greater use of the euro).
But even were the world to switch entirely over to the euro as the currency of international preference, US banks would remain active and important (just as today British, French and German banks are important in a US dollar world). However the US Treasury would lose some seigniorage and have to pay higher interest on its debt. So the US would be a little worse off, and no doubt would feel it had lost some prestige.
It is possible that the oil-dollar nexus is the primary reason for the US invasion, but if so it is surely based on miscalculation – the same misunderstanding of the effect of the three functions of money that are also made by the articles that argue that the nexus is the reason for the invasion.