The Price of Oil and the Value of the US Dollar

[Exsubmariner]

Some thoughts about relationships. Another post that may quasi fit in politics.

There are two oil bourses in the world. One is in New York and the other in London. They both trade oil in dollars. This means that in order to buy oil on the world market, your country needs dollars. That means they have to trade either directly or indirectly with the US for dollars.

The US federal reserve bank has the window wide open 24 hours a day to the federal government. Any time the US government wants to sell a bond, the Federal reserve is happy to buy it. Then, the federal reserve counts the value of the bond they have just bought from the federal government as an asset and immediately lends against it. Because of the rules of fractional reserve banking, they can only lend out something like 80%. Lets imagine they lend the money to five other banks. Those five other banks can then lend out 80% of their deposits immediately to other banks who can in turn lend out 80%. The net result is that for every $1 in federal bonds that the federal reserve buys, something like $5 of money goes out into the economy in the form of loans. This is called the multiplication effect. It has the result of putting ever more currency in ciruclation which in turn drives the value of that currency down.

Now we come to the meat of the post. If the only commodity that the dollar was pegged to was oil, and there are lots of cheap dollars floating around, wouldn't it be in the interest of the Government to set policies which would keep the price of oil high therefore increasing demand for dollars and artificially inflating it's value relative to other currencies. In effect, exporting inflation?

Thoughts/discussions?

[Borodog]

Yes. Although your numbers are overly optimistic. The actual reserve rate fluctates at around 1%.

[tomdemaine]

There's government and there are politicians and what is in the interests of one is usually against the interests of the other. See yes minister.

[bobman0330]

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Yes. Although your numbers are overly optimistic. The actual reserve rate fluctates at around 1%.

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Cite please?

[Borodog]

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Yes. Although your numbers are overly optimistic. The actual reserve rate fluctates at around 1%.

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Cite please?

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Personal communication; an economist friend of mine. I'll see if I can't get him to cough up a citation.

[morphball]

There are too many dollars being bought and sold on the markets for oil to impact the demand. Also, keep in mind that Washington wants a cheap dollar to close the trade deficit.

[Exsubmariner]

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There are too many dollars being bought and sold on the markets for oil to impact the demand. Also, keep in mind that Washington wants a cheap dollar to close the trade deficit.

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Cheap dollars to close the trade deficit equals inflation. The precise reason for the high demand for dollars is that you need them to buy oil.

[hmkpoker]

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Cheap dollars to close the trade deficit equals inflation.

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I have given lots of money to McDonald's through trade, but McDonald's has not given me any money back. Clearly there is a trade deficit, and McDonald's should buy whatever I'm selling. Right?

[morphball]

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There are too many dollars being bought and sold on the markets for oil to impact the demand. Also, keep in mind that Washington wants a cheap dollar to close the trade deficit.

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Cheap dollars to close the trade deficit equals inflation. The precise reason for the high demand for dollars is that you need them to buy oil.

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Yes and no. Cheap dollars means something from Europe or Japan costs more for US consumers, which can be seem like inflation to consumers of foriegn goods, but something from the US costs Japanese and Europeans less, which increases demand for US goods. This will increase the purchasing power for domestic producers, who have been paid in more valuable Euros or yen. The inflation you are speaking of is highly dependent on your point of view. If you shop at Walmart, you'll say "wow things are getting expenisive," if you work for say, a GM plant that sells to Europe, you'll say, "wow I am swimming in money."

Cheap dollars also reduces the return a European can expect in dollar denominated assets, which lowers demand and hence the price for such assets. So, if you want to buy IBM or Microsoft, you'll say, "wow this is a good deal."

A cheap dollar means, the trade gap will close and dollar denominated assets will shift to do domestic holders. In fact, one can argue the current trade problems are caused by an artificially high dollar, and he would be right. Because Uncle Sam runs a continual deficit, there is always someone willing to buy dollars--i.e., Uncle Sam. Without Uncle Sam's prolific deficit, the demand for dollars for only come from people receiving Yen or Euros for their goods or returns on capital who need to convert them to dollars so they can be spent here.

[Borodog]

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There are too many dollars being bought and sold on the markets for oil to impact the demand.

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You keep saying this.

Prove it.

[morphball]

I assume many on this Board, as are others on the conspiracy boards, are giving too much credence to Ron Paul's little speech

Boneheads, Iraq and the Artificial Dollar (http://www.safehaven.com/showarticle.cfm?id=720&pv=1)

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First, let's look at his first thesis: if OPEC began to sell oil for euros, it would doom the dollar and be a catastrophe for the US: "The USA could collapse economically."





You could make a case that in 1971 the oil for dollars deal was good for the US, but it was not some conspiracy or "deal." At the time, there was no other major currency with enough scope and supply to function as a major trading currency. The euro did not exist. The German mark and British pound did not simply have the supply of currency necessary without stretching the currency markets.





That was a period in which central banks had some measure of short and medium term control over the valuation of their currencies. By working together, they could establish a price range between currencies.






Then came 1992. The foreign currency markets had grown dramatically, and central banks were struggling to control their currencies. George Soros and the legions of traders who were investing/betting in the currency markets decided the pound, among other currencies, was over-valued, and were shorting the British pound.





Legend has it that a reporter came to him and asked him what he was going to do because the Bank of England was going to spend $30 billion pounds defending the value of the British pound. Supposedly his answer was, "What are they going to do in the 30 minutes after that?" $30 billion pounds was about 30 minutes of trading on the currency exchanges at that time.








..........







Today, Chuck Butler, currency trader at Everbank tells me the world currency markets trade $1.2 trillion a day. That is almost one half a quadrillion dollars a year. To provide some perspective, the entire US economy is "only" $12 trillion or so.





The total value of oil trades a day is a drop in the bucket compared to the currency markets. If OPEC wanted to be in euros all they have to do is convert to euros. You could price oil in terms of any currency, but those who sell must do something with the dollars or yen or yuan or pesos they get. After the money is in an OPEC bank account, they can do anything they want with it.





If OPEC decided they wanted to price oil in euros, it would make no difference to the US price in dollars. It is supply and demand, and currencies are extremely liquid.





Heard writes "If other nations have to hoard dollars to buy oil, then they want to use that hoard for other trading too." In light of the liquidity in the currency markets, this is a stupid statement. You could "hoard" any major currency (yen, pesos, euros, pounds, won, renminbi, etc.) and when you want to convert it into dollars to buy oil you can do so instantly and with almost no transaction cost. A country or business will keep its reserves in whatever currency it thinks is the best at the time and then convert for the sale. There is no "hoarding" of dollars, unless that is the currency the various central banks or businesses want to use.





As an example, let's look at gold. Gold is in a great bull market, right? On July 1, 2001 gold was 265, and today it is around $330. That is a $65 rise for about a 25% gain.





On that same day, the euro was $.8378 and today the euro is $1.07. The euro has risen almost 30%. Which is the bigger bull market?





Furthermore, if you live in Europe, there has been no gold bull market since July, 2001. Gold, in terms of euros, is actually down slightly, depending on what day you look at gold and currency prices. On July 1, 2001 you got 316 euros when you sold an ounce of gold. Today you only get 299 (at $1.07).





The same applies to oil. In the US, we have watched as oil prices go through the roof. Depending on what period you use, oil is up only slightly in Europe. Is that because OPEC loves the French? Of course not. It is entirely because the dollar has dropped against the euro.





If oil were priced in euros, the results would not be any different. The price would have risen in the US and been almost flat in Europe. The reasons for the drop in the dollar have nothing to do with Iraq or oil. We will discuss the real reasons a bit later.





Look at it this way: there is x amount of oil available for sale on any given day. It will go to the highest bidder. If someone from Europe wants to buy oil, in reality he is paying in euros. The conversion to dollars is transparent to him. In large amounts, it costs almost nothing to convert to dollars or pounds or any currency. Oil is no different than wheat or sugar or any other commodity. It is supply and demand that determines the price, and the currency used for the transaction has nothing to do with it, as long as it is liquid.





To claim, as Geoffrey Heard does, that the dollar would drop because of oil being priced in euros is absurd and shows a complete lack of understanding of how the currency markets work.





Further, to suggest that "If America invades Iraq and takes over, it will hurl the EU and its euro back into the sea" is equally absurd. What if America decided to invade Australia to take over its wheat crop? Would that hurl Canada and its dollar into the sea?





Heard's thesis is based upon the presumption that the US wants to maintain a strong dollar, when in fact the clear leaning, if not actual private preference, at both the Treasury Department and the Federal Reserve is to allow the dollar to drop. While the Bush administration gives lip service to a strong dollar, they have also made it clear that they do not intend to intervene to support it. "Let the market work" is the mantra. A falling dollar helps the Fed control deflation.





A gradually falling dollar works to our benefit by making our products cheaper on the world markets. It allows US producers to compete with foreign companies for the American consumer dollar. It helps stem the deflationary tide. And it helps lower the trade deficit, as it makes imports more costly and helps our exports.





Further, Heard's thesis assumes the US is capable of controlling the value of a dollar. It is not. The world currency markets are far bigger than the US Federal Reserve. The only unilateral power a central bank has is the ability to destroy its currency by printing too much of it.



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[Exsubmariner]

Morphball,
Thanks for posting that link. I didn't get around to reading the whole thing until today. Wow, that really shifts the focus. I was really hung up on the actions of the Fed (spoken Dollar Cartel). But it is clear that they can only do so much in face of world trade. I did not realize the scale of the currency markets.

In a way, this kind of makes me more paranoid as a big way to help the US currency would be to seek to inhibit or influence foriegn trade between other nations, if that makes any sense. But it is plain that the central banks can only buck a trend for so long.