THE BLOG
03/18/2010 05:12 am ET Updated May 25, 2011

Bidding the Dollar Adieu

The new favorite attire for revolutionaries now appears to be pin-striped suits, wing-tipped shoes, and green eyeshades. Yes, green eyeshades -- the headgear once favored by accountants, auditors, bank managers and economists. A case in point, Robert Zoellick -- the current World Bank President -- told an audience last week, "The United States would be mistaken to take for granted the dollar's place as the world's predominant reserve currency." While Zoellick's statement was likely spurred by ongoing efforts to reform the International Monetary Fund, recent developments suggest the World Bank President was closer to the mark than he probably suspected.

On October 6, 2009, the Independent, a left-leaning British newspaper, published an article that declared "Gulf Arabs are planning -- along with China, Russia, Japan and France -- to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen, Chinese yuan, the euro, gold, and a new, unified currency planned for nations in the Gulf Cooperation Council." According to the Independent, finance ministers and central bank governors from Brazil, China, Japan and Russia have been holding secret meetings to implement this plan by 2018.

The newspaper goes on to argue American officials are aware of the meetings, but have not been read in on the details. Not that it seems to matter. Chinese financial sources who spoke with the Independent said they believe President Obama is too preoccupied with the U.S. economy to focus on the "extraordinary implications" of the possible transition from the dollar less than a decade from now. Chinese bankers, however, do seem to understand what is about to happen, as one told the Independent, "These plans will change the face of international financial transactions. America and Britain must be very worried. You will know how worried by the thunder of denials this news will generate."

Interestingly, the initial thunder did not come from Washington. Instead Kuwait, Saudi Arabia and Russia rushed to comment on the report. In all three cases high-ranking officials denied plans to move away from the dollar. I, for one, am not reassured by these immediate protests to the contrary. Given the size of Kuwaiti, Russian and Saudi Arabian dollar holdings they are well advised to downplay stories that serve to further erode international confidence in our ever-weakening currency. The same is true of the Chinese and many other Gulf states. But all that can change with the passage of time.

Why would this collection of unlikely partners propose such a deal? I suspect it is because the current dollar-based trading arrangement compels them to subsidize Washington's fiscal mismanagement -- or should that be fiscal incompetence? Allow me to explain.

The existing dollar-based oil trading system is a historical legacy. As the oil industry was largely born and raised in Texas, the trading system was logically conducted in nickels, dimes, and dollars. The original Bretton Woods agreement served to verify the wisdom of this decision, but as we know then-President Nixon pulled the wheels off that bus in 1971. Nonetheless, the oil trade remained dollarized -- much to our advantage.

By compelling oil producers to conduct their trade in dollars we ensure a steady demand for our currency -- oil importers must hold enough dollars to make large, recurring purchases of the black gold -- and win ready customers for our Treasury notes and other domestic investment options as petro-states seek to recycle their earnings in the safest, simplest way possible. (Cycling petrodollars directly back into the U.S. economy eliminates currency risk.) Here's the rub, China, Russia and many Gulf States now have large dollar reserves--and they are increasingly concerned about the value of those holdings.

Washington's efforts to alleviate the current economic crisis by monetizing our debt and throwing money at failing industries is proving deeply disturbing for our former benefactors. In fact, they would now like to diversify their foreign exchange reserves in a manner that reduces losses before the dollar is only useful when hauled to the grocery store in wheelbarrows. As such, the push to move the oil trade from dollars should not come as a surprise to Washington, even if we have not been invited to the meetings concerning this decision.

Can the apparently guilty parties pull this off by 2018? That depends on who you ask. Some analysts contend the current market structure -- essentially monopolized by the New York Mercantile Exchange -- rules against such a development. Others contend the fact that China's yuan and many Gulf currencies are not fully convertible will slow the process. However, there are also signs that change is afoot. In 2000 Iraq declared it would only sell oil in euros, and in September 2009 Iran announced a similar plan.

I have to admit it will be interesting to see how Washington reacts to this news. Neither I nor many informed investors are betting on a sudden bout of fiscal responsibility. The continuing climb in gold prices -- we are now at record levels -- suggests investors are running in fear of impending inflation. As it turns out, gold prices have a historical record of forecasting inflation. This happened in 1980 and seems likely to occur again in 2010. It seems Washington can't run record debt and deficit levels indefinitely without suffering the consequences. We now have a significant indicator of major investor distrust on our hands. How many more signals will have to be sent before Washington becomes serious about fixing the problem?