How the "Nixon Shock" Brought us the Petrodollar and Changed the World
On August 15, 1971, President Richard Nixon shocked the world when he killed the international gold standard. It was a time of global instability, fueled by the Vietnam War. Foreign nations were starting to challenge the gold holdings that supposedly backed every US dollar. President Nixon knew the US had run up so much debt that it couldn't pay any of it off with the yellow metal in the event that the US was asked for that kind of payment. He knew it would be disastrous if other countries panicked and started, en masse, a kind of bank run on the US Treasury, which seemed inevitable if the country stayed on the gold standard. So he addressed the nation -- his speech came to be known as "The Nixon Shock" -- and announced that the dollar was no longer backed by gold.
In retrospect, it would have been the perfect time for America to recognize that we needed to get our fiscal house in order, that we were spending ever more than we actually had. But that never happened. Rather, the dollar was established as a "fiat currency,". i.e. a currency whose value is based solely on the world's faith in the sponsoring government. As a result, the US continued printing dollars, no longer with any restrictions in the form of gold requirements.
Billions were needed to pay for the ever-expanding war in Southeast Asia. And that was on top of ballooning costs from Lyndon Johnson's "Great Society" government expansion. Sure enough, with freshly printed dollars flooding the markets, Nixon began to worry about the weakening of the dollar. So, love him or hate him, Nixon and his staff came up with what most agree was a brilliant way to (temporarily) sidestep the problem.
Nixon's secretary of state, Henry Kissinger, made a "Faustian deal" with Saudi Arabia's royal family, represented by King Faisal. It was a deal that would dramatically impact the global economy for the next 42-plus years. Essentially, they agreed to replace America's gold-backed dollars with oil-backed dollars.
Best of all, the backing would not even be oil that the US owned! And in March of 1973, the plot was put into effect with this promise: Kissinger and Nixon offered military protection for Saudi Arabia's oil fields from any enemy (the most likely candidate being the Soviet Union). In return, Saudi Arabia would price all of its future oil sales in US dollars only, and would then invest those US dollars in US Treasury bonds. It was a win-win by all appearances. Saudi Arabia would provide plentiful oil to its biggest customer (the USA). America would protect Saudi borders. And in exchange, the Saudis would prop up the US dollar by buying mucho Treasury bonds.
The Saudis readily agreed to the arrangement, and the "petrodollar" -- the oil-backed dollar -- was born. And by 1975, all the members of OPEC had joined the petrodollar system. That included Iran, Iraq, Kuwait and Venezuela, plus Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria and Ecuador. Therefore, pretty much anyone buying oil anywhere in the world, now had to pay for that oil with US dollars. This established the US dollar as the de facto reserve currency of the world, and instantly handed America three huge financial benefits.
First, it increased demand for the dollar, thereby boosting the dollar's value all around the world. This rising tide in turn lifted the value of all kinds of America's in-house assets, i.e. housing, businesses, and stocks. And it not only gave the country a feel-good sense of prosperity (albeit an impermanent one, as you'll see), but it also provided a big advantage in international trade.
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