Inflation and the Petrodollar Buffer

For most people, economics is that subject toughest to understand and explain. For most economists, it’s the subject toughest to understand and explain, as well. Economists are wrong frequently because there are almost a limitless number of factors that may result from a change in economic activity. Most economists take a “static” approach, making observations and predictions as though an action taken by one individual or industry does not impact multiple other aspects of the economy.

Inflation is one of those subjects that is difficult to explain and all the more difficult to predict. The popular understanding of inflation is that it is the rise in prices, but this is not necessarily accurate. Besides inflation, price pressures include the availability of materials, labor, and demand for product. VCRs are not in demand any longer, so they no longer cost $600 as they did when they were new and uncommon.

Despite the popular view, the definition of inflation is “too many dollars chasing too few goods.” Factors such as supply and demand get washed away by an over-abundance of currency. Look at it another way. For a person who is worth millions of dollars, to buy a $50,000 car is similar to someone who makes $50,000 a year purchasing a new television. Now imagine that a fast food worker is paid $500,000 a year. That would not mean that the fast food worker is well off, because the value of the job to society has not changed. Rather, if the fast food worker makes that much money, a cheeseburger would likely cost over $100.00.

If there is so much money in the economy that a job not in high demand and that does not require a great amount of skill fetches a high salary, then the currency is not valuable.

When the Federal Reserve prints too much money, the currency is devalued, and prices rise. Possessing a twenty-dollar bill is not the same as it used to be. So the question is, if the Federal Reserve has printed incredible quantities of money for release into the economy (quantitative easing), why isn’t inflation high?

First, they have not pumped the money directly into the economy, rather it has gone to banks and to the Federal Reserves of foreign nations in order to help bail out their economic problems. Second, this is where the Petrodollar becomes a factor. Without understanding the Petrodollar, one cannot fully understand what has kept our economy from being hit with high, debilitating inflation.

When Peru buys oil from Mexico, they buy the oil with American Dollars. When Japan buys oil from Saudi Arabia, they pay in Dollars. This is not just a question of stability- which is more stable, the Mexican Peso or the Dollar?- but also consistency. What concern there is about the stability of American currency is balanced by the concern for other currencies. In other words, if our currency collapses, so will all other currencies because of the chain reaction. But if another country’s currency collapses, that does not necessarily mean that ours will because of the size and strength of our economy- at least that is how the theory goes.

Now to the frightening part of all this. If the Federal Reserve is printing too much money, which is largely not being injected into our economy, and the world trades in our currency, so we have a buffer, what happens if other countries stop trading in our currency? What happens if the Petrodollar is undercut? Communist China is working on finding out the answer to that. They are convincing other countries to do business in the Yuan. That means that a country no longer trading in Dollars would not need to keep their large reserve of Dollars, so they would send that money, through trade, back to the United States. Right now, they need that money to trade in the worldwide market. If the need for Dollars goes away, it would be foolish for them to sit on that American money. The best play for that country would be to send it back to where it came.

A rush of Dollars into our economy would result in too many dollars chasing too few goods:  inflation. If multiple countries did this at the same time, that would be ruinous for our economy because the flood of currency to our shores would create an incredibly high ratio of dollars chasing the same amount of goods. An end to the Petrodollar would make inflation likely worse than anything seen on our shores since the economically chaotic days during and after the American Revolution.

Such a scenario, for a rich country like the United States, sounds far-fetched. No matter how rich, no matter how strong we are, just because we are Americans does not mean that we can negate the laws of economics, any more than we can negate gravity. Understanding these concepts does, however, help us to explain to others what is happening and what could happen in our economy.

So far, we have avoided the consequences of excessive Federal Reserve printing. The Petrodollar has been the buffer against those consequences. However, with the unending evolution of international relationships, one day that buffer might not be there.