War, Oil and Land Prices

Gavin Putland

[Reprinted from Progress, May-June 2003]

In November 2000, Iraq stopped taking U.S. dollars for oil, and started demanding euros instead. That was bad news for property investors in America, Britain and Australia.

THE GOLD STANDARD

Under the Bretton Woods Treaty of 1944, each participating government agreed that its currency would be "backed'' by gold; that is, the government promised to buy and sell gold for a fixed price in its own currency. As long as these promises were credible, the exchange rates between the participating currencies were fixed. But because of the vast array of goods and services available in America, the U.S. dollar was the easiest currency to spend in the global market, and consequently the most acceptable foreign currency in other countries. The demand for dollars grew until the late 1950s, when the recovery of Europe and Japan caused a suspicion that there were too many dollars in circulation, so that dollar holders began to demand gold. In 1971, in response to the depletion of U.S. gold reserves, President Richard Nixon announced that America would no longer keep its commitment to give gold for dollars [1], causing the system of fixed exchanges rates to unravel. So the U.S. dollar is now a "fiat'' currency: its only official ``backing'' is the legal obligation to accept it as payment in the USA and its territories.

Internationally, however, there is no such thing as fiat money, and a currency is not acceptable unless it is somehow guaranteed to buy something of value [2].

BLACK GOLD

In 1973, the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of oil but continued to accept only U.S. dollars in payment, so that the demand for dollars soared. From then on, the dollar was effectively backed by oil instead of gold -- and the U.S. government didn't even have to own the oil!

Because dollars can buy oil, countries that need to import oil -- i.e. most developed countries -- will accept dollars for their exports. Hence everyone who needs to buy from those exporters will accept dollars as payment for other things, and so on. To pay their bills, importers must have reserves of dollars. To prop up their currencies against speculative attacks, the central banks of all countries must have reserves of dollars. To get capital, poor countries must borrow dollars, and to service these debts they must export goods to obtain more dollars. About 2/3 of all currency reserves, more than 4/5 of all currency transactions, more than half of the world's exports, and all loans from the International Monetary Fund (IMF) are denominated in dollars. As these things create demand for the dollar and shore up its value, OPEC is the more willing to accept payment in dollars. This self-reinforcing process is called "dollar hegemony''.

So America exports dollars and receives real goods and services in return. America's real imports now exceed its real exports by almost 50%, or 5% of GDP. Its net foreign debt is more than a quarter of annual GDP, and its public debt is about 60% of annual GDP. But when the exported dollars eventually find their way into foreign reserves, they can only be invested in American assets such as treasury bills, real estate, and shares. This inflow of investment creates a surplus on the "capital account'' and balances the deficit on the "current account'' (which includes imports, exports, interest, rent, and dividends). If the value of the dollar rises, the current account deficit widens because imports increase and exports fall, while the capital account surplus narrows because investment in the country becomes more expensive; so dollars flow out of the country and counteract the rise in value. If the value of the dollar falls, the opposite effects occur. At equilibrium, the value of the dollar is that which balances the current account and the capital account.

LAND PRICES, RENTS, AND INTEREST RATES

Investment in real estate necessarily includes investment in land, and the supply of land is fixed. So when foreign reserves of U.S. dollars are invested in U.S. real estate, they push up land prices. They also push up rents, because potential renters are in competition with potential buyers. The winners are the big property owners (i.e. the rich). The losers are first-time buyers and renters (i.e. the poor). So we find full-time workers living in "trailers'' (caravans) on the fringes of American cities because they do not ``earn'' enough money to buy or rent a home.

Ordinary home owners are easily convinced that they benefit from rising land prices. But in fact, every time a home owner moves to a new home, the higher sale price of the old home is offset by the higher purchase price of the new one. If the only property that you own is your home, you cannot benefit from an increase in its value unless you somehow turn it into a retirement income stream -- in which case you forfeit the option of bequeathing it to your heirs, who will then be among the losers!

The flow of foreign investment into real estate also pushes up share prices, because land constitutes part of the asset backing of shares. Shares are also partly backed by other non-replicable assets ("land-like assets''), including natural monopolies (e.g. water and electric power distribution), statutory monopolies (e.g. patents and mineral extraction rights), and other licenses and privileges conferred by governments. As the market cannot produce more of these assets in response to increased demand, foreign investment in the share market pushes up share prices for the benefit of current shareholders.

Simple arithmetic dictates that America's current account deficit must be either eliminated (e.g. by allowing the dollar to depreciate, so that living standards fall) or balanced by a stream of foreign investment. One way to attract foreign investment is to offer high interest rates on treasury bills. This of course forces other financial institutions, and other countries needing foreign investment, to raise their rates in order to compete. But the growth of currency reserves that can only be invested in American assets has allowed America to obtain the necessary investment with lower interest rates than would otherwise be needed [3]. Not much of this investment finds its way into export industries or import replacement industries, however, because the competitiveness of these industries is damaged by the high dollar. So the investment does not address the cause of the current account deficit, but merely masks the symptoms while propping up the prices of land and shares.

Another common motive for raising official interest rates is to restrict credit creation, thereby fighting inflation. Clearly the price of oil must be included in any realistic measure of inflation. But because oil is priced in dollars, an increase in oil prices attracts dollars out of the USA, reducing the inflationary impact within the USA. Thus America is protected from the inflationary effects of oil price rises without resorting to high interest rates.

Low interest rates are generally desirable because they encourage productive investment rather than hoarding of money, and because they minimize the flow of income from debtors to creditors (debtors being generally poorer than creditors). However, the benefits of low interest rates extend higher up the socio-economic scale than one might think. The price of a land-like asset is roughly equal to its rental value divided by the real interest rate (i.e. the interest rate net of inflation). So lower interest rates mean higher land prices. Big property owners are again the obvious winners. Owners with mortgages are also among the winners, because their equity increases while their interest payments decrease. Intending buyers do not gain so much, because the benefit of lower interest rates is offset by the need to borrow more; indeed, people who buy when interest rates are lowest are actually buying at the top of the market, which is a fool's game.

THE EURO THREAT

The biggest impediment to global hegemony of a single currency -- whatever that currency may be -- is the desire for diversity in investment [4]. Dollar hegemony was secured by the size of the U.S. economy and the pricing of oil in dollars. But if a second currency were to enter the oil market, the desire for diversity would soon establish that currency as a second general-purpose trading and reserve currency, especially if that currency were legal tender in an economy comparable in size to the USA.

In 1999, eleven member states of the European Union (EU) adopted the euro as a common accounting currency. Greece joined the Euro Zone a year later. On January 1, 2002, the twelve countries withdrew their old money from circulation, completing the biggest currency reform in history.

The Euro Zone already has a bigger share of world trade than the USA. In particular, it imports more oil than the USA and is the main trading partner of the Middle East. It offers higher interest rates than the USA, but does not have a huge foreign debt or trade deficit. Member states must accept tight constraints on budget deficits, and the European Central Bank has an exceptionally strong mandate to preserve the purchasing power of its currency. These things inspire confidence in the euro. It was perhaps for that reason that in 2002, Russia and China started converting some of their currency reserves from dollars to euros, while North Korea abandoned the dollar and started using euros for trade. The strength of the euro also encourages expansion of the EU and puts pressure on current members Denmark, Sweden and the U.K. to join the Euro Zone. In December 2002, ten new countries were accepted for EU membership with effect from May 2004. This will create a common market of 450 million people, which will buy more than half of OPEC's oil.

So the only remaining argument for preferring dollars to euros is that dollars can buy oil. As that argument does not affect OPEC, it would make sense for OPEC members to convert most of their reserves to euros by mid 2004. If OPEC members were then to price their oil in euros, whether for all customers or only for customers in the Euro Zone, they would increase demand for the euro, causing a handsome increase in the value of their new euro reserves. Similar arguments apply to non-OPEC oil exporters such as Norway and Russia. In short, if the oil-exporting nations treat the euro on its merits, dollar hegemony will end.

If the demand for dollars falls, the consequences for America are clear. Fewer dollars will be exported for goods and services, and fewer dollars will return to prop up the real estate market and stock market. The dollar prices of American land and shares will fall, and the real values will fall further because the dollar itself will be devalued. The excess dollars on the global market will flow back into the American domestic market, where they will be spent on goods and services, fueling inflation and increasing exports. The increased exports will reduce the current account deficit to compensate for the slowdown of foreign investment, but will also reduce domestic living standards as measured by consumption of goods and services. Inevitably, the Federal Reserve will raise interest rates in order to reduce the inflation, support the dollar, attract more foreign investment, and delay the day of reckoning on which America will have to pay its way by producing and exporting real goods and services in return for its imports. But that will not rescue the landowners and shareholders, because, to the extent that land and shares are not devalued by reduced foreign investment, they will be devalued by the higher interest rates.

If interest rates are raised in America, they will also have to be raised in other countries which have large current account deficits, and which therefore compete with America for foreign investment. Those countries notably include Britain and Australia. So if the reign of the U.S. dollar ends, land prices and share prices will fall not only in America, but also in Britain and Australia.

ROGUE STATES

The first OPEC member to show serious disloyalty to the dollar was Iran, which has expressed interest in the euro since 1999. In January 2002, George W. Bush named Iran in his "axis of evil'', provoking a wave of anti-American demonstrations reminiscent of the Khomeini era, and undoubtedly setting back the political and religious liberalization of that country. Undeterred, Iran converted most of its currency reserves to euros during 2002, and a proposal to price Iran's oil in euros has been submitted to the central bank and the parliament.

Let us see whether the Americans find an excuse to destabilize Iran's fledgling democracy in favour of a dictatorship that just happens to prefer dollars to euros.

The second offender was Venezuela. In 2000, Venezuela's President Hugo Chavez called a conference on the future of fossil fuels and renewable energy. The report of the conference, delivered by Chavez to the OPEC summit in September 2000, recommended that OPEC set up a high-tech electronic barter system so that members could trade oil for goods and services without the use of dollars or any other currency. The chief beneficiaries would be OPEC's poorer customers, who did not have large currency reserves. Chavez made 13 barter deals. In one of them, Cuba provided health services in Venezuelan villages.

In April 2002 there was a coup against the twice elected Chavez. The coup was welcomed by the Bush administration and by editorials in numerous American newspapers, but collapsed after two days, leaving evidence that the U.S. administration was behind it [5][6].

The third and most blatant offender was Iraq. In October 2000, Saddam decreed that Iraqi oil would be sold for euros instead of dollars, with effect from November 6. Soon afterwards, Saddam converted Iraq's entire $10 billion "oil for food'' reserve fund from dollars to euros. These events went unreported in the U.S. media.

Given America's record of toppling elected governments whose policies it didn't like (as in Chile, Nicaragua, and almost Venezuela), it is hard to believe that the motives of Operation Iraqi Freedom are as pure as its name suggests, especially considering how cheap ``freedom'' has become in U.S. domestic politics [see the Appendix].

Answering the allegation that the war was all about oil, George W. Bush assured the world that Iraq's oil belongs to the Iraqi people. But any asset priced in dollars is at least partly an American asset because it adds to the demand for dollars, allowing America to export more dollars and import more goods and services. The exported dollars eventually return and drive up land prices and share prices, making rich Americans richer. So the test of America's sincerity will be whether the new regime in Iraq continues to accept euros for oil.

APPENDIX: THE PRICE OF FREEDOM IN AMERICA

It is well known that more than 100 death-row prisoners in the USA have been found to be innocent since 1973. When we add non-death-row prisoners found innocent after serving long periods in prison, the number rises to over 200, most of whom were cleared by DNA evidence in the last decade.

What is not so well known outside the USA is that more than two thirds of these people got NO COMPENSATION. Not even reimbursement of legal costs. Not even back-pay at standard rates for the work they had to do in prison.

Only 15 of the 50 American States have laws providing compensation for wrongful imprisonment. In 13 of those States the compensation is capped, and the limit is invariably less than what a film star would expect to receive for a defamatory media report. In the other 35 States the legislature can pay compensation if it wants to, which it usually doesn't. The Federal jurisdiction has a compensation scheme under which the maximum payout is $5000 (yes, five thousand dollars).

Some wrongful convictions, though not all, are honest mistakes. But when a wrongful conviction is discovered and publicly admitted, any failure to compensate the victim for years of incarceration and vilification cannot be explained by ignorance, misunderstanding, error, lack of freedom, or (especially in America) lack of resources. It can be explained only by callous indifference.

REFERENCES

1. Howard Wachtel, ``Adventures of the Dollar'' (1987) http://www.npq.org/archive/1987_fall/adventures.html.
2. "In the international arena... no overarching sovereign exists to decree what is money. Instead, a myriad of private agents must somehow reach agreement on which currency to use... [If a currency is] to be acceptable, market participants must be willing to hold it as a store of value. A necessary condition of that willingness is that a currency's future value in terms of goods and services be viewed as predictable.'' --- Alan Greenspan (Chairman of the U.S. Federal Reserve), "The Euro as an International Currency'', remarks at the Euro 50 Group Roundtable, Washington D.C., Nov. 30, 2001.
3. An exception occurred in the late 1970s, when falling oil prices and mounting third-world debt -- both denominated in U.S. dollars -- undermined confidence in the dollar. The Federal Reserve responded by raising interest rates to record levels (reference [1]). Heavily indebted poor countries are still paying for that episode. But demand for the U.S. dollar rose again in response to the second oil shock of 1979-80.
4. "[T]he most important factor inhibiting the emergence and persistence of a single vehicle currency throughout the world is the attraction of portfolio diversification. This can be a powerful counterforce, especially because currencies offer far greater opportunities for diversification than most other assets. The average price of all currencies, by construction, is trendless, tending to increase the negative covariance within a portfolio of currencies." --- Alan Greenspan, loc. cit.
5. FAIR: "U.S. Papers Hail Venezuelan Coup as Pro-Democracy Move'', Media Advisory, April 18, 2002, http://www.fair.org/press-releases/venezuela-editorials.html.
6. Ed Vulliamy (New York, April 21, 2002): "Venezuela coup linked to Bush team'', THE OBSERVER.