the jinn in the machine

February 4th, 2009

The Chinese had tied their yen to it for a time, but they stopped a few years ago.  Industrialized nations the world over hold the dollar as a reserve currency since holding vast amounts of dollars makes buying oil and other commodities cheaper, but some nations want to switch over to the euro or ruble.  And no one even knows how many dollars are even out there, as each and every one of them is in fact loaned into existence.  Our dollars are not backed by a set amount of gold, or a set amount of anything at all – the Federal Reserve simply agrees to electronically conjure them up as it sees fit.

This is a difficult and paradoxical concept, but here’s an explanation that will help: Imagine that you borrow ten-dollars from your friend Rob, and write him a note saying IOU Ten Bucks.  Your friend Mary then needs to borrow ten-dollars, and so you pass the ten-dollar bill you’d gotten from Bob on to her, and she writes you a note saying IOU Ten Bucks.

Now pretend that you or Mary or Bob could walk into almost any store and use the IOU Ten Bucks note instead of a ten-dollar bill to buy some coffee or a book.  So if you pretend each IOU Ten Bucks note can be actually used as a ten-dollar bill, there are thirty usable units of currency in circulation even though there’s just one ten-dollar bill.

Well, you don’t have to pretend.  Because that’s really what you’re doing every single day.

Every single strip of printed currency is actually an IOU Note, it’s just that the entities that did the lending are enormous, private financial institutions like banks and mortgage companies.2 And chances are you’ve never used printed money to make a purchase of more than one-hundred bucks anyways, the vast majority of our financial interactions are purely electronic.  When’s the last time you mailed $250 in cash to Pepco, or put down a down payment of more than $50 on anything?

If all the clients of a bank showed up demanding to cash-out their accounts, no bank in the country would be able to supply them with the cash – because there simply aren’t anywhere near enough real American dollars in the world to cover all of the electronic, loaned, IOU Note, American dollars out there.

Understanding this concept is at the core of understanding the ongoing mortgage and credit crises.  If your friends full-names were Fannie Mary and Bob Sterns, all that’s happened is your friend Bob wanted to buy from a store that won’t accept IOU Notes, and has come back for that ten-dollars he originally lent you, so you go to Mary with the IOU Note which she wrote you – but all she has is an IOU Note from someone else since she too lent the ten-dollar bill out.

And that someone also lent the ten-dollar bill out for an IOU Note, so if there are five or six more people down the line the original ten-dollars now represents almost one-hundred IOU Note dollars.  Instead of IOU Notes we just have mortgages and car loans.

That’s the simple and inescapable reality at the core of our economic predicament, which just gets more complicated as you substitute nations for individuals, electronic exchanges for written IOU Notes, and more and more layers of lending.

On top of that, there’s the role the American dollars plays as an international currency reserve, since the most industrialized nations want to hold as many dollars or IOU Notes as they can, a kind of inflation sink is created.  But there’s one very exposed and brittle gear in the machine our country depends on.

Our present geo-economic system only begin forty-years ago, back when you could supposedly still redeem your printed dollars for a set amount of gold bullion.  But then De Gaulle and other heads of state, suspecting we were printing way more dollars than we had gold to back, tried to cash in France’s bucks for gold.

De Gaulle and the rest of the world were right, and so in response the U.S. “closed the gold window” and told the world they were going to just keep on printing out – really, loaning out – dollars as they saw fit.

In response, the world pretty much just shrugged and international financial interactions went along as they had before.  There wasn’t really much reason to make much of a fuss, as the most powerful nations in the world had agreed in the Bretton Woods agreement to accept the dollar as the international reserve currency.  So in the years since then countless billions of dollars have been loaned into electronic existence across the globe since there was no practical way to replace all of them.

Two other important gears connect to this one: the Carter Doctrine of defending our Gulf oil interests at any cost, and Saudi Arabia’s decision to only allow their oil to be purchased in dollars.

Exactly how big each of these gears is and precisely how they effect each other is impossible to see.  There are now uncountable trillions of electronic American dollars in existence across the globe, and no one, including the Saudis themselves, know how much extractable oil is left beneath their sands.  The world just knows the dollar is the most important international currency unit, and Saudi Arabia has the largest remaining oil reserves on the planet.

But even though there’s no way to tell how these gears work together, the fact remains that the relationship is there as a vital part of the international economic system, maybe even the most important one.  Should Saudi Arabia decide to stop accepting dollars for oil, or even just accept other world currencies, these two gears would be wrenched apart and the economic system we have now would end.

As bad as the current crisis may be, the essential underpinnings of the system have remained intact.  The Stock Market has crashed before, that doesn’t mean the entire system will come crashing down with it.  Detaching the dollar from Saudi oil would unavoidably cause a much more dire result.

Our American economic machine, which has been leaking and sputtering for several months now, would simply grind to a screeching and violent halt.

Looking at America’s confrontation with Iran like a chess match you see the obvious threats, the potential checkmates: an American naval blockade of Iran or an outright airstrike against Iranian nuclear sites, and Iran’s threat to sink oil tankers in the Strait of Hormuz or launch missiles at America bases in Iraq and at oil facilities across the Gulf.  Which is why you should remember that chess doesn’t serve as a good metaphor for geopolitics, and it shouldn’t worry anyone too much that Persians invented the game.

But if the Middle East is one big, brown, sandy poker table – a much more interesting analysis can be made.

There are several players sitting at it.  Including America and Iran, there’s also Russia, China, Saudi Arabia, Israel playing each and every pot  along with a few smaller more disreputable characters like Hezbollah and Halliburton.

More than just chips in play, occasionally someone will bet blood, bombs, or treasure – the proverbial shirt off their backs – and raise the stakes.  The game’s not entirely straight up, sometimes during a hand Iran will lift up one of their hole cards to show Russia, and another to China, but not both to either one and never showing a single card to America or Israel.  And sometimes America will chase Iran out of a pot that Israel is also in after Iran re-raises Israel’s initial bet.

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One Response to “the jinn in the machine”

  1. gareth thomas

    All very interesting and I was going along nicely until you mentioned the Chinese Yen…. its the Japanese Yen and the Chinese Renminbi or Yuan.

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