Well, well, well... grab on to the gunwales ladies and gentlemen because Saudi Arabia has just reminded Bernanke what the consequences of damaging their holdings could be (hat tip Don):

Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East.

This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

"Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.

As a close ally of the US, Riyadh has so far tried to stick to the peg, but the link is now destabilising its own economy.

One of the more misguided things that people say about the economy is to look at any given segment and say "oh, it's only x% of the economy, therefore it's not a big deal." Some money -- hot money -- matters a lot more than the amount involved. Saudi money, Saudi investments, are mostly "hot money", they can be pulled out of the US relatively quickly. If tens of billions or hundreds of billions all moves out of security markets more or less at the same time the end result would be a crash much larger, with much larger effects, than the nominal amount in question (especially when you take into account unwinding leverage.)

This is the problem that Uncle Ben has -- if he raises interest rates he's going to send both the markets and the economy into a tailspin. If he doesn't, foreign investors in dollar denominated securites are going to think that perhaps being in the dollar isn't a good thing. Every percent the dollar depreciates against another currency is effectively a percent off your earnings (or more, thanks to leverage).

More After the Jump

This pattern is really familiar to me, because it's where Canada was in the early nineties. We relied a lot on foreign funding of our debt, and the foreign holders were getting really twitchy about the debt ratios (far lower than the US's, but then Canada isn't a hegemonic power). The result was nearly a decade of relatively high interest rates and those interest rates hurt economic growth and kept unemployment relatively high compared to the US, even given methodological differences. Fortunately the government at the time weren't tax cut zealots, and were lead by a very competent finance minister, who worked together with the Bank of Canada to get the debt and deficit under control. A lot of people laugh at Paul Martin, but Canadians actually owe him a big, er, debt of thanks.

Now what the US has had going with major foreign governments is what Stirling and I have called the "death bet." That is to say -- they bet that because the consequences of not propping up the dollar are so high for them, that they'll just keep doing it. As a result the US can run its monetary and fiscal policy however it wants, because no one will have the guts to pull the carpet out from underneath them.

This is probably still true of Japan and China -- not so much because of their dollar denominated assets -- everyone knows those will eventually be worth a lot than their nominal value; but because both of them are getting to run their export industries -- they lend the US consumers money, US consumers send it back. In the case of China, they send it back along with lots of jobs and lots of industry that China wants to move from the US to China. There'll be a price for it, maybe even a huge one, but in exchange for industrialization it's worth it. As for Japan, they're in a bind -- their economy is in the doldrums and they don't want to send it into a depression.

Other than the money the Saudis have invested in the US, and perhaps for security concerns, the Kingdom isn't in the same situation. They don't export squat to the US except for oil, and it's not like Americans can stop buying that, or that there aren't plenty of other customers. So all they risk losing by pulling out is money that if they don't pull out, because of the long term prospects for the dollar, they're going to lose much of the value anyway.

If the US dollar is going to drop relative to other currencies, if keeping your money in the Kingdom is better than having it in the US, then why keep it there? The Saudis may want to stop a rout (though one wonders if they're just saying that while they edge to the exit) but it could be rather hard to stop even if they're serious.

But the real message to the US in this policy move is simpler: that the US can no longer act as if it is the only center of economic gravity. The House of Saud isn't willing to just suck up the losses, and they have just made it crystal clear by not just making threats (like the Chinese did) but by a concrete action (or, as it were, non-action).

So Bernanke will now have to decide what to do: continue to ease to help the markets and the chances of Republican re-election, in an attempt to avoid a wipe-out at the polls -- but by doing so risk a dollar run or even just an acceleration of the dollar's decline; or tighten and send the economy and the markets into a tailspin.

The correct thing to do at this time is to tighten. No one wants to hear that, but that's what needs to be done. At the same time, since rich people aren't spending their money on generating useful economic activity, the fiscal authority should be taxing back money from the rich and from corporations which have made out like bandits, then taking that money and investing it in infrastructure and demand (energy, telecom, etc.).

But that's not going to happen, because the US doesn't have a functioning Congress; and if it did, they'd still have too many anti-tax zealots (against taxing rich people that is) to do what needs to be done on the fiscal side. Since Congress won't do it, since they want the monetary authority to be responsible, Bernanke will have to choose.

What the Saudis have done is just make the choice both harder and more clear. Easing for domestic political reasons will not be acceptable to them.

Like any death bet the question is "who's going to blink?" But it's no longer a real death bet, because while it'll hurt the Saudis, it'll hurt the US a lot more -- no matter what Bernanke chooses.

I wonder if Bernanke's still glad he got the job? Sometimes there are not good answers.

If it were me, I'd look in the mirror and say "what would Volcker do?" Then I'd raise rates, become the most hated man in America, and tell the legislature and presidency that I've done my job, and now they can either do their jobs, or blame it on me and get voted out of office anyway.

That's what you'd do if you were non-partisan, anyway.

What'll Ben do? Well, we'll see. We shall see.