Revaluing the Dollar

The WSJ has an article today on the possibility of the Gulf Nations ending their dollar ties. There’s nothing all that interesting about it, except that it points out this:

The countries of the Persian Gulf are struggling with the impact of their own good fortune as rising oil prices bring a windfall. Normally, when the price of a country’s major export rises, that pumps up the local currency, which helps restrain inflation.

Instead, much the opposite has happened. As the price of oil has skyrocketed in recent years, Gulf currencies tied to the dollar have fallen relative to other currencies such as the euro and British pound, making many of their imports more expensive.

The UAE and Qatar have suffered some of the worst inflation, as the oil gusher has triggered a building boom. In Qatar, inflation hit 11.8% last year, and the International Monetary Fund estimates it willaverage 12% this year. This week, officials in Doha, the capital, raised taxi fares by a third.

This is why I have long opposed currency unions – whether the proposed union of the US and Canadian dollar (something we hear a lot less about these days, but which was highly touted in the 90s) or the Euro. And tying your currency to another currency, in effect, is very similiar to currency union. Of course, it’s not identical, since you retain the ability to get rid of the peg.

When your currency is tied, you get currency feedback that is designed for, or caused by the other countries currency. It can be designed, as in Bernanke’s deliberate rate cuts, which are underming the dollar even more, and will lead to even more inflation; or it can be appropriate, in the sense that pressure is also on the dollar due to massive trade and balance of payment deficits. Either way, it’s a happy accident if it turns out to be appropriate to you, but it doesn’t have to be.

Of course, for the gulf nations, it often was. If America was in recession, well then, odds are so were they. If America was booming, then oil demand was up, and times were good. But that link has been broken for the time being.

Or so it seems. In fact, of course, it really hasn’t. If the US goes into a real demand driven recession (something I expect) then odds are that everyone will. China may be attempting to decouple, but it simply hasn’t happened yet and I don’t believe the Chinese consumer can take up the slack when America’s consumers falter in a credit crunch.

This is mitigated by the fact that we’re pushing right up against the supply envelope for oil. So if demand drops relatively speaking, will it drop enough to reduce oil prices significantly?

That depends on how bad the recesssion is, or if it turns into a depression.

But what the Gulf has to fear most is not that, but the possibility of substition. Many rich areas were destroyed economically when a substitute became available for their resource. And substitution away from oil is what the major oil consuming regions – whether China, or India, or the US, or the EU need to work on.

If there is a major financial wipeout and a reaction against that wipeout as there was in the thirties, paper games will dry up to a large extent. At that point the substitution away from oil will start to make sense. It may not pay the double digit returns you could get these last few years playing leverage games, but it will pay decent returns in an economy where those unproductive uses of money have been largely shut down.

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Ian Welsh

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  • They’ve been through the substitution cycle before, whereas Hugo Chavez and Ahmadinejad have not. They know oil can go from $80 to $10 in a few years if the world gets serious about oil substitutes.

    But they also know this time is a little different. The west has exhausted all the cheap and easy substitutes, and any serious competitor to oil would require research, development, and a huge, expensive change in infrastructure. New customers such as China and India are far less equipped than the west to fund such changes, though they do have the advantage of building a new infrastructure now before it is too late and their economies are tied into hydrocarbon fuels like the west.

    So the Saudis don’t want to precipitously junk the dollar, at least as the pricing basis for crude oil. They certainly must be looking at diversification of their reserves, and possibly at loosening the link of the rial to the dollar.

    These are the three policy decisions that will determine the fate of the dollar as the world’s reserve currency. It is already under attack by nations which are abandoning their currency pegs to the dollar, and by many countries which are diversifying into euros and swiss, etc. But the pricing of oil in dollars is the ultimate blow.

    U.S. consumers and countries have had a century of luxury in which their only concern about oil price fluctuations is the price of oil itself in dollars. But if you combined that with having to hedge this price because it is denominated in euros or a basket of currencies, and suddenly the U.S. economy is exposed to a significant currency risk it didn’t have before. We would be like everybody else – Canadians for example, who always worry about both the oil price and the exchange rate.

    This would be a fitting cap to George Bush’s administration – trashing the reserve status of the dollar, along with all his other transformations of the U.S. into a banana republic.

  • One of deals for Saudi oil was Uncle Sam’s willingness to put military iron, flesh and treasure into protecting their crown. With the incentive of King Greenback disappearing, becoming just another piece of paper to the Saudi’s and other oil producers will the U.S. be willing to protect the one product that keeps the Euro in the drivers seat?

    “There are two types of folk music:
    quiet folk music and loud folk music.
    I play both.”

    Dave Alvin

  • I had a friend who worked in banking. For years over beers we would argue about the state of the US economy. I talked for years about the coming devaluing of the US dollar and he would smugly sit there and say “So….?” When I pressed him he did his best Rush Limbaugh voice saying “You don’t understand how this works do you? Look just like in the 80’s when the dollar fell and the Yen soared all the Japanese beat down doors to invest in US commercial assets and tangible goods. Everyone invests in the US. We’re the rock. So what if the Euro is ‘valued higher’ doesn’t mean anything. All that investment money in whatever currency is going to come back to the US of A and fuel our next 90’s boom. You liberals just don’t get economics…”

    He still made the same argument to me last night. It’s frustrating because I have a poli sci degree and this guy just worked at a major financial institution straight outta college and he poo-poos everything I say…is there something fundamental about what he’s saying that’s right? I’m a politics guy, not an economics guy and I run out of terminology to argue with him when he throws all these things like “asset driven markets” and crap at me. It just looks like common sense to me…

  • Arguing that the U.S. is the preferred place for investment, over China, Russia, western Europe, or any other alternative, is an opinion based on one’s nationalist viewpoint. It isn’t born out by economic statistics – money today is flowing into China and other emerging markets, or places like western Canada with large hydrocarbon resources. The investment balance on the U.S. current account hasn’t shown any great improvement, certainly not in relation to these other investment magnets.

    Your friend is expecting the 1980s and 1990s to replay themselves, but if that were the case we would see that by now. U.S. corporate earnings would be predominantly from within the U.S., whereas most successful corporations these days are generating their earnings overseas (see Hewlett-Packard’s numbers this morning).

    I think your friend, and maybe even his financial institution, are going to have some rough times ahead if they continue to think nothing has changed for America in the past twenty years. But whatever happens, it sounds like your friend will never change his political tune and will always think of some glib retort to any argument you can make.

  • You got that right – like those three carrier strike groups cruising in the Gulf and Arabian Sea right now. That cost doesn’t get entered into the idea of subsidy. Ditto for the twenty-two brigade groups on the ground in Iraq costing a cool $200 billion per year. We’d be one hell of a lot closer to having renewables actually in widespread use in the economy if we had spent $200 billion per year for the last four years instead of literally pissing it into Mesopotamian sands. To whom do we send the bill for subsidy?

  • Well, those twenty-two brigade groups in Iraq gotta go somewhere when we pull them out of Iraq. Over the horizon into Saudi Arabia is as good as over the horizon into Kuwait. We’ve already built the roads along the Saudi/Iraqi border which we could use for logistics – fifteen years ago.

  • is much the same way. He’s argued that the lack of cellphone/internet provider choices in the US is a sign of a healthy, optimized market. And that the quality of cable TV and the amount of commercials on it are entirely justified because “that’s what they need to do to make a living.” And that black people are less successful than whites because of “genetic differences… or maybe cultural ones too.” (We had a looong talk after he spouted that crap). He also says he’s conservative because “he doesn’t believe in helping people. If you give them everything they need, like liberals want to do, then they won’t work hard, they won’t be proud of themselves, and they’ll do nothing.” Apparently, wallowing in poverty and barely scraping by day-to-day makes you more “proud” than getting a little cash to get back on your feet.

    It’s the right-wing bizarro world. This same guy stood in line for 4 hours to get Sean Hannity’s autograph and listens to conservative talk radio all the time. Luckily, he doesn’t use terminology like “asset driven markets,” though he just got a job that may introduce him to such things… That’ll make our conversations harder, as he learns new phrases to throw out like chaff and distract from real debate.

  • The Euro didn’t come a moment too soon. At this point it is the only viable contender as an alternative to the US $ for the status of world reserve currency. The fact that the European Central Bank’s prime prerogative is to contain inflation also makes it better suited for this task than the Fed’s competing mission goals.

    It is one thing to combine several smaller economies and currencies into one juggernaut – it is an entirely different story to have Canada essentially being absorbed by the US and surrender sovereignty without getting anything in return.

    I moved from the US to Canada last year in part because I was concerned about the coming US $ melt-down. I am very happy to earn Can $ if Canada was to seriously entertain a currency union I’d be moving back to the EU in a hurry.

    That in a nutshell is the difference between these currency unions: I am happy to accept Euros for payment any day – US $ not so much. Odd thing to observe how this sentiment goes mainstream now.

  • …all day with my friend via email. He is a libertarian by nature, and is an Obama supporter. He isn’t necessarily conservative, except his economic views are very hard right. He reposnded to me when discussing the importance of the devaluing of the dollar with this statement:

    “There is only one thing in play, too many dollars outside of Treasury’s control. Oil has even less to do with this, that’s a total political argument, not reality. The only thing oil affects are the stock and futures markets. If people start grabbing Euros as an investment, that’s great news. The Euro will start feeling the downwards pressure of currency outflow and the dollar will rise. There’s no magic to the way floating currency markets operate. They float based on supply and demand. It’s math, not speculation.”

    I just don’t get it that he doesn’t get it and that it IS about the oil (and the dollar and the Yuan…and the Euro..), that this is a dismantaling of the entire global economic system…

  • Europe is not all one economic area operating on the same import replacement/expanstion cycles. And that means that large chunks of it are constantly getting the wrong feedback.

  • “If people start grabbing Euros as an investment” this does not lead to downward pressure on the currency. The only outflow of significance would be the interest payments on the investment, say about 5% p.a., which is dwarfed by the principal being invested. It would take about 15 years for the interest payments to even equal the amount of the investment, so clearly the pressure in the FX markets of the one-time, initial investment is much greater than the interest payments over time.

    If OPEC producers decided to accept only euros in payment for oil, and refuse dollars, the effect in the exchange market would be immediate and ongoing pressure on the U.S. dollar.

    Let us trust your friend is not in some significant position in his financial firm, like investment advisor, because his knowledge of the markets is sketchy.

  • … about Canada – Alberta, Ontario out of sync – and the US – California versus the rest. I don’t deny the validity of the observation but I don’t think that ever fragmenting currencies could be the answer. I think in the EU the overall ease of business facilitated by one currency is a net benefit. Especially taking into account the transfer payments that happen within the EU between countries (similar to the transfers between provinces). I.e. in my view its just fair that Germany as one of the biggest beneficiaries of the euro pays the most into the EU budget.

  • how many vital regional cities did the US have 100 or 50 years ago as compared to now?

    Transfer payments don’t cut it, they aren’t feedback.

    I won’t deny there are advantages to having one currency over a large area. However, in my view, the loss of feedback is almost never worth it.

  • … that migration and geographic concentration of economic activity will be the outcome of the lack of feedback?

    I think a very good example for this is the migration from East Germany and the economic malaise there when the old currency was abandoned after reunification.

    In the case of Europe as a whole I believe that cross country migration is still severely stalled by language barriers and an overall stronger cultural bias against relocation when compared to North America. In West Germany I found that most people rather go without job for a long stretch of time rather than to relocate to another city.

    Also if you go back a couple of century pretty much every European currency was based on gold. I strongly suspect that Europe is just to diverse and densely populated to play out the same dynamics as the US.

  • explains it best in Cities and the Wealth of Nations, but basically, in a properly functioning currency:

    1) the currency goes down when your economy needs a boost in exporting and should be import substiting.
    2) the currency goes up when your economy should be buying other people’s goods. (First you have to buy them, then you substitute them, with a few exceptions).

    Since economic regions are not country based, but are based around functioning metropolitan areas, if you have too many metro areas with the same currency they get inappropriate feedback.

    Gold backed currency did not mean there were no currency fluctuations, in fact there were.

    Universal currencies are a bad idea. And we haven’t even really touched on what happens when you have one central bank.

    Anyway, I’m not talking about migration per se, although that can be one side effect of booms and busts and backwards areas.

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