Exporting Inflation
by Thomas E. Brewton
Issue 98 - December 26, 2007

Ever since World War II, the U.S. dollar has been the de facto world monetary standard. A responsible central bank in that circumstance has a duty to maintain a sound currency to prevent disruptions and dislocations in world commerce. The Federal Reserve has signally failed to fulfill that role. At its most recent meeting, it increased the funds rate again, ignoring the inflation risk.

The fault is not entirely the Fed's. It can be traced to the Employment Act of 1946, which enshrined John Maynard Keynes's socialistic economic doctrines as the official policy of the United States. The Fed was directed, among other missions, to manage the economy via currency manipulation in order to maintain full employment. Keynesian orthodoxy, which is the ideology of the Democratic Party, dictates that every economic glitch can be cured by increased Federal spending.

The Fed's ever-ready response to the spurs of Federal spending has made it a poor steward of a sound currency for the rest of the world.

The steepening downward trajectory of the dollar exchange rate has compelled Middle Eastern oil-producing nations to rethink linkages of their currencies with the dollar. Those nations now are at a decision-making point.

If they diversify their central banks' reserves of foreign exchange out of dollars, that will dump more dollars into the world market, driving the dollar exchange rate down still more. If they don't do so, they will have to raise oil prices or demand payment in currencies other than the dollar.

The latter amounts to a price increase in dollars, because U.S. importers will have to sell larger amounts of dollars to obtain the necessary amount of other currencies to pay for oil imports.

In a page-one article the Wall Street Journal (Wealthy Nations In Gulf Rethink Peg to Dollar ) reported:

For many years, oil-rich Persian Gulf states have pegged their currencies to the dollar. Now that link is stoking a bad bout of inflation in their red-hot economies and putting policy makers in a dilemma: Break the dollar peg and risk undermining the U.S. currency, or keep it and face growing local discontent.

The dollar peg has "served the economy...very well in the past," said Sultan Nasser al-Suweidi, the governor of the United Arab Emirates' central bank, last week. "However, we have reached a crossroads."

Because countries such as the UAE, Saudi Arabia and Qatar sit on large reserves of U.S. dollars, their decisions will have repercussions beyond their borders. If they move away from their strict dollar pegs - perhaps following Kuwait, which earlier this year switched to a basket of currencies - it could undermine demand for dollars and encourage others to diversify their holdings. Many nations have already created sovereign wealth funds to invest their holdings in a broader array of assets...

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.

Sound familiar?

Thomas E. Brewton is a staff writer for the New Media Alliance, Inc. The New Media Alliance is a non-profit (501c3) national coalition of writers, journalists and grass-roots media outlets.