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December 7, 2006

A Losing War, a Failed President, a Weak Dollar: We've Been Here Before

by Leon Hadar

I'm not a financial speculator, and I don't play one on television. So please don't base your decision on whether or not to bet against the U.S. dollar on my thoughts about the fate of the greenback, which has fallen to a 20-month low against the euro recently. But for someone like myself who is interested in the relationship between economics and politics, especially as they affect global affairs, the current weakness that the U.S. currency seems to be experiencing hasn't come as a total shock.

Hence while economic analysts have been examining the volatility of the dollar and searching for explanations by focusing mainly on U.S. economic indicators, including the restless housing market and the weakening confidence of consumers, or the structural differences between the U.S. and European economies, it seems to me there is a need to integrate the discussion into the larger domestic and global political context. The problems of America's mighty currency need to be viewed from the perspective of the U.S. capital.

After all, it would be inconceivable to examine one of the most important economic decisions made by a U.S. president in the 20th century – Richard Nixon's "closing of the gold window" in August 1971, that is, making the U.S. dollar inconvertible to gold directly (and basically abolishing the Bretton Woods System) – without considering the geopolitical environment in which it was made and which exposed an erosion of U.S. hegemony in the Western alliance.

Specifically, the Vietnam War and the increasing military expenditures to finance it resulted in an increased dollar outflow and accelerated inflation by the 1970s, leading to rising balance-of-payment and trade deficits. The dollar was overvalued while the Deutschemark and yen were undervalued, and the attempt to defend the dollar at a fixed peg was becoming increasingly untenable. Ripping the dollar loose from gold was designed to boost U.S. exports and cut the country's worsening deficits.

In a way, Nixon's decision to delink the dollar to gold followed by his 1972 visit to China reflected the relative decline in U.S. global political and economic power – brought about by the devastating geopolitical and economic impact of the Vietnam war – and Washington's adjustment to these changes (the two decisions together are appropriately known as the Nixon Shocks) in American political history.

So you recall one failed war (Vietnam), U.S. presidents fighting for their political survival (Lyndon B. Johnson and Nixon), and a weakening U.S. dollar, and suddenly it seems that someone has produced a remake of that old horror movie. Once again there is a failing war (Iraq), a beleaguered U.S. president (George W. Bush), and erosion in the value of the U.S. dollar. As in the case of the U.S. quagmire in Southeast Asia (which spread from Vietnam into Laos and Cambodia), the current military quagmire in the Middle East (which is producing shock waves also in Iran, Lebanon, and Israel/Palestine) has led to a major increase in military spending (and not unlike in that period, no effort has been made to cut domestic spending), resulting in rising budget and trade deficits.

If in the 1960s and early 1970s the Germans and the Japanese were helping finance the U.S. military intervention in Vietnam, China and other East Asian central banks are playing a similar role today. Hence the need to reevaluate the dollar can be seen now like then as a recognition that American geopolitical and economic power is declining and that some kind of readjustment is necessary. From that perspective, the erosion in the U.S. currency was inevitable under these conditions – although the slowdown in the U.S. economy and the attractive economic conditions in the euro zone may have been the direct trigger for the dumping of U.S. dollars and the buying of the euros.

Things can get even worse if the rising populist and protectionist wing of the Democratic Party that has taken over Capitol Hill adopts policies to punish China for its "unfair" trade practices, which are supposedly responsible for the giant American trade deficit with the Chinese. The Chinese, who until now have continued to invest in the U.S. economy, thus preventing an even more dramatic and painful drop in the value of the U.S. dollar, might then have no choice but to change course.

One of the main reasons why U.S. Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke are traveling to Beijing this month is to work together with the Chinese to prevent the kind of worst-case scenario that could result from the political pressure by the Democratic trade warriors on Capitol Hill. That makes a lot of economic sense, but it doesn't deal with the geopolitical sources of the problem: the bloody and costly war in Iraq and the potential for wars with Iran and other parts of the Middle East that are going to drive U.S. military spending and the deficits into the stratosphere and put even more pressure on the dollar.

Only a readjustment of the United States to the new global political and economic realities could relieve that pressure. Who knows? Perhaps the implementation of the recommendations of the Baker-Hamilton Commission could help not only stabilize the U.S. position in the Middle East but also have a similar effect on the U.S. dollar. The Baker Shock?

Copyright © 2006 Singapore Press Holdings Ltd. All rights reserved.

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  • Leon Hadar is the author of Sandstorm: Policy Failure in the Middle East (Palgrave Macmillan). He is the former United Nations bureau chief for the Jerusalem Post and is currently the Washington correspondent for the Singapore Business Times. Visit his blog.

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