Comments about the U.S. dollar at a recent OPEC meeting illustrate a common fallacy: that because oil is priced in dollars, a weaker dollar doesn’t affect our energy costs.
This is a comforting idea, but it is false. World currency and oil markets are complex and incorporate many factors. The declining price of the U.S. dollar already affects us because the dollar’s exchange value is an important factor in determining oil prices.
Indeed, the slide of the dollar against the euro has been an important cause of recent oil price increases. Sellers know that as it takes more dollars to buy any other major currency, the effective buying power of oil – even at a constant dollar price – is falling.
When selling oil at $90 buys less from every other country in the world save one, you are less willing to sell additional barrels. That drives up the price in dollars, although the cost increase in Europe, Japan and elsewhere is less, because the dollar continues to lose value.
The question of whether other nations continue to hold many dollars is more important.
Most nations maintain substantial balances in the currency of other countries that are more important economically. Such foreign exchange reserves pay for imports and service debt owed other nations. Maintaining comfortable balances avoids the economic harm that might arise if vital imports were interrupted by some economic crisis. In general, the smaller the nation or the more dependent on imports, the greater its relative level of foreign currency reserves.
Some exporting nations also keep large balances for domestic policy reasons. China and other East Asian exporters buy dollars to keep their own currencies-and thus their own exports-cheap. This fosters domestic employment and economic growth even though it penalizes their own consumers. Thinly populated oil exporting nations hang onto foreign currency balances because they lack profitable investment opportunities at home.
When money was gold or silver, the question of what foreign currency to hold was irrelevant. Then, for many decades, the British pound functioned as the global “reserve currency.” The U.S. dollar began to replace the pound after World War I and reached complete dominance after World War II.
The dollar was everyone’s choice. Its value was stable, and it was instantly acceptable as payment everywhere. But, beginning in the 1970s, U.S. economic mismanagement eroded that dominance. By 1999, many thought the new euro would gain a large share. That change hung fire for eight years but is happening increasingly now.
A vicious circle looms. The less valuable the dollar, the less other nations want it for their foreign exchange reserves. The less desired the dollar is as a reserve currency, the faster it loses even more value. U.S. inflation and interest rates can rise as a result. Hold onto your hat.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.