ECONOMIC SCENE: More spending on Afghan war could hurt the dollar

Could an expanded war in Afghanistan be the costly straw that breaks the dollar’s back, exacerbating already high concerns around the world over its value and damaging its central role in global commerce?

The war’s cost and the weakness of the dollar “definitely” should influence President Obama’s decision on troop levels, says Clyde Prestowitz, president of the Economic Strategy Institute, a Washington think tank. “I don’t think the guys in the White House have recognized this issue.”

The Afghan war is presently budgeted for $65 billion in fiscal 2010, more than the Iraq war. Extra soldiers would add to its cost and to a federal budget deficit now projected at a record $1.58 trillion in the fiscal year, swelled by economic stimulus spending against a major recession.

Because the US has long had a large deficit in its international balance of payments, and because money is fungible, it could be argued that China, Japan, and other nations accumulating dollars in their reserves are paying for the two wars.

The dollar is already down 11.9 percent against major currencies since Obama took office. This drop raises the dollar cost of both wars.
If foreigners decide the dollar is too risky an asset and try to switch some reserves into euros or some other currency, the dollar could plunge further in value.

In this regard, Washington got a scare earlier this month when a British newspaper, The Independent, published a report that a number of Gulf states plus China, Russia, Japan, India, and Brazil have been holding secret meetings to develop a plan eliminating the US dollar as the main currency in international oil transactions. The article was titled “The demise of the dollar.”

Under the plan, the dollar would be replaced in oil deals in 2018 with a basket of currencies including the Japanese yen, the Chinese yuan, the euro, gold, and a planned new currency for some dollar-rich Gulf nations.

The scheme was immediately denied by some of its supposed participants. Harald Malmgren, a consulting Washington economist with high-level contacts around the world, says he’s been told that the replacement of the dollar in oil transactions is not official policy, but merely rumblings of lower-level officials.

“The story that the dollar will keep weakening is foolish,” Mr. Malmgren says.

Some on Wall Street suspect the US heard vaguely about the presumed discussion, prompting Treasury Secretary Timothy Geithner to proclaim, only days before the Independent’s story, that it is “very important” for the US to have a strong dollar and to pledge to preserve its role as a world currency.

Should oil be priced in a nondollar currency (as Iran does already), it would devalue the greenback as a whole in international transactions, Mr. Prestowitz says.

Four years ago, Prestowitz imagined a dollar crash in a book, “Three Billion New Capitalists.” He had China and Japan racing each other to get rid of their huge dollar reserves. “Oh, man, what a prophet I am,” he says jokingly.

The dollar’s role as the main reserve currency gives the US an extraordinary privilege. Other nations help finance US budget deficits by buying oodles of Treasury bonds and other American debt instruments because they’re considered a safe store of value – for now.

“We are printing money,” warns Prestowitz, and too much of that leads to a currency collapse, as has happened in the past in Argentina, Germany, Russia, and Japan.

_______

Be sure to check in with us on Twitter.