There have been strong empires with weak currencies, but not often and not for long.  The Soviet Union, Spain after Philip II, the Ottoman Empire after Suleiman, and an impoverished Britain after Versailles all come to mind.  That financially fragile states cannot support ambitious political and military ventures is obvious to common sense and confirmed by experience.  It was, therefore, interesting to observe the surprising lack of geo-economic excitement, in the last week of May, when the euro hit an all-time high against the U.S. dollar.  At $1.20, Europe’s common currency completed a 16-month rally from a low of only 82 cents.  “We are in a very pessimistic dollar season,” a leading German banking analyst said, and, “as long as there are no reasons to correct that view, it will go on.”  While such pessimism is beneficial to the recovery of the American economy—who can be against cheaper exports and lower trade deficits?—the political significance of the dollar’s continuing weakness deserves closer scrutiny.

After the victory in Iraq, the United States appears more powerful than ever, mightier than any power in the whole of history.  For better or worse, the Bush administration proved that it was able to do what it had set its mind to many months ago.  It has stepped on many toes in the process, humiliating “Old Europe” (avoidable), embittering the Arab world (inevitable), and rendering the United Nations irrelevant (a good thing).  The aftermath of the victory creates an excellent basis for a creative American role in the Israeli-Palestinian conflict and for a gradual rapprochement with the Europeans and Russians from a position of statesmanlike strength devoid of arrogance.

There is a problem, however.  The advocates of global dominance in Washington have always seen the war against Iraq merely as a stepping-stone to greater things.  The Project for a New American Century, conceived and staffed by people destined to become key players in President Bush’s administration and their neoconservative friends and allies, was created specifically to advocate a world order completely dominated by unrestrained American power.  Their tool of choice, the theory of preemption, was inaugurated in the new strategic doctrine in September 2002 and tested this spring.  Its advocates will call the initial result an unqualified success, and they will clamor for more of the same.

The global-imperial scheme has a weak spot: the dollar.  The U.S. currency is increasingly seen—at home and abroad, by proponents and opponents of the New American Century alike—as the potential Achilles’ heel of the project.  When the war in Iraq was launched last March, many voices all over the Arab world demanded that OPEC countries start selling oil for euros, not U.S. dollars.  The threat is not new: A generation ago, it backfired when oil producers’ demands for payments in gold briefly drove its price to over $900 per ounce.

Today, an alternative to gold exists, however, and it is called the euro.  Saddam Hussein made the switch last fall and reaped considerable benefits from it in the remaining months of his rule: The ten billion dollar Iraqi oil-for-food fund at the United Nations gained a hefty billion, thanks to the conversion.  That option remains open to the House of Saud, in Iran, and along the coast of the Gulf.

To the United States, the benefits of the current arrangement are considerable.  As long as oil is traded in dollars, central banks around the world have to prevent speculative attacks on their currencies by holding huge dollar reserves.  According to Henry C.K. Liu of the New York-based Liu Investment Group, the higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold.  This creates a built-in support for a strong dollar that, in turn, forces the world’s central banks to acquire and hold more dollar reserves, making it even stronger:

This phenomenon is known as dollar hegemony . . . the peculiarity that critical commodities, most notably oil, are denominated in dollars.  Everyone accepts dollars because dollars can buy oil.  The recycling of petro-dollars is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973.

Other countries’ dollar reserves must be invested in American assets, creating an artificial capital-accounts surplus for the U.S. economy.  It is, therefore, significant that the euro—now the joint currency of most E.U. member-states (including Old Europe’s Franco-German axis)—has appreciated by well over a third against the dollar since early 2002, when it traded at 84 cents.  This is a truly astonishing gain, in view of the fact that the economy of the European Union is neither booming (in Germany’s case quite the contrary) nor absorbing huge investment funds from around the world.  It demonstrates the underlying weakness of the dollar, which still accounts for 68 percent of global currency reserves.  If the “petro-euro” threat were carried out, global demand for dollars would slacken and throw exchange rates into turmoil.  Some analysts predict that something like two dollars per euro would be the likely result within a year.

The consequences for the global economy would be incalculable and—for the United States—catastrophic.  Global trade would cease being “a game in which the US produces dollars and the rest of the world produces things that dollars can buy.”  The U.S. economy would no longer enjoy the benefits of a gigantic subsidy provided by the goods and services of countries holding their reserves in dollars—notably Japan, which imports four fifths of its oil from the Middle East.  Fewer dollars circulating outside the United States would soon translate into fewer goods and services that the United States could obtain from abroad on what amounts to interest-free credit.  American consumers would no longer be able to buy cheap imports, and the most obvious result would be at the pump: The price of euro-discounted oil would soon exceed $40 per barrel, pushing a gallon of unleaded above $3.  Spiraling energy costs would turn the current recovery—sluggish and uncertain as it is—into a slump unseen since Herbert Hoover’s presidency.  Current-account deficits—half a trillion dollars last year alone—would no longer be financed by foreign capital, because its influx would simply cease.  Global demand for shares of American companies and U.S. Treasury bonds, already weak compared to the heady days of the 90’s, would collapse altogether if oil producers stopped unloading their petrodollars on the American market.  The Dow would drop below 5,000 within weeks, and property markets would collapse within months.  Without foreign investors, interest rates would zoom into double digits, and the Fed would find inflationary pressures simply irresistible.  Mr. Green-span would excuse himself from another term on the grounds of age and poor health.

The consequences for the rest of the world—the non-oil-producing, non-European world, that is—would also be dire.  An International Monetary Fund report released on June 6 warned that the dollar’s further steep fall would threaten economic growth all over the world, but most notably in Latin America.  An extended period of slow global growth would erode fundamental prospects of emerging market economies.  It would also cause a decline in foreign direct investment, a main-stay of finance for emerging markets south of the Rio Grande.  With Argentina’s meltdown and the presidential power in heavily indebted Brazil in the hands of a leftist-populist demagogue, the political fallout could negate the fruits of a decade of democratization and market reform in the hemisphere.  It is not just the current holders of dollar reserves who would be hurting.

In Washington, the threat is currently regarded as remote, because any significant decline in the value of the dollar would hurt major oil producers.  The Saudis and others cannot afford to see the value of their U.S.-currency reserves and Treasury bonds depleted, the argument goes, and the resulting economic downturn in the United States would be felt around the world and would hurt Arab oil revenues by reducing demand.  The additional, unspoken assumption is that the United States will retain control, by whatever means, of the Iraqi oil, and that it will be traded in dollars, come what may.  The oil “belongs to the people of Iraq,” we are repeatedly assured, but the U.N. Security Council has approved the United States as the trustee of that wealth.  Whoever is eventually recognized in Washington as “the people’s” legitimate representative will be expected to use a sizeable chunk of those dollars for the rebuilding of Iraq by Bechtel et al.

The economic argument for the switch, however, seems compelling.  It would mean that, whatever you can get for dollars, you could get for euros—and your euro reserves would be safer in the long term.  Unlike the United States, the eurozone does not run huge trade deficits.  It is not heavily indebted to the rest of the world, and it is not subject to the political will of a single national decisionmaking structure.  Europe is the Middle East’s biggest trading partner; it imports more oil and petroleum derivates than the United States; and it has a bigger share of global trade.  Even the short-term prospect may be inciting: If oil producers play their hand right and convert their dollar assets to euros before they start demanding payment for oil in euros, those assets would immediately increase in value.

The political argument is even more compelling.  In the aftermath of the war in Iraq, its most determined advocates demand that the United States proceed with her “mission” of bringing democracy to the Middle East, and even such “friendly” states as Saudi Arabia and the United Arab Emirates are feeling nervous.  In the short term, U.S. military power makes it very difficult for Europe and the oil-producing states to use the euro as a tool to challenge American power, but future developments will depend on the policy decided in Washington, and on the signals sent to the region.

Those signals remain ambivalent.  Secretary of State Powell would deny it, but there are figures within the Bush administration more powerful than he—notably Paul Wolfowitz—who regard the Middle East as a project that has only just begun.  Former CIA Director James Woolsey frankly states that the United States is fighting an open-ended campaign for “democracy” in the Middle East.  The media chorus echoes the theme: Norman Podhoretz dubbed the project “World War IV,” aimed at “regime changes” all over the Middle East.  It is winnable, he says, provided that America has “the stomach to impose a new political culture on the defeated parties.”

Arab oil producers and Iran see that as a threat, and they may conclude that the monetary weapon is the only one they can effectively use without inviting military retaliation.  Unlike the neocon-dominated U.S. administration, the eurozone countries do not threaten them.  Quite the contrary: The powers of Old Europe are busy staking their claim as the Arabs’ best friends in the Western world.  They also remember that the Eisenhower administration used not only diplomacy but the power of the dollar to force Britain and France to withdraw from Egypt in 1956—and from the rest of the region soon after.  Those who recognized echoes of “Suez in reverse” in the French approach to the recent Iraqi crisis will see other parallels in the financial sphere.

Paradoxically, the danger to the dollar may be used to argue for speeding up the “liberation” of the Middle East.  As British analyst Michael Stenton says, “If the neocons don’t ‘do’ Saudi Arabia, the US might lose the Saudis at just the point in time that Iraq becomes most difficult.”  Their rallying cry must be, “We can’t stop now!” because only by marching on can they protect the dollar—the greatest weapon the United States has.  They know that if the dollar goes, the project of global hegemony goes with it.  The ultimate corollary of this argument is that only an American-ruled world will be safe for the dollar.  The notion is pleasing to the neocons, but it is inherently unhinged and certain to result in America’s destruction, which would be more thorough and irreversible than any dislocation arising from the war of currencies.

Defense of the dollar demands the emergence of a realistic and prudent approach to Middle Eastern affairs.  If a further steep decline is considered to be contrary to the U.S. national interest, it is necessary to remove political incentives for the region’s oil producers to switch to the euro as a defensive ploy against what they perceive as unrestrained U.S. interventionism.  A scrupulously evenhanded and creative American approach to the Israeli-Palestinian problem would be a visible litmus test of a more benevolent regional intent.  It makes a lot of sense on geopolitical and moral grounds, and it can be made conditional on the retention of the financial status quo by the key players needed for its success, such as Saudi Arabia.  The looming danger to the dollar, with all its incalculable consequences, necessitates a new start in the Middle East on the grounds of enlightened American self-interest.