Will the Arab Revolution Topple the Dollar?

As unrest in the Arab world has grown over the past few weeks, the dollar has fallen in value. That would seem anomalous, since the dollar has served for decades as a safe haven in times of crisis. But investors apparently have noticed that the U.S. is unbalanced: too much in the way of imports, not enough in the way of exports, and a growing federal deficit that is likely to punish holders of U.S. Treasury securities if it isn't brought under control.

Exacerbating things is the rising price of oil. Since oil is traded in dollars, the lower the value of the dollar, the cheaper oil becomes to holders of other currencies. One player to watch in particular is China, a large consumer of oil with a growing appetite. The Chinese have already been gradually diversifying their foreign currency investments away from the dollar. Rising oil prices may, more than all the political pressure that can be exerted by the U.S. and other Western governments, convince the Chinese government to truly de-link the yuan from the dollar. As the yuan rises, oil becomes cheaper for the Chinese. If China can turn its economy toward domestic consumption--a goal the Chinese government acknowledges--look for the yuan to rise markedly against the dollar.

Some in the U.S. government would contend all this is good. A cheaper dollar enhances America's exporting competitiveness. But the price of a cheaper dollar is likely to be higher inflation--in gasoline prices and also the price of our numerous imports. The Fed's ultra-easy money policies would have to end and interest rates would rise. That would throw a wrench into the economy in many ways, from slowing the still feeble real estate market to discouraging business expansion to wrecking Wall Street profitability (which rests on a zero cost of funds) to knocking down stock prices.

The Arab revolution is almost entirely out of the control of Western governments, especially the mess in Libya. And even if things in the Arab world settle down in a few months, growing demand from Asia will continue to support and maybe push up oil prices. It's in the interest of the rest of the world to weaken the dollar in order to make oil cheaper. Even serial exporters like China and Japan have to weigh the increased cost of oil against their export revenues in deciding whether or not to keep their currencies weak against the dollar. Also, it seems to be a goal of the Federal Reserve's relentless easy credit policy to weaken the dollar. As the dollar drops, OPEC and other sellers of oil may begin to demand payment in other currencies. The dollar would drop further in such a scenario. Even though America would get an exporting boost from a falling dollar, rising interest rates here would slow the economy at the same time. How this mix of countervailing forces would play out is anyone's guess.

In the financial markets, something unexpected usually causes market breaks, crashes and other singularities. After all, expected events are quickly incorporated into asset prices. The dollar market is too big for an abrupt crash. But the Arab revolution has unexpectedly highlighted the dollar's weaknesses. That won't be good for the greenback.