The Moribund Dollar's Blowback in Middle-East Economies

The Middle East's oil exporters need to end their peg to the dollar. Virtually all the oil-rich states peg their currencies to the greenback; the combination of skyrocketing oil prices and a dollar that is devaluing by the minute is distorting their economies and fueling inflation. This week's Economist says:

The argument for linking to the greenback was to provide an anchor for the region's economies, many of which are small, open and financially immature. In effect, the Gulf states import America's monetary policy. The trouble is that a fixed currency makes it hard for oil exporters to adjust to swings in the price of oil. And monetary policy in the world's largest oil-importer is not always right for those who sell the stuff...Some smaller Gulf economies now have inflation rates of around 10%.

What should be done about this problem? Switching the peg to a basket of currencies that included both the euro and yen would give the Gulf States more protection against oil-price fluctuations, but this is hardly a panacea for the region's monetary problems. This would still force the Gulf States to link their currencies to monetary conditions that might not suit them, as most big currencies belong to oil importers.

The best idea is probably to abandon currency pegs altogether and adopt the system that developed economies have in place: floating currencies. But instead of aiming for an exchange-rate peg, the States should have an inflation target.

One interesting idea involves including the oil price as part of an amalgam that includes the leading currencies. This would allow their currencies to absorb some of the impact of fluctuations in the price of oil. The worry is that the end of the Gulf States' dollar peg would cause a panic among investors, a real and palpable risk. But with oil prices rising and the dollar continuing to tank, inaction poses a greater threat.