All wars generate conspiracy theories. The most interesting theory doing the rounds in relation to the war in/on Iraq is based on the struggle between the US dollar and the euro for pre-eminence as an international reserve currency, and, in particular, a basis for trade in oil. Until recently, this theory has been widely circulated among opponents of the war, but a version recently appeared in Newsweek with the implication that the shift to trade in dollars was justified as ‘spoils of war’.

Although the factual details and the supporting analysis vary from version to version, the common factual core is the fact that both Iraq and North Korea have recently switched their reserves from dollars to euros and that Iran is considering following suit. This, rather than weapons of mass destruction, is seen as the real cause of the war. In some accounts, this is tied to the attempt coup, generally welcomed in the US, against Venezuelan President Hugo Chavez who had also undertaken some diversification of foreign exchange holdings. One report, widely circulated on the Internet, includes an anonymous insider who is quoted as saying ‘Saddam sealed his fate when he decided to switch to the Euro in late 2000’.

The North Korean angle can be dismissed fairly quickly. North Korea’s annual trade is roughly comparable with Tasmania’s and its foreign exchange reserves are negligible. Then again, by many accounts, North Korean was something of an afterthought in the Axis of Evil, brought in to replace Syria when it was realised that an all-Muslim Axis would not play well with the world public.
More generally, the focus on Middle Eastern petrodollars is redolent of the 1970s thinking that still dominates much policy debate on both sides of the politicla divide. The characteristic feature of this thinking is an overemphasis on the economic importance of oil. The vast majority of US-dollar denominated assets are held in Europe and (East) Asia, and it is the sentiments of investors in these regions that will determine whether the US remains dominant as a reserve currency. In economic terms, a decision by OPEC to quote in euros rather than dollars would make very little difference.

Before going on to look at the implications of the war for the dollar, it is worth asking ‘does it matter if the dollar is the world’s reserve currency?’ After all, the pound sterling was an important reserve currency until the late 60s, and this did not seem to do much for the British economy.

The US directly benefits from the ‘reserve currency’ status of the dollar through international seignorage, that is, the fact that the US government can print dollar notes for which foreigners, notably in Eastern Europe, are willing to exchange real goods and services. A shift towards the euro would reduce or eliminate this benefit. However, as Lawrence H. Meyer of the US Federal Reserve Board of Governors, has observed, the total benefit of international seignorage is about $US15 billion per year – not much of a motive for a war that has already cost about $US50 billion and is likely to cost much more.

The real issues are subtler and relate to the complex relationship between military power, economic power and the ‘soft power’ of cultural and diplomatic influence. A successful outcome in Iraq may be seen as reinforcing US hegemony and therefore increasing the willingness of market participants, including central banks, to take actions that reduce their own returns but bolster the status of the dollar as a reserve currency.

Taken as a whole, I would argue the Iraqi war has done the opposite. The effect has been to make the US appear dangerous and unpredictable and to increase the desire of most people and governments to constrain its hegemonic power. Moreover, Bush’s willingness to spend vast amounts on war while making yet more dramatic cuts in taxes has strengthened the perception that US debts will sooner or later be repudiated either directly or through inflation.

However, this is not the view in Washington, where military and economic power are still seen as going hand in hand. It’s clear that, in the minds of those formulating US policy, military victories achieved in the face of European opposition will pave the way for continued US economic dominance.

Thus far, the foreign exchange markets don’t seem to agree. Although the $US is still well above its fundamental value, it has declined steadily during the Iraq war, with little regard for whether the war news is good or bad.

Update This piece from the UK Centre for Economic Policy Research considers a wider range of effects including benefits for ‘home’ financial institutions, relaxation of the ‘external constraint’ on macroeconomic policy, the role of the region in international institutions, effects on macroeconomic policy coordination, and the wider consequences of exercising ‘currency hegemony’. They conclude that the impact of the euro replacing the dollar for most international transactions would be

The consequence could be a welfare gain of 0.5% of GDP (annually) for Europe, with a similar loss for the US – as well as the other economic and geopolitical attributes of the ‘hegemonic’ world currency.

On this estimate the cost to the US would be around $50 billion per year, still well below the cost of maintaining military hegemony, which will certainly raise annual US defence expenditure by at least $100 billion per year, while having only a marginal impact on currency hegemony.