US Economic Decline Top Issue

The most important long-term strategic challenge facing the Gulf Cooperation Council is not the threat of Islamic extremism or the rise of Iran -- it is the continuing economic decline of the United States.

Ever since 1980, when Jimmy Carter, then president, first publicly committed the United States to use military force to defend the free flow of oil from the Middle East, the United States has been the region’s unquestioned hegemon. And ever since the GCC was formed in 1981, its members have relied on the United States as the ultimate guarantor of their security.

To support the US security umbrella, GCC states have extended various types of co-operation to the United States -- such as basing rights, pre-positioning of equipment and making their own militaries more “interoperable” with US forces. In addition, GCC states have tied their economies to the United States -- through petrodollar recycling, importing US capital goods, pricing international oil sales in dollars and pegging their own national currencies to the greenback.

Looking ahead, the United States will remain the Middle East’s military hegemon for years to come, with a unique ability to project substantial military power into the Gulf for at least the next quarter of a century. The United States economic hegemony, however, is in a serious and continuing decline, as the country continues its run as the world’s leading debtor and the dollar reaches historic lows against other major currencies.

In recent years, GCC states have provided vital financial and monetary support for America’s increasingly strained international economic position. But the costs of extending such support to the US economy are steadily rising -- a reality reflected in recent debates about the wisdom of the GCC states’ continuing peg of their national currencies to a falling dollar. Also, rising economic powers in Asia are emerging as increasingly important trade and investment partners for the GCC, as the United States becomes more marginal to the region’s economic future.

All of this is occurring as a series of strategic blunders by the United States -- invasion and occupation of Iraq and feckless stewardship of the Arab-Israeli peace process, first among them -- are raising doubts in GCC leaders’ minds about the competence with which the United States exercises its military and diplomatic hegemony in the region. Under these conditions, Gulf Arab leaderships will be challenged to maintain effective security co-operation with Washington while also managing more diversified foreign policy agendas and preserving conditions for economic growth at home.

Since the turn of the millennium, three critical developments have overlapped, almost as a “perfect storm”, to put the United States’ continued international economic leadership in serious jeopardy.

First, fundamental shifts in international energy markets have driven energy prices dramatically higher since 2002. While downwards fluctuations in price are inevitable in a volatile market, energy prices will continue to be much higher on average in coming years than in the 20th century’s last decade and a half.

Second, the sustained increase in energy prices is redistributing wealth across the world. The winners in this process, measured by their rising current account surpluses, are major oil exporters -- primarily in the GCC and Russia -- and the major industrial exporters (ie, China, Japan and Germany, the countries with the three largest current account surpluses in the world) that serve them. The principal loser, of course, is the United States, whose international financial position has deteriorated substantially since 2001.

Third, the transfer of wealth from the United States and other energy importers to energy exporters and a small number of manufacturers, such as China, is the main impetus for ballooning global economic imbalances. And, as China and other Asian manufacturers, along with energy exporters in the GCC and Russia, become the dominant capital providers funding these imbalances, foreign government agencies -- central banks and, more recently, sovereign wealth funds -- have surpassed private purchasers of US assets as the most important sources of financing for the current US account deficit.

This perfect storm is putting unprecedented strain on the dollar’s international standing. It also makes the sustainability of global economic imbalances a hot topic of debate among economists and financial market players around the world. The policy decisions by GCC states will be critical to determining how this debate ultimately plays out. In the aggregate, the GCC is now almost as important to financing America’s current account deficit as China. On a per-capita basis or as a percentage of gross domestic product, the GCC’s aggregate current account surplus is larger than China’s.

Although the GCC states are beginning to diversify their reserve assets, a wholesale move by the GCC away from the dollar as the basis for currency pegs and the transactional currency for international oil trading seems unlikely for now. Saudi Arabia is staunchly opposed to these steps, on what Saudi officials candidly describe as “strategic” rather than economic grounds.

Other GCC states are constrained to follow the Saudi lead to avoid damaging prospects on currency pegs for eventual monetary union. Even Kuwait, which shifted the peg for its dinar last year to a “basket” of currencies, gives the dollar disproportionate weight in that basket. And the kingdom carries sufficient weight within Opec to block precipitous shifts in the currency regime for international oil trading.

But, over time, the costs to GCC states of providing continued financial and monetary support for the US economy will grow. And that will pose hard economic and strategic choices for Gulf Arab leaderships.

During his recent trip to the Middle East, Henry Paulson, the US treasury secretary, tried to project a welcoming US posture towards financial flows from the GCC. He also went beyond conventional “strong dollar” rhetoric, pledging his determination to keep the dollar as the world’s leading reserve asset. Mr. Paulson’s observations notwithstanding, why should anyone believe that the current Bush administration, in its last months, or the next US administration will seriously pursue policies to defend the dollar’s value, such as balancing budgets and raising interest rates? The political debate over economic policy in the United States is headed in precisely the opposite direction.

Under such circumstances, how high a price are Gulf Arab states willing to pay to prop up a “deadbeat” United States, which may well choose to let dollar depreciation and inflation write down significant parts of its debt to the GCC and other international creditors?

On the strategic front, are GCC states prepared to use their financial support for the United States to influence the ways in which Washington exercises its military hegemony in the region? In private, Gulf Arab officials and elites complain about the consequences of US strategic initiatives in recent years, voicing concerns that US foreign policy may be creating more numerous and potent threats to the security of GCC states than those against which the US military protects them.

But, for all that GCC states complain about the invasion and occupation of Iraq, for example, they have effectively financed the whole operation by continuing to purchase US treasury securities and other dollar-denominated reserve assets. Will GCC states be so accommodating again -- if, say, the United States initiated a military confrontation with Iran?

The next US president, whether John McCain or Barack Obama, will be challenged to put US policy in the Middle East on a course more productive for the interests of US allies in the region as well as the interests of the United States. For their part, GCC states will be challenged to manage their relations with the United States in ways that increase the chances Washington will actually find that more productive course. And that will mean being frank with US partners about what Gulf Arab states need from their alliances with the United States, what they are prepared to put on the table to make strategic co-operation more effective, and -- just as importantly -- what they are not prepared to pay for.