Russian Aggression and The Dollar

August 13, 2008

Extremely high policy-induced U.S. interest rates, a ballooning Washington deficit and a sharp break in America’s inflation fever were the main dollar supports during President Reagan’s first term.  An important background factor, however, was a big anxiety premium from increasingly strained East-West and North-South relations.  An image of U.S. military ineptitude and foreign policy appeasement had taken hold during the late 1970’s following the Tehran hostage situation and Russia’s largely unchallenged invasion of Afghanistan.  That perception melted away when President Reagan refused to blink after Kremlin leaders warned that disarmament talks would break down if Pershing II and cruise missiles were deployed in Western Europe.  Reagan also disregarded the misgivings of many Europeans over those plans to accelerate the arms race.  A toll was exactedl on U.S. public finances but the weak Soviet economy suffered a politically fatal blow.  Soviet leaders could not back up their tough rhetoric, and in that era dollar strength came to be viewed in part as a barometer of  America overtaking Russia in the cold war.  The U.S. had flexed some muscle, and Europe and Japan were cast in the role of needing American protection.

Alas, the cold war only hibernated, and the pendulum may now be swinging back.  President Bush used tough rhetoric to condemn Russian aggression in Georgia , but Moscow saw that the U.S. military as over-committed to its wars in Iraq and Afghanistan and acted in an unimpeded way to recapture a piece of the Soviet empire.  This is still an unfolding story, and what happened in Georgia could be replicated in other former Soviet satellites.  If investors come to fear that the U.S. super-power role is compromised, history suggests that the dollar will be victimized.  So far, that has not happened.



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