Members of the Gulf Cooperation Council, which includes Saudi Arabia and many other rich oil countries, have a very neat policy. They currently peg their currency to the dollar.

If the dollar goes up, their currency goes up. If the dollar goes down, their currency goes down.

They are thinking about abandoning this policy. Why? Because of inflation. The weaker the dollar gets, the weaker their currency gets, and the more it costs them to import food and other resources.

To my knowledge there has not been rampant inflation in America, yet. But these are smaller countries with a greater dependency on imports for most of their raw materials. So they are much more sensitive to the weakening of the dollar than America is itself.

However, I think this is only an issue of time. If these countries are being hurt by inflation because of the weak dollar, then this will eventually also be the case in America. (And by the time you begin to feel it in your wallet, it’ll be much harder to fix the problem.)

For a long time, the American dollar has been the world’s currency. You can’t buy oil without it. Many countries don’t hold gold in their treasuries, but tons American 100-dollar bills. So long as there is the perception that America is strong, and its currency is strong, this will continue to be the case.

Now for a variety of reasons the American dollar has been declining. And here is the dangerous part. There has to be some threshold, a kind of psychological breaking point, where people overseas will abandon the dollar. This is a totally subjectively thing. No one knows where that point would be. But at some point, if the dollar’s decline goes too far, all those people supporting it outside of America will inevitably decide to ditch it. Oil countries will want Euros or Yen, and China will try to get rid of its dollars as fast as they can, while it still has some value … a panic ensues. A kind of Black Monday for the dollar.

If that were the happen, the dollar would not be worth picking up off the ground. You’d have hyper inflation. Note, that historically this has been the fate of most non-gold backed currencies (fiat currencies).

Whether this happens or not depends on many different factors. The government has to curb it’s debt, that is cut spending. The federal reserve needs to keep rates as high as possible (without choking off investment and stalling the economy.) Between the war in Iraq, the subprime mortgage problem, and the usual spendthrift congress this is unlikely to happen. It’s even expected that the Feds will lower the prime rate on December 11. Maybe boosting stocks a bit, but further damaging the dollar.

Remember high stock prices are meaningless if measured in declining dollars.

The main problem here is we are talking about a psychological threshold. A point at which people lose faith in the dollar? Inevitably the powers that be will not guess that point correctly. They will presume to be safer than they are, merely because accepting the truth is simply too hard for them. But ultimately no one can tell whether this point is right around the corner, or still a ways off. No one really knows.

It’s sort of like this, the prestige of the American dollar was so high, that in an indirect way it became possible for politicians to turn on the printing press, like a kind of credit card, to buy all they wanted. Now with a power like that, do you think any politician could resist the temptation to spend, spend and spend again? Many people should answer that question only after taking a fresh look at their own credit card debt.