In another thread covering a basket of issues ranging from tax policy, deficit spending, assessing economic policy, etc., I made a point (Senator Clinton, caught rigging town hall meeting.) that the foreign exchange value of the U.S. dollar is an important barometer in how markets perceive U.S. economic prospects and risks.

There is a broader point about such perceptions. Markets can and do make linkages. What happens in one area of economic activity can impact decisions in another area, even when such matters are largely isolated from one another on account of market psychology, which is increasingly difficult as the integration of the world's markets intensifies. Underscoring this reality, former Treasury Secretary Robert Rubin observed of the 1997-98 Asian financial crisis, "The global crisis underscored the reality that in an economically integrated world, prosperity in faraway countries can create opportunities elsewhere, but instability in a distant economy can also create uncertainty and instability at home. One country’s success can enrich others, and its mistakes can put them at risk."

Such factors are at play even now. In rejecting a U.S. request for a fresh increase in oil production, OPEC argued that increased geopolitical risks and the falling dollar are playing important roles in driving the price of oil higher. The geopolitical risks that have been adding a risk premium to oil prices include but are not limited to instability in Iraq (domestic and cross-border Kurdish terrorist operations in Turkey and Turkey's possible military operations in northern Iraq), growing international tensions with Iran and modest possibility of a U.S. attack on Iran's nuclear infrastructure/Iranian retaliation, the ongoing political crisis in Pakistan, continuing threats tied to radical Islamist terrorism, etc.

Abdulla El-Badri, OPEC's Secretary General dimissed notions that there is currently a "shortage of oil."

The Financial Times reported:

Mr El-Badri said, however, that the the "US should help to resolve the problem" and enumerated several factors, among them bottleneck in refining, geopolitical concerns and the weakness of the US dollar, that were affecting the oil price... "We have also the problem of the dollar," the secretary general added.

During the past 6 months, the Federal Reserve's Price-Adjusted Broad Dollar Index has fallen 8% and its Price-adjusted Major Currencies Dollar Index has fallen more than 10%. Statements by U.S. Treasury Secretary Henry Paulson in favor of a "strong dollar" have been insufficient in stemming the dollar's slide on account of market fundamentals responsible for its slide. In fact, Paulson's statements in the face of continuing declines may well be eroding his credibility. Reflecting this development, Ernest-Antoine Seilliere, President of BusinessEurope, advised, "It's increasingly urgent that the U.S. bolsters its rhetorical position." In short, a credible step toward addressing the nation's annual budget deficits (nearly $300 billion in FY 2007 if one includes the off-budget costs of the continuing operations in Iraq and Afghanistan, which have been financed by borrowing which leads to interest costs) might well be needed to rebuild marketplace confidence in a U.S. commitment to a strong dollar.

OPEC's assessment notwithstanding, economic fundamentals have also created a solid foundation for higher energy prices. This year, the quantity of oil demanded has grown much faster than the quantity produced (which has been essentially flat). Shortages have not yet resulted. In the longer-term, a sustained demand imbalance could lead to spot shortages. However, the higher prices commanded by this year's demand imbalance have been exacerbated by geopolitical tensions and the declining dollar. Indeed, some traders have been purchasing oil futures as an inflation hedge. These hedging transactions have increased demand for oil relative to production.

In the end, if the U.S. is to reduce its vulnerability to volatile and high energy prices, it will need to proceed from the standpoint that many of its policy options are intertwined. A comprehensive approach would include restoration of sufficient fiscal discipline to address its short-term and long-term fiscal challenges (so as to maintain the value of the dollar on world markets and assure that it retains the capacity to safeguard its geopolitical interests and advance its geopolitical objectives), improvement of its trade position through increased marketplace competitiveness (which will require investments that enhance future productivity, e.g., education), reduction of its contribution to increased geopolitical risk by returning to a pragmatic Realist approach to foreign policy that is centered around the national interest and is constrained by balance of power considerations, etc., and development of a credible energy policy that reduces its dependence on imported oil (to reduce long-term demand imbalances that could result as developing nations consume an increasing amount of oil for their energy production and exposure of risk associated with nationalized oil industries whereby countries such as Venezuela and Iran might well use energy resources to advance political objectives at the expense of market needs).