America's foes prepare for a monetary jihad

The US dollar has long been the currency of the oil industry. But members of Opec are contemplating

However darkly terrifying America's Iraqi horror story, a small voice of comfort has broken through US night sweats. You are still the most powerful and richest nation on earth: you will get through this, it murmurs. But that reassuring whisper comes from a small devil on America's shoulder, speaking mischief that will land the listener in deep trouble.

A great many people - if not in the White House - have grasped the reality that America's huge, all-conquering economy is genuinely vulnerable for the first time since the 1930s, and that its fragility coincides with a period of expanding and expensive military exposure around the world.

US bestseller lists are stuffed with books agonising about whether the American empire is finally coming to a close; uncanny parallels are drawn between the military and financial overstretch of imperial Rome and imperial Washington. George W Bush's pre-emptive doctrine in foreign policy is enormously costly; on top of billions of dollars' worth of tax cuts, largely for the rich, it is prohibitive. It is predicted that the federal budget deficit will reach $2.4 trillion over the next ten years. To finance that deficit, the US needs to persuade investors - more often than not from overseas - to lend it up to $4bn net every day.

Even without America's apparently infinite capacity for foreign military adventurism (how much would tackling Iran or North Korea cost?), its fiscal outlook seems dire. Two experts on the US budget position, Niall Ferguson and Laurence Kotlikoff, estimate that the country faces a $45 trillion gap between the money it has and the money it needs to finance existing social security, Medicare and pensions commitments ahead.

It is not just the federal government that is in trouble. When adjusted for inflation, the wage for the average American male working full-time has fallen over the past 30 years; and, because of that, five times as many mothers - even those with young children - must now work to make a decent living wage. Not since the Depression have Americans saved so little and, at the same time as running down their rainy-day money, been so neck-deep in debt. By 2003, total debt had soared to $37 trillion; that's $128,560 for every man, woman and child in the country. Some of that debt has been racked up on mass retail therapy (Americans love to say "when the going gets tough, the tough go shopping"), but a lot of it has been the inevitable result of the Average American Joe struggling to make ends meet.

The richest nation on earth is living way beyond its means, and yet the Bush administration blithely continues to spend. It takes no steps to rein in the deficit - sometimes, indeed, it seems that the deeper the deficit, the more reckless the administration becomes. No other nation on earth can behave this way - in every other case, governments know that if their deficits run out of control, they will be "punished" by the market: investors will lose confidence, interest rates will have to be raised to attract capital, financing the deficit will become more expensive, and a vicious spiral will be in place. Why, then, can the US run a deficit of more than 5 per cent of its gross domestic product and still manage to attract $4bn a day at interest rates of only 1.75 per cent?

The US has been running a bubble economy for decades; the recent dotcom boom and bust was a minor episode in a history of deficit-financing since the 1960s. Then, as now, the US borrowed with impunity; whereas other countries have always had to choose between guns and butter - foreign policy expansionism or domestic prosperity - the United States has spent profligately on both. John F Kennedy spent freely on New Deal social programmes and the Vietnam war; George W Bush has emptied the coffers on tax cuts and Afghanistan and Iraq.

There has never been a shortage of people willing to lend to the US; after all, as the richest nation on earth, it has to be good for the money, doesn't it? Even when investors have become nervous about its profligacy, there has been plenty of credit because the US economy is a crucial market for the world's producers. In living memory, the United States has been the sole engine powering the world economy: there has been no alternative to continually injecting it with fuel.

But the US has a stick to add to the carrot: since the end of the Second World War, it has had the unique privilege of "owning" the world's reserve currency - the notes and coins used for trade and investment more than any other currency for 60 years. This confers unimaginable advantages. America is able to ignore the discipline of having to balance its books because, if it runs out of money and can't find anyone to bail it out, it can simply print dollars, inflating away the value of its debt and destroying the value of the assets held by its creditors. In other words, it can threaten financial blackmail.

In the 1970s, European and Asian governments started complaining about lending America the money to finance the Vietnam war; the US simply responded by engineering a catastrophic fall in the dollar, which erased its deficit over time but also crucified the economies of its trading partners in the process. Now, with the deficit soaring again to finance foreign wars, the US is repeating the trick. It has encouraged the dollar to fall; exporters to the US such as China and Japan have had no choice but to try to arrest that decline to protect their trade. How? By buying dollars, which they invest in US treasury bonds, thus financing the deficit. How very neat.

But the United States cannot count in perpetuity on winning this game of financial chicken, based on the pre-eminence of the dollar. Its angriest political enemies have worked out the game and have been mulling over their counter-moves. Al-Qaeda has already targeted the soaring symbols of US economic power, from the twin towers to the New York Stock Exchange; now Muslim fundamentalists are trying to topple the dollar. A plan being pushed in particular by Mahathir Mohamed, former prime minister of Malaysia, for a new gold-backed Islamic currency - the dinar - is a rallying point. "Stealth Bomb to Dollar: Islamic gold dinar!" one website proclaims, describing the currency as "the second prong to planned Muslim terrorist attacks on the United States, intended to annihilate US economic power in a world of rising gold prices and a persistently declining dollar". The dinar, it says, is the tool of "monetary jihad".

Rejection of the dollar is increasingly being used as an act of political aggression, and nowhere more acutely than in oil-producing countries. The trailblazer was none other than Saddam Hussein who, in 2000, announced that Iraq would henceforth make all its oil trades in euros, a decision that conspiracy theorists - and not a few eminent Middle Eastern experts - say triggered the US invasion. The United States derives substantial benefits from the dollar being the established currency of the oil industry. Because most countries import oil, they must maintain reserves in dollars to pay for it - two-thirds of the world's currency reserves are kept in dollars. This is a major factor upholding the dollar's position as the world's reserve currency; a switch out of dollars in the oil industry would be a major assault on the currency's pre-eminence.

In April 2003, Indonesia's state oil company, Pertamina, said it was considering using the euro for its oil and gas trades. Even more significantly, in October last year President Vladimir Putin hinted that Russia, the world's second-largest oil exporter, might switch to euros. A Russian move would be enough to tip the balance for other major oil producers. As Arab disapproval of the US war in Iraq has mounted, so a consensus for switching out of dollars has been building; Opec has openly discussed the option and even Saudi Arabia, once America's staunchest Middle Eastern ally, is reported to be considering rejecting the dollar. For now, the euro is the most viable alternative; in future, it could be the Islamic dinar or, far more likely, a new Asian currency.

Western storytellers would relate the tale of the emperor, his new clothes and the little boy who saw his nakedness; perhaps Arab fablers might talk about desert mirages. America's economic dominance was once real; it is now a receding reality, a confidence trick. Washington might ponder that before scattering its dollars and daisy-cutters next time around.

Janet Bush is writing a book about the unravelling of the dollar hegemony