The latest revision to the forecasted federal deficit has implications beyond the sustainability of current government spending. Reading a pair of high-profile, skeptical assessments of Peak Oil in the context of a $9 trillion deficit projection for the next decade, it occurred to me that the most serious risk of higher oil prices in the near future might not be flagging production or surging demand but the further depreciation of the US dollar. The quickest route back to $4 gasoline could run through Washington, DC, rather than Riyadh or Beijing, and that might not be as helpful for renewable energy as its advocates might guess.

The main worry I've heard expressed about the size of the federal deficit has focused on the risk of inflation. However, high deficits carry another risk that could have a much more direct effect on energy prices, which in turn could help re-ignite inflation. The problem is acute because it goes well beyond the one-time impact of federal stimulus efforts, which have apparently ballooned this year's deficit to $1.6 trillion. Fundamentally, there is a persistent and growing gap between government revenue and expenses, exacerbated by high unemployment and lower income--and thus lower tax collection--particularly from the top quintile of earners who have consistently been paying 86% of the federal income tax. Unless that gap can be brought back into line with recent history, the government will soon face a difficult choice. Financing a steady stream of trillion-dollar annual deficits will require either interest rates high enough to attract investment from all over the world--and thus high enough to stifle a nascent recovery--or the monetization of the debt by means of the Federal Reserve printing even more money than recently. The latter course, which seems likely to be more politically palatable, despite Dr. Bernanke's reappointment, would inevitably weaken the dollar and lead in fairly short order to higher energy prices.

We got a taste of this effect in 2007, when oil prices and the dollar moved in opposite directions in an oil-dollar price loop that looked more than merely coincidental. A weaker dollar encourages producers to raise prices, or to consider pricing their output in a stronger, more stable currency. Meanwhile, non-US consumers experience stable or falling energy prices that encourage demand growth, which eventually leads to higher prices in all currencies. Either way, US consumers would see higher prices for petroleum products, though it's not clear how much further demand could fall in the near term, with US oil consumption already running 10% below 2007's, on a comparable year-to-date basis.

The dollar has already weakened by about 10% against the Euro and 5% vs. the Japanese Yen since March, as the resolution of the financial crisis and early signs of a global recovery have eased the fears that prompted a classic flight to dollar safety. This shift merely returns the exchange rate to roughly its level of pre-crisis 2008. Oil prices have risen by around 40% over the same interval, though how much of that is due to a weaker dollar is far from clear. However, from today's $70/bbl level, another 25% drop in the value of the dollar could return us to the threshold of $100 oil.

Higher oil prices due to a weaker dollar would not necessarily be beneficial for biofuels and other alternatives to oil, either. If we learned anything from the oil price spike of 2006-'08, it was that higher oil prices don't automatically make alternative energy more competitive. If only oil prices were moving, it might be helpful, but the only way to achieve that is through taxation, not inflation or currency depreciation. Just as oil functions in a global market, so too the components of the main alternative energy technologies have become global, with wind turbines and solar panels sourced globally and in high demand in many regions. So too for the steel and other basic materials for constructing such installations, as well as the grains and oilseeds turned into ethanol and biodiesel. A weaker dollar wouldn't just mean higher oil prices, but higher prices at least for all of the new energy sources to which we are turning in our effort to address climate change and bolster our energy security.

At an average price for 2008 of $93/bbl, oil made up just 15% of the value of the goods and services we imported last year, and a weaker dollar would see the prices of a host of other things--cars, electronics, call-center assistance, for example--go up, as well, fueling inflation and further depressing our standard of living. That scenario is hardly inevitable. A sea change on the part of the American public could convince the Congress and administration that we are finally prepared to pay for the government we have been demanding, or to see government services fall to a level commensurate with the level of taxation we appear willing to bear. Or the Fed could start raising interest rates to defend the dollar, in spite of the consequences for economic growth and unemployment. I'm pretty sure which choice I'd vote for.

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