Resident Fellow Desmond Lachman

Your editorial "Dollar-pegged out" (July 8), on the Gulf countries' inflation problem, correctly diagnoses that at the heart of the matter are these countries' dollar pegs, which rigidly link these countries' monetary policies to that of the U.S.. However, your proposal that these countries instead peg their currencies either to a basket of currencies or else to oil offers these countries at best only a very partial solution to their inflation problem.

Pegging to a basket of currencies would not provide the Gulf countries with the monetary policy independence that they need to set their domestic interest rates at levels that might be appropriate for reducing their close to double digit rates of inflation.

For in the same way that the dollar peg limits these countries' ability to raise their domestic interest rates above those in the U.S., a peg to a basket would not allow them to raise their interest rates above the weighted average of interest rates of the countries to whose currencies they would be pegged.

With domestic inflation rates at about 10 percent, would it really make much difference to their efforts to combat inflation if the Gulf countries were able to raise domestic interest rates to about 4 per cent from their present level of about 2 percent?

In a world of open goods and capital markets, the only way the Gulf countries could regain monetary policy independence would be for them to have at least some measure of a floating exchange rate. It is in that direction that the Gulf countries should be moving without delay before inflation really takes hold in their economies.

Desmond Lachman is a resident fellow at AEI.