HAPPENINGS IN THE TWO GLOBAL MARKETS that do not conform to Adam Smith's model frequently roil free-market economies such as America's. The foreign exchange market is dominated by central banks that manipulate the value of national currencies for reasons unrelated to what we think of as natural economic forces. And the oil market is heavily influenced by a producer cartel determined to keep prices well above those that would prevail in a competitive market.

So when the Korean central bank announced that it had lost interest (no pun intended) in acquiring more dollar assets to add to the $200 billion it already holds, and the OPEC oil cartel drove prices above $50 per barrel by suggesting that it would cut output, shivers ran up the spines of investors. Share prices and the dollar both lost 1.5 percent of their value in a single day.

Panicked investors foresaw a run on the U.S. currency. That would force the Federal Reserve Board's monetary policy committee to abandon its policy of "measured" interest rate increases in favor of much more rapid increases. The so-called house-price bubble that has kept consumer confidence at high levels would be pricked, consumers rattled, the economy slowed, profit growth curtailed, and share prices driven down.

Worse still, the oil cartel plans to reduce output despite rising demand due to a cold snap in the United States and China's insatiable appetite for oil--and shrinking supplies due to a decline in Russian oil production as Vladimir Putin's old KGB pals take control of the industry.

The resulting higher prices would, in the words of the new annual report of the President's Council of Economic Advisers, constitute "a headwind for the economy because they raise the cost of production, thus weakening the supply side of the economy, and absorb income that could have been used for other purchases, thus weakening the demand side of the economy."

Worse still, prices of commodities other than oil are soaring, in part because of China's massive purchases. Last week, Anglo-Australia's Rio Tinto raised the price of the iron ore it sells to Nippon Steel by a staggering 72 percent, and others in this highly concentrated industry quickly followed suit. Many investors fear this commodity-price surge will add to inflationary pressure created by high oil prices just as the U.S. economy slows, reintroducing America to the stagflation last seen when voters ejected Jimmy Carter from the White House.

It is not unreasonable to ask, in the face of this plausible and unsettling scenario, just how the president's economists can conclude that the U.S. economy will grow this year at an annual rate of 3.5 percent, "faster than its historical average," driven by consumer spending, investment growth, and stronger exports.

The answer, in part, is that the Asian central banks have watched their Korean colleague dip its toe in the water of "let's get out of dollar assets," and get scalded in the process. So they have rushed out statements saying that they have no intention of unloading dollars. Even the Bank of Korea looked at what it had wrought and was displeased.

In its report to the National Assembly, the Bank had said that to increase earnings on its reserves it would "expand investments into nongovernment bonds . . . and diversify the currencies in which it invests." Surveying the carnage that statement created, Kang Myun Mo, head of reserve management, issued a "clarification." He said that although he indeed intends to invest in higher-yielding nongovernment bonds, he has no plan to decrease the proportionate share that dollars represent in the Bank's total holdings.

The dollar recovered, as it became clear that the Asian banks are aboard a tiger, and would see the value of their assets eaten if they climb off. Were they to unload dollars, they would lop billions off the value of the dollar reserves they hold in their vaults.

So they will continue to buy dollar assets, although at a slower pace and shifting to nongovernment bonds. Unless the gradually declining dollar sufficiently stimulates exports and shrinks imports, the U.S. trade deficit, running at 6 percent of GDP, will at some point become difficult to finance without a significant rise in interest rates.

But that day has not yet arrived. The U.S. economy is far more attractive to investors than the sclerotic European Union, a Russia led by a president unfamiliar with the concept of private property rights, a Middle East in turmoil, and a United Kingdom heading down the European path of ever-higher taxes. So investors still want to acquire dollar assets in sufficient quantities to prevent a run, although not a slide, in the dollar.

The more difficult problem relates to oil prices. OPEC has decided to adjust output to prevent consuming nations from accumulating inventories to dampen price run-ups. The cartel will henceforth aim to maintain prices in the $40-$50 per barrel range, Saudi Arabia announced late last week, finally officially abandoning it previous target of around $25.

The higher price confers political--in addition to economic--advantages on producing countries. Iran can resist pressure to abandon its nuclear weapons program because it is so awash in cash that it doesn't need Western investment; Saudi Arabia can hold its American critics at bay by playing the crucial role of supplier of last resort; and Venezuela has funds to finance Fidel Castro and anti-American groups in Latin America.

The disadvantages to America are obvious. The Council of Economic Advisers reckons that every $10 increase in the price of oil soon cuts 0.4 percent off real GDP. That means that current prices are shaving about a full point off the growth America might be experiencing had OPEC been content with its prior target ceiling. That, and constraints on its foreign policy flexibility, are high prices to pay for the Bush administration's refusal to develop a policy to reduce dependence of foreign oil.

Irwin M. Stelzer is director of economic policy studies at the Hudson Institute, a columnist for the Sunday Times (London), a contributing editor to The Weekly Standard, and a contributing writer to The Daily Standard.

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