For years, policymakers have fretted about the global imbalances embodied in the US trade deficit and associated surpluses in China, Japan and oil-exporting countries. The fear was that if these were to unwind rapidly, with confidence evaporating in the US economy and the dollar, the outcome would be grim.
In 2006, the International Monetary Fund said a disorderly reduction in the US trade deficit would involve “a more rapid fall of the US dollar, volatile conditions in financial markets, rising protectionist pressures, and a significant hit to global output”.
Dominique Strauss-Kahn, the IMF managing director, yesterday made it clear that some of those fears are materialising. “For a long time the dollar was in a situation where its downward movement was predictable. We are now in a situation that is more stretched,” he said. “It's a problem for economic growth. We clearly face a situation in which the risks to economic growth are more and more serious.”
Though the cause of the current crisis – domestic lack of confidence in US mortgage-related assets – was not widely foreseen as the trigger for an unwinding of global imbalances, the subsequent events in global financial markets resemble the worst fears policymakers have long expressed.
The IMF's 2006 analysis in its World Economic Outlook, for example, warned that a severe disruption in financial markets would result in “even worse outcomes” than their pessimistic scenario. Such a situation could lead to a shock to aggregate demand, protectionism and “a substantial reduction in living standards across all countries”.
Many of the elements it feared are now in place.
The dollar's steady decline has gathered pace as investors increasingly see the US as anything but a haven for funds. Large foreign losses on holdings of US assets suggest that financing could be less forthcoming in future, threatening a downward spiral for the dollar.
While both the declining dollar and slowing US demand for imports has helped reduce the trade deficit faster than expected, there is little sign that other engines of world growth are ready to take up the slack.
Turbulent financial markets and falling asset prices are not conducive to stronger consumption. And commodity prices, which are surging in dollar terms and even rising when denominated in other currencies, are raising inflation, taking a further bite from households' purchasing power and leading to greater caution among central banks in setting monetary policy.
So far, at least, there is one bright spot in the darkening economic picture. Sinking confidence in US assets has been limited to the private sector and has not yet spread to US Treasury bonds. Government bond yields have thus continued to fall, giving the Federal Reserve leverage in setting monetary conditions with lower interest rates.
But other elements make the dollar's decline even more alarming than has been feared. The expectation was that the dollar would fall furthest and fastest against the big surplus countries and this would help eliminate imbalances.
But as Sir John Gieve, deputy governor of the Bank of England, said last week, the dollar has fallen less against currencies with the largest trade surpluses. “There is a risk, therefore, that the fall in the US current [account] deficit will not be matched by a fall of surpluses in high-surplus countries but a rise in deficits in other deficit countries,” he said.
In these circumstances, imbalances will not reduce as hoped. Indeed, they threaten only to fall once demand in the rest of the world falls as fast as it appears to be declining in the US.
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