These Are Perilous Days for the US

I don't think Americans get it. I don't think they realise quite how serious the collapse of the dollar is for the global economy, nor the long-term consequences of this decline for the position of the US in the world. Sure, they grumble about prices in London and find it odd that US lawyers want to be transferred to the UK because they can earn more money here. But at a fundamental level, to judge by the conversations I have had in recent weeks, I don't think the US financial community appreciates quite what peril it is in.

There have been periods of dollar weakness before. The most notable marked the end of the fixed exchange rate system in the early 1970s. There have been periods of excessive dollar strength too, one of which led to the Plaza Accord in 1985 - so called because the agreement by the US and other major economies that the dollar needed to be capped was reached in the Plaza Hotel in New York.

Now it may be that in another five years the dollar will be strong again and Britons who used this age of the pound above $2 to buy property in the US will feel rather smug. Maybe. At some level, the dollar will become good value again and while currencies do overshoot their true long-term values, they do bounce back.

But there seems to be at least half a dozen reasons why what is happening now to the dollar is very serious indeed. Most obviously, the present fall is going further than previous declines. The most marked collapse is against the euro but if you measure even against sterling, a rate of $2.10 cannot be justified by the relative purchasing power of the two currencies. It may not happen, but you hear talk in the City that the rate may go to $2.40, which would be back to the old dollar/sterling rate under the fixed exchange rate system. The greater the decline, the greater the disruption to the world economy.

Why such a large fall? That leads to the second feature that distinguishes this bout of weakness: the US current account deficit is much larger both in absolute terms and as a percentage of GDP than in previous dollar cycles. Every year, the US has to borrow around 6 per cent of its GDP just to pay for its imports. Until a few months ago it was able to do so. Foreign investors were impressed by the sales pitch they got from the US banking community: buy these sophisticated financial instruments our brilliant maths experts have created and you will get a higher return than you can get from anywhere else. Now those US bankers don't look so smart and more than one non-US investor has indicated to me they felt they have been stuffed with rubbish. They won't trust those bankers again.

So, the third new element: trust in US financial sophistication has been shattered. The problem is not just the dollar; it is the integrity of US financial institutions. The pitch that the US has more transparent and more resilient markets than other countries is no longer credible.

The fourth element is that there are other places to invest. I was at a Middle East fund management conference last month and everyone wanted to talk about opportunities in Asia. This year, for the first time ever, China is adding more demand to the world economy than the US. It is still a smaller economy and will be for another 20 years at least. But the direction is clear, with China set to pass Germany to become the world's third largest economy some time next year. India is also extremely attractive to Middle Eastern investors, thanks in part to the physical proximity of the sub-continent and the cultural links between the two regions. Anyone who invested in India five years ago will have done wonderfully well, far better than they would have done had they invested in the US.

Connected with this, point five, is the deterioration in the cultural relationship between the US and the rest of the world in the past few years. The US no longer appears quite the safe haven for investments that it used to, for a variety of reasons. One has been resistance in Congress to foreign takeovers. Another has been the change in visa requirements - why invest in the US if it is awkward to visit your investment? Can you really trust the US legal system to be dispassionate in a dispute between a foreigner and a national? At a low enough price, US assets will still be attractive, but they do carry a handicap and will continue to do so.

Finally, and this is perhaps the most important thing, there are now alternatives to the dollar. There is the euro, of course, and foreign central banks are building up their reserves in euros. The pound is now being held much more widely in central banks too. Most important, there are a basket of other currencies, including the Chinese yuan, which international investors feel they should hold. A decade or more ago, the options were much narrower.

So what is going to happen? Well, it is true that a very weak dollar creates problems for other countries as well as the US. It is not just that any non-American investor will have seen a large fall in the value of their investment; any foreign company trying to sell into the US or compete against US exporters will find it harder to do so.

That does not mean that US companies will always win. It was interesting that Airbus managed to secure a huge order this week from Emirates, against Boeing's more established competitor. But a weaker dollar does create problems for the rest of us.

The problems for the US, though, will be more serious, for it needs to import, amongst other commodities, half its oil. The high dollar oil price is already increasing inflation elsewhere - here in the UK for example - but the burden on the US is relatively worse. The more the dollar weakens, the greater the difficulty the US Federal Reserve will have cutting interest rates, for to do so would make the dollar weaker still.

We may just muddle through with the dollar falling for some months more, the US going into recession, the rest of the world pulled along mainly by demand from China and from the rest of Asia, and then eventually the dollar and the US recovering.

I am not too worried about the UK economy, though things are clearly slowing here. What we have to recognise is that there is such a thing as a global economic cycle. Some sort of downturn, maybe not too serious a one, in the next couple of years does seem inevitable.

There may need to be, however, an international rescue of the dollar. The world's central banks, including, crucially, the Bank of China, would come together and agree a package of measures to support it.

Were that to happen, it would be a mark of the way economic power is shifting in the world. It is slowly and inexorably shifting away from the US and that will, to many Americans, come as a shock.

--h.mcrae@independent.co.uk

(c) 2007 The Independent