Skipper required to steer home dollar

THE LAST time the dollar crashed against a clutch of currencies, between 1985 and 1988, there was no doubt who was in charge of economic policy in Washington.

James A Baker, the polished but ruthless Texan, ruled at the US Treasury and the White House. Alongside him, uncomfortable at times but steadfast, stood Federal Reserve chairman Paul Volcker. His political courage and economic judgment had rescued America from rampant inflation in the early 1980s. So he was held in as much awe by Wall Street and the world's financial markets as was his successor Alan Greenspan in the late 1990s.

Back then, as the US currency slumped 53% against the Japanese yen and German mark, the two men shaped the response of America and the world. They bullied and cajoled other members of the Group of Seven industrial countries into co-ordinating economic policy in order to manage a drastic dollar devaluation designed to correct the burgeoning trade deficit.

So how different do things look today? Once again, America is hostage to the whims of foreign investors in order to fuel its nascent recovery. Even though the US economy veered off course last year, it still required more than $400bn (£273bn) of foreign funds to keep the wheels turning. Jim O'Neill of investment bank Goldman Sachs says that by 2006, unless the dollar falls, foreign inflows of an unimaginable $800bn a year could be needed to allow America to go on living beyond its means - spending more than it is saving and borrowing the balance overseas.

It is 18 months since the mighty dollar peaked in value against the puny euro. But in the past week, as the single currency has risen to close on 92 US cents - 9% above its October 2000 low - the question of whether or not the gravity-defying greenback has finally hit the skids has taken on a new urgency.

Falling share prices in New York and the recent rise in the price of gold are just some of the signs that confidence in US dollar-denominated assets is waning. The Swiss National Bank was recently forced to cut interest rates by half a percentage point to only 1.25% explicitly to try to stem the tide of currency flooding out of the US dollar and into the Swiss franc - another traditional bolt hole in turbulent times.

Equally worrying, organisations such as UBS Warburg and State Street bank, which monitor clients' vast international investment flows, say they see signs that even US investors are moving into non-dollar assets. This has not happened since before the Asian and Russian crises of 1997-98 says Avinash Persaud of State Street.

How much damage a dollar dive would do to Europe would depend first and foremost on how far and fast it fell. At a seminar in Brussels last week, anxious EU officials offered bucketfuls of reassurance.

Johnny Akerholm, the Finn who chairs meetings of EU finance ministers, captured the mood of happy disbelief when he remarked that, given the mess America was in - the words he actually used were 'imbalances in the US economy' but we all know what that means - things were turning out better than expected.

As he pointed out, unlike the US, Europe's economy is not out of kilter. The current account is in balance. Consumers are cautious - too cautious perhaps - about spending their own money and are certainly not bingeingon borrowed funds they can barely afford.

Corporate profits are proving quite resilient in spite of the slowdown, not slumping to 10-year lows as in the US. And if the dollar drops too sharply against the euro the European Central Bank is already preparing, like the Swiss, to cut interest rates quite quickly. So perhaps the hopes of the euro's founding fathers can be fulfilled and the new single currency help to insulate the Old World from the tremors shaking the New.

This, however, is not the view of Professor Alexandre Lamfalussy, the vastly experienced former head of the central bankers' bank, the Bank for International Settlements.

The world has changed since visionaries dreamed of a single currency for Europe. The globalisation of financial markets means asset market valuations now have a much bigger influence on economic perfomance. As the collapse of hi-tech shares around the world two years ago showed, Euroland cannot decouple from financial turbulence on Wall Street.

Perhaps euro-denominated bonds would be a bit of safe haven if the dollar fell - but European equities? International Monetary Fund simulations suggest even an 8% fall in the dollar against the euro would slow far-from-robust European growth by about half a percentage point as EU companies would find it harder to sell into American markets and to compete with Asian rivals.

Germany, already puffing hard as it tries to accelerate, would suffer more because of its big export sector and the fact its manufactured goods are so directly in competition with America's.

But the biggest worry for the dollar is who is in charge of international economic policy if things turn really nasty. Unlike the formidable James Baker, Treasury Secretary Paul O'Neill, Alan Greenspan's long-standing associate and friend, is cutting an increasingly feeble figure in Washington - witness his dire performance before Congress last week. Greenspan is said to be concerned about the interlinked political and economic strains tearing at the Atlantic alliance.

And in Euroland, weak governments and the lack of a firm political underpinning of the single currency mean that, apart from on monetary policy issues, there is still no Mr Euro to take command. No wonder markets are nervous.