Weak dollar threatens global economy

THE plunge in the dollar against the euro poses the single biggest threat to global economic stability of recent times. Transatlantic divisions in the currency markets could become every bit as bitter and dangerous as those over Iraq.

If anyone thinks that the dollar's dive against the euro - and to a lesser extent the pound - does not matter then they should take a look at modern financial history.

It was the build-up of America's huge trade and budget deficits in the early 1980s - and the negative impact on growth in Europe - which led to the Plaza Accord (see chart) in 1985 and the organised devaluation of the dollar by the then Group of Five richest nations.*

Similarly, differences over transatlantic interest rates between the United States and Germany in 1987 became so acute that they sapped confidence in financial markets and were a big contributor to the October 17 crash in share prices.

The current differences between Europe and the United States could be equally explosive. Stephen Jen, of Morgan Stanley, notes that the problem is that the United States, the eurozone, Japan and China are talking across each other. It is unlikely that they can reach any agreement at the upcoming economic summits. As a result, the 'market is likely to conclude that the key countries disagree more than they agree', says Jen.

The American Treasury Secretary John Snow made it clear this week that the US government is not in the mood to do anything to stem the dollar's slide. Speaking in London, Snow claimed that the strong dollar policy had not changed. He went on to say: 'The only way to get prosperity is to follow the marketplace.'

In other words, the Americans are not interested in another Plaza-style deal which would lower the euro. The second Bush administration faces the daunting task of tackling America's huge current account deficit which this year looks to be heading for a record-breaking $600bn, or 6% of national wealth.

A weaker dollar makes US exports cheaper and imports more expensive. It also heaps the pressure on China to slow its economy by revaluing the renmimbi, which is currently pegged against the dollar. China and the other Asian countries must be acutely aware that with every fall in the dollar, their official reserves, held in US government bonds and securities, become worth less.

The Europeans are caught in this US-Asian crossfire. The 'brutal' devaluation of the dollar against the euro - to borrow the words of European Central Bank president Jean-Claude Trichet - carried the euro to the record level of $1.30 this week.

But the European currencies and the pound are in free float, whereas the Asian currencies, with the exception of the Japanese yen, largely are pegged. So it is Europe which is taking the pressure and being forced to scale back export prospects and growth.

Britain is caught between two trading blocs. The pound has firmed against the dollar to $1.85, but has weakened against the euro to 70p. This will not be an entirely unhappy outcome for Chancellor Gordon Brown.

But the stand- off between the US and Europe on the foreign exchanges is a dreadful start to Bush's second term.

Tensions across the Atlantic are rising to a new peak and there must be concern that the markets will overshoot. The fear must be that divisions will deepen and that the dollar tumble will spread to other financial markets and may even threaten economic cataclysm.