The two-dollar pound

Even a stopped clock tells the right time twice a day. But until the final week of November 2006 economists who or years have forecast a collapse in the dollar must have been tempted to throw their watches away. At last, perhaps, their time has come.

Five years ago the International Monetary Fund among many others began to flag up the dangers that the huge deficits being amassed by the United States would eventually trigger a collapse in its currency. Since then, however, the dollar has proved impervious to terrorist attacks, a US-led war and a sharp and prolonged rise in oil prices.

The fall against the euro and the pound was not life-threatening on its own. But it was significant precisely because there was no specific trigger provided by the economic news. Investors ignored this week’s spate of corporate takeovers to ditch their dollar holdings.

Why should we care? As the dollar falls so the pound goes up and transatlantic festive shoppers will be able to snap up good bargains down Fifth Avenue – perhaps at the long awaited $2-pound level. They had better make the best of it. The US is in hock to the rest of the world, which has been happy to fund its record trade deficit by buying dollar assets to make sure the books balance.

But if foreign investors decide that imbalanced growth between an indebted West and cash-rich East, particularly China, cannot be sustained, they will want to get out quick. If they rush to sell their dollar assets, the dollar will fall in value. This will force Americans to use more of their dollars to buy the same record volumes of imports, in turn putting up prices on Main Street and forcing the central bank, the Federal Reserve, to raise interest rates.

The US economy is already slowing and sharp rises in interest rates could transform its stagnant housing market into a financial disaster zone. A consumer-led recession would hit those countries that have done well by selling to Americans. If the US sneezes, the rest of the world catches a cold; if the US succumbs to a cold then the rest of the world will get the flu.

On this side of the pond Mervyn King, the Governor of the Bank of England, has said that the last 10 years have been a NICE decade – Non-Inflationary Consistent Expansion. He warns it may be replaced by something more nasty. Certainly yesterday’s falls in share prices reminded investors that stock markers are not a one-way bet.

Finally after years of issuing its warnings over the dollar, the IMF is taking action. It has launched multilateral talks to allow big players such as the US and China to talk frankly in private about the possible ways to reduce these imbalances without triggering the market reaction they do dread.

Gordon Brown has played a major role in ensuring that this initiative won full political support. When Mr Brown moves on – either to Number 10 or the backbenches – his successor must make sure that countries do not allow the timetable for a more stable world lapse.