Market Advisory Features

The Disappearing Dollar
A Clouded Outlook

The Dollar’s Demise
America's Financial Markets
China's  Interest-rate Hike
The Dollar

All that Glisters
Currency Conundrums

Oil Company's Profits



World economy

The disappearing dollar
Dec 2nd 2004
From The Economist print edition

How long can it remain the world's most important reserve currency?

THE dollar has been the leading international currency for as long as most people can remember. But its dominant role can no longer be taken for granted. If America keeps on spending and borrowing at its present pace, the dollar will eventually lose its mighty status in international finance. And that would hurt: the privilege of being able to print the world's reserve currency, a privilege which is now at risk, allows America to borrow cheaply, and thus to spend much more than it earns, on far better terms than are available to others. Imagine you could write cheques that were accepted as payment but never cashed. That is what it amounts to. If you had been granted that ability, you might take care to hang on to it. America is taking no such care, and may come to regret it.
The cost of neglect

The dollar is not what it used to be. Over the past three years it has fallen by 35% against the euro and by 24% against the yen. But its latest slide is merely a symptom of a worse malaise: the global financial system is under great strain. America has habits that are inappropriate, to say the least, for the guardian of the world's main reserve currency: rampant government borrowing, furious consumer spending and a current-account deficit big enough to have bankrupted any other country some time ago. This makes a dollar devaluation inevitable, not least because it becomes a seemingly attractive option for the leaders of a heavily indebted America. Policymakers now seem to be talking the dollar down. Yet this is a dangerous game. Why would anybody want to invest in a currency that will almost certainly depreciate?

A second disturbing feature of the global financial system is that it has become a giant money press as America's easy-money policy has spilled beyond its borders. Total global liquidity is growing faster in real terms than ever before. Emerging economies that try to fix their currencies against the dollar, notably in Asia, have been forced to amplify the Fed's super-loose monetary policy: when central banks buy dollars to hold down their currencies, they print local money to do so. This gush of global liquidity has not pushed up inflation. Instead it has flowed into share prices and houses around the world, inflating a series of asset-price bubbles.

America's current-account deficit is at the heart of these global concerns. The OECD's latest Economic Outlook predicts that the deficit will rise to $825 billion by 2006 (6.4% of America's GDP) assuming unchanged exchange rates. Optimists argue that foreigners will keep financing the deficit because American assets offer high returns and a haven from risk. In fact, private investors have already turned away from dollar assets: the returns on investments in America have recently been lower than in Europe or Japan (see article). And can a currency that has been sliding against the world's next two biggest currencies for 30 years be regarded as “safe”?

In a free market, without the massive support of Asian central banks, the dollar would be far weaker. In any case, such support has its limits, and the dollar now seems likely to fall further. How harmful will the economic consequences be? Will it really undermine the dollar's reserve-currency status?

Periods of dollar decline have often been unhappy for the world economy. The breakdown of Bretton Woods that led to a weaker dollar in the early 1970s was painful for all, contributing to rising inflation and recession. In the late 1980s, the falling dollar had few ill-effects on America's economy, but it played a big role in inflating a bubble in Japan by forcing Japanese authorities to slash interest rates.

This time round, it is a bad sign that everybody is trying to point the finger of blame at somebody else. America says its external deficit is mainly due to sluggish growth in Europe and Japan, and to the fact that China is pegging its exchange rate too low. Europe, alarmed at the “brutal” rise in the euro, says that America's high public borrowing and low household saving are the real culprits.

There is something to both these claims. China and other Asian economies should indeed let their currencies rise, relieving pressure on the euro. It is also true that Asia is partly to blame for America's consumer binge: its central banks' large purchases of Treasury bonds have depressed bond yields, encouraging households in the United States to take out bigger mortgages and spend the cash. And Europe needs to accept, as it is unwilling to, that a weaker dollar will be a good thing if it helps to shrink America's deficit and curb the risk of a future crisis. At the same time, Europe is also right: most of the blame for America's deficit lies at home. America needs to cut its budget deficit. It is not a question of either do this or do that: a cheaper dollar and higher American saving are both needed if a crunch is to be avoided.

Simple but harsh

Many American policymakers talk as though it is better to rely entirely on a falling dollar to solve, somehow, all their problems. Conceivably, it could happen—but such a one-sided remedy would most likely be far more painful than they imagine. America's challenge is not just to reduce its current-account deficit to a level which foreigners are happy to finance by buying more dollar assets, but also to persuade existing foreign creditors to hang on to their vast stock of dollar assets, estimated at almost $11 trillion. A fall in the dollar sufficient to close the current-account deficit might destroy its safe-haven status. If the dollar falls by another 30%, as some predict, it would amount to the biggest default in history: not a conventional default on debt service, but default by stealth, wiping trillions off the value of foreigners' dollar assets.

The dollar's loss of reserve-currency status would lead America's creditors to start cashing those cheques—and what an awful lot of cheques there are to cash. As that process gathered pace, the dollar could tumble further and further. American bond yields (long-term interest rates) would soar, quite likely causing a deep recession. Americans who favour a weak dollar should be careful what they wish for. Cutting the budget deficit looks cheap at the price.


A clouded outlook
Dec 3rd 2004
From The Economist Global Agenda

High oil prices have dimmed the world economy's prospects, the OECD says in its latest economic outlook. But it is hard to put numbers on some of the biggest worries for the world economy

EACH year, the 30 relatively wealthy nations of the Organisation for Economic Co-operation and Development (OECD) make, sell and buy about $30 trillion-worth of goods and services. Forecasting whether these nations will add another trillion, or merely a few hundred billion, to this total next year is no easy matter. On Tuesday November 30th, the OECD once again gazed into its crystal ball, offering its latest projections for the world’s big economies. It foresees growth of 2.9% next year among its members, slower than this year’s pace of 3.6%. OECD economies’ fortunes have darkened since the spring, when they were expected to expand by as much as 3.3% in 2005.

What has changed since then? The answer is not very mysterious. When the OECD made its June forecast, its members could buy a barrel of Brent crude oil for about $32. By mid-October, they were paying $50. Of the OECD’s members, only Canada, Denmark, Mexico, Norway and Britain (for the time being) are net exporters of oil. The rest spent over $260 billion last year importing the stuff.

That bill will be much bigger this year. But Jean-Philippe Cotis, the OECD’s chief economist, offers some words of comfort. There is some evidence, he notes, that oil prices have overshot. They have already fallen back to less “onerous” levels this month. Expensive oil might slow the world’s major economies for a quarter or two, but it should not condemn them to stagflation (low or no growth coupled with high inflation). This, says the OECD, is a “tribute” to the credibility of central bankers. Their commitment to defeating inflation has prevented an upward spiral of higher wages chasing higher prices.

Of course, not everyone is comforted by the “received wisdom” of economists, Mr Cotis concedes. “Oil price fluctuations take centre stage in the public debate,” he notes, “and strongly influence economic confidence.” Expensive oil leaves consumers with less to spend, but if they worry about spending even that, the economic damage is redoubled. Perhaps the main thing we have to fear about oil prices is fear itself.

Numberless fears

Economists are tempted into forecasting, despite the difficulties, because economies tend to follow familiar cycles of expansion and contraction, greed and fear. But at the moment, none of the main economic blocks—the United States, the euro area or Japan—is conforming to a normal business cycle. America never suffered a full-blown recession: its firms shed labour, but its households did not rebuild their savings. The euro area has yet to enjoy a full-blown recovery: strong demand for its goods abroad has yet to spill over into strong demand at home. As for Japan, the phases of its “cycle” are best measured in decades, not years.

The OECD is willing, says its chief economist, to place a “reasoned but positive bet on Europe”, forecasting that angst-ridden Germans, in particular, will start spending at last. But the odds seem to be lengthening. Economic sentiment, which has been building in the euro area relatively steadily since March 2003, fell last month, according to the European Commission. And manufacturers, surveyed by NTC on behalf of the Reuters news agency, reported the biggest fall in activity since October 2001.

The OECD is also sanguine about Japan's prospects. The forecasters predict that its decade-long struggle against deflation will come to an end next year, and that the country’s interest rates—zero for most of the past five years—will rise in the first quarter of 2006. Lauding the economy's “spectacular comeback” at the turn of the year, Mr Cotis described its current slowdown as a “pause”. It is difficult to judge how long the pause will last. Though industrial output fell in October and unemployment edged up, Japan's corporations reported solid sales, strong investment and surging profits in the Ministry of Finance's quarterly survey, released on Friday. Some economists now hope that Japan's miserable growth figures for the last quarter will be revised up in the coming days.

As for America, the OECD is not so foolish as to bet on a revival of thrift in the world's biggest spender. The American government’s budget deficit will remain above 4% of GDP both next year and the year after that, it predicts. And the country’s current-account deficit—which reflects how far its savings fall short of its investment needs—will widen from 5.7% of GDP this year to 6.4% of GDP in 2006 (about $825 billion).

In its forecast, the OECD assumes the world will continue to finance these deficits comfortably. Long-term interest rates in the United States, currently about 4.3%, will edge up to 4.7% next year and 5.3% in 2006. It also assumes that the dollar will fall no further during its two-year forecasting horizon. Neither assumption is entirely safe. As the OECD admits, America cannot continue to accumulate debts at its current pace indefinitely. And the dollar has already lost more than 2% of its value against the euro since the forecast was prepared. An unexpectedly weak report on jobs—just 112,000 workers were added to the payrolls in November—did not help the greenback's cause. The jobs recovery remains “historically lean”, as the OECD puts it.

How can a forecast reflect these risks? It could simply average them up, weighting them according to their likelihood. But since risks either materialise or they don’t, such a forecast will almost certainly be wrong. The weighted average for the throw of a six-sided die, for example, is 3.5—a number we can safely predict will never actually appear. And so the OECD’s projections do not put a number on these risks. It assumes that America’s profligate government and its profligate households will continue to roll the dice, racking up debts whatever the risks to the dollar or to interest rates. And for two more years at least, it must assume they will continue to get lucky.



All that glisters
Nov 30th 2004
From The Economist Global Agenda

Is the rise in the price of gold merely the flipside of the dollar’s fall? Or does it point more broadly to a loss of faith in central bankers’ promises?

ALAS, the nearest that Buttonwood gets to visiting jewellery shops these days is a trip to Claire’s Accessories, a chain of fabulously tacky shops beloved of his daughters. To be fair, Claire’s (“Where getting ready is half the fun”) does not pretend to be anything other than cheap and cheerful. Nothing seems to cost more than £2.99. The jewellers in Bond Street, just round the corner from The Economist’s offices, are about as different from Claire’s Accessories as it is possible to get. The stuff in them costs rather more than £2.99. And their already steep prices have been going up because the prices of precious metals have been rising, gold’s not least. In the past week, gold has topped $450 an ounce, its highest level in 16 years—and up from a low of $253 in the late 1990s. What, if anything, does this tell us about investors’ faith in paper currencies.

The financial world, it sometimes seems, is broadly divided into those who believe in gold as the ultimate currency and those who don’t. In the latter camp are most economists, the most famous of whom, John Maynard Keynes, described gold as a “barbarous relic”. But even as late as the 1960s, Charles de Gaulle, then president of France, claimed that gold was the “unalterable fiduciary value par excellence”.

Gold or silver were money for most of human history, either directly or indirectly. Once paper currency was introduced, it was, in theory at least, backed by either of the two metals. Silver was gradually edged out as a monetary metal in the 19th century, from which time the “gold standard” reigned supreme. This arrangement, in its purest form, collapsed in the 1930s, but it continued in a bastardised form after the second world war, when America, which by then held three-quarters of the world’s gold reserves, again tied the dollar to gold, and the rest of the world’s currencies tied themselves to the dollar. In 1971, the dollar was forced off the gold standard because of mounting inflationary pressures. Since then the world has had so-called fiat currencies, which are backed by nothing more than the promises of central bankers and politicians that they will uphold the value of those currencies. Fans of gold—known as gold bugs—wonder whether those promises are worth the paper they aren’t written on.

They certainly weren’t in the early years. Inflation ate away at the value of anything with a fixed monetary value, and during the 1970s the price of gold rose from $35 to $850. But in 1979, Paul Volcker, then chairman of the Federal Reserve, stomped on inflation and the price of gold fell sharply. In its place came a bull market in the price of government bonds.

The dollar, it must be said, fared less well. It may have become the world’s reserve currency, even without the backing of gold, but it has been anything but a splendid investment, especially in recent years. While its internal value has not fallen as much as it once did, thanks to lower inflation, its external value—ie, in relation to other currencies—has been in remorseless decline, albeit punctuated by some longish rallies. In recent weeks, encouraged by malign neglect from American politicians and central bankers, the fall has shown signs of becoming a rout. As the dollar has fallen, so the dollar price of gold has risen.

It used to be that gold bugs touted the yellow metal’s credentials as a hedge against inflation. But the link was anyway pretty feeble, except for currencies with hyperinflation. And though consumer prices have risen a bit this year, it would be hard to make the case that inflation is about to roar anywhere in the developed world. Why, then, is gold prospering at a time when inflation is low? Perhaps it reflects nothing more than the fall in the dollar: gold transactions are denominated in dollars, and in euros the rise in the gold price has been anaemic.

However, there is no law that says a falling dollar must translate into a rising gold price. Apart from a rise in demand for jewellery, the rise in the price of gold may, at the margin, reflect demand for real, hard assets, as opposed to the paper sort. And the reasons are not hard to find, for across the developed world, debts have escalated alarmingly in recent years—and in America not least, hence the vast and growing current-account deficit. While central bankers are generally trusted not to “monetise” these debts by rolling the printing presses, history would suggest that this displays a touching naivety. As James Grant, publisher of an eponymous financial newsletter, and the most erudite of the gold bugs, says: “[Alan] Greenspan, the figurehead of the dollar, was trading at three times book in the late 1990s; I think he may return to book value.” Or lower.

Gold’s virtue, says Mr Grant, is that it is a monetary metal, because of its scarcity and, of course, its history. Actually, Buttonwood can’t help feeling, gold’s history counts against it. Of all the metals, the market for gold is probably the most rigged. It is because of history that central banks hold in their reserves almost a quarter of all the gold that has ever been mined. They would like to sell at least some of it, but the vast amount that they hold means doing so would drive the price down. In 1999, central banks therefore came to an agreement to restrict gold sales. The agreement—or cartel, if you will—was extended in September. But it would presumably be torn up if the gold price rose sharply: the Bank of France said this month that it wants to offload some 500 tonnes over the next five years.

And that would presumably limit gold’s upside. Perhaps a better argument can be made for other scarce metals: platinum, say, or silver. Silver, after all, not only spent centuries vying with gold as a form of money, but also has many industrial uses and is not held by central banks; annual demand is much higher than annual production. Along with many other metals, the price of silver fell sharply in April, but unlike gold it has not even regained the ground it lost. Also in its favour is that it is not exactly sold in industrial quantities at Claire’s Accessories.



The dollar’s demise
Nov 23rd 2004
From The Economist Global Agenda

Is the dollar’s role as the world’s reserve currency drawing to a close?

WHO believes in a strong dollar? Robert Rubin, Bill Clinton’s treasury secretary, most certainly did. John Snow, his successor but two, says he does but nobody believes him—if only because he wants other countries’ currencies, in particular the Chinese yuan, to go up. Mr Snow’s boss, President George Bush, in one of his mercifully rare forays into economics last week, also said he wants a muscular currency: “My nation is committed to a strong dollar.” Again, it would be fair to say that this was not taken as a ringing endorsement. “Bush’s strong-dollar policy is, in practical terms, to maintain a pool of fools to buy it all the way down,” a fund manager was quoted by Bloomberg news agency as saying. It does not help when the chairman of your central bank, Alan Greenspan, whose utterances on the economy are taken rather more seriously than Mr Bush’s, has said the day before that the dollar seems likely to fall: “Given the size of the current-account deficit, a diminished appetite for adding to dollar balances must occur at some point,” were his exact words. The foreign-exchange market immediately decided that it was sated, and the dollar fell to another record low against the euro.

Mr Greenspan’s words were of huge moment, and not just because he spoke clearly, unusual though this was, nor because the Federal Reserve rarely comments on foreign-exchange movements. No, Mr Greenspan’s words were significant because he was tacitly admitting what right-thinking economists the world over have long believed: that the emperor has no clothes.

Mr Greenspan’s previous line had been that America’s ever-expanding current-account deficit was not a problem when capital could flow so freely around the world; and that, in effect, it would continue to flow to America because the country is such a wonderful place in which to invest. Now he is saying that it won’t, or at least that investors will demand a cheaper dollar, or cheaper assets, or both, to carry on financing America’s deficit.

But Buttonwood suspects that the deeper significance of Mr Greenspan’s admission is that the game that has been played since the collapse of the Bretton Woods system in the early 1970s is drawing to a close. The dollar’s status as the world’s reserve currency—its preferred store of value, if you will—is gradually coming to an end. And, ironically, the fact that it has become so popular in recent years will only hasten its demise.

One man who undoubtedly believes in a strong dollar is Japan’s prime minister, Junichiro Koizumi. Unlike America, Japan has been putting its money where its leader’s mouth is. On behalf of the finance ministry, the Bank of Japan has bought more dollars than any other central bank has ever done. At last count, it had the equivalent of $820 billion in foreign-exchange reserves, most of it denominated in the American currency.

As goes Japan, so goes the rest of Asia. In an interview this week with the Financial Times, Li Ruogu, the deputy governor of China’s central bank, the People’s Bank of China, said that his country would not be rushed into revaluing the yuan, and that America should put its own shop in order. Mr Ruogu’s bank, too, has been a huge buyer of dollars in recent years. China and the rest of developing Asia now have $1.4 trillion of reserves, mostly dollars. This is more than the combined reserves of the rest of the world (excluding Japan). Thanks mostly to Asian intervention, foreign-exchange reserves at the world’s central banks have climbed from $2 trillion in 2000 to $3.5 trillion in 2004.

It used to be that countries amassed reserves as a war chest to protect against a run on their currencies of the sort suffered by East Asia in 1997, or Russia in 1998. But Asian countries have snaffled up far more than would be justified to prevent such crises. Their aim in accumulating these reserves is generally different now: to stop their currencies rising against the dollar and so keep their exports competitive. In effect, they are trying to peg their currencies; China’s peg is explicit. Huge foreign-exchange reserves are the result.

Some pundits have dubbed this arrangement the new Bretton Woods. The Bretton Woods arrangement (a post-second world war agreement that tied the dollar to gold and other currencies to the dollar) collapsed in 1971. The present arrangement seems similarly doomed to failure. The big question is whether the world will suffer similarly ill effects when it collapses.

Past saving?

The upward pressure on Asian countries’ currencies stems either from their saving too much and consuming too little, or from America saving too little and spending too much. American politicians, naturally, tend to concentrate on the first interpretation, because it stops them having to recommend unpleasant remedies, such as cutting deficits or encouraging Americans to save more. But Mr Greenspan’s most recent comments show that he recognises the problem is more home-grown. Personal saving in America, as a percentage of household income, slumped to just 0.2% in September, close to a record low. Indeed, the savings rate has been declining remorselessly since 1981, when it reached a high of 12.5%. This lack of saving shows up in the current-account deficit, which is a record near-6% of GDP and rising.

In effect, foreigners are saving on America’s behalf. In a recent study for the New York Fed, two economists, Matthew Higgins and Thomas Klitgaard, point out that the United States now absorbs more than the measured net saving of the rest of the world combined (suggesting someone’s got their figures wrong somewhere). The American economy cannot continue to expand at its current rate without those foreign savings. The question is whether foreigners will be happy to carry on financing this growth with the dollar and asset prices at their present level. The private sector is already voting with its wallet: it has been financing an ever smaller percentage of the deficit, and there has been a net outflow of direct investment. That leaves the public sector—ie, central banks—and those, in particular, of Asia.

At the heart of the central banks’ calculations is a trade-off: intervening to keep your currency down can be costly, but it is good for exports. Though the costs of intervention are hard to quantify, they are potentially big. Because the domestic money supply is expanded—those dollars must be paid for with something—it can cause inflation (though this can be neutralised through “sterilisation”, ie, bond sales). But the big potential cost is in amassing a huge stash of dollars with precious little exit strategy. Quite simply, Asian central banks now own too many of them to exit en masse, for their exit would cause the dollar to crash and American interest rates to soar, which would cause huge losses on their holdings of Treasuries.

Get out while you can

The biggest risk, of course, is that lenders would lose pots of money were the dollar to fall. As the printer of the world’s reserve currency, America can pass on foreign-exchange risk to the lenders because, unlike other indebted countries, it can borrow in its own currency. Messrs Higgins and Klitgaard reckon that for Singapore, the most extreme example, a 10% appreciation against the dollar and other reserve currencies would lead to a currency capital loss of 10% of GDP. Though loading up with even more dollars might of course stop the dollar from falling for a while, it would increase the risk of still larger losses were it eventually to do so. America already needs almost $2 billion a day from abroad to finance its spending habits, and the situation deteriorates by the week because America imports more than it exports, which worsens the current-account deficit.

The incentives to flee the Asian cartel (to give it its proper name) thus increase the bigger the game becomes. Why take the risk that another central bank will leave you carrying the can? Better to get out early. Because the game is thus so unstable it will come to an end, and probably a messy one. And what will then happen to the dollar? It is hard to imagine its hegemony remaining unchallenged when so many will have lost so much. And doubly so given that America has abused the dollar’s reserve-currency role so egregiously that its finances now look more like those of a banana republic than an economic superpower.


Currency conundrums
Nov 19th 2004
From The Economist Global Agenda

Finance ministers and central bankers from the G20 meet on Friday, against the backdrop of a weakening dollar and a move into Asian currencies. Can they do anything to assuage the world’s exchange-rate angst?

WHEN the ringmasters of the world economy are flummoxed by a crisis, their instinctive response is to create a new committee, forum or group. In the wake of the 1997-98 Asian financial crisis, they created one of each: the International Monetary and Financial Committee, the Financial Stability Forum and the Group of 20 (G20). This oddball group, which convenes for its annual meeting on Friday November 19th in Berlin, brings together finance ministers and central bankers from the big rich nations, several big oil exporters and some big emerging markets. It meets against the backdrop of a falling dollar and rising economic tensions between its members. Indeed, according to Stephen Jen, an economist at Morgan Stanley, the crisis that befell Asia seven years ago may be about to repeat itself. Only in reverse.

The legacy of that crisis still inhibits Asia’s policymakers. In the seven years since, they have sought to keep the region’s currencies cheap and its dollar reserves deep. The South Korean won, the Indonesian rupiah and the Taiwan dollar, which fell like dominoes after the Thai baht came off its peg in July 1997, have yet to regain their pre-crisis parities. The won is still undervalued by about 5% against the dollar, Mr Jen calculates. The Malaysian ringgit, which is pegged to the dollar, is about 25% below its fair value.

On Thursday, however, the won was bid up to its highest price since the crisis. The baht and the Taiwan dollar have also strengthened in recent days. Seven years after they suffered a dramatic run on their currencies, Asia’s emerging markets now find themselves trying to resist a (somewhat less dramatic) run into their currencies.

In 1997, the Asian countries exhausted their foreign-exchange reserves trying to prop their currencies up. Since then, they have dramatically expanded their dollar reserves in an effort to hold their currencies down. These purchases of American assets have helped to prop up its currency and finance its vast trade deficit. But they may not last much longer. For a country such as South Korea, buying dollars is both costly and possibly inflationary. The country’s excess savings, parked in low-yielding American Treasuries, would earn a higher return invested at home. And the finance ministry’s weak won policy, by making imports more expensive, has hampered its fight against rising prices. In the summer, annual inflation reached its highest rate for three years, though it has since eased.

South Korea’s ambivalence about its won policy may be shared by the other post-crisis countries in the region. But their freedom for manoeuvre is limited by China’s dedication to its peg against the dollar. During the financial storms of 1997 and 1998, the peg provided an important anchor for the region. Even as currencies collapsed all around it, China refused to beggar its neighbours by devaluing the yuan. But China’s peg, a bulwark against the financial crisis, is now blocking the “reversal” of the crisis that Mr Jen foresees and the dollar needs. To its neighbours, China is such an important trade partner and competitor that they dare not let their currencies strengthen too far against the yuan. Even Japan is wary.

Much of the G20, then, is now waiting for just one of its members, China, to unpeg its currency. Some speculators can wait no longer. They are already swapping their dollars for yuan, betting it will soon jump in value. To deter such speculation, Chinese banks on Thursday raised the interest they pay on dollar deposits.

If the dollar is not allowed to fall against the yuan, it will probably continue to fall heavily against something else. On Friday, the American currency fell to its weakst level against the yen since April 2000. It also remained around record lows against the euro. Earlier in the week, Nicolas Sarkozy, France’s finance minister, had declared that “the greenback has become unhinged”.

But Europe’s finance ministers can do little about it. They have surrendered control of the currency to an independent central bank that targets inflation, not the exchange rate. The European Central Bank has not intervened directly on behalf of the euro for four years. It is unlikely to do so again without American backing.

Japan’s monetary authorities have no such compunction. The finance ministry happily spent over ¥20 trillion ($170 billion) propping up the dollar last year and over ¥14 trillion in the first three months of this year. For Japan, unlike South Korea, buying dollars is profitable. And if it is also inflationary, so much the better for a country still gripped by deflation. Interest rates on American assets, such as Treasuries, may be low. But they are higher than the zero interest rates on offer in Japan. Moreover, printing yen to buy dollars is one way to inject liquidity into Japan’s moribund financial system.

The constraints on Japan are not economic, but political. Heavy interventions in the foreign-exchange markets always raise a stink at the groups, forums and committees where Japan’s policymakers come face to face with their American counterparts. At the meeting in Berlin, Japan will no doubt promise once again to leave the value of the yen to market forces. But one suspects that Japan’s yen policy, just like China’s yuan policy, is ultimately decided not by a committee of 20 nations, but by a group of just one.


America's financial markets

The Bush bounce
Nov 11th 2004 | NEW YORK
From The Economist print edition

Investors cheer the election, shrugging off higher interest rates and economic fears

THE American stockmarket's verdict on the election was plain: hooray for George Bush. When early exit polls on November 2nd suggested that John Kerry would become president, equity prices dropped. They changed course abruptly once the true result emerged: according to a survey of 40 hedge funds by International Strategy & Investment, a research firm, these investors went from net short to net long as soon as the election results became clear.

A week later, the market had not given up its gains. A surprisingly good jobs report on November 5th, indicating that non-farm employment had risen by 337,000 in the previous month, did the market no harm at all. And share prices were never likely to be perturbed by the Federal Reserve's decision, on November 10th, to increase the federal funds rate by a quarter-point, to 2%. The Fed's plans had been clear long before, and the rise had been priced in. Indeed, several further increases are generally expected.

By and large, Mr Bush's re-election has been good news for companies that benefit from increased public and private spending, friendly government and low taxes—most companies, in other words. The gainers include department stores, health care and defence (see chart), along with heavy machinery, air freight and industrial metals. Stocks with large dividends also rose strongly, reflecting a belief that under Mr Bush taxes on capital will be lower than they might have been under Mr Kerry. Only two sectors have slipped. One is energy, perhaps because Mr Bush would allow more drilling in America and thus boost supply. The other is textiles, possibly because Mr Bush seems keener on free trade than Mr Kerry.

Furthermore, it could be that investors were quite happy with continuity. Despite a lot of gloomy talk—about rising oil and petrol prices, and the slow pick-up in employment as the economy has grown—the American economy is not in noticeably poor shape. Growth is pretty strong. Inflation is low, though showing some signs of rising. Unemployment, at 5.5%, is a little lower than when Bill Clinton was re-elected in 1996.

Corporate profits have risen by 75% over the past three years and profit margins are approaching their highest in three decades, according to Silvercrest Asset Management. Interest payments as a percentage of GDP have fallen back to the levels of the early 1980s, before junk bonds and highly leveraged acquisitions became popular and made it easy for companies to pile up debts. Bond defaults are low. Small and mid-sized companies are in better shape than they have been in four years, says James Hance, vice-chairman of Bank of America. For the first time in years, there are signs that these companies' deposits are beginning to fall. This might be a sign that demand for commercial and industrial loans, which has stagnated in the past few years, is about to increase.

There is more. Although the Bush administration is not perceived to be especially close to Wall Street—unlike Mr Clinton, Mr Bush has not yet appointed a treasury secretary from a financial firm—it is seen as a friend of business. Thus the election relieved the market's concerns that new taxes would be imposed. Besides the Republicans' successful defence of the White House and gains in Congress, judges backed by business groups were elected in several states. Initiatives to curtail litigation were passed in California, Florida, Nevada and Wyoming. That may help businesses facing class-action lawsuits over asbestos, medical malpractice and behaviour in securities markets. President Bush wants still more tort reform. President Kerry might have looked more threatening, with John Edwards, a former trial lawyer, as his vice-president.

However, by no means is everything rosy for the stockmarket, which has had a curious year. Although the economy has been doing decently and profits for the companies making up the S&P 500 are likely to be 20% higher this year than last, on the eve of the election share prices stood roughly where they had on January 1st, having surrendered all the gains they had made earlier in the year. Maybe uncertainty about the election had something to do with this.

The cloud around the silver lining

Looking ahead, the sinking dollar (should be a fillip to American exporters, but it will also add to inflationary pressures. Household savings are low: if these have to rise, then consumers will spend less. Corporate earnings are still growing strongly, but the pace is fading. Profit growth of 10% next year, which many analysts expect, sounds brisk but is only half this year's rate; the year after, it may be slower still. If the job market is tightening at last, then this will push up wage costs. Worse, America has a huge government budget deficit that can only be reduced by extraordinary economic growth, higher taxes or spending cuts. Worse still, Mr Bush shows little inclination to plug it: many on Wall Street hoped for a Kerry victory if only because a split between Congress and the executive might have halted spending growth.

This caution about the economy is visible in the niggardly yields on Treasury bonds. Despite the Bush victory—possibly meaning more government borrowing than a Kerry presidency—the latest, bullish jobs report and the upward path that the Fed appears to be setting for short-term interest rates, the ten-year note still yields a mere 4.2%, the stuff of fantasy for most of the past four decades. Though this spells bliss for borrowers, it may also signal that bond markets are gloomy about growth.

And after the markets' brief burst of post-election euphoria, they will have to look ahead to what Mr Bush might do in his second term. Several initiatives he intends to pursue will have a direct impact on the public markets, notably the creation of some form of individual retirement accounts in place of Social Security and a broad revision of the tax code. None of this will be easy nor perhaps even feasible. Making it all a bit more difficult will be the likelihood that Alan Greenspan, chairman of the Federal Reserve, will finally retire at the end of his term in two years. The name of his replacement may mean as much to the markets as did the American people's verdict on November 2nd.


The world on his desk
Nov 4th 2004 | NEW YORK
From The Economist print edition

A briefing for the weary winner from the man in charge of policy and planning at the State Department in 2001-03

AS GEORGE BUSH contemplates his second term, he faces far more challenges, and more difficult ones, than he did four years ago. The first reason for this is the objective state of the world, with a host of problems, from Iraq to North Korea to HIV/AIDS, demanding urgent attention. The second is the current condition of the United States. America remains the world's pre-eminent actor, but it is also stretched militarily, in debt financially, divided domestically and unpopular internationally. It all makes one wonder why Mr Bush seemed so keen to keep the job.

The United States is engaged in at least three conflicts. First, terrorism. Although al-Qaeda's original membership may be diminished, some of its leaders (including Osama bin Laden himself) remain at large and many have joined them. Mr Bush may find himself dealing with groups that possess not just box-cutters and access to aircraft, but nuclear material or, worse, a nuclear weapon.

In Iraq, America and its foreign allies are continuing, slowly and against resistance, to train Iraqis to look after their own security. Achieving stability will not be easy. Nor will conducting elections that will be accepted by Iraqis and the world as legitimate.

In Afghanistan, the task of creating a modern state still suffers from the initial decision to limit America's role in nation-building. The central government is weak, warlords are strong and poppy production is at record levels. It is unlikely that this effort, any more than those against terrorism or in Iraq, will be completed before Mr Bush leaves office.

The biggest challenges, however, may lie elsewhere, in North Korea and Iran. North Korea reportedly possesses between six and ten nuclear weapons, or at least the fuel to make that many. Iran is farther along on the path to enriching uranium than anyone knew. Either regime, if nuclear-armed, could prove the tipping-point for its region as neighbours decide to follow suit. Either regime might also slip fissile material to terrorists. Mr Bush will have to decide in a hurry what he can tolerate and what he cannot.

Then there is the matter of Israelis and Palestinians. Where there was once a “peace process”, there is now little peace and even less process. Mr Bush will need to figure out what the United States can do to make sure that Ariel Sharon's policy of Israeli disengagement from Gaza does not become Gaza only, and that Gaza does not become a lawless failed state. Failure here would not only make it much more difficult for the United States to promote democratic reform in the Arab world or slow terrorist recruitment, but would damage its reputation everywhere.

Darfur is a humanitarian tragedy that continues to unfold while the world debates whether what is going on is genocide. The question is what more the United States and others are prepared to do, whether to stop the killing or to assist those whose lives have been devastated.

Turning to the major powers, the issue with most potential to cause real harm is China-Taiwan. There, it is getting harder for America to balance its “One China” policy with its security obligations to Taipei. If Taiwan's leaders insist on more trappings of statehood, China may go to war. Coming to Taiwan's defence could well poison America's relations with one of the world's emerging powers, and undermine chances of an acceptable resolution of the North Korea problem; not doing so could raise fundamental questions about America's reliability, and give the impression that China had replaced the United States as the region's dominant force.

Russia is a problem largely of its own making. It is fighting a costly and possibly losing war in Chechnya; alcohol and AIDS are ravaging the population; and democracy is being rolled back as Vladimir Putin takes advantage of high oil prices and fears of terrorism to consolidate his rule. But the United States needs Russian oil, as well as Russia's co-operation to deal with Iran.

One last set of challenges requires a mention. Call them (as Donald Rumsfeld might) the unknown unknowns. The most obvious is another massive terrorist attack that sets America reeling, economically, psychologically and politically. There could be assassinations; imagine the difficulties of building Afghanistan without Hamid Karzai, Pakistan without Pervez Musharraf, or Iraq without not just Iyad Allawi but much of his team. The departure of Fidel Castro, too, though hardly a cause for grief, could lead to instability that some in the United States might find it hard to ignore.

The stretched superpower

Tackling such an array of challenges would be difficult if America was in the best of shape. But it is not. The economy is growing at a reasonable clip, but the foundation of this growth is vulnerable. When Mr Bush ran for president four years ago, the budget was in surplus to the tune of $236 billion; now the annual deficit is more than $400 billion. Calls to reduce growth in federal spending will put pressure on funds available for defence, foreign aid, HIV/AIDS and homeland security.

Add the fact that the current-account deficit is expected to be more than $600 billion this year, or around 5.5% of GDP. All this leaves the economy at the mercy of bankers in Asia and elsewhere who have accumulated massive dollar holdings. As Herb Stein said, that which can't go on forever, won't. A day of reckoning could well come over the next four years. If it does, Alan Greenspan or his successor will have to put up interest rates sharply.

The deficit has grown so much, in part, because of the cost of defence and homeland security. Related to this is the fact that the United States is so active militarily. Some 135,000 troops are in Iraq, another 15,000 in Afghanistan. Reserve call-ups are being extended. The United States would be hard pressed to meet the demands of a crisis on the Korean peninsula. Preventive strikes on a would-be nuclear state are one thing, but it is difficult to see how the United States could take on a full-scale war with even a medium power at this point.

Making matters worse is America's energy dependency. The United States now imports some 12m barrels a day, more than half the oil it consumes. There is no reason to believe that the oil price will soon come down from its $50-a-barrel perch. Besides, the balance between world supply and demand is sufficiently tight that it would not take much disruption in a medium producer (say, Venezuela or Nigeria), not to mention Saudi Arabia, for the price to spike through the roof.

It will not be all doom and gloom, of course. Relations overall with the other big powers—China, Japan, Russia, India—have never been better. In addition, India and Pakistan have moved back from the brink, and links between the two are growing. East Asia is on the economic rebound. South Africa is faring relatively well, as is much of Latin America.

The state of America, too, should be put in perspective. For all its weaknesses, it remains the world's dominant power. Americans support an active world role, despite the costs. Mr Bush could benefit considerably from simply adjusting the tone and style of his diplomacy.

What to focus on

What should rise to the top of Mr Bush's agenda? Let me suggest nine items.

Success in Iraq. This need not require transforming Iraq into a shining city on a hill. It does mean making it a functioning country. Elections will have to be held as scheduled, and the training of Iraqi security forces accelerated. It may be both desirable and necessary to increase American troop levels in the run-up to January's elections, coupling any such increases with an announcement that reductions would follow the vote. America would also be wise to declare publicly its lack of interest in holding on to any bases in Iraq once its troops depart. To be avoided are an arbitrary exit date that would require forces to leave without establishing relative stability, and any appearance that the United States is being driven out of Iraq as it was out of Somalia.

Engage North Korea and Iran. The United States, with others, should make comprehensive offers to both North Korea and Iran. In both cases, the offer should include security assurances and political and economic incentives in exchange for giving up nuclear ambitions. It should also indicate the price to be paid if the world's concerns are not satisfied. Two other good ideas: accelerate efforts to secure Russia's “loose nukes”, and get the nuclear haves to agree that no other country should be able to gain access to nuclear fuel which could be used as, or in, a weapon.

Revive Middle East peace efforts. Making sure that an Israeli withdrawal from Gaza goes ahead and leaves something stable in its wake will require American, European and Egyptian collaboration. Ensuring that diplomacy begins rather than ends with Gaza will require America to speak out about where peace efforts should lead, and show greater commitment to getting there. Appointing a senior envoy who clearly enjoys White House backing would be a start.

Prevent a Taiwan crisis. This means continued pressure on Taiwan's leaders not to go too far, along with continued warnings to China's leaders to pursue their goals peacefully. Both should be left in no doubt that they would not benefit from a crisis of their own making.

Drive Doha. A new WTO agreement would be a boon for both America's economy and the world's. America should set an example by eliminating all its remaining subsidies, quotas and tariffs.

Help Darfur. America should make intelligence, logistics, training and equipment available to the African Union, and push for targeted sanctions against Sudan's leaders.

Repair transatlantic ties. Further continental drifting apart will serve neither America's nor Europe's interests. Alas, there is no quick fix available. Europeans (read French and Germans or, better yet, NATO) must find some way to help meaningfully in Iraq; a failure there would do them as little good as it would the rest of the civilised world.

Stay the course on terrorism. Continue to go after terrorists and frustrate their recruitment efforts, but also keep investing in homeland security. Lowering America's profile in Iraq will help, as will raising it on the Palestinian issue. The United States should also stick with efforts to promote political, economic and education reform in the Arab world.

Get your house in order. The United States will not remain a great power for long if the economic foundation of its power erodes. It must rein in domestic spending, including tackling entitlements. America must also develop a serious and responsible energy policy. The only debate needed is over the right mix of mandated efficiency improvements, investment in alternative fuels and (get the children out of the room) new taxes.

All these challenges will add up to a more restrained America. New wars of choice are less likely; Mr Bush will have his hands full. Many around the world will no doubt welcome this. But they should be careful what they wish for. The world is a very dangerous place and, unlike the economic marketplace, there is no invisible hand making sure all turns out for the best. As Mr Bush well knows, only the United States can fulfil this role.


Not exactly what they seem to be
Oct 29th 2004
From The Economist Global Agenda

Big western oil companies’ record profits may be masking future problems

LEADING oilmen gathered this week in London for the “Oil & Money” conference, an annual expense-account jamboree often preoccupied with the industry’s woes. This year, though, the tone was cheerful. Jeroen van der Veer, head of Royal Dutch/Shell, reassured his audience that Americans are “still driving their SUVs to Wal-Mart”. Lord Browne, the boss of BP, gave a sunny speech insisting that without petroleum “the world would be a dark, cold and miserable place.”

The explanation for such exuberance? The remarkable rise in oil prices—from around $10 a barrel in 1998 to an all-time nominal record of $55.67 this week—which has left leading western oil companies awash with cash. On Thursday October 28th, Royal Dutch/Shell, which has had a rough time this year due to a scandal involving exaggerated oil reserves, posted a whopping 120% rise in third-quarter profits, to $5.4 billion. (It also announced that it will merge its British and Dutch parent companies, ditching a longstanding dual-ownership system that has lately displeased its shareholders.) Earlier in the week, BP revealed that its third-quarter profits shot up by 43% on a year earlier, to nearly $4 billion.

The big firms have been busy handing back cash to their shareholders in various ways. BP and Exxon Mobil have been buying back shares like mad: BP is likely to purchase $7.25 billion-worth this year; Exxon Mobil, whose third-quarter profits rose by 56% to $5.6 billion, will buy back some $9 billion-worth. Shell has chosen to dole out the windfall as fat dividends.

So oil’s well, then? Not quite. Despite their current profitability, the majors face big trouble in three areas: rapidly declining reserves; soaring costs; and lack of access to cheap new reserves. Tom Wallin, head of the Energy Intelligence Group, an industry publisher, argues their future “is more in doubt than at any time since the nationalisations of the 1970s.”

The last spectacular wave of growth for the big western firms came several decades ago after they were kicked out of the giant fields of the Persian Gulf. Out of desperation, Exxon, BP and others poured billions into non-OPEC areas such as the Gulf of Mexico, the North Sea and Alaska.

Alas, those fields are now ageing and their reserves rapidly declining. In its annual World Energy Outlook, released this week, the International Energy Agency, a quasi-governmental body, estimates that the size of the “reserve challenge” is staggering. Some $3 trillion will have to be invested in global oil infrastructure between now and 2030 if anticipated demand is to be met, most of it to offset declines in production at existing fields.

The second problem is that costs are soaring. One immediate issue is the weak dollar, the only currency in which oil is priced; this makes it expensive for oil firms to buy in other currencies. Another soaring cost is the price of steel, which BP cited this week as a reason for exceeding its targets for capital spending.

A more worrying cost, however, is that of finding and developing new oil fields. Through the 1980s, the exploration cost per barrel tumbled from around $20 to between $5 and $7 thanks to several breakthrough technologies, including 3D-seismic imaging. Through the 1990s, costs remained fairly flat. Over the past three years, though, they have risen sharply. Douglas Terreson of Morgan Stanley, an investment bank, thinks costs are soaring because the blizzard of breakthroughs that reduced the cost of finding and developing oil has now slowed to a trickle.

Andrew Gould, the head of Schlumberger, an oil-services giant, is not so pessimistic. He thinks that new breakthrough technologies might already be at hand. And yet even he believes that the majors cut research too much and the industry has been slow to adopt new technology. Breakthroughs are clearly needed, though, if firms are to find oil economically in tricky places such as the Siberian tundra or the ultra-deep waters off Africa and Brazil.

Ian Howat of Total, a French oil giant, argues that these riskier areas are the future for western majors. As it happens, Total already produces more oil in non-OECD areas than either Exxon or Shell. The reason? “France never had any oil of its own, so we had to go looking.”

The search in such inhospitable places points to the third reason that the big oil firms are in trouble: lack of opportunity. Perversely, the industry’s best firms are forbidden to invest in the cheapest and best assets. Saudi Arabia and its four Gulf neighbours sit atop two-thirds of the world’s oil—and they have no welcome mat out for the biggest companies.

Going for gas

Do not weep for these firms, though. Alan Kelly, head of corporate planning at Exxon, insists “we are not opportunity-constrained right now”. Lord Browne also rejects the pessimistic view. He points to BP calculations suggesting that the top 30 oil firms have increased their spending on exploration and development from around $70 billion in 2000 to $100 billion last year. He insists that for the next ten years or so, there is “no shortage of investment opportunities” for oil—although after that, he concedes, there is a question mark.

Look, however, at the ways the big companies are spending money in areas other than conventional oil, and it becomes clear that they are slowly transforming themselves into energy firms. One shift is into “unconventional” hydrocarbons, such as the mucky tar sands of Canada and the shale of Venezuela. These can be made into oil, but at greater cost and environmental damage than normal oil. Exxon’s boss, Lee Raymond, recently vowed to produce technological breakthroughs that would make “unconventional oil conventional”.

Another significant way in which the big firms will change, argues Robin West of PFC Energy, is through their push into natural gas. Gas has never been as sexy as oil; indeed, it was often seen as an unwanted by-product. But no more: by 2030 or so, gas may pass oil as the dominant global fuel. It is much better distributed around the world than oil (see chart), and countries are generally happy to have help in getting it to market.

And what of green energy? BP says it stands for “Beyond Petroleum”, and Shell makes similarly ambitious claims. But their investment in renewables and hydrogen is trivial compared with the billions they spend each year on oil and gas. With oil at over $50 a barrel and enough hydrocarbons in the ground to last for many decades, that is unlikely to change.


Ah, there's the brake pedal
Oct 29th 2004
From The Economist Global Agenda

China's central bank has raised interest rates for the first time in nine years. Can overinvestment be curbed without the economy slowing too sharply?

AS EVERY disciple of Milton Friedman knows, the effects of monetary policy are felt only after a “long and variable” lag. Central bankers cannot wait for inflationary threats to materialise; they must pre-empt them, by raising interest rates at the first hint of price pressure. China’s central bankers follow different rules. Consumer-price inflation has been rising for a year or more. By July, it all but matched the rate of interest: borrowing was, in effect, free. But the central bank, the People’s Bank of China, has been slow to react. Finally, on Thursday October 28th, the People's Bank raised interest rates for the first time since July 1995, lifting its benchmark lending rate from 5.31% to 5.58%. The lags in Chinese central banking, it seems, are invariably long.

In the past nine years, China's economy has doubled in size. In 1995, China bought 5% of Japan's exports and 7% of South Korea's. Now Japan sells over 13% of its exports to its giant neighbour and South Korea sells more than 20%. In 1995, China consumed about 3.3m barrels of oil per day. Now it guzzles about 6.3m. The men at the helm of this economic juggernaut remain inscrutable, but they no longer labour in obscurity. Their decision on Thursday had a worldwide effect on commodity markets. The price of oil and metals fell back on the announcement. Australia, a big exporter of iron and other commodities, saw its currency wobble.

Nine years on, however, the Middle Kingdom is still caught betwixt plan and market. The price of capital plays a relatively small role in how it is allocated. China has no corporate-bond market to speak of and its stockmarkets, in Shenzhen and Shanghai, are still thin and patchy. Most capital is thus provided by banks, and the most important banks are still owned by the state. Some of their customers bid for capital at the prevailing rate of interest. Others, the least enterprising and best connected, hustle for it, by pulling strings or calling in favours. But perhaps two-thirds of the banks' loans serve to prop up state-owned enterprises. The best way to get capital in China is to be too big to fail.

Stuck between plan and market, China is also caught between overinvestment and underemployment. With borrowing cheap and loans easy to come by, investment has flowed blindly into industries, such as construction, cement and steel, which must have long since passed the point of diminishing returns. The Chinese authorities need to curb this overinvestment, but they cannot afford to slow the economy too sharply. Jobs need to be found for the 150m peasants who, according to the International Monetary Fund (IMF), are underemployed in the fields, and the 10m-11m surplus workers in state enterprises, which specialise in disguising unemployment. Even at the high rates of growth China has maintained in recent years, unemployment is likely to get worse before it gets better, the IMF predicts.

China’s dilemma is complicated by its exchange-rate regime. The yuan, pegged at 8.28 to the dollar since 1995, is considered cheap in many quarters and ripe for revaluation. Speculators are thus anxious to pile into it. To maintain its peg, the People's Bank has to meet this demand by printing yuan (it spent 536 billion yuan, or $65 billion, in the foreign-exchange markets in the first half of this year). But this only adds to the money supply. To compensate, the bank sells its own bills, thus taking yuan out of circulation. But these “sterilisation” efforts are often fruitless. The capped rates the central bank can offer on its bills are not very attractive to commercial banks, which often fail to bid for them. Thursday's rate hike will put further upward pressure on the yuan.

Slow to raise interest rates, China’s authorities have clamped down on investment by more direct means. They have lifted reserve requirements for banks, hectored speculators and ordered lending to the steel, cement and car industries, among others, to be cut. What has this fussing, fiddling and fulminating achieved? The economy has slowed, growing by 9.1% (year-on-year) in the third quarter, compared with 9.6% in the quarter before. Inflation has also stabilised, edging downwards from 5.3% in August to 5.2% in September.

But these administrative ploys have also created distortions. They have starved the most enterprising firms of capital—black-market interest rates are 20% or more—while the well-established and best-connected firms still find a way to raise the money they want. As Diana Choyleva of Lombard Street Research puts it, “dirigisme tends to favour the status quo.”

Dirigisme is no longer enough, China’s policymakers seem to have concluded. Their first rate hike in nine years was a small one. But they have also lifted the cap they had imposed on the rates banks could charge on their loans. Thus banks, which could previously lend at no more than 1.7 times the benchmark lending rate, will now be free to practise usury as they please. This will help to bring down the 20% rates prevailing in the black market for capital. It is also a welcome sign that China’s authorities are willing to let prices, not politics, allocate capital.


The dollar

The wolf at the door
Oct 28th 2004
From The Economist print edition

A further steep decline in the dollar seems inevitable

MOST economists, and this newspaper, have been fretting about America's huge current-account deficit and predicting the dollar's sharp decline for years. The trouble with crying wolf too often is that people stop believing you. After slipping 14% in broad trade-weighted terms since 2002, the dollar had stabilised this year, even as the current-account deficit continued to grow. This has encouraged some economists to offer theories explaining why America's current-account deficit does not matter and why the dollar need not fall further. But the dollar has now started to slide again: this week it hit $1.28 against the euro, within a whisker of its all-time low of $1.29. Trust us, the wolf is real.

The dollar's latest slide seems to have been triggered by uncertainty about the presidential election and a flurry of comments from Fed officials. Robert McTeer, the president of the Dallas Federal Reserve, mused (only “theoretically” of course) that when capital inflows into America dry up, “there will be a crisis that will result in rapidly rising interest rates and a rapidly depreciating dollar that will be very disruptive”.

Policymakers' usual reply when asked about exchange rates is to say that they are set by the market. But if the dollar was truly being set by the market it would now be much weaker. The dollar has fallen by over 30% against the euro since 2001, but its trade-weighted index has fallen by much less because of heavy intervention by Asian central banks, aimed at holding down their currencies against the dollar. This policy seems likely to continue, despite China's decision this week to raise interest rates for the first time in nine years. That decision was aimed at curbing its overheating domestic economy, rather than bolstering its currency.

Because Asian currencies have been held down against the dollar, America's current-account deficit has continued to swell, reaching almost 6% of GDP in the second quarter. The dollar is already below most estimates of its fair value against the euro, but it will need to undershoot if the deficit is to be reduced. Economists at UBS estimate that the dollar's trade-weighted value might need to fall by another 20-30% to trim the deficit by enough to stabilise the ratio of America's external liabilities to GDP. Though it might seem unthinkable, that could imply a rate of around $1.70 against the euro.

Other economists, however, argue that America can sustain its large current-account deficit for at least another decade, without a sharp fall in the dollar, because it will be happily financed by China and other Asian countries. In a series of papers Michael Dooley, David Folkerts-Landau and Peter Garber at Deutsche Bank have argued that the present arrangements resemble a revived Bretton Woods, the system of fixed exchange rates after the second world war.

Asian economies, they argue, have chosen to link their currencies to the dollar at undervalued rates, supported by heavy purchases of dollar reserves. Asian countries want to keep their exports cheap to support rapid growth and are in consequence happy to keep acquiring dollars indefinitely. In turn, by buying Treasury bonds, they reduce interest rates, which supports spending and ensures that American consumers keep buying Asian goods.

Since 2001, Asia's official reserves have increased by $1.2 trillion, equivalent to two-thirds of America's cumulative deficit over that period. Currency intervention by Asian central banks helps to explain why America has so far been able to finance its deficit without higher American bond yields or a bigger fall in the dollar. However, the claim that the deficit is sustainable for another decade is highly dubious.

An excellent paper by George Magnus, an economist at UBS, argues that the parallels with Bretton Woods are superficial. One big difference is that in the 1960s the United States ran a current-account surplus and was a net creditor to the rest of the world. Today, America is the world's biggest debtor, which could undermine the dollar's role as an anchor currency.

Second, it is wrong to describe the Asian countries as habitual “peggers”. In the 25 years to 1998, non-Japanese Asian currencies typically fell against the dollar, and over the same period their countries mainly ran current-account deficits, not surpluses. Their more-firmly-tied exchange rates and current-account surpluses generally date only from 1998 when these countries needed to rebuild reserves after the Asian crisis. Their desire to tie their currencies to the dollar may be a temporary response to a cyclical problem.

A third important difference is that, unlike under the Bretton Woods regime, most Asian countries have scrapped capital controls or where they still exist, as in China, they are leaky. This requires much greater “sterilisation” by central banks to prevent an increase in reserves spilling into faster credit growth. As sterilisation has become less effective, excessive credit growth is pushing up inflation and causing overinvestment in property, especially in China. As the inflationary costs of maintaining their link to the dollar grow, Asian countries may shift to more flexible regimes.

Lastly, under Bretton Woods there was no real alternative to the dollar as a reserve currency. Today there is the euro, into which Asians could diversify.

Mr Magnus reckons that the revived Bretton Woods is an illusion which will crack within a year or two. Even if it lasts longer, it is a dangerous way to run the world, for it encourages both China and America to pursue reckless policies. Excessive liquidity is causing the Chinese economy to overheat. Meanwhile, by buying Treasury bonds, Asian central banks are subsidising American borrowing costs, encouraging more consumer profligacy, and so allowing the current-account deficit to get even bigger. The inevitable correction will then be all the more painful.

Until recently, some argued that America's current-account deficit was sustainable because foreign investors were eager to buy American assets to take advantage of the economy's faster productivity growth and hence its higher returns. But private inward investment has slumped, leaving America dependent on foreign central banks. And foreign savings are no longer financing investment and hence future productivity gains as they were in the late 1990s. Foreigners are now financing consumption and government borrowing.

America's current-account deficit largely reflects puny domestic saving, so dollar bulls often argue that a fall in the dollar is neither necessary nor sufficient to trim the deficit. But Stephen Roach, chief economist at Morgan Stanley, reckons that a weaker dollar would spark a rise in real bond yields, as foreign creditors demanded extra compensation for currency risk. That would slow consumer spending, boost saving and reduce the deficit.

In the three years from 1985, the dollar fell by 50% against the other main currencies. Inflation and bond yields rose and, in October 1987, the stockmarket crashed. America's current-account deficit is now almost twice as big as it was then, so the total fall in the dollar—and the fall-out in other financial markets—could well be larger. The wolf is licking his lips.