Long fuse of dollar crisis will be lit in 2007

Guardian Unlimited Business

In January 1985 the pound was plunging towards one dollar and the British prime minister telephoned her friend President Reagan for support.

Margaret Thatcher may have believed that "you can't buck the market" but when she saw the pound threatening to fall below $1 her eyes did not focus on the greenback. She saw red.

Thanks to a concerted effort by central banks to prop up the British currency, the pound was kept above that politically humiliating level.

The Iron Lady knew a virility symbol when she saw one, and Reagan helped her to preserve it.

There have been no corresponding telephone calls from Tony Blair to George Bush recently as the pound has approached, but not quite reached, $2.

A $2 pound is not an obvious embarrassment to Britain. Indeed, a $2 pound is, superficially (as often happens in the macho world) one hell of a virility symbol - for the UK, that is; not so much for the US.

Financial markets will no doubt quieten down over the holidays, as the key decision-makers take a break - although in the world of the BlackBerry one can never be quite sure.

But 2007 is surely going to be the year when the long fuse of the dollar crisis is finally lit, and people wake up to the implications of the necessary "rebalancing" of the world economy.

Or, rather, to what I suspect may be a very distorted movement in exchange rates which could lead not so much to rebalancing as to a different form of imbalance.

Indeed the beginnings of new distortions are already with us.

Behind the government of Thailand's attempt to impose financial sanctions on inflows of foreign currencies last week lay understandable concern at the impact the falling dollar was having on the Thai baht, which was manifesting the kind of virility referred to above.

A strong currency in fact signifies weakness for the competitiveness of exports, via its impact on prices or profits or both.

For despite all the publicity given to the supposedly low-profile efforts of Washington to induce a serious revaluation of the Chinese yuan, the adjustment promises to be a characteristically long Chinese march.

The yuan remains seriously undervalued, thereby helping to foment protectionist sentiment in the US and elsewhere, while the Japanese yen has been hitting new lows against the euro.

The real pasting of the dollar's recent decline has been taken by the smaller Asian currencies such as the Thai baht.

It is no wonder the Thai government and central bank are worried.

The outcry, and impact on the stock market, have forced them to back-pedal, as if they were outcasts.

Yet the principle of what they were trying to do resembles what the Swiss, those paragons of financial rectitude, were forced to resort to occasionally in the late 1960s and early 1970s - that is, attempting to discourage unwanted inflows via financial disincentives.

Those were in the far off days of the Bretton Woods system. In a speech in Australia Mervyn King, the governor of the Bank of England repeated his criticisms of the inadequacy of the Bretton Woods institutions such as the International Monetary Fund in circumstances such as these, when the US has been running current balance of payments deficits of more than 3% (and now 7%) since 1999 and "imbalances can apparently persist almost indefinitely".

Mr King's reminders also evoke memories of the 1970s with his point that the combined trade surplus of Opec, thanks to the oil price bonanza (in part caused by Chinese demand) is likely, at some $400bn, to be well over twice the estimated Chinese trade surplus of $150bn this year.

Mr King has also complained about the inadequacy of the Group of Seven, something of which he has first hand experience, since he is one of the G7 central bankers.

He says: "The inability of the G7 to deal with the major spill-over effects in the world economy has become more and more evident.

"Adding new members, even if they were willing to join, is not the answer." (This is an ex cathedra statement; the governor does not say why it is not the answer).

The answer, he tells us, is "to use the IMF as [a] flexible forum to bring the relevant group of countries together to handle issues as and when they arise".

Mr King also argues that the IMF should concentrate on macroeconomic issues and the Organisation for Economic Co-operation and Development on micro ones. But this would surely be a pity.

The OECD has a good record at macroeconomic analysis, and Mr King's own criticism of recent IMF macroeconomic analysis (that institution's apparent failure to stress the importance of the impact of Chinese demand on the price of oil) suggests that the continuation of competition in analysis from the OECD might not be a bad thing.

The thing about the G7 (or an expanded version) is that it has, or could have, potential political clout.

The IMF is a collection of bureaucrats, with little political authority.

But it is good that Mr King is stirring up the debate, and it is interesting that some observers believe he sees himself as the natural man to run a beefed up IMF when his term at the Bank of England (as a member of an ineffective G7!) comes to end.

Meanwhile, my bet is that with so many holders of dollars getting worried (they only have to stop accumulating them to cause mayhem in the markets) 2007 is going to be an interesting year for the European Central Bank, as it decides how to cope if the euro, like the Thai baht, but on a much bigger scale, is driven too high for comfort.

It could, to coin a phrase, be "brutal".