World weary: trade imbalances

World economy vulnerable to jittery markets
Fri Jan 20, 2006
By Mike Dolan

World economy grows, faces dangerous balancing act
By David J. Lynch

Challenges ahead for US economy
By Steve Schifferes

Many experts fear our nation’s trade deficit is dangerously high, threatening the stability of the world economy. “The USA's fat current account deficit could sink the dollar. As it plummets, emerging markets' exports dry up and oil prices, which are denominated in dollars, rise. In no time, what starts as one country's difficulty becomes a global contagion,” writes David J. Lynch of USA Today.

U.S. current account deficit in goods, services and investment income is almost $800 billion, or more than 6 percent of national output, according to Mike Dolan of Reuters. These growing deficits need to be funded by overseas investment. Net increases in overseas inflows of almost $3 billion are needed every working day in the case of the United States.

So, while world growth remains strong, it is increasingly being financed by investors sending ever-larger proportions of their capital and savings overseas.

Rising trade surpluses in developing Asia and the major oil exporters, meanwhile, has led to a boom in governments' foreign currency reserves to more than $4 trillion. World currency markets alone now turn over almost $2 trillion in trading volumes daily. Emerging markets could be most vulnerable.

As the deficit keeps growing, fears are growing that there will be a run on the dollar, which would force the Fed to intervene. It will interesting to watch the new Federal Reserve Chairman, Ben Bernanke, handle this situation. (Mr. Bernanke will succeed Alan Greenspan at the end of this month.)

Mr Bernanke's plan is to change the way the US central bank does business. He is a leading advocate of "inflation targeting", the idea that central banks should set a target for inflation (in the UK for example it is 2%) and stick to it. Steve Schifferes of BBC News notes that Mr Bernanke's approach is widely adopted in Europe, by both the Bank of England and the European Central Bank, and supporters say it has helped to lower expectations of inflation among the public.

This approach was opposed by Mr Greenspan, who believed central banks needed to keep the markets guessing on how tough they would be on inflation.