The weather may be cold and wet, but in the rich world’s financial markets it is beginning to feel like August all over again. Credit spreads have widened and shares are pitching from gloom to elation as investors look to the Federal Reserve for solace. The anxiety is unmistakable. But this time the scare is about more than bad mortgage loans and their baleful effect on the credit markets. America may be falling into recession. And a new fear now stalks the markets: that the dollar’s slide could spin out of control.
A full-blown dollar crisis on top of a credit crunch and a weakening economy would be frightening. It would send financial markets reeling and tie the hands of the Fed, perhaps forcing it to raise interest rates even as recession looms. The sky-high euro would soar further, choking off Europe’s growth. Political tensions would also rise. Already Airbus has called the dollar’s decline “life-threatening” and France’s president, Nicolas Sarkozy, has given warning of “economic war”.
At worst, the shadows could darken further. For half a century the dollar has been the hegemonic currency. A large slice of global trade is counted in dollars. Central banks hold most of their foreign-exchange reserves in dollars, a boon for America that has allowed it to issue debt more cheaply. That dominance has survived dollar slides before, as in the late 1970s and mid-1980s. But now, with the euro as an alternative, the fear is of a sudden shift in the global monetary system, with investors switching quickly from one currency to the other.
So far, this remains only a fear. Although the dollar has been falling at quite a lick，it has seen no chaotic slump, but a slide interspersed, as this week, with brief rallies. Americans’ expectations of future inflation have not yet risen much. Yields on government bonds have fallen: clearly, investors do not yet expect higher premiums for safe American assets. Whether disaster strikes depends on what exactly is driving the dollar down and on how policymakers react.