Dollar on verge of a dramatic descent

It may seem a perverse claim at a time when the euro has barely crawled off its record lows, but there is a good argument that it is the US not euroland which is facing a looming currency crisis. Once the markets wake up to the new economic reality, it could be that the dollar will tumble in an even more spectacular fashion than the euro has done during the past 18 months.

It may seem a perverse claim at a time when the euro has barely crawled off its record lows, but there is a good argument that it is the US not euroland which is facing a looming currency crisis. Once the markets wake up to the new economic reality, it could be that the dollar will tumble in an even more spectacular fashion than the euro has done during the past 18 months.

The logic is straightforward. The dollar's rise is based on the belief that the US economy as a whole, and US equity markets in particular, can continue to defy gravity. Investment funds have poured out of the euro zone, attracted to the superior returns in US markets, bolstering the dollar and causing the euro to plummet.

But once the markets begin to perceive the full extent of the series of sharp rate rises needed to control the booming US domestic sector, the turnaround could well be rapid. When the US stock markets begin to correct, the dollar will slide. The US economy will become trapped in a vicious circle with a falling dollar heightening pressure on the Federal Reserve to raise rates further to counter the growing inflation risks. This will in turn increase the chances of the US economy sliding into recession and that consequently will hurt equity markets and the dollar.

Most currency analysts continue to argue that the euro will remain weak for the foreseeable future. However, a few are starting to question this. Brian Reading, an economist at Lombard Street, believes the euro could rise by as much as 50 per cent in the next 12 months - more than reversing its slide since its launch last year.

This view is also beginning to gain credence with fund managers. The latest Merrill Lynch survey of big institutional investors - taken in the week the euro hit its all-time low in early May - found that nearly two-thirds of fund managers believed the euro would be the strongest currency in the next year. The message is, beware the strong euro.

But the main lesson is that serious currency misalignments expose all sides to economic risk. And it is the dollar's excessive strength, rather than a weak euro, that will present far more of a problem, over-stimulating the inward-looking part of the US economy and boosting asset prices to an unsustainable level.

International policy makers, however, have so far seemed loth to act. The G7 nationsare sitting on reserves of $700bn (£480m), and there's little doubt that even a simple verbal commitment to concerted action by the world's major economic powers could still have the desired effect in the currency markets.

With an election coming up, though, US policy makers won't be worrying about the medium-term prospects for the world economy. A strong currency may damage exporting firms but voters feel wealthier due to the cheaper imports and good rates on holidays abroad.

As long as the US stays lukewarm about intervention, there is little reason to think Europe will act on its own. After all, the euro's decline so far has generated political rather than economic problems. Although the European Central Bank has expressed concern about the effects of inflation on a falling currency, it is under little pressure to raise interest rates. Rather, European leaders see euro weakness as an embarrassment and that the single currency is losing some credibility among citizens.

It's in Britain where the debate is most intense about the need for intervention. But the point is less about whether the pound is weak and more that currency volatility makes life difficult for investors, exporters and governments, as well as central banks pur-suing stable economic policies.

The Bank of England is acutely aware that the pound looks almost as vulnerable as the dollar to a sudden surge in the euro, with the consequent threat of further UK interest rate rises. Implicit in a recent speech by Peter Mandelson was the assumption that a clear commitment to joining the euro at a lower rate may offer a long-term solution. But the Government's dithering on the single currency has greatly increased the political risks associated with euro membership for Britain. Trapped between two great currency blocs, the Government looks powerless to ease sterling's problems without the support of Europe and the US.

Perhaps Gordon Brown, the Chancellor, should ring Washington, Berlin and Paris as soon as possible. A joint attempt to persuade the markets to sort out the currency misalignments may be the only way to ward off the dangers of the strong euro.

* Alasdair Murray is the economist research director at the Centre for European Reform.