Playing with fire

Old men should know better than to play with fire. But that is precisely what the old men of the G7 and International Monetary Fund (IMF) are doing.

Many private observers and public officials have long maintained the large U.S. external imbalance was a major risk to the world economy. The solution that appeared to have been embraced was a multi-prong approach: The U.S. would boost domestic savings and Europe and Japan would boost domestic demand, while Asia needed to adopt more flexible capital markets. However, the lack of political will to implement this strategy led to the more expedient course of signaling the currency market should bear a greater burden of the adjustment, which in turn has sparked a dramatic decline in the U.S. dollar.

Officials have warned the U.S. trade deficit is not sustainable and that it injects unnecessary volatility into the capital markets, which distorts investment and economic decision making.

But the real disruption to the capital markets in April and May — and one with the potential to negatively affect world growth was not the U.S. trade deficit (which has, in fact, in recent months been smaller than the consensus forecasts), but rather the clumsy attempt by the G7 and IMF to fix the “problem.” Global equity markets sold off and the rise of global interest rates accelerated.

The sharply falling dollar makes the ability to smoothly finance the U.S. current account deficit more difficult, as reflected in the lukewarm reception to the mid-May Treasury auctions.