The outlook for the global economy has become clouded since the September annual meetings of the International Monetary Fund and World Bank in Dubai. Going into the meetings, views were broadly optimistic, tied to the familiar, reassuring sense of a recovering U.S. economy, the prospect of rising exports, and a firm dollar. America, an oasis of firmer demand growth in a desert of global excess capacity, was back-again, for the second time since the bubble economy burst in March 2000. Only this time, it was for real, not like the false, post-9/11 recovery that fizzled out in the spring of 2002. Or, so it seemed.

Coming out of Dubai a sense of unease prevailed. Doubts about the strength of the U.S. recovery lay just below the surface calm of reassuring official forecasts. The mixed signals coming from U.S. data had turned weaker during September as hints appeared that capital spending growth, the sine qua non of sustainable recovery, had weakened in August. High frequency data showed hesitation in consumer spending and confidence. Moreover, the awkward reality of stagnant U.S. employment persisted. September's "positive surprise" in U.S. employment-the first reported increase in several months, albeit a less-than-robust rise of 57,000-was still a week away as delegates exited Dubai. However, after the employment data had appeared, those who cared to look carefully at the numbers could hardly turn euphoric. Behind all the noise surrounding the employment report lay the discomforting fact that the total number of Americans employed was 0.3 percent below where it had been a year earlier-exactly as it had been every month since spring.

But the most concrete disquieting reality at Dubai was the change in America's attitude toward its own currency, troubling both in its own right and also as a signal of concern about the strength of the U.S. economy. An economy that is strengthening as rapidly as the U.S. economy is supposed to be doing is not supposed to care about its currency and, indeed, should be espousing the familiar "strong dollar" policy without qualifiers. But a world in which nearly every country prefers a weaker currency-a world that has arrived now that America has expressed a coded preference for such by seeking "fair markets in goods and fair markets in currencies"-is an uneasy world burdened with excess capacity. There are deflationary tendencies in goods and disinflationary tendencies in services. (Even services are becoming the economic equivalent of traded goods; witness the outsourcing of computer consultancy and design services to engineer-rich countries like India and Pakistan.)

For the record, America's core-good prices-those excluding volatile food and energy prices, increases of which amount to a tax on households loathe to make do with less of either category as prices rise-are falling at a 2.2 percent annual rate. That core goods deflation has accelerated from its approximately 1 percent year-over-year rate a year ago. Core services disinflation persists as year-over-year increases have fallen from 3.6 percent a year ago to 2.7 percent in August of this year.

On the currency front, since early September the trade-weighted dollar has weakened about 7 percent with a little more than half of that coming since America expressed a preference in Dubai for non-interference in market-determined exchange rates. A weaker dollar means that America, heretofore the world's most reliable importer of deflation, happy to let its currency appreciate while basking in the reassuring mantra of a strong dollar as something good for a strong America, has now become an exporter of deflation to a world of commodity deflation and services disinflation.

The proximate signal of America's desire to shift more demand onto its own producers, and away from foreign producers concentrated in Asia, is a pointed invitation to the central banks in Japan and China especially to stop buying dollars as part of an effort to prevent dollar depreciation and thus to prevent appreciation of their own currencies. Indeed, there is a pretty good case for offering this invitation in view of the fact that so far this year, Japan's purchases of dollars have totaled about $125 billion while those by China and other Asian exporters have totaled over $100 billion.

At the behest of their governments, foreign central banks have financed about half of America's much-bemoaned current account deficit, which is up sharply from a year ago. This action amounts to a substantial subsidy to U.S. consumption or equivalently to the producers of the imports that Americans are happy to buy. Of course it also amounts to a handicap on U.S. producers that rely primarily on U.S. inputs. They have been protesting that fact to the U.S. Treasury in statements pointing to unfair foreign manipulation of exchange rates. U.S. high-tech firms, like those in information technology products, have been generally silent since they import many of the components of the computers and cell phones they produce and a stronger dollar actually cuts their costs.

The purchasers of dollars, who in turn acquire roughly equivalent amounts of U.S. government securities (made more plentiful by a rising U.S. budget deficit), have expressed dismay at America's currency protest. In effect they ask, "Doesn't America appreciate our subsidy to American consumption implicit in our purchase of their Treasury securities?" If foreign central banks stop buying Treasury offerings, won't U.S. interest rates rise? The American answer, for better or worse, is that the tax from an overvalued currency on U.S. producers is not welcome. Far more importantly for Japan and Europe, more expansionary monetary policy, with more money printing in Japan and lower interest rates in Europe, would help to balance the support for global demand growth that heretofore has been coming largely from American consumers.

The American initiative for an end to artificial dollar support, largely by Asian central banks, amounts to a call for a weaker dollar to drive enhanced liquidity creation in Asia. For Japan, this should be a welcome invitation since it needs in its own interests to end deflation and boost domestic demand.

China, however, poses a major problem as the U.S. pushes for a weaker dollar. Given that the Chinese yuan is pegged to the U.S. dollar, a weaker dollar only enhances China's already substantial competitive advantage in global markets, especially in Asia. While a weaker dollar constitutes a global zero-sum game for the world economy taken as a whole, the Chinese peg to the dollar turns a weaker dollar into a decidedly negative- sum game for the world economy outside of China.

The Chinese probably will not soon break the yuan peg to the dollar and let their currency rise in value. They have internal policy reasons not to do so, and a country acquiring foreign exchange to keep its currency from strengthening, as China is doing, is in a much stronger position than a country that is selling its limited holdings of foreign exchange to keep its currency from weakening. The major problem the Chinese face in the currency sphere is the possibility that its central bank purchases so much foreign currency, largely dollars, that money growth in China surges enough to create bubbles in the property market as inflation runs away. The fact that some 10 percent of the world's large construction cranes are now in Shanghai is an ominous sign. The bursting of China's property bubble could be as traumatic as the 1997 bursting of the Asian tigers' bubble.

If China refuses to revalue and the U.S. dollar continues to fall, the global economy faces a deflationary shock from the ending of American passivity that heretofore has enabled the United States to be the major source of global demand growth. The heavy dollar buying coming out of Asia in effect short-circuits the stimulus from expansionary U.S. monetary policy by preventing depreciation of the dollar. With Asian currencies kept undervalued, American tax cuts tend to spill abroad as well. During the second quarter of this year (the latest for which data are available), net exports subtracted 1.3 percentage points from U.S. growth-over triple the average subtraction since 1991 and over six times the average subtraction for the entire postwar period. Without that subtraction, the U.S. second-quarter annual growth rate would have risen from 3.3 percent to 4.6 percent, sufficient to reverse the decline in employment.

The combination of America's newest export-deflation-and China's intransigence on its currency peg to the dollar confronts central banks with the challenge to reflate more aggressively. In Japan this means more liquidity creation, and in Europe it means more cuts in interest rates. The Fed too may need to cut interest rates and increase liquidity. While the Bank of Japan on October 10 did take a modest first step toward increasing liquidity, much more needs to be done. Meanwhile, the ECB and the Fed are firmly on hold.

Escaping the deflationary consequences of global excess capacity and moving toward higher sustainable global economic growth that absorbs excess capacity will require central banks to set inflation targets of 1 or 2 percent. Given measurement error, that amounts to a target of stable prices. Unfortunately, the current generation of central bankers is not inclined to move to inflation targeting. Achieving stable prices in a deflationary environment requires targeting because that enables central banks to signal markets that in order to achieve price stability, inflation will be pushed up to above its ultimate target and then credibly be brought back down to its target level. The overshoot serves both as a way to catch-up to an inflation target and as a signaling device from the central bank to markets and consumers that it is serious about stabilizing the price level.

A move toward global reflation to absorb excess capacity would be a positive-sum game. History has shown that the alternative, competitive currency devaluation and tariffs, is a negative-sum game that unfolds only too readily. Those who doubt the possibility that an irrational negative-sum game could be close at hand need only have a look at markets and newspapers. After the Dubai meeting and the sharp drop in the dollar, global stock markets fell, interest rates fell, and gold, the "no place to hide" asset, rose in value. Stocks have since recovered but remain highly volatile. Where they and global growth stand a year from now will depend on the outcome of a race between central banks moving to stimulate faster demand growth and legislatures moving to enact restrictive trade measures. Right now, the legislatures, especially the U.S. Congress, are ahead in the race.