Resident Fellow  Desmond Lachman

The recent crisis in the US sub-prime mortgage market has raised questions anew as to whether the US dollar's day of reckoning might not now be upon us. How will the US be able to finance its record external current account deficit should the US economy falter and should US financial assets lose their luster to foreign investors? Might not a weakening in the US dollar intensify foreign central banks' desire to reduce their unusually large dollar reserve holdings, which would thereby remove a principal support to the beleaguered greenback?

Raising questions about a potential slide in the dollar would seem valid at this time of gathering storm clouds over the US economy. However, they would seem to overlook currency questions of perhaps even greater concern for the long-run global economic outlook. How can the euro survive in its present form if an undue strengthening in the euro fatally exposes the fault lines between the euro's northern European and its Mediterranean members? And what might happen to the European economy if Italy and Spain were forced to leave the euro?

In the period ahead, the principal driver of global currency movements is very likely to be the present deflating of the US housing market bubble. For following an 80 percent increase in US home prices at the national level between 2000 and 2006, the housing market bubble now shows every sign of having burst. Indeed, US housing prices are already falling and vacancy rates are at record levels, while there is every prospect that housing demand will be crimped substantially in the rest of the year.  Among the factors that can be expected to constrain demand are an overall tightening in lending standards in response to the sub-prime mortgage lending fiasco, the resetting at higher interest rates of Adjustable Rate Mortgages, and the unwinding of large speculative positions.

Any significant housing-led US economic slowdown must be expected to threaten the US dollar. For a start, the relative interest rate differential that presently favors the US dollar would most likely be eroded as the Federal Reserve cuts interest rates to support a flagging US economy. Perhaps an even more important source of weakness for the dollar would be the likelihood that US financial assets, including equities, might lose their appeal. This would seem to be all the more likely since these assets are presently priced without much regard to risk and on the premise that all will remain well with the US economy.

The problem for Europe with any further decline in the US dollar is that the euro would be the major global currency that would continue to bear the full brunt of the dollar's decline. Already since 2003, when the gradual secular decline of the US dollar began, the euro has appreciated against the dollar by around 40 percent. It has done so even though European surpluses have hardly been the counterpart to the ballooning US current account deficit.

In the period ahead, one must expect this state of affairs to continue since the Asian currencies are unlikely to shoulder much of the burden of a weaker dollar. After all, the Chinese, who now enjoy the world's largest external current account surplus, show no sign of backing off their weak-currency strategy, which they continue to back with foreign exchange purchases to the tune of US$250 billion a year. For their part, the Japanese, fearful of a renewed bout of deflation and also having a very large current account surplus, show little sign of urgency to normalize interest rates anytime soon. By refraining from normalizing interest rates, the Bank of Japan virtually ensures a weak Japanese yen by make it amongst the favorite vehicles for the "carry trade."

The challenge to the euro's survival in its present form is that the individual countries within the euro are very differently placed to cope with a strong euro. In particular, Greece, Italy, Portugal, and Spain would be the countries most squeezed by a rising euro, given the erosion that has already occurred in their relative wage and price competitiveness positions over the last few years. Since 1999, these countries have lost anywhere between 33 and 45 percent in competitiveness with respect to Germany on account of higher relative wage and price inflation.

Within the constraints of a currency union, the Mediterranean countries cannot resort to currency devaluation to restore competitiveness. Nor can they use interest rate policy to stimulate domestic demand. Instead, the rules of the currency union require them to endure deflation or to increase productivity as the only means of restoring their eroded competitiveness.

Over the past year, increased dissatisfaction with the constraints of the euro was vociferously expressed in both the Italian and French election campaigns. How much more so will the political noise rise when the Mediterranean members are condemned to prolonged periods of slow or negative growth for want of international competitiveness? How will Italy be in a position to manage its poor public finances in the context of a weakening domestic economy? And what happens to a country like Spain when its present international competitiveness problem is compounded by the bursting of its outsized housing market bubble?

Europe's present predicament underscores the need for the Asian currencies to shoulder at least part of the burden of a further weakening in the dollar. However, if past experience is any guide, one should not hold one's breath for this to happen.

Desmond Lachman is a resident fellow at AEI.