When will foreigners stop financing the US?

I shouldn't write anything about the weakness of the dollar. The Governor of the Bank of England, Mervyn King, who has a much better idea of what's going on than me, said the other day: "I have no idea where exchange rates will go in the future and I have no intention of ever starting to forecast exchange rates." And recently, Alan Greenspan, chairman of the US equivalent, the Federal Reserve Bank, was equally dismissive, citing as evidence the "statistically robust finding that forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss."

I shouldn't write anything about the weakness of the dollar. The Governor of the Bank of England, Mervyn King, who has a much better idea of what's going on than me, said the other day: "I have no idea where exchange rates will go in the future and I have no intention of ever starting to forecast exchange rates." And recently, Alan Greenspan, chairman of the US equivalent, the Federal Reserve Bank, was equally dismissive, citing as evidence the "statistically robust finding that forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss."

Why should two of the world's leading central bankers emphasise the impossibility of predicting exchange rate movements at this particular moment? Because, I suggest, they both sense, though they cannot be sure, that the decline in the value of the US currency could gather pace. If it does, they wouldn't want to be criticised by politicians for not having warned them. For a dollar collapse would be an unpleasant experience both for the United States itself and for Europe.

In terms of the euro, the dollar has never been lower. Even in the few weeks since President Bush was re-elected, the dollar has dropped by 2.5 per cent in euro terms. Altogether it has lost 40 per cent of its value in the past two years. The pound has behaved broadly as if it were in the euro camp. That is why we find American holidays good value. That is why British suppliers of goods and services have a hard time exporting to the US.

Thus far this quite substantial decline, with its inevitable effects on trade, has passed largely unnoticed. Of course financial markets are up to speed, and so are companies whose international business is affected. The reason why the rest of us have hardly realised what is going on is that America's huge trade deficit has been financed without the least bit of trouble.

Compare the American situation to what ours would have been if Britain had had, as the US now does, a trade deficit equivalent to 5 per cent of our economy's annual output. A sharp decline in the pound would have brought much higher interest rates in its wake, house prices would have collapsed, economic growth would have given way to recession, the Chancellor of the Exchequer would have been reshuffled and possibly the Government would have fallen.

Yet none of this has happened in the US. Interest rates have scarcely risen from exceptionally low levels. The economy keeps on growing. The President has just been re-elected with an increased share of the votes.

On Friday, however, in what could prove to be a historic warning, Mr Greenspan said that this happy state of affairs cannot continue forever. Unless there is a change of course, there will come a reckoning. What might bring this dread event about would be a hardening of attitudes by foreign investors, including central banks around the world, governments with oil revenues to place, financial institutions and rich families.

To see what is at stake, look what happened in the 12 months to 30 September. The US had an astronomical trade deficit of $445bn. Yet foreigners bought $675bn worth of US securities during the same period. Result? Deficit covered. This margin of safety, however, is steadily shrinking.

Mr Greenspan pointed to two developments that could remove it altogether. First, all this foreign capital that the US is attracting has to be serviced. Foreigners are not making charitable donations. They expect interest or dividends in return for their money. This payments burden is growing exponentially. Second, these same foreign investors will eventually find that they are holding more dollar securities than is prudent; they will come to feel that they are overexposed.

Thus the circumstances that would bring about a serious dollar crisis can defined: it is when investment by foreigners in the US no longer covers the American trade deficit (technically its current account deficit). In consequence, the dollar would fall further and US interest rates would rise significantly. The economic consequences would be a faltering in American business activity with the result that Europe would face even greater difficulties in exporting into the US. European growth and employment would suffer accordingly. The world economy would enter recession.

What would stop the crisis developing further is pretty clear. Finance ministers and central bankers of the Group of 20 large economies have been discussing over the weekend three escape routes. The European economies could grow faster, thus providing a more buoyant market for American exports. Easier said than done. China, with its huge trade surplus with the US, could revalue its currency. Inscrutable. Or American consumers could spend a bit less and save a bit more. Probably wishful thinking.

Whether any one of these paths will be followed does not, however, represent the key uncertainty. That concerns the attitude of foreign investors in US securities. When will they have had enough? They don't even know themselves. Nobody can tell. Not even Mr King or Mr Greenspan. For all that, the threat is no less real.