Christopher Smallwood: The global economy could face disaster if the West shrinks from protectionism

The international economy is disfigured by large "imbalances" which, far from getting smaller, continue to grow. As the first chart shows, Asian economies are running huge trade surpluses at the expense of the US, which now has the biggest current account deficit ever recorded. They are also generating excess savings, which are being exported to the US, where they have led to the lowest interest rates in living memory, associated with an unprecedented consumer boom, hugely overindebted consumers, and bubbles in the property and stock markets.

The dangers of imbalances on this scale are plain - a slump in the US affecting the entire world, when American consumers finally have to draw in their horns; a collapse in the value of the dollar, which respectable estimates suggest could take it down twice as far again as the fall we have already seen; and painful readjustments in those overblown markets. Yet no progress to resolve them is being made. Hence the need for some sort of action to force the issue.

Is it fair to blame the Chinese and their Asian neighbours for the parlous state of the world economy? There is no doubt that the imbalances hail from Asia. As Ben Bernanke, of the Federal Reserve, says: "It is not true that the recent deterioration in the US current account primarily reflects economic developments within the US itself." Instead, it reflects "a global savings glut", which has arisen because many of the Asian economies do not invest enough to absorb the savings they are generating. The second chart shows savings rates in major regions of the world. It illustrates starkly the exceptionally high savings of the Asian emerging economies, and the low savings in the US.

The brutal fact is that, had the US not been prepared to soak up the tide of savings from Asia - by expanding its budget deficit and allowing interest rates to drop to 1 per cent, so stimulating massive consumer borrowing - there would have been a slump. In effect, the US government and the Federal Reserve were left with no choice but to act in this way to keep growth going in their own country, and indeed the rest of the world. They still have no choice, which is why their imbalances, most spectacularly the trade deficit, continue to grow, making the economic dangers facing the world ever more menacing.

In theory the international monetary system should regulate these imbalances and prevent a country such as the US from being backed into a corner and forced to amass ever-higher mountains of debt. But that system is failing in a crucial respect: exchange rates are not being permitted to adjust so as to reduce Asian surpluses and American deficits. This matter has to be addressed if the world economy is to be put back on an even keel.

After the exchange crises of the late 1990s, China and the Asian Tiger economies, such as Korea, concluded that for growth to be sustainable it must be export-led. They adopted the policy of keeping down the value of their currencies to achieve this. China has been the most resolute in this respect, intervening to buy dollars on a massive scale to fix the yuan against the dollar for no less than a decade. Other Asian countries have had to follow suit, driven by fear of Chinese competition. The dollar has depreciated in value against the euro, since the European currency has been allowed to float, but it needs to fall against Asian currencies because these countries are the fastest-growing in the world, thus offering the best prospects for rapid US export growth and because Asian products constitute the fastest-growing part of the US import bill.

So the position is clear. A depreciation of the dollar is desperately needed to turn around a trade deficit of frightening proportions and rebalance the US economy, but it is being prevented from happening as an act of deliberate policy on the other side of the world. The situation cannot be allowed to continue.

What should be done to prevent the world staggering on to disaster? The sine qua non is that the Chinese should abandon their policy of maintaining a fixed exchange rate against the dollar. This will enable other Asian economies, including Japan, to revalue their currencies at the same time. But the Chinese are very reluctant to do this.

Last month, as a token response to a long period of US pressure and after 10 years of the fixed-rate policy, they revalued their currency by 2 per cent. The Chinese Central Bank said it was a one-off move. Much more needs to be done. How can it be brought about?

In an ideal world there would be a grand strategic agreement between the US, on the one hand, and China, representing Asia more widely, on the other. The Chinese government would agree to reduce overall net savings in China, probably by borrowing more itself, at the same time as the US administration took action to reduce the federal budget deficit, and it would set its currency free so that the dollar could depreciate against Asian currencies.

But such a co-operative strategy - desirable as it certainly is - seems well beyond reach. In the real world, the best hope of progress is likely to come as a result of continuing the protectionist challenge - a policy of hitting Chinese exports with surcharges until the Chinese government comes to see a change in currency policy as the better option. China has moved at all only because of threats by Congress to penalise it by imposing a 35 per cent surcharge on its exports, and there is no indication that it will respond to any other type of policy.

In a world where markets were allowed to operate freely, protection would be a highly undesirable course to pursue. But given the dangers inherent in the world in which we actually live, the imposition of punitive tariffs may well be preferable to allowing events to continue along their present, potentially disastrous, course.

Christopher Smallwood is a director of Lombard Street Associates

Stephen King is away