Currency Leaders Still Playing With Fire

Old men should know that playing with fire is dangerous. Yet that is precisely what the old men in the G7 and IMF are doing with regards to the U.S. trade deficit.

Many have argued, for some time, that the large U.S. external imbalance was a major risk to the world economy. The previous solution was for the U.S. to boost domestic savings, for Europe and Japan to make structural reforms to boost domestic demand and for Asia to adopt more flexible capital markets. But the current leaders' lack of political will to implement the strategy led to the more expedient course of signaling that the currency market should bear a greater burden of the adjustment. That in turn has sparked a near freefall in the U.S. dollar.

Officials warned that 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, with potentially negative impact on world growth, has been the clumsy attempt by the G7 and IMF to try to fix the problem.

Global equity markets have sold off, and the rise of global interest rates has accelerated. And with a sharply falling dollar, the ability to smoothly finance the U.S. current account deficit is called in to question, as evidenced by the lukewarm reception to the Treasury's recent auctions by indirect bidders.

In sum, the cure seems worse than the disease.

Although a number of officials, including the ECB's Trichet, the Fed's Bernanke and at least two senior officials from Japan's Ministry of Finance, indicated the G7 did not signal a general dollar selloff, the market suspects otherwise and understands those comments as half-hearted attempts to maintain an orderly market.

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At the time of publication, Chandler was long yen vs. USD and long Swiss francs vs. euros, although holdings can change at any time.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.