The week that risk became reality

From the Financial Times

Published: August 15 2008 19:31 Last updated: August 15 2008 19:31

Trouble has been in prospect ever since the credit squeeze began last summer, but this was the week when both shoes dropped at once, everywhere from the UK to Japan and most points between. For decades, a concerted world slowdown would have only one cause: a US recession. That is no longer entirely true. To paraphrase Tolstoy, each unhappy economy is unhappy in its own way.

Japan has begun to contract, and plummeting exports are not the sole culprit: domestic demand is weak and consumer confidence has never been lower.

Spain’s economic woes have persuaded the prime minister, José Luis Rodríguez Zapatero, to interrupt his summer holiday; the key problem there was a housing boom, an unsustainable overhang of new property, and the subsequent collapse of a construction sector that provided every eighth job. The UK’s housing boom has ended for a different reason: the banks no longer care to play the game.

Meanwhile, Germany’s resurgent export sector seems to have been smothered by a strong euro, and perhaps the hangover from an unexpectedly good first three months: the economy shrank by 0.5 per cent in the second quarter.

Yet in spite of this wide range of predicaments there is a common thread: the soaring price of commodities, coupled with the return of inflation, is hurting consumers and tying the hands of central bankers.

That suggests that there may be some sunshine behind the storm clouds. Commodity prices are falling, although they are hardly a bargain. That is a consequence of weakening demand, of course, but it is also an antidote. Yet it is too early to write off the slowdown as an oil-induced blip. Oil prices may yet rise from here, and would have to fall much further before they reached the levels to which the world has become accustomed.

Meanwhile, global imbalances have not gone away, and the absence of co-ordinated economic and exchange-rate policy is bringing real costs. The current mantra among central bankers is that each of them is struggling to deal with imported inflation; it may look that way, but the world as a whole cannot import inflation. Globally, monetary policy has proved too loose to keep prices in check.

An obvious culprit has been the combination of low US interest rates and several developing countries – especially China – pegging their currencies to the dollar.

Since China is not about to subject itself to the shock of a sudden switch to a floating exchange rate, the world’s finance ministers need to discuss – seriously, this time – how else to unwind the current global imbalances. The recent appreciation of the dollar, and thus the renminbi, gives the Chinese a chance to lock in some of the appreciation against the euro and the pound. They should take it.