Economics: Last week the US trade report for November was published. It showed a record deficit of $60 billion (€46.3 billion) for the month, foreshadowing a deficit for 2004 as a whole that will amount to the equivalent of over 6 per cent of GDP, writes Jim O'Leary.

This means that spending in the US economy now exceeds the value of what is being produced there by over $600 billion on an annual basis.

This is an enormous gap. It is also unsustainable. The US cannot indefinitely run a deficit of this magnitude: it is certain that it will be reduced. What is not so certain is when this will start to happen and what combination of events will bring it about.

It remains likely however that an even weaker dollar will be part of the rebalancing that must occur. The last time I wrote on this subject ("Inflated dollar facing a painful correction", September 24th, 2004), I quoted the views of two prominent US economists, Maurice Obstfeld and Ken Rogoff. They estimated in July of last year that the dollar would need to depreciate by 20-40 per cent in overall trade-weighted terms. Since they did their calculations, the overall value of the greenback has fallen by something of the order of 5-6 per cent. Clearly, if Obstfeld and Rogoff are anyway close to the mark, there is still some way to go.

Of course, if we lived in a world of exclusively floating currencies, the substantial further decline in the dollar's value that seems necessary would be achieved mostly if not entirely by a depreciation against those Asian currencies (especially the Chinese yuan) in respect of which the US unit appears to be greatly overvalued, and not at all, or to a comparatively modest extent, by a further fall against the euro.

However, many of those Asian currencies are fixed against the dollar, and there is no sign yet that the governments of the countries concerned are going to abandon their dollar pegs. For so long as this remains the case, the euro will probably continue to appreciate and European exporters continue to bear an arguably unfair share of the burden of adjustment.

The scale and dynamics of the US trade deficit is such that a dollar depreciation on its own could not bridge the enormous gap anyway. Moreover, because the US economy is currently operating close to its productive capacity, a dollar depreciation on its own would be a recipe for accelerating inflation.

Put another way, the US economy doesn't require a boost to output at this point - it's growing quite fast enough as things are.

What it does require is a big shift in production away from the sheltered sectors of the economy to those sectors that are engaged in international trade: industries that export and/or compete with imports. A dollar depreciation therefore must be accompanied by some combination of monetary tightening and deflationary fiscal policy.

Given the scale of tax cuts that the Bush administration is committed to and the limited scope for cutting public spending, monetary tightening seems set to be the dominant element in this combination. It is very likely that higher US interest rates (perhaps very much higher US interest rates) are on the way.

It would be nice to think that the requisite rebalancing of US economic activity will occur painlessly, that productive resources will switch seamlessly from satisfying the demands of domestic consumers to satisfying the demands of export markets, and that the transition can be effected without the economy slowing down a lot or unemployment rising too much.

The circumstances in which something approaching this best case scenario is most likely to eventuate are those in which the decline in the dollar and the rise in US interest rates occur smoothly and gradually. Under these conditions, the economy has time to adjust and redeploy its resources.

But even under these conditions, it is probable that the pace of overall economic activity would slow down, because the firms and individuals that are involved in serving sheltered local markets are typically not the same as those that produce exports or compete with imports, and cannot readily transform themselves into internationally trading entities.

A firm of estate agents (or realtors in US-speak), for example, cannot readily become an international management consultancy; hairdressers cannot just put down their combs and scissors and start making pharmaceutical products.

Of course, the disruption and dislocation caused by the rebalancing of economic activity would be maximised and the resultant slowdown in growth and increase in unemployment most pronounced in circumstances where the trigger mechanisms kicked in with unexpected and violent speed.

A rapid downward spiral in the dollar's value, precipitated perhaps by news that the Chinese had abandoned their dollar peg, and the sharp rise in US interest rates that this would likely provoke, would almost certainly cause a steep fall in US bond, equity and property markets and bring an economic recession in its wake.

This would spell serious trouble for the rest of the world, too, given the globalisation of so much economic activity and asset markets.

I have painted two scenarios here: the first in which the US economy adjusts relatively painlessly; the other where that adjustment is brought about violently and with severe disruption. One can construct a range of intermediate cases. Attaching objective probabilities to the various scenarios is very difficult, if not impossible.

Most current forecasts for the world economy incorporate the view that the benign scenario will win out. That said, I (and, I suspect, most forecasters) would find it hard to characterise the probability of the malign scenario coming about as trivial.

Which brings me back to the sort of question I posed at the end of my article of a fortnight ago. If, over the next couple of years, the Irish economy is to grow at a rate materially different from the 5-5.5 per cent currently being forecast on average by the guys with crystal balls, will it be faster or will it be slower?

Well, the threat to the international economy posed by the scale of US financial imbalances is one reason to suppose that the answer is the latter.

Jim O'Leary lectures in economics at NUI-Maynooth. He can be contacted at jim.oleary@may.ie