Chairman Bernanke's first concern: what if the world economy slows?

• Author: Smick, David M.

Reading the news commentary the morning alter President Bush nominated Ben S. Bernanke for Chairman of the Federal Reserve, there was a sense the United States is about to enter a period of danger. This is because the entire discussion was solely domestic, including subjects such as inflation targeting, the stock market bubble, tax cuts, the deficit, and every other domestic concern. Missing was any mention of the brutal global challenges ahead for the next Fed chief.

After all, the Federal Reserve Chairman has become essentially central banker to the world. Bernanke will be working within a largely dollarized foreign exchange system in which most economies a) are seeking as strong a tie to the dollar as possible; and b) are heavily dependent on exports, in many cases to the United States, as their main engine for growth. For better or worse, America has become the global consumer of last resort in an increasingly mercantilistic world.

Many of these economies therefore have become dependent on American growth both as a market for exports but also as an attractive repository for investment (because of safety and higher U.S. rates of return), including investment of recycled dollar holdings. The downside is if the American economy stumbles. Specifically, the danger is if the Federal Reserve, in its current tightening cycle in response to rising energy prices, "overshoots," raising short-term interest rates until signs of weakness appear but by then it's too late. (Rate hikes take effect alter a six to nine month lag. Once the weakness appears, a lot more tightening is still in the pipeline.) None of this may be a huge problem for the United States, but if the U.S. growth rate next year slips, say, from the current 3.8 percent to 2 percent, the international consequences, particularly for China and Europe, could be financially destabilizing. The United States develops a chest cold while large parts of the world face pneumonia.

Consider the weakening nature of the international landscape. China laces an enormous challenge--integrating a population nearly the size of Canada's into its workforce each year for the next twenty-five years. Such a goal requires virtually the impossible: 9.5 percent growth rates and 40 percent investment rates again each year, every year, for as far as the eye can see.

Recently though, Chinese inventories have started to accumulate. In response, authorities wisely are working to try to ignite consumer demand. But the...