THE weather may be cold and wet, but in the rich world's financial markets it is beginning to feel like August all over again. Credit spreads have widened and shares are pitching from gloom to elation as investors look to the Federal Reserve for solace. The anxiety is unmistakable. But this time the scare is about more than bad mortgage loans and their baleful effect on the credit markets. America may be falling into recession. And a new fear now stalks the markets: that the dollar's slide could spin out of control (see article).

A full-blown dollar crisis on top of a credit crunch and a weakening economy would be frightening. It would send financial markets reeling and tie the hands of the Fed, perhaps forcing it to raise interest rates even as recession looms. The sky-high euro would soar further, choking off Europe's growth. Political tensions would also rise. Already Airbus has called the dollar's decline “life-threatening” and France's president, Nicolas Sarkozy, has given warning of “economic war”.

At worst, the shadows could darken further. For half a century the dollar has been the hegemonic currency. A large slice of global trade is counted in dollars. Central banks hold most of their foreign-exchange reserves in dollars, a boon for America that has allowed it to issue debt more cheaply. That dominance has survived dollar slides before, as in the late 1970s and mid-1980s. But now, with the euro as an alternative, the fear is of a sudden shift in the global monetary system, with investors switching quickly from one currency to the other.

So far, this remains only a fear. Although the dollar has been falling at quite a lick—down 6% against a trade-weighted basket of currencies since August—it has seen no chaotic slump, but a slide interspersed, as this week, with brief rallies. Americans' expectations of future inflation have not yet risen much. Yields on government bonds have fallen: clearly, investors do not yet expect higher premiums for safe American assets. Whether disaster strikes depends on what exactly is driving the dollar down and on how policymakers react.

Headwinds and tailwinds

Much of the dollar's weakness is driven by economic fundamentals. Since peaking in 2002, it has fallen by 24% against a trade-weighted basket of currencies. Given America's need to borrow from abroad to finance its consumption, that is neither surprising nor sinister. By inducing Americans to import less and export more, a weaker dollar helps cut the current-account deficit. For America, the medicine has been working—the deficit is down to 5.5% of GDP from a peak of almost 7%.

If the dollar's decline has accelerated of late, that is largely because of the cyclical divergence between America's economy and the rest of the world. America fears recession; the Fed has already cut interest rates by 0.75 percentage points and financial markets are convinced that it will cut another quarter point on December 11th, when it next meets. When America's growth prospects and interest rates fall relative to those elsewhere, a cheaper currency is inevitable.

But economic fundamentals are not all that is hurting the dollar. The currency is also suffering because the credit mess is concentrated in dollar assets. Investors' conviction that transparent markets and vigilant regulators make America a safe place to store money has taken a battering from the revelations of recent weeks. Net private capital inflows into America seem to have evaporated since the credit turmoil began. The subprime crisis has tarred the dollar as a subprime currency.

In recent years a fall in private inflows has usually been offset by central banks in emerging economies that link their currencies to the dollar. This system (often known as Bretton Woods II) has thus propped up the dollar. But this time these central banks have been less willing to take up the slack. Right on cue, the cracks in Bretton Woods are becoming clear. China is routinely attacked in America and Europe for linking its currency to the dollar. Squeezed between rising oil prices and the falling dollar, the Gulf states face rising inflation: speculation is rife that one or more of them will modify their currency pegs at a regional meeting on December 3rd.

Handle with care

There you have it: the ingredients of a nasty crash. But self-interest and sensible policy can cut the odds of trouble. The first step is for American policymakers to pay more heed to their currency. For all their talk about a strong dollar, American officials have behaved as if they cared little about its worth. A reserve currency is supposed to be a store of value; by running a huge current-account deficit America has left the dollar vulnerable. At such a tricky time, benign neglect will no longer do. For the moment, this need mean little more than some carefully chosen words. If the slide becomes chaotic, it could demand currency-market intervention and a willingness to hold back interest-rate cuts for the sake of the dollar.

The other part of the solution lies elsewhere, particularly with those countries with dollar-pegging currencies. These economies need to allow their currencies to rise, both to curb inflation and encourage the rebalancing of the global economy. Appreciation would mean that these countries accumulated new dollar reserves at a slower pace. That in turn would lead to a loss of the dollar's pre-eminence and the emergence of other reserve currencies: there is no rule to say you can have only one reserve currency. But this need not—and in today's febrile environment must not—mean dumping existing dollar reserves. That would impose a far higher cost on everyone, including the dumpers.

The history of international co-operation on currencies is patchy. But China and the oil-rich Gulf states have ample reason to play their part in an orderly decline of the dollar's dominance. Despite the opprobrium heaped on them, the Chinese do not want to see the Fed's hands tied by a dollar crisis; nor do they want to see the euro zone, one of their best markets, slow sharply; and they have little interest in the external value of their existing dollar reserves plunging. Beyond all that, China's leaders want to be taken seriously as responsible actors in the international system. Now is their chance.