The last time the pound was at this level against the dollar was in the uneasy days of 1992 between John Major's April election victory and the cataclysm of Black Wednesday, when the markets realised that Britain's economic policy was based on smoke and mirrors.

With the economy deep in recession and unemployment heading to 3 million (again), Britain badly needed deep cuts in interest rates to stimulate growth. Yet the foundation stone for the government's anti-inflation policy was membership of the Exchange Rate Mechanism, which required rates to be kept high to defend the pound's value.

Policy was pulled in two directions at once but the government's credibility was at stake, so it talked tough and hoped the financial markets did not spot that it was acting weak. But the markets latched on immediately, sensing that Major and his chancellor, Norman Lamont, would not follow through on their blood-curdling public statements to do whatever it took to maintain the pound's ERM parity because that would have killed off any hopes of economic recovery. Once the markets woke up to the fact that the Tories were paper tigers, Black Wednesday was inevitable.

It's hard not to feel a sense of deja vu now, with the Federal Reserve facing a milder version of the dilemma that troubled the Treasury and the Bank of England 14 years ago. There are real differences between Britain then and the US now: the dollar is floating, rather than fixed; it is underpinned by its status as a global reserve currency; and the US economy has not been mired in recession for two years.

Even so, Ben Bernanke, the Fed's chairman, knows his credibility is on the line. Inflation is high enough to make the central bank nervous and that ought to mean the 18th rise in interest rates since the trough of 1%, taking them to 5.5%. But the deflating housing bubble is now affecting the rest of the economy. Friday's manufacturing snapshot was a lot weaker than Wall Street expected, with an index of below 50 suggesting that industry's output is falling.

Dean Baker, of the Centre for Economic Policy and Research in Washington, is predicting a recession in the next year, with the economy contracting by 0.7% and more than a million added to the dole queues. Most analysts are not that gloomy - at least not yet - but most expect this year's slowdown to persist through 2007 and to prompt the Fed to ease policy in the first half of next year.

So Bernanke's warning last week on the need for vigilance against inflation fell on deaf ears. The dollar fell because the markets do not believe the Fed will make good on its threat. Bernanke is wary of cutting rates for fear of looking soft on inflation; he is wary about raising rates for fear of weakening the economy. So, for now, he'll do nothing and hope that something comes up to get him out of the bind he's in. That doesn't always work: ask Major or Lamont.

Rebalancing

One lesson from the ERM experience is that a weaker dollar is not necessarily a bad thing. In the context of the US trade deficit, it is to be welcomed that the dollar is likely to get a lot cheaper. Sterling's devaluation in 1992 and four points off interest rates coupled with a tighter fiscal policy helped rebalance the UK economy, boosting production at the expense of consumption. A similar rebalancing is long overdue in the US.

Indeed, it is unclear why a $2 pound is being greeted with such enthusiasm on this side of the Atlantic. It makes a Christmas shopping spree in New York far cheaper but the British economy's problem is not that we shop too little but too much. Sterling's trade-weighted index hit a six and a half year high on Friday and the UK trade deficit is at about 5% of GDP. Economic fundamentals suggest the pound must go lower, just as it is obvious the dollar had to fall.

Bernanke's problem, however, is that there is the world of difference between a gentle but steady decline in the dollar and a pell-mell crash. A controlled depreciation would ease strains caused by global imbalances - US trade deficits, Asian trade surpluses - and insulate the US economy a little from the impact of a severe housing market downturn. A crash in the dollar would lead to turmoil on the world's markets, an increase in long-term US interest rates and a vastly increased risk of a hard landing.

One difficulty in analysing how the markets will react is that nobody is sure why the dollar has suddenly fallen out of favour. Some commentators say the trigger was the hint from China that it favoured diversifying reserves so they were less weighted towards dollars. But Beijing has said this regularly over the past three years but carried on buying US assets and thus propping up the dollar. There seems no logical reason why Asian central banks should start dumping greenbacks; not only would they be selling their US assets at a loss, it would make their exports more costly.

Carry trades

A greater risk is that private investors change their behaviour. Hedge funds could determine what happens next. One issue is the growth in carry trades, which is when money is borrowed in a country with low interest rates (such as Japan) and invested in a country with high rates (the US, say). This is lucrative for investors and supports the dollar but risky and attractive to speculators only if the currency in the country with high rates remains strong. If it doesn't, gains from the differential in rates are wiped out by the depreciating currency.

All in all, the prognosis is not good for the dollar. The economy is weak, policymakers seem paralysed and speculators look ready to stampede for the exit. Doing nothing is sometimes the least bad option; it is hard to see that it will be this time. There is a risk that the Fed will get badly behind the curve, and that every bit of gloomy economic news triggers more selling of dollars. Bernanke needs to start preparing the markets for rate cuts or he could be facing a real panic.