Editor's Note: This is Part 2 of a 2-part series. Part 1 can be found here.

Trade Illusions

An accepted article of economic faith is that failure of economic co-operation, resurgent nationalism and trade protectionism (for example, the Hawley-Smoot Act) contributed to the global financial crisis of the 1930s.

The slowdown in central bank reserve re-circulation affects global trade through the decrease in the availability of financing for purchasers to buy goods and services. This is apparent in the sharp slowdown in consumer consumption in the US, UK and other economies.

The availability of cheap finance also helped drive up the prices which, in turn, allowed excessive borrowing against the inflated value of these assets that fueled consumption.

Weakness in the global banking system (in particular, loan losses, the lack of capital and concerns about counter-party risk between large financial institutions) contributes to restricted availability of trade letters of credit, guarantees and trade finance generally. This exacerbates the problem.

It isn't easy to fix this problem. Redirection of capital held in central banks and sovereign wealth funds to domestic economies affects the global capital flows needed to finance the debtor countries -- such as the US -- and re-capitalize the banking system. Maintenance of the cross-border capital flows to finance the debtor countries' budget and trade deficits, slows growth in emerging countries, and also perpetuates the imbalances.

Trade has become subordinate to and the handmaiden of capital flows. As capital flows slow down, global trade follows. Indirectly, the contraction of cross border capital flows and credit acts as a barrier to trade. In each case, deleveraging is the end result.

This opens the way to "capital protectionism". Foreign investors may change their focus and reduce their willingness to finance the US. Wen Jiabao, the Chinese Prime Minister, indicated that China’s "greatest contribution to the world" would be to keep its own economy running smoothly. This may signal a shift whereby China uses its savings to invest in the domestic economy, rather than to finance US needs.

China and other emerging countries with large reserves were motivated to build surpluses in response to the Asian crisis of 1997-98. Reserves were seen as protection against the destabilizing volatility of short term capital flows.

This strategy is deeply flawed. It promoted a global economy based on "vendor financing" by the exporting nations. It also exposed the emerging countries to the currency and credit risk of the investments made with the reserves. Significant shifts in economic strategy are likely.

As Chinese President Hu Jintao recently noted: "From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies."

The change in these credit engines also distorts currency values and the patterns of global trade and capital flows.

The current strength in the dollar, particularly against the euro, reflects repatriation of capital by investors and the shortage of dollars from the slowdown in the dollar liquidity re-circulation process. It is also driven by the reliance on short-term dollar financing of some banks, as well as the need for re-financing. This is evident in the persistence of high inter-bank dollar rates and dollar strength.

The strength of the dollar is unhelpful in facilitating the required adjustment in the current account, and also in financing of the US budget deficit.

The slowdown in the credit and liquidity processes outlined may have long-term effects on global trade flows. As Mark Twain observed: "History doesn't repeat, but it rhymes."