My colleague Martin Walker wrote last week of the possibility that U.S. economic profligacy could have its principal adverse effect on the European Union economy, through the deflationary effect of an overvalued euro. Fun though this might be for President George W. Bush to contemplate, and attractive though it is to think of French president Jacques Chirac contemplating it, I consider the prospect unlikely.

This “Texas revenge” thesis is an attractive idea, at least for those “red state” types who regard continental Europe with the deepest suspicion and Chirac as a treacherous foreigner who needs to be taught a lesson after his un-supportiveness on Iraq.

The mechanism whereby the United States’ excessive budget deficit and trade deficit might cause a deep recession in the anti-U.S. parts of Europe while producing no great problems in the U.S., is that dollar weakness, produced by the twin deficits, would cause European exports to shrivel and their economies to stall, driving them into yet another period of economic stagnation. Meanwhile the weak dollar would boost U.S. exports, allowing the U.S. economy to avoid a second recessionary dip. However, the economic conditions under which such a thing might happen don’t seem to apply.

The idea that Europe should want to run a trade surplus rests on old-fashioned mercantilism. As Thomas Mun said in his 1635 classic “England’s Treasure by Foreign Trade:” “The ordinary means therefore to increase our wealth and treasure is by Foreign Trade, wherein wee must ever observe this rule; to sell more to strangers yearly than wee consume of theirs in value.” By Mun’s standards, the U.S. has been giving the rest of the world a free ride for the last decade — by running a trade deficit of $400-600 billion it has been depleting its own “treasure” alarmingly and allowing the rest of the world to pile up “treasure” in a very satisfactory manner, in the case of Asian central banks to the tune of trillions of dollars of U.S. Treasury securities.

Mun’s approach to economics is very psychologically appealing, and may well be deeply engrained in Chirac’s Elysee Palace, in a country where Adam Smith never really defeated Louis XIV’s finance minister Jean-Baptiste Colbert. However, for the rest of us who have moved on from the seventeenth century, mercantilism is now recognized as a dangerous fallacy: it is a policy that by definition is impossible for every country at once to follow successfully, and it runs the danger of producing an outbreak of protectionism, destructive to world trade and to prosperity in general.

The reason why the “Texas revenge” fantasy is unlikely to happen becomes clear when you look at the mechanism by which the dollar might continue its decline and trade patterns might be shifted.

If everything were to stay as it is at present, the U.S. trade deficit would continue to be financed by massive purchases of Treasury securities by Asian central banks. Thereby, their own currencies would be kept more or less level against the dollar, while the dollar itself would fluctuate against the euro, but show no great downward trend. The U.S. trade deficit would continue around $600 billion per annum, and the United States would plunge deeper and deeper into debt against the rest of the world, most of that debt taking the form of very short term Treasury securities. However, provided the administration and Congress followed through on their announced determination to reduce the U.S. budget deficit, or at least did not allow it to get any bigger, this position could continue for several more years. The U.S. would be impoverishing itself and storing up trouble in the long run, but assuming the U.S. domestic economy did not fall back into recession (a dubious assumption, in my view) there would be no reason for either a crisis or a U.S.-driven impoverishment of Europe in the short to medium term.

There are a number of things that could disturb this pattern. First, and in my view most likely, the U.S. economy could fall back into recession, causing a consumer credit problem of massive dimensions, as interest rates trended upwards, house prices ceased to increase and consumer debt levels became intolerable. On the international front, this would solve rather than cause problems. U.S. imports would drop naturally, U.S. labor (and particularly, its grossly overpaid top management) would become more affordable, making U.S. exports more competitive, and if the budget deficit were kept under control (very difficult) the trade deficit would improve, reducing the downward pressure on the dollar and bringing the world economy back towards equilibrium. The EU would suffer marginally because of reduced exports to the U.S., but this would just partially reverse its exceptionally favorable bilateral export position of 1995-2004. The EU would not find itself priced out of third country markets, and would not necessarily go into recession, nor suffer more than a modest imbalance of trade.

Second, the U.S. budget deficit could start increasing again. Whether or not caused by a recession, this would certainly produce one, because interest rates would go up. In this case, the domestic U.S. position would be thoroughly unpleasant, and the downward pressure on the dollar would continue, because the budget deficit would tend to suck in imports. Whether any of this increased pressure on the EU economy would depend on the investment behavior of Asian central banks – if they shut their eyes firmly and went on buying increased quantities of Treasuries, nothing much would change, except that the ultimate nemesis would approach more quickly.

Third, the Asian central banks might change their behavior. Currently, they are investing almost all their increases in reserves into U.S. dollar assets, in an attempt to hold down the values of their currencies against the dollar. As an investment policy, this is insane – it leaves them hopelessly undiversified, and subjects them to portfolio losses every time the dollar declines. Purely as investors, it would make much more sense to diversify a part of their portfolio into euros, thus taking advantage of the rise in the euro’s value. If they did this, the dollar might fall against their own currencies, but the euro would presumably rise, allowing them to make up through greater exports to the euro zone what they lost through lower exports to the United States.

Interestingly, some dollar-holding central banks appear to be realizing this. Early last week, Russia, with over $100 billion in foreign exchange reserves, almost all of them in dollars, announced that it would keep one third of its reserves in euros in the future. Friday, a rumor emerged in the market that China was diversifying out of U.S. Treasuries. China quickly denied it, as the dollar sank to a record low of $1.33 against the euro. Nevertheless, the probability must be that over the next several months, Asian central banks will buy fewer U.S. Treasuries, and more euro denominated securities.

If this happens, it will cause a sharp rise in U.S. interest rates, as the market would adjust to the lower demand for Treasuries. This in turn would be deflationary in the United States, while in Europe the increased portfolio inflows would cause a downward trend in interest rates, allowing for greater growth. The dollar’s fall against the euro would slow, as interest rate sensitive investors bought more Treasuries and fewer euro denominated bonds and bills. In other words, the market would work, the United States would suffer the recession it deserves and the EU would be largely unaffected.

Unless Asian central banks remain completely irrational, both economically and as investors, Chirac is likely to have the last laugh.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.