Over the past decade or more, the United States has been living far beyond even the vast means commanded by the world’s largest economy. America’s households have spent far more than they earn, borrowing extravagantly against the rising value of their homes and other assets. The US Government has been no less profligate, dramatically increasing spending while making hefty cuts in taxes.

The consequences have been predictable. Over the past five years, America’s national spending has outstripped its income by more than a fifth, leading to a rising tide of red ink. In little more than a decade, the US has become the world’s biggest debtor. America now runs an annual current account deficit approaching 6 per cent of GDP, or more than $660 billion (£370 billion), while its Government’s borrowing this financial year is heading for a record $422 billion.

All of this has been made possible by confidence in the continuing outperformance of the US economy and its financial assets, and the unprecedented willingness of foreigners to accept vast piles of American IOUs in the form of dollar holdings and US Treasury bonds — effectively, cheques that go uncashed. And the keystone supporting the weight of this system has been the dollar’s dominant status as the world’s international reserve currency — a status now seen as being under threat.

Over a decade, the proportion of US government debt held overseas has more than doubled from 20 per cent to about 45 per cent. Underpinning this massive expansion of overseas borrowing has been an inadvertent and undeclared currency pact between America and Asian economies.

Desperate to prevent their currencies rising against the dollar and undercutting their booming exports to the US, Asian nations have bought up billions of dollars and US Treasury bonds to shore up America’s greenback and keep their exchange rates pegged against it. The accidental quid pro quo has been that Asia has been able to continue to keep selling its goods to Americans at highly competitive exchange rates, while America has been able to run up ever-increasing debts to pay for them — helpfully financed by the Asian central banks.

Asia’s huge appetite for American assets to maintain its currency parities with the dollar has sustained heavy demand for US Treasury bonds. In turn, this has kept US market interest rates remarkably low, at levels of 5 per cent or less, even as America’s debts have ballooned.

As Niall Ferguson, the economic historian, has remarked, this looks like “the biggest free lunch in modern economic history”. He and others have compared this Asian-American dollar area to a reincarnation of the post-war Bretton Woods system of largely fixed exchange rates. Taking in China, Japan, and other Asian states, this dollar-dependent zone accounts for more than half of the world’s GDP.

The trillion-dollar question is, of course, can America continue to dine out at the expense of its Asian neighbours. For optimists, the answer remains a resounding yes. This confidence is based on the belief that the US economy will continue to outstrip its rivals, preserving the attractiveness of its assets, while Asia’s central banks will continue to snap up dollars and Treasury bonds, backed by the unlimited finance of their own printing presses.

But just as Bretton Woods I collapsed in the early 1970s, a growing number of commentators believe that the present “Bretton Woods II” will ultimately collapse under the weight of the burgeoning imbalances it has institutionalised. As ever, what looked like a economic free lunch will emerge as a mirage.

No one can predict with certainty if or when the edifice will crumble, but it seems more and more inevitable that, sooner or later, it will. Already, a reviving Japan has abandoned efforts to restrain a rise in the yen, removing one key prop for the system. Perversely, Washington seems intent on kicking away another, persisting in its efforts to persuade Beijing to scrap its currency’s dollar peg and revalue the yuan.

Only last week, President Bush was on the telephone to Beijing, pressing his Chinese counterpart on the yuan issue. Yet, as Avinash Persaud, the leading currency economist, suggested in a speech last Thursday, a yuan revaluation, or even the first steps towards one, could prove the catalyst for collapse of “Bretton Woods II”, and a period of economic trauma for America.

There can be little question of the intensely painful implications for the US should the present Asian-American equilibrium unravel rapidly. A sharp fall in the dollar and the US bond market would simultaneously stoke inflation and drive up market interest rates. And as Professors Persaud and Ferguson, as well as others, have argued, such as scenario could well spell the beginning of the end for the dollar as the world’s reserve currency. Without that status, America could face an avalanche of uncashed Asian IOUs, and US interest rates could be pushed much higher, with horrible repercussions for America’s heavily indebted Treasury and households.

This frightening prospect raises a fascinating and fundamental question: which rival might take the dollar’s place as the world’s dominant currency? For Ferguson, the euro is the strongest candidate, not least since more international bonds are already issued in euros than in dollars. However, the euro’s claim could be hindered by the eurozone’s persistent failure to foster strong growth.

Instead, Persaud argues provocatively that the dollar will be displaced by the yuan as China’s economy overtakes America’s in coming decades.

It is a tantalising prospect, although one that will depend on China’s ability to preserve political stability as its prosperity grows. However, it is not impossible that, in our lifetimes, markets will hang, not on the words of Alan Greenspan or his successor, but on those of the chairman of China’s central bank.

The implications of such a shift would be truly seismic.

Explore Economics

• Autumn Budget 2007

• Budget 2008

• World Economic Forum

• The Times MPC

Times Recommends

• UK shares dive on manufacturing low
• LVMH wins €40m fight with eBay over fakes
• Annual house price falls worst since 1992