At the peak of free-market fundamentalism in the 80s, it was fashionable to argue that the size of a country’s current account deficit – the shortfall between the amount of money earned abroad and the amount owed to foreign creditors – did not matter, writes Charlotte Denny in today’s London Guardian.

As private borrowing began to outstrip public, some argued that there was no danger of default. Unlike governments – irresponsible wastrels capable of borrowing money and then deliberately stoking up inflation to erode the real value of their debts – private companies and individuals were making perfectly rational assessments about their capacity to repay.

This doctrine took a bit of a battering during the Asian crisis. The countries at the centre of the storm were running healthy government surpluses – it was the supposedly rational companies which had built up debts abroad.

Yet investors decided to take their money and run, forcing a succession of governments to abandon currency pegs and making default inevitable as companies suddenly found the dollar value of their loans increasing rapidly.

Even the International Monetary Fund agrees these days that private sector borrowers can get it wrong. In its latest assessment of the world economy it notes: “To err is human and this is as true of private sector investors as anyone else.”

The IMF believes that sooner or later the external imbalances between the world’s largest economies will have to be corrected.

The borrowers – the US, UK, Australia, New Zealand and, until recently, Canada – are likely to suffer falling currencies and slower growth, while the lenders, the Asian and European economies, ought to grow faster as their currencies strengthen.

In theory, the change could happen smoothly – the US has already begun to slow and the dollar has lost some of its shine. But neither the US or the UK current account deficit is closing. The US has been running a current account deficit of more than 4% for three years in a row, an historically unprecedented position.

If the US economy is offering higher returns than Europe’s because of higher productivity, then it would be rational for Europe’s investors to be funding America’s borrowing. But, as the IMF notes, much of the borrowing over the past few years has gone to fund the IT bubble and higher consumption in the deficit countries.

The chances of sharp correction are therefore quite high. As the IMF says, the longer the imbalances persist, the more painful the correction. In a world of free capital markets, there is not much policymakers can do to insure against sharp adjustments in exchange rates.

The IMF recommends keeping a tight rein on government borrowing. It’s too late for the US, where the Bush administration has already thrown fiscal caution to the wind. Its advice is not likely to be popular in the UK either, where Gordon Brown plans to borrow to fund public investment.