The sliding dollar: both boon and bane

An ominous indicator has moved to center stage for world financial markets: the US dollar's plunging value relative to other currencies.

How this dollar drama unfolds could end up affecting more than just the price of T-shirts at Wal-Mart or the number of German tourists visiting Yosemite National Park.

A weaker dollar, over time, could help the world economy become better balanced – with America less reliant on borrowing and Asia less dependent on exports to fuel development. But currency realignment also holds risks. It would impose some hardship on Americans, and on the many nations that sell goods to them. A sudden shift could jolt US consumers with higher prices at a time when some economists worry about a possible recession.

But down is exactly where the dollar's value has been headed of late. After a quiet summer, the greenback has fallen since mid-November by 4 percent against the euro. It is also down by lesser amounts against the Japanese yen and Chinese yuan.

"Most economists agree that in the long term the dollar has to go down," to help shrink the mammoth US trade deficit, says Axel Merk, who manages the Merk Hard Currency Fund in Palo Alto, Calif. Yet in the short run, "it's in nobody's interest in the world for the dollar to go down."

The current slide may or may not persist. But when the dollar falls relative to other currencies, it tends to make US exports cheaper and, thus, more attractive on world markets. And it makes foreign imports more expensive to American consumers.

That doesn't mean the dollar's value is a magic fix for the US trade deficit, which has reached unprecedented proportions in the past few years. But many economists see it as part of the answer to this dangerous imbalance in global trade.

The dollar's recent weakness continues a pattern that began early in 2002.

Currency watchers see a range of factors propelling the dollar now and possibly in the months ahead. Among them:

•Interest rates are shifting. The European Central Bank is expected to raise its benchmark interest rate on Thursday, boosting what investors can earn in the euro. European economies seem to be strengthening even as US bond yields have fallen on signs of weakening in the US economy.

•Inflation threats linger. Currencies tend to lose value when a central bank fails to tame inflation. Some experts worry that the Federal Reserve will cut interest rates next year – in a bid to prevent a recession – before the job of squelching easy monetary conditions is really done.

•Politics has an effect. A newly elected Democratic Congress could lean toward protectionism or higher taxes, either of which could dampen foreign interest in dollars. Perhaps more important is the situation in Iraq. A loss of US prestige as a military power can also affect the dollar.

•The yuan has edged up. China has allowed its currency to rise a bit this year. Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke will visit China this month, and will push for still more currency flexibility. But some analysts say a major shift may be unlikely before of 2008, when Beijing hosts the summer Olympics.

•China is diversifying. With some $1 trillion in foreign reserves, Beijing has said it won't put as much of its reserves into dollars as in the past.

"Foreign exchange traders are speculating at what point are Asian nations going to stop accumulating US assets," says Charles Engel, an economist who studies currency issues at the University of Wisconsin in Madison.

A weaker dollar would affect the purchasing power of Americans when they buy goods or services from other countries. The shift wouldn't be noticed at the supermarket as much as it would be at stores like Target or Best Buy.

"It would mean those things that are so unbelievably cheap at Wal-Mart would be a little bit more expensive," Dr. Engel says. "The flip side of that is that workers ... might move back toward some sort of export industries. That adjustment's going to happen over time."

To some degree, the trade deficit and the buoyant dollar in recent years are signs of US economic strength. Imports often surge in an expanding economy.

Still, many economists say that at some point – and sooner might be better than later – the trade deficit needs to fall.

America's deficit in the current account, a broad measure of cross-border commerce and payments, has surged to more than $800 billion a year – an amount equal to about 7 percent of the gross domestic product. That's up from 1.7 percent of GDP a decade ago.

There's no precedent for a major economy to maintain this level of imbalance. In effect, the US is borrowing more than $2 billion a day to finance its spending on imports. The higher the imbalance goes, the greater the risk of a hard adjustment, if foreigners decide they can earn better returns by taking their dollars elsewhere.

Exchange rates are one piece of a larger puzzle. Another key factor is that the US has an unusually low rate of savings, thanks to federal deficits and consumer borrowing. The trade deficit mirrors this.

Trade barriers in other nations are another factor.

Still, a lower dollar could play a role in resolving the imbalance.

"If China did its part," by allowing the yuan to rise, "the dollar would also fall against most Asian currencies," says Peter Morici, a University of Maryland economist.

Falling imports would push up the US savings rate, he says.

Martin Feldstein, a Harvard University economist, has pointed out that the late 1980s offer precedent for a currency- driven easing of the trade deficit. Then, as the dollar fell, the trade gap closed without fanning inflation or causing a recession.

In a March speech, he said that America should have a "competitive" (lower) dollar abroad alongside a "strong" dollar at home – a currency whose purchasing power is not eroded by domestic inflation.