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A slide in the U.S. dollar spooked stock and bond markets this week, a reminder of the calamitous risk that a dollar crash poses to the U.S. and global economies.
A rise or fall in the value of the dollar against other currencies matters little by itself for most consumers unless they travel overseas. Yet a sudden change in the exchange rate can have profound indirect effects that raise or lower the cost of goods in the stores, influence job creation, investment, and mortgage interest rates, and could potentially batter the value of retirement portfolios.

In recent years, foreigners buying dollars and investing in the United States have been an important prop for the economy. Should they suddenly get cold feet, propelling the dollar down, they would likely pummel the stock market, drive up interest rates and push up the price of imports, stoking inflation. Such a shock would drag down other economies as well because so many countries depend heavily on the huge U.S. market to sell their goods.

While many economists agree that the dollar is too strong and should weaken, they are hoping for a gradual fall instead of a sudden plunge. But herein lies the danger. The herd mentality of markets can turn a gradual decline into an all-out run on the dollar. If investors believe the dollar is headed down, they will sell their dollar holdings. Those sales will depress the dollar, sparking a new round of dollar selling in what can quickly become a self-reinforcing downward spiral.

That fear drove down stock and bond markets Monday and well into Tuesday. Stocks fell further on Wednesday amid fears of another threat to the global economy: rising oil prices. The Organization of Petroleum Exporting Countries surprised markets by announcing it would curtail production by 900,000 barrels a day, about 3 percent of total production.

Economists say the dollar, despite falling 33 percent against the euro and 17 percent against the yen since early 2002, remains overvalued. The U.S. currency needs to fall much farther to emerge from the danger zone, they say.

"The road ahead will be long and arduous, and not without risk, especially in oft-volatile currency markets," Stephen Roach, the chief economist at Morgan Stanley investment bank in New York, wrote in a commentary this week.

Behind the dollar's vulnerability is the huge U.S. current account deficit, which consists of the trade deficit along with some financial transactions.

America has in essence been living beyond its means, importing more than it exports, and relying on money from abroad to get by. That money can come in foreign investments in U.S. stocks or foreign purchases of U.S. bonds.

The current account deficit is headed toward a record $550 billion this year, the equivalent of $1.5 billion a day.

As the deficit grows, foreign investors could lose faith in America's ability to repay its debts. Any sign of weakness could lead them to dump their holdings, causing a dollar collapse.

"You're piling up more and more dry kindling, and at some point, there could be a spark," said Jay Bryson, global economist at Wachovia Corp., a Charlotte, N.C.-based bank.

There is reason for hope, however. The dollar, which rose from 1995 and peaked in early 2002, has declined gradually since then. A dollar buys about 111 yen today, down from 135 yen in February of last year. The euro has risen from 86 cents to about $1.15 over the same period.

A weaker dollar makes imports more expensive and U.S. exports cheaper for foreign customers. Over time, that should decrease sales of imports and boost exports, in turn chipping away at the trade deficit, by far the largest piece of the current account shortfall.

But the dollar is only halfway there, according to Fred Bergsten, the director of the Institute for International Economics, a research group in Washington.

The Bush administration, facing a re-election campaign next year, is trying to talk the dollar down further to help beleaguered domestic manufacturers boost exports.

Treasury Secretary John Snow succeeded last weekend in getting finance ministers from Japan, Canada and four European countries to join him in a statement calling for more flexibility in exchange rates. The implication was that China and Japan should let their currencies strengthen against the dollar.

China has a fixed exchange rate of 8.3 yuan to the dollar, so change isn't expected soon from Beijing. Analysts are unsure whether Japan will yield either, because a stronger yen would hurt its exports.

By: Ken Moritsugu