New Business October 14, 2009, 7:08PM EST

What Happens If the Dollar Crashes

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The Bearish Case

Obama Administration officials don't seem perturbed by the dollar's slide so far. A weaker dollar helps shrink the trade deficit by making American-made goods more competitive in world markets. Drew Greenblatt, owner of Marlin Steel Wire Products in Baltimore, which makes high-tech baskets for assembly lines, says he's winning orders from countries that are better known as exporters. Exults Greenblatt: "We are shipping ice to Eskimos."

This state of calm would vanish overnight, though, if the financial markets got a sense that the dollar's decline was starting to snowball out of control. At that point, the invisible "force field" protecting the dollar would fade away, says Martin D. Weiss, chairman of Weiss Group, a financial data and analysis firm in Jupiter, Fla. Says Weiss: "We would become more like ordinary mortals and more vulnerable to attacks on our currency."

The bearish case for the dollar is that the decline takes on a life of its own. Selling begets more selling. The world's central bankers and finance ministers intervene to prop up the currency, but speculators, having tasted victory, aren't scared off. Princeton University economist Paul R. Krugman once called this the Wile E. Coyote scenario, after the character in the Road Runner cartoons who runs off a cliff but doesn't start to fall until he looks down and sees there's nothing beneath his feet.

Speculation that the dollar is headed for a tumble can become self-fulfilling if traders rush for the exit. Ashraf Laidi, chief foreign exchange strategist at CMC Markets, a London currency and commodity brokerage, says "right now there is around a 30% to 40% chance we are going to see the dollar falling toward a crisis point."

Dollar bulls like to point out that the currency rallied strongly last year during the worst of the financial crisis. But Laidi says that was no show of support for the dollar or the U.S. economy. Rather, he says, investors retreated from all types of risk and put their money into the most liquid, short-term instruments they could find—which just happened to be U.S. Treasury bills, which are held in accounts all over the world. Agrees Barclays' Englander: "It wasn't a long-term bet that the U.S. economy would be the most dynamic in the world."

Inflation Could Emerge Quickly

Currency traders don't put much stock in the statements of support for a strong dollar by Treasury Secretary Timothy F. Geithner and other Administration officials. They note that Treasury chiefs dating back to the Clinton Administration have said they support a strong dollar, yet the U.S. has not supported its currency through purchases since 1995.

If the dollar did tumble, import prices might rise faster than most economists now expect. New research by Columbia University economists Emi Nakamura and Jon Steinsson shows that the "pass-through" from a cheap currency to high import prices was underestimated because of poor data. In other words, inflation could emerge more quickly than is commonly believed. It would be disastrous for the economy if the Federal Reserve had to jack up interest rates to cool inflation or defend the currency while growth remained weak. A lower dollar makes Americans poorer by cutting the purchasing power of their currency. And there's no guarantee it would bolster U.S. industry, says David Malpass, president of New York research firm Encima Global. Malpass says the fall of the dollar in the late 1980s hurt rather than helped Detroit by giving Japan the buying power to strengthen its automakers. Says Mallpass: "We can make ourselves poor enough that we can't import very much and we'll have balanced trade. But how would that be good for the U.S.?"

In the short run, the biggest risk would be the failure of some firm that made a highly leveraged bet that was vulnerable to a falling dollar. A dollar plunge would affect not only currency trades but also interest-rate derivatives and credit default swaps. Five big banks accounted for 88% of the credit-risk exposure from derivatives in the entire U.S. banking system in the second quarter.

No one knows whether the dollar is headed for disaster. But assuming the best is perilous.

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What Good Are Reserves?

After the Asian financial crisis of the late 1990s, emerging-market nations built up huge foreign-currency reserves. But new research by the International Monetary Fund shows that those reserves didn't help the countries weather this decade's crisis. A possible explanation: Countries feared that using any of their hard-earned reserves might be taken as a sign of weakness.

To read the IMF's analysis, go to http://bx.businessweek.com/emerging-markets/reference/

With Theo Francis in Washington. Coy is BusinessWeek's Economics editor.