Should we be worried about the falling dollar?

In the best of circumstances, the floating value of the global currencies helps grease the wheels of commerce and balance economic growth. The key word here is “relative.” Changes in the dollar against other countries’ currencies can be good or bad for different parts of the economy. But the impact can be mild or serious depending on how far apart currencies drift or how quickly things change.

In one sense, the value of the dollar is determined by a massive, multi-trillion-dollar, minute-by-minute popularity contest made up of various players in the financial markets — from people who trade currency directly to those who buy or invest in anything priced in dollars. (Central bankers like Ben Bernanke and his Fed colleagues can weigh in — just like Simon, Paula and Randy "on American Idol" — but the audience gets the final vote.)

As the currency of the world’s largest and most powerful economy, the dollar rises and falls based on the strength of that economy — and the confidence investors have in its future. With other economies in Europe and Asia growing more rapidly and the outlook for the U.S economy slowing, the dollar has been weakening.

U.S. interest rates can have a direct impact on the dollar’s value. If interest rates fall, investors who buy Treasury bonds priced in dollars get a lower return. So the dollar is worth less to them. The recent drop in interest rates here is part of the reason for the dollar’s fall.

Other countries with large central banks use interest-rate policy to “manipulate” the value of their currencies, too. If the European Central Bank wants to tame the Euro, it can flood the currency markets with more of them — or buy dollars. Some countries prefer to simply “peg” their currency to the dollar — essentially riding on the back of U.S. monetary policy (for better or worse.)

A weak currency comes with a very important trade benefit, however; it makes everything based on that currency much cheaper in the global marketplace. Whether you’re buying a condo in Florida, or a share of IBM stock, or a ticket to Disneyland, everything is on sale here if you’re paying in, say, Euros. That tends to help American companies sell more of their products, which boosts the U.S. economy. That, in turn, should create more jobs. In theory, all that expanded economic activity helps strengthen the dollar — which is why floating currencies tend to have a self-regulating effect.

The flip side is that a Hamburger in Hamburg will cost you $50. And if Americans buy more stuff from other countries than we sell to them, the weaker dollar raises the net cost for a typical American’s shopping basket. Paying more each year for the same basket of goods is the textbook definition of inflation. So a weak dollar could push U.S. inflation higher. (That’s one reason higher rates can help tame inflation.)

Eventually, all those dollars we’ve sent overseas to buy cheap clothes and big screen TVs have to come home; they’re not doing any good sitting in foreign banks or other countries’ treasuries. If too many of those dollars come home at once, and there aren’t enough things to buy with them, the value of each dollar declines.

For now, countries with extra dollars have been happy to lend them back to us — buying up hundreds of billions worth of government IOUs (aka Treasury debt).  And since we’re not willing to raise taxes or cut government spending to balance the federal budget, we’re churning out plenty of Treasury debt. It’s one of our most popular exports.

All this is fine until those overseas buyers lose interest in our Treasury debt. If you can get a higher return on a Eurobond, why buy a bond from Uncle Sam? To keep those investors buying, the Treasury pays higher interest rates. And that raises the cost of all forms of borrowing for Americans.

Selling all this debt to foreign investors and governments doesn’t necessarily pose a direct threat to national security: It’s not like they can demand their money back all at once. (The Treasury’s IOU specifically says they have to wait until the bond matures.) True, if everyone sold their bonds all at once, that would sharply weaken the dollar. But that kind of massive selloff would be like a rush to the jailhouse door: If a government started dumping U.S. bonds abruptly, the value of the rest their unsold holdings would plummet.

A security — generally speaking — is the name given to a piece of paper that represents financial value and can be bought or sold. Two common forms are “equity” securities, or stocks (which represent a share of ownership in a company), and debt securities, or bonds (which are, in effect, a piece of an interest-paying loan).

But the well-paid wizards of modern finance have cooked up many more. The biggest growth has been in a category known as “derivatives” — so-called because they’re “derived” from other securities like stocks or bonds. You can buy a futures contract, for example, that promises you a stock, bond or commodity at a future date for a price set when it’s issued. An option gives you the buy or sell before a certain date at a certain price.

With ever more powerful computers, Wall Street rocket scientists have expanded their quest for new paper to trade (and commissions to book) by creating more complex securities. You can buy and sell pieces of paper based on the future direction of interest rates, or stock indices, or the consumer price index.

By doing so, you‘re spreading risk. If I hold a lot of bonds, and I’m worried that a big drop in interest rates will hurt their value, I can “hedge” that loss by also holding interest rate futures that will pay me if rates go down. If interest rates go up, the person who sold me those futures makes money (but I make money on my bonds).

Over the past few decades, Wall Street has figured out how to buy and sell of all manner of risk. The current mortgage mess resulted from the belief — now understood to be mistaken — that by spreading around the risk of a mortgage defaulting, more people with shaky credit could be accommodated by the system. By bundling good loans with bad, and paying higher interest rates to investors who bought paper that was last in line if some borrowers didn’t pay, the pool of people who qualified for loans was rapidly expanded.