(FORTUNE Magazine) – PERHAPS it was inevitable that the dollar would dip and dance like a kite on $ its long glide to earth. Its January dive, the most abrupt fall in the decline that began two years ago, reflected a latent instability that needed only the right combination of events to provoke it. The events: Treasury Secretary James Baker insisted that the dollar keep heading lower until the U.S. trade deficit showed improvement. Germany made no significant response. Japan dithered. So traders drove the buck down -- it briefly hit its postwar low vs. the yen -- and the international game of chicken raised fears of a rout to the highest levels since 1978. Where does the dollar belong? That depends on which other currencies change in value, how fast foreign economies grow, and how tightly the U.S. squeezes its deficit. Many forecasters, including FORTUNE, believe that the dollar will decline 15% or so over the next year or two. That would be enough, combined with the lagged effects of the fall so far, to cause a gradual but sizable increase in the volume of U.S. exports relative to imports. Scarcely any economist expects to see the trade deficit wiped out; many doubt that the U.S. should aim for balance since debt-ridden less developed countries need to expand exports and Japan needs a place to invest its abundant savings. Some economists think a more modest decline could suffice. C. Fred Bergsten, director of the Institute for International Economics and former Assistant Treasury Secretary for International Affairs, believes the yen is about where it should be. A further fall of 10% or less for currencies of European countries would be adequate if they and Japan could boost their annual growth rates by two percentage points and the U.S. federal deficit were cut at least in half by 1990. Bergsten adds that Taiwan, which only recently allowed its dollar to appreciate against the U.S. dollar, can and should accept a further significant appreciation. Its economy is sufficiently hale to absorb the resulting hit to export sales and would benefit from its increased ability to buy foreign raw materials. Korea is more fragile, with a huge external debt to service. The country has tied its currency, the won, to the U.S. dollar and is likely to resist untying it anytime soon. How far and how smoothly the dollar falls will depend heavily on how Japan and West Germany pursue their widely differing goals. Japan is hurting worse by far because it is more dependent on exports to the U.S. They account for just 11% of Germany's export sales, vs. over 40% for Japan. To earn the same number of yen on U.S. sales, a Japanese exporter would have to charge U.S. customers $175 for what they could have purchased with $100 two years ago. Japanese companies responded by squeezing profit margins and squeezing them again. Finally they are crying uncle. As the dollar plunged in January, Japanese Finance Minister Kiichi Miyazawa dramatically flew to Washington to discuss matters with Treasury Secretary Baker. But their meeting yielded only vague statements with no promise of action by either side. Japan's best medicine would be a more vigorous economy, which would increase demand for Japanese as well as U.S. goods. But greater growth looks unlikely. The administration has submitted its budget for the coming fiscal year, and it is not expansionary. The country may cut interest rates in response to U.S. pressure, but with capacity utilization low and consumer incomes weak, the lower rates probably will not stimulate much activity. West Germany is far better situated to boost growth, but the country's economic strength gives it less incentive to try to satisfy the U.S. Germany's export-oriented economy has more shock absorbers than a Mercedes stretch limo. About three-quarters of exports are high-quality capital goods, such as precision machine tools and luxury cars, less sensitive to fluctuations in currencies than to the business cycle, which is still in a moderate upswing. While the mark rose 15% against the currencies of its foreign markets in the past year, the yen rose 33%. Germany's January discount rate cut was apparently little more than a sop to the U.S. and is unlikely to do much. But the country is more likely than Japan to spur its economy in other ways -- planned tax cuts may be accelerated -- despite fear of inflation. As with Japan, that would be good news. The U.S. Administration's goal is not complicated. Secretary Baker wants to produce signs that the trade balance is improving in time to ward off protectionist legislation in the spring. He has also hoped for an earnest of cooperation from Japan and Germany -- such as Germany's discount rate cut. While that probably won't affect the trade balance much, it should please another major player in Washington, Federal Reserve Chairman Paul Volcker. Further rate cuts overseas would have the immediate effect of moderating the dollar's decline and would give Volcker more freedom to keep U.S. rates low, protecting the economy's expansion. The U.S. trade deficit is already starting to narrow. Even if Japanese and German markets don't grow as fast as Secretary Baker would like, the dollar's two-year decline has made it easier for U.S. companies to compete in those countries and -- at least as important -- with them in other markets. Up 6% in the past year, the volume of U.S. exports should rise another 4% during 1987. Imports will slow by 2%. The combination accounts for a quarter of the GNP growth FORTUNE expects. With the higher cost of imports, the monstrous current account deficit won't shrink very much this year. But the change in direction should be apparent soon. Once it becomes clear that the trade tide has turned, pressure on the dollar should ease. While currency values influence trade hugely, trade influences currency values much less than it used to. John Williamson, a senior fellow at Bergsten's Institute for International Economics, notes that 95% of today's currency transactions are for capital market purposes, not trade. The ratio was more like fifty-fifty two decades ago. While foreigners are loaded up with U.S. securities, they will probably buy a lot more. The world is awash in liquidity, with money supplies increasing rapidly in major industrialized nations, and the U.S. still looks like the world's best investment. Most economists agree that a weaker dollar raises the likelihood of higher inflation. But the risk could be much greater than previously thought, according to a recent study by Joseph A. Whitt Jr. and other economists at the Federal Reserve Bank of Atlanta. The Fed economists concluded that a 10% depreciation of the dollar adds 1.6 percentage points to the consumer price index after one year -- and 4.9 points before its effects are all absorbed. Few other economists foresee such powerful effects. The Administration will get the dollar decline it wants. But how America and its trading partners behave will determine whether the fall is orderly or cataclysmic.

CHART: NOT AVAILABLE CREDIT: ILLUSTRATION BY JAVIER ROMERO CAPTION: The Buck's Diverging Fortunes The dollar has taken a beating from the mighty mark and yen. But Taiwan and Korea, which have big surpluses with the U.S., have not let their currencies strengthen much. DESCRIPTION: Value of dollar vs. Korean won, Taiwanese dollar, yen, and D- mark, 1985 to first three weeks of 1987.