(FORTUNE Magazine) – CONFUSED about the dollar? So are Washington, Wall Street, and financial markets the world over. As the dollar danced the limbo in late October, sometimes dropping more than 1% a day against the yen and the West German mark, investors apparently interpreted the decline first as good news, then bad. Policymakers seemed equally perplexed. Officials at the Treasury, the White House, and the Federal Reserve alternately said they wanted the dollar to fall still lower and that it had gone far enough. The uncertainty over how to think about the dollar is understandable. Determining the ''proper'' exchange rate is nearly impossible. Martin Feldstein, a former chairman of President Reagan's Council of Economic Advisers, says the dollar should drop another 10% in the coming months and 30% over the next five years. Deborah Allen Olivier of the Claremont Economics Institute, a forecasting firm that always swims far from the mainstream, argues that the dollar already is undervalued by 20% to 25%. Yet she predicts a continuing slide. Says Olivier: ''Fundamental economic values have nothing to do with where the dollar is going in the near term. What's operating in the market is psychology and politics.'' The most common view, and the one FORTUNE believes is probably correct, is that the dollar is still slightly overvalued and should decline modestly in the coming months. That is what Americans should be cheering for. What they should be praying against is a genuine free fall that takes the dollar down another 25% or more in a matter of days or weeks. That kind of shock could bring on the worldwide depression that people have been worrying about since the stock market crash. A lower currency carries plenty of costs. Its most widely felt effect will be to make the U.S. poorer. American goods, securities, and real estate become cheaper for foreigners, while Americans must work harder and pay more for anything that comes from abroad. The falling dollar also feeds inflation, both by making imports more expensive and by giving U.S. companies more latitude to raise prices.

BUT THE FALLING DOLLAR also carries pluses that should outweigh those minuses. For one thing, the crisis atmosphere created by the dollar and the stock market crash, like nothing else before, appears to have persuaded Congress and the Administration to take action on the budget deficit. For another, a lower dollar bolsters the competitive position of American industry. Eventually, though not as soon as many expect, it will help bring down the trade deficit. Most important, the dollar decline was inevitable and overdue. The Federal Reserve and other central banks had been holding the dollar artificially high. The manipulation worked, but only at a very stiff price. From February through mid-October, the Fed kept the dollar levitating with an excessively tight monetary policy that helped push interest rates up, threatened the economic expansion, and probably contributed to the stock market crash. If the Fed really is free of its dollar fixation, it now has a chance to pursue the kind of moderate money growth that can finance continuing economic growth without adding to inflation. The policy of manipulating the value of the dollar was the chief reason it tumbled so fast after the stock market crash. The money massage began in September 1985, when Treasury Secretary James A. Baker III met with the finance ministers of other major industrial countries at New York's Plaza Hotel and agreed to intervene in foreign exchange markets to help bring down the dollar, which was then greatly overvalued. The crucial, if unstated, component of the so-called Plaza Agreement was that the U.S. would pump up its money supply, thus lowering U.S. interest rates and making other currencies more attractive. The Fed pumped away with a vengeance throughout 1986, and the policy worked. Indeed, it worked too well. The dollar slid so fast during 1986 that other countries apparently reversed their policies. Instead of selling dollars to drive the exchange value down, the central banks of West Germany, Japan, and Britain bought dollars to stem the decline throughout most of 1986. Lars Pedersen, an international economist at Merrill Lynch, estimates that those three central banks together bought an average of $2.4 billion a month. By last winter Baker and his counterparts abroad had had enough. Meeting in February at the Louvre, which houses the French finance ministry as well as the ''Mona Lisa,'' they agreed to an ambitious plan to slow the dollar's fall. The ministers would attempt to peg exchange rates within an undisclosed, narrow range while the nations worked to bring their fiscal policies more into line. The U.S. would aim to cut its budget deficit; the Germans and Japanese would stimulate their economies to offset slowing growth in the U.S. And the Fed made an abrupt reversal in monetary policy. It slashed the growth of M1 (currency and checkable deposits) from 17.3% in 1986 to an annual rate of 3.2% from March through September. EXCHANGE RATES were relatively stable through the spring and early summer as foreign central banks bought the dollar to prop it up whenever selling pressure appeared. Pedersen estimates that West Germany, Japan, and Britain had spent some $52 billion by October, $13 billion in the month of April alone. Others guess that total intervention by all central banks was as much as $100 billion. Foreign countries paid for supporting the dollar in two ways. As they created currency to buy dollars, their domestic money supplies bulged, creating inflationary pressure in their economies. And ultimately the dollars they bought had to decline in value, giving them an investment loss to boot. The parties to the Louvre Accord, as that agreement is known, had begun bickering by late September. The Germans, in particular, were annoyed that Alan Greenspan, the new chairman of the Federal Reserve, had boosted the discount rate (the interest rate the Fed charges on loans to banks) without consulting them. They also complained that the U.S. had done nothing substantive about the fiscal 1988 deficit. Baker, meanwhile, thought the Germans were dragging their feet on promises to stimulate their economy, and were keeping their money too tight. The already fractured Louvre Accord broke fast after the stock market crash. Greenspan reacted as a central banker must in a financial panic: He flooded the markets with money. This helped quell the panic, but it also drove U.S. interest rates down by 1 1/2 percentage points and put extreme pressure on the dollar. Less than two weeks later the president of Germany's central bank, Karl Otto Poehl, pronounced rate pegging more or less officially dead in a New York speech that virtually ridiculed James Baker. Rejecting Baker's complaints about Germany, and reiterating his country's unhappiness with U.S. policy, Poehl went on to say that the Louvre attempt to prop up the dollar was overambitious and might collapse when the markets tested it, bringing down the < central banks' credibility in the process. FOR HIS FINAL SHOT, Poehl drew a bead on yet another Baker initiative, the idea that the industrialized countries tie the values of their currencies to the price of a basket of commodities, including gold. Like most economists, Poehl is deeply skeptical of the whole idea and said so. Regarding gold in particular, he recalled a 1975 meeting aboard the presidential yacht Sequoia at which the major industrial powers agreed to banish gold forever from the international monetary system. ''Everybody was convinced at that time,'' said Poehl, ''that it would not occur to anybody to pull gold back up again from the silent depths of the Potomac into the daylight of the international monetary policy discussion.'' Three days after Poehl's speech, the Wall Street Journal quoted Baker as saying that the U.S. would let the dollar fall rather than risk recession by tightening monetary policy. The White House first stood behind Baker's remarks. But as the dollar tumbled -- it fell 1.2% against the yen that day, 1.6% against the mark -- the White House stepped back, saying the U.S. remained committed to the Louvre Accord. Maybe so, but it appeared that hardly anyone else was. And when the world's central banks finally let the dollar go, eight months of dollar depreciation was compressed into a few days' trading. Many bankers and economists have been rankled by Baker's high profile. With the U.S. now the world's largest debtor nation, he cut an unseemly figure as he barked orders at his creditors. Says Jerry Jordan, chief economist at First Interstate Bancorp: ''Here's the Treasury Department leading the easy-money parade! It scares the daylights out of the whole world.'' Manfred J.M. Neumann, an economist at the University of Bonn, is blunter: ''I would say, 'Fire Baker.' His behavior is irresponsible.'' Why has the dollar fallen so far over the past two years? Partly because it was so high. From the beginning of the Reagan Administration to February 1985, the dollar leaped 73% against the currencies of America's ten major trading partners. By then virtually everyone agreed that the dollar was grossly overvalued and had to fall. So part of the decline represents a correction of that overvaluation. In fact, measured on a trade-weighted basis against the ten other currencies, the dollar was just 1% lower in early November than it had been in 1981. SEVERAL OTHER FACTORS, including productivity growth and monetary policy, - also contributed to the dollar's demise. A country's currency tends to fall when productivity growth lags behind that of its major trading partners. Since other countries are becoming more competitive, the depreciating currency is the market's way of restoring balance. The lagging country regains its lost competitiveness, but only by accepting a lower real price for its goods. In effect, the cheaper currency is the market's way of cutting wages in the lagging country. U.S. productivity is still the world's highest in many industries, but productivity growth has trailed that of Japan and many European countries for decades. Data compiled by the American Productivity Center in Houston show that productivity growth in the U.S. petered out in the Seventies -- the annual average increase was a mere 1.1% from 1973 to 1981 -- while Japan and other big trading partners continued to show solid gains of 3% a year and more. The growth rates converged somewhat in the Eighties, but U.S. productivity gains were one percentage point a year less than Japan's from 1981 to 1984. That trend was at odds with the sky-high dollar and most likely was a factor in the subsequent slide. Happily, U.S. manufacturing productivity has been growing faster than in other countries for the past two years, which suggests that the dollar's future may not be all bleak. Similarly, if one nation's monetary policy is more inflationary than another's, the relative value of its currency should fall. U.S. inflation was consistently higher than that of Japan and Germany in the Seventies, which accounted for much of the dollar drubbing during the Carter years. And apart from the Louvre Accord period, U.S. money growth has outpaced that of most other major countries since 1982. This ''monetary'' devaluation can be intentional, as it was following the Plaza Agreement, or simply a side effect of inflationary domestic policy. Either way, a purely monetary devaluation does nothing to help competitiveness in the long run. Once inflation rises, workers will demand higher wages, and any temporary lift in competitiveness will disappear. That the dollar needed to fall even after the Fed tightened this year at least partly reflects the market's bet that inflation lurks in America's future. FOREIGN EXCHANGE markets deliver another, even more painful, message: They tell a country when its economic policies and spending habits have become unsustainable. If a country continually runs large trade deficits (which are ; usually accompanied by big budget deficits), the rest of the world eventually forces a correction by refusing to accept any more of its currency. For most countries that means a trip to the International Monetary Fund, which makes emergency loans and exacts a promise that the delinquent will clean up its act. But the U.S. is a special case. The world cannot refuse dollars altogether because other economies are too dependent on U.S. purchases and because the dollar is the world's reserve currency and principal means of international exchange. So all that the world can do to force reform in the U.S. is push the dollar down. Defenders of Reaganomics ridicule the notion that the towering budget or trade deficits caused either the stock market crash or the fall of the dollar. If deficits mattered, they argue, problems would have shown up earlier. The budget deficit dropped by a third last year, and the trade deficit has begun to shrink as well. This analysis misses two crucial points. First, the deficits are not static. Each year's adds to the last, and to America's mounting external debt -- a constant flow of some $150 billion a year into a marketplace that is showing signs of dollar satiety. The argument also ignores the importance of market psychology and the speed with which perceptions have changed. Economists seeking to explain America's policy options tend to use Mexico or Brazil as analogies, not Japan or Germany. Some quipsters have even taken to calling Reagan a ''banana Republican.'' Whatever one may believe, the markets have decided that deficits do matter, and have focused on America's budget deliberations with monomaniacal fervor. The day President Reagan signed the modified Gramm-Rudman-Hollings budget act in late September, the dollar jumped 1.5% against the yen. By mid-November, bankers and economists had greater expectations: Only a two-year deficit reduction package exceeding the Gramm-Rudman targets would be taken as bullish; a one-year compromise would be seen as failure, especially since the prospects of Washington revisiting the question next year on the eve of the presidential election seem slim. The trade deficit matters as well. An unexpectedly high deficit of $15.7 billion in August, reported the week before Black Monday, was widely cited as a contributor to the crash. When September's trade numbers were announced November 12, showing that the deficit had narrowed to $14.1 billion, both the dollar and the stock market rallied briskly. The latest decline in the dollar will help narrow the trade balance, but not right away. As the dollar goes down, Americans pay more dollars for imports and collect less foreign currency for exports. Which means that the physical volume of trade flows must shift in favor of the U.S. just to offset the dollar depreciation, and shift still more to reduce the deficit. The improvement does come, but with a delay that economists call the J curve. Before a drop in the dollar can help -- or to think of it graphically, move from the leftmost point of the letter J upward to the right -- it first pushes the balance into the bowl of the letter, and the deficit worsens. THE DEFICIT expands mostly because it takes time for companies to switch from foreign to U.S. suppliers, and because most corporations -- both in the U.S. and abroad -- do not adjust their export prices to reflect the new currency values immediately. Economists tend to put the duration of the J- curve phenomenon at 12 to 18 months. But what if a currency just keeps sinking, as the dollar has done for nearly three years now? In that case a series of attenuated J curves might result, further muddying the effect. Foreign competitors, fighting like tigers for a greater share of the vast U.S. market, also have blunted the effects of the falling dollar by raising prices much less than their currencies have gone up. The companies can do that, and still preserve some of their profit margins, by selling dollars short in the foreign exchange futures market, by cutting production costs, and by setting up plants in the U.S. The Japanese, of course, have been doing all three. Says economist Olivier of the Claremont Institute, who recently visited Japan: ''There's a feeling there of invincibility. It's like Rocky. You know, 'Hit me again.' They feel they could compete with the dollar 10% lower than it is now, and they've had a lot of time to think about it.'' What's more, the dollar has fallen hardly at all against the currencies of some major foreign competitors. The South Korean won has risen less than 10% against the dollar since early 1985. The Canadian dollar, the currency of America's largest trading partner, is up less than 7%. The comparatively robust health of the U.S. economy has been another contributor to the continuing trade woes. The dollar's decline and good productivity performance have already made many U.S. products ferociously competitive in overseas markets. Yet some producers aren't even trying to ( boost exports. They are barely keeping up with U.S. demand, and the idea that they might further their long-term interests by exporting at the expense of their domestic customers -- a given in Germany or Japan -- is, well, foreign to them. The U.S. paper industry, now the world's low-cost producer, is humming at 98% capacity, and producers are leery of building the new plants they would need to boost exports. Paper makers were burned the last time the dollar declined. In the late 1970s, persuaded that the dollar would remain low, the industry made huge investments. When the dollar rocketed in the early 1980s, they got reamed: The U.S. paper industry went from being the world's most competitive to its least in about three years. For all that, the cheaper dollar has begun to do its work, just as the high dollar helped build the trade deficit to such a daunting height. The volume of trade already has improved, and it appears that the deficit itself has finally begun to shrink. Allan Meltzer, an economist at Carnegie Mellon University, predicts that the trade deficit will be close to zero within four or five years: ''It took four or five years to build the deficit. It will take that long to get it back down.'' If U.S. exporters do gear up, or if domestic demand falls, industries like paper, drugs, and chemicals could boost sales to Europe and Japan. Manufacturers who are already strong exporters, such as aircraft and computer makers, are well situated to sell more abroad. Builders of power-generating equipment and industrial machinery could reverse the downward trend of their exports to Europe. Companies that have been squeezed by import substitution, like auto parts producers, should regain market share at home, especially if foreign carmakers shift more production to U.S. factories. Says Jerry Jordan of First Interstate: ''It's smokestack America's turn to get rich.'' (For the effect on U.S. stocks, see Personal Investing.) The greatest improvement in the trade balance is likely to come via fewer imports. Indeed, the basic cause of the trade deficit is too many imports, not too few exports. The U.S. has been on a consumption binge for five years, and much of what it consumes comes from abroad. Robert S. Gay, an economist at Morgan Stanley, estimates that personal consumption now accounts for around 67% of GNP, three percentage points above where it should be at this point in the business cycle. The U.S. savings rate is three percentage points below the - norm, and imports' share of GNP is three percentage points above its trend. Says Gay: ''It's no coincidence that those three numbers are the same, and it's no coincidence that the 3% equals $150 billion, which equals our current account deficit.'' Automobiles top the list of imports that are coming under pressure from higher prices. Unless Detroit uses the opportunity to raise its prices, sticker shock will slow imports from Japan, Germany, and France. Machine toolmakers in Europe and Japan also will be hurt, as will European chemical and industrial machinery manufacturers. But in consumer electronics -- a field U.S. producers have abandoned -- the benefits of a falling dollar will go to Asia's newly industrializing countries (NICs), whose currencies have appreciated more slowly. And don't look for much decline in apparel imports. Americans will find their fancy Italian shoes a little more expensive, but more than half of clothing imports come from NICs. The cheap dollar cannot fix any of America's competitiveness problems. Rather, it is largely a symptom of those problems, the market's way of bringing world trade and capital flows back to sustainable balances. Other measures are needed to effect a true cure. U.S. tax policy should be tailored to promote more savings. And the most avaricious consumer of all, the federal government, must take control of its spending. The failure of the Louvre Accord may finally have proved that currency manipulation is fruitless in a world of sovereign states. Intervening in currency markets -- even strong statements of an intention to intervene -- can have a powerful effect on exchange rates for a while. The dollar, for instance, dropped 5% the day after the PlazaAgreement was announced. But intervention has a lasting effect only if it is accompanied by equally lasting changes in monetary and fiscal policy. Short-term intervention is costly and simply delays the inevitable triumph of the market's judgment. Thus, intervention should be saved for special occasions. As the dollar declines -- or for that matter, if it rises -- the wisest policy appears to be hands off. But if the dollar should go into free fall, very loud statements and massive intervention are probably the only things that could stop it. Whether such steps -- or anything, for that matter -- could halt a dollar rout of the magnitude of Black Monday's stock market crash is something no one knows. And something the world would be better off never finding out.

CHART: NOT AVAILABLE CREDIT: ILLUSTRATION BY ANDERS WENNGREN CAPTION: THE DROOPING DOLLAR. Central bankers greased the dollar's slide against currencies such as the yen from late 1985 until last February. From then until the crash, they propped it up, then let go. The Atlanta Fed index fell less than the Federal Reserve's because it includes currencies pegged to the dollar. DESCRIPTION: Value of dollar vs. Atlanta Federal Reserve, Federal Reserve Board and yen averages, quarterly, 1985-1986; monthly, 1987; and daily, 10/19/ 87-11/10/87.

CHART: NOT AVAILABLE CREDIT: ILLUSTRATION BY ANDERS WENNGREN SOURCE: MERRILL LYNCH CAPTION: PROPPING UP THE DOLLAR. Exchange rate stability can cost a lot. Merrill Lynch estimates that Germany, Japan, and Britain bought big to keep the dollar high this year. After October the banks backed off and the dollar plunged. DESCRIPTION: Net purchases of dollars by Britain, Japan and W. Germany, monthly, 1987, with monthly average for 1986

PIX CREDIT: MARTY KATZ CAPTION: Imports to Baltimore harbor: Deere and Ford tractors made in Japan DESCRIPTION: Color.

CREDIT: MARTY KATZ CAPTION: Exports from Baltimore harbor: a Combustion Engineering boiler steaming to Korea DESCRIPTION: Color.

CREDIT: KARL SCHUMACHER CAPTION: Baker, banker, beginner: Treasury's Baker and Bundesbank chief Poehl feuded. Greenspan got on-the-job training. DESCRIPTION: Color: James Baker.

CREDIT: POLY-PRESS CAPTION: See above. DESCRIPTION: Color: Karl Otto Poehl.

CREDIT: ROBERT TRIPPETT -- SIPA-PRESS CAPTION: See above. DESCRIPTION: Color: Alan Greenspan.