What's sinking the dollar?

More from Fortune

Will Mmmhops be a hit? NBA confirms L.A. Clippers sale to ex-Microsoft CEO Steve Ballmer FBI and SEC probe into Carl Icahn and golfer Phil Mickelson

FORTUNE 500 Current Issue Subscribe to Fortune

(Fortune Magazine) -- Things do tend to go to hell all at once, so maybe it should be no surprise that the dollar tanked as the subprime mess was getting rapidly worse and stock markets were whipsawing, mostly downward.

The dollar's fate is especially worrisome because of its historic role as the world's reserve currency and its obvious importance to the world's largest economy. In today's interconnected global markets the dollar's movements are part cause, part effect -- but on net it's hard to see the dollar getting much stronger anytime soon.

The forces behind the dollar's weakening have been building for years but didn't have much effect until recently.

Most fundamentally, we Americans have been living beyond our means, buying more from the rest of the world than the world buys from us (that's the trade deficit); to do that, we have to give foreigners claims on our assets in the form of government bonds and corporate bonds, or sometimes the assets themselves.

A country as rich as America can do that for a long time, but eventually the world ends up holding more dollars than there is dollar-denominated stuff they want to buy, so they start offloading dollars. They also worry that any country with loads of debt -- even the U.S. -- may be tempted to inflate its currency, and that fear reduces its value.

Since the U.S. has been running huge trade deficits the past several years -- about $700 billion this year -- the stage has long been set for the dollar to drop. What shoved it over the edge was the subprime mess and worries about a U.S. economic downturn. If the economy looks to be slowing down, investors bail out of U.S. assets and turn to investments that must be bought with other currencies. When the Fed tries to perk up the economy by cutting interest rates, as it has done twice recently, it makes the dollar even less attractive because investors can get better rates in other currencies, such as the euro.

What makes investors really nervous is that the trend could become self-reinforcing. A Chinese government official sparked a particularly sharp selloff of the dollar when he said his government would be moving its reserves out of weak currencies and into strong ones -- goodbye, dollar; hello, euro. Since China holds more than $1 trillion, its actions could move markets, pushing the dollar down further, prompting dollar holders to shift out of it further, and so on.

Even if we avoid that scenario, more dollar weakness is probably ahead, at least relative to China's yuan and other currencies of developing nations. As Alan Greenspan points out, when their living standards are rising faster than ours, their currencies will probably appreciate vs. ours. Remember, he says, that the Japanese yen was once 300 to the dollar and eventually strengthened to below 100 (it's now around 113). The trend continues: In just the past year the dollar has weakened 13% vs. the Indian rupee and 11% vs. the Colombian peso, for example.

By the way, Warren Buffett told us all this would happen. In mid 2002, for the first time in his life, he began buying foreign currencies, thus betting against the dollar. He explained his reasons most extensively in a Fortune article he wrote (Nov. 10, 2003). The main factor he cited, the trade deficit, is much worse now. For a year or two after the article, his bet seemed to be a loser. But now, as usual, he looks prescient.