Currency management turns on tightrope walk by policymakers.

MANAGING the U.S. economy continues to be a delicate balancing act--keeping economic crises at bay while creating jobs so the economy can chug along at a solid pace.

The United States transformed itself from a creditor nation with a large budget surplus in the late 1990s into a debtor nation with massive budget and trade deficits. The U.S. now owes foreign creditors nearly $3 trillion--an amount equal to roughly 25 percent of gross domestic product.

How the U.S. got to this juncture and how it can get out of it are the subjects of vigorous debate among economists.

Two major events of the past decade help explain why the dollar has weakened so dramatically and what the currency's devaluation means on the world economic stage.

First, when the stock market bubble burst in 2000, the global economy got hit with a variety of deflationary shocks that nearly prompted a world recession. Then, China and India began flooding world markets with cheap labor, exerting downward pressure on wages.

The United States was forced to step up with an assorted bag of tricks--from tax cuts to lower interest rates--to stimulate the American economy.

"One of the offshoots of stimulation is you get a bigger budget deficit by cutting taxes and stimulating spending, which pushes up the trade deficit," said Michael Bazdarich, senior economist at the UCLA Anderson Forecast and principal at consulting firm MB Economics. "The deficits are the side effects of the same underlying cause--stimulation."

Bazdarich pointed out that fallout from the market decline in 2000 hit government budgets hard.

Prior to the fall, California had been collecting $18 billion a year in state personal income taxes--just on stock options and asset sales. Nationally, $400 billion a year in federal taxes evaporated with the market collapse.

Other unexpected events--the 2001 terrorist attacks and the wars in Afghanistan and Iraq that followed--caused defense and national security outlays to swell, aggravating the impact on the budget.

Foreign fallout

The dollar's fall is directly related to these problems.

For years, the United States has been considered a safe haven for foreign money, particularly among Asian central banks that hold reserves of $2.35 trillion, with 60 percent to 70 percent believed to be in U.S. dollars.

Their holdings have risen sharply in the past decade as Asian economies pursued policies of buying dollar assets to keep their own currencies cheap and their exports competitive.

Those foreign investors have provided much of the money the U.S. government has borrowed to cover its $413 billion budget deficit for the fiscal year ended Sept. 30, 2004.

The-flow of foreign savings into the U.S. has advantages for both sides. By purchasing billions in bonds, Asian countries helped fund U.S. spending and kept U.S. interest rates low. Moreover, with China's exchange rate pegged to the value of the dollar (at roughly 8.28 yuan for every $1), American consumers could continue to buy a record number of cheap electronics, apparel and furniture from China, as well as Indonesia, Sri Lanka, Thailand, Malaysia and India.

The Federal Reserve's stimulative of sharply cutting interest rates sparked a housing and auto sales boom. American homeowners refinanced and put more money into their pockets so they could buy more Asian goods.

Asian central banks have begun diversifying into other currencies, notably the euro, to protect themselves from further dollar declines. There also is fear that as the dollar continues to fall, oil producers will push up prices to make up for exchange-rate losses, since most oil products are priced in U.S. dollars.

Many economists point out that a wholesale dumping of U.S. dollars would not only slow the U.S. economy, but also cripple markets worldwide.

The Fed's reversal in recent months, raising interest rates at a measured pace over six consecutive meetings, will eventually remove the "accommodative" stance toward stimulating the economy, and perhaps take pressure off of dollar's decline.

But in China, the central bank is mulling the removal of the peg that ties its currency to the dollar. Other Asian central banks have apparently begun selling the dollar as well. And if the selling accelerates, the dollar's fall may shift into overdrive.