Good arguments can easily be made for the U.S. having a weak dollar. Asset markets tend to appreciate strongly when investors are convinced that cash is a bad investment, and multinational corporations can better compete on price when selling their goods and services abroad (to say nothing of the currency gains made when foreign profits are repatriated).

Depreciating the dollar was an essential tool in the Fed’s war on deflation, a far more insidious and dangerous problem than inflation. Falling asset values (in housing and 401k’s) are death to consumer confidence and spending. True, a 10% unemployment rate doesn’t help the situation either, but the point is that when deflation is rearing its ugly head even people who have jobs tend not to spend.

Certainly, the Fed’s weak dollar policy has helped turn the economy back on the road to expansion. But some very good reasons also exist to have the dollar relatively strong.

Officially, it is the purview of the Treasury (and the President) to establish a dollar “policy.” The Fed, under the vast majority of circumstances, tends to not comment directly on the dollar at all. The policy of the U.S. is to have a “strong” dollar, one which trades on the open market and whose price is driven by fundamentals and investor sentiment. So, as the fundamentals for the U.S. improve, investors should bid up its price without fear of interference from government intervention.

The U.S. is going to run about a $1.4 trillion budget deficit in fiscal 2010 (which began in September) and it’s going to need foreign investors to continue their purchases of Treasuries. This will be especially true now because the Fed, which bought about $700 billion of debt in fiscal 2009, will no longer be a player in this market. That’s a huge void which will need to be filled.

The problem is that investors will not have confidence in U.S. debt if the dollar keeps depreciating as the fundamentals improve. In fact, the U.S. would lose an enormous amount of credibility if that were to happen. Think of the situation from the lender’s point of view and you’ll see what I mean.

If you’re a foreigner, who eventually will need to repatriate, would you lend (which means buying Treasuries) if you were convinced that no matter how well the U.S. economy did you would lose money when you had to exchange your dollars back into your home currency? I think not.

True, there are ways to hedge with currency forwards and interest rate swaps, but these operations don’t always work and they’re expensive to administrate.

Left unchecked, a weak dollar tends to be inflationary since pretty much everything is priced in them. And as they depreciate, those things obviously become more expensive.

So, it’s important for the U.S. to maintain credibility, especially as huge budget deficits are likely to be with us at least through the new decade. We’ll need to have plenty of foreign interest for U.S. debt issuances and with the Fed out of the picture as a buyer (at least for now), an appreciating dollar following a healthy expansion (being priced by the fundamentals) will be an essential tool in maintaining trust and confidence that official U.S. policy is to be believed in.

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