What do we do about the dollar?

At the beginning of 2002, a dollar could buy 1.1 Euros. Americans visiting France could happily tell the waiter, "We will have the dessert and the cheese!"

Today, a dollar buys 67 European cents -- and it’s no cheese for you.

The weakness of the dollar has touched off two reactions.

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Critics of the administration see the decline of the dollar as a harbinger of American decline. Cue The Wall Street Journal:

"The larger mistake is to believe that any nation can devalue its way to prosperity. As other currencies rise in value and force productivity gains, the U.S. economy will become relatively less efficient. American living standards will decline, as those in Asia rise."

Defenders of the administration - cue Ezra Klein -- say:

"A 'weak' dollar is actually the one that builds America's manufacturing economy, as it makes our exports more competitive. A ‘strong’ dollar, conversely, builds the production base of other countries, as it encourages Americans to import goods. . . . It's terribly hard for a politician to advocate a ‘weak dollar’ policy. It sounds like you're throwing Osama bin-Laden a birthday party."

They’re both right.

The decline of the dollar is bad news for everybody who owns dollars. Dollar-holders are suddenly a lot poorer than they used to be -- and no euphemism about "high dollar" and "low dollar" can conceal that. To dramatize, a British friend shared this piece of family lore. Shortly before the First World War, his great-grandfather sold a short story to a popular magazine. He was paid two guineas. The guinea was a unit of money roughly equal to a quarter-ounce of gold. In the United Kingdom, it was about as much money as a skilled worker would earn in a week. But outside the United Kingdom -- that was a very different story. His great-grandfather spent one of the guineas to buy himself an austere third-class passage to a Greek island. Once arrived, the other guinea bought an entire month’s worth of bed, food, and wine.

Obtaining more value in exchange for less work is the whole point of economic activity. And whether you call it "high" or "strong," a dollar at 1.1 euros commands more than a dollar at .67.

On the other hand, Americans are a lot poorer than they used to be. In fact, they were never as rich as they imagined they were back in 2004-2006: They were spending money they had borrowed, not earned.

In the years to come, Americans will have to repay that borrowing. They will have to consume less and save more. Repaying debt in depreciated dollars eases the way from here to there. It conceals a little of what has happened. Yes, imported goods cost a little more. But services don’t, because the pay of dollar-earning service providers has been cut in equal proportion to that of dollar-earning service buyers. So if you have a salary of $80,000, it has been cut from 88,000 euros to 54,000 euros. But from your dollar point of view, your salary has stayed stable at $80,000. You have not had a pay cut. The rest of the world has had a pay raise. Totally different!

All right, it’s not quite so neat as that. Some people do lose more than others when the dollar depreciates. (You won’t want to be a BMW dealer in a dollar decline.) Others benefit from an increase in demand for U.S. exports, made more attractive to global markets by a cheap dollar.

The most important complication is the effect on debts. Americans who loaned money or bought assets abroad will be enriched: If you loaned one million euros at five percent interest back in 2002, your annual interest will jump from $45,000 to almost $75,000. On the other hand, if you are (just to pick a wild example out of the air) a Chinese bank that bought $1 million of U.S. debt, you are looking at potentially very serious losses.

Those losses remain only "potential" because Chinese authorities have tied the value of their currency, the renminbi, to the dollar -- thus it falls in tandem with the dollar. Understandably, the Chinese want to protect the value of their assets. Not so forgivably, they also want to maintain their dominance of export markets by manipulating their currency to sell their goods at more competitive prices than would obtain if they allowed their currency to float free.

But not even the Chinese central bank can defy markets forever. By keeping its currency undervalued, China imports inflation. Monetarists look at recent U.S. money creation -- to shore up the sagging economy, the Fed has pumped $2 trillion into the financial system in the past year -- and wonder: "Where’s that inflation?"

Answer: in China. While the Chinese run their printing presses to match ours, they do so under markedly different circumstances. China’s economy is growing, not contracting, and their monetary velocity remains stable while ours has dropped. By continuing to dump under-priced Chinese goods on world markets, China risks a gathering asset bubble inside China. It’s a tough dilemma for them -- and one that they can only resolve by making the fateful decision to become something more like a normal economy with normal patterns of consumption and domestic-led growth.

When that happens, Americans will pay more for Chinese-manufactured goods at Wal-Mart. Meantime, they’ll pay more for a lot else, too. It’s going to be an uncomfortable decade for Americans with a taste for foreign goods and travel, and a long season of bargain-hunting for foreign buyers of dollar-denominated assets.

Take it from a Canadian who earned a lot of his living in 62-cent Canadian bucks back in the 1990s: a cheap dollar is no fun at all. But for the United States today, it is essential to recovery -- almost as essential as a higher Chinese currency is in order to prevent the mother of all asset bubbles from popping in the mother of all asset crashes on the Pacific's opposite shore.