Just six years ago, one U.S. dollar could purchase one euro. Today, it takes $1.57 to get a euro. The dollar has also fallen dramatically against the Japanese yen and many other major currencies. How much should we be worried?

A depreciating currency does have its proponents. American exporters, for example, love a falling dollar, because it makes their goods more competitive on world markets. Exports have doubled as a percentage of U.S. GDP in the last 50 years, though they still represent only 12 percent of the U.S. economy. And, as the world’s largest borrower, the U.S. government itself benefits from a falling dollar, since it can repay debts using a less valuable currency.

However, the advantages of a falling dollar look like small beer when compared to the costs. A depreciating currency often contributes to the scourge of inflation. Rising prices hurt all consumers, especially those on fixed incomes. But inflation also distorts interest rates and the relative price structure in an economy. It is caused mainly by an increase in the money supply, which leads to both a declining currency and artificially low interest rates. Falsified rates induce investment in errant capital projects—for example, too many houses are built—many of which are unsustainable because they are not justified by the real rate of interest.

Even in the short run, a stronger dollar would mean lower oil prices, less inflation, and more job-creating capital inflows.

Eventually rates rise in the new inflationary environment, and the projects that attracted investment because of falsified interest rates must be liquidated. A painful adjustment then ensues, with rising unemployment, rising consumer prices, and falling capital asset prices. During the last great surge of inflation in the United States, which occurred between 1966 and 1982, bonds declined by 2 percent per year and U.S. equities fell by 4.9 percent per year—all as the dollar fell continuously.

Inflation makes investors skittish about long-term investing. With future currency values and investment returns uncertain, long-term capital projects become riskier, and investment horizons are shortened. Savers also lose faith in the future, and they reduce their saving in favor of more consumption. All of this serves to raise demand and the prices of consumer goods at the expense of long-term capital formation and job creation.

International trade also declines, as currency risk can override prospective gains from trade. This harms the international division of labor, guaranteeing declining productivity. Trade-related jobs are then lost in many countries, and per capita incomes decline. It is as if all trading nations are forced to become more self-sufficient and to forfeit the real wealth that comes from trade and specialization.

All the problems associated with a declining currency are magnified when the currency in question is the U.S. dollar, because the world is on a de facto dollar standard. When the world’s key reserve currency is unstable, global inflation is the sure result, bringing in its wake $145-a-barrel oil and $1,000-an-ounce gold. The important functional role of money in the economy having been impeded, global recession becomes a possibility.

So who is to blame, and what can be done? Certainly the Federal Reserve has been a poor steward of the value of the U.S. dollar, in spite of Fed Chairman Ben Bernanke’s stated commitment to strengthen the greenback. The U.S. government’s tax, trade, and regulatory policies, combined with its profligate spending, have also harmed confidence in the long-term stability of dollar-denominated asset values. Since Senator Barack Obama secured his party’s presidential nomination, the Dow Jones Industrial Average has fallen by more than 1,000 points and the dollar has sunk further, due mainly to the greater likelihood of a $280 billion tax hike after 2010 (when the Bush tax cuts will expire).

In the short run, the Fed must defend the dollar’s value with tighter monetary policy. Meanwhile, in order to minimize the pain of adjustment, Congress should reduce spending, slash the corporate tax rate, and make permanent the Bush tax cuts (which lowered marginal income tax rates and also lowered tax rates on capital gains and dividends).

In the long run, a dollar linked to gold is the only sure answer to the failings of our fiat currency. We must also maintain low tax rates and promote free trade, both of which bolster the U.S. currency by encouraging the formation of capital. Even in the short run, a stronger dollar would mean lower oil prices, less inflation, and more job-creating capital inflows.

In Washington, unfortunately, politics often trumps economics, especially in an election year. At this point, it seems as if a 1970s-style malaise, with higher interest rates, unemployment, and inflation, is guaranteed. One other thing is guaranteed: the starting point for any recovery in the U.S. economy will be a stronger dollar.

John L. Chapman is a researcher at the American Enterprise Institute.

Image by The Bergman Group/ Darren Wamboldt.