Illustration by S. Kambayashi

THE credit crunch vindicated the bears, although some were right for the wrong reasons. They did not expect subprime mortgages to bring the global economy down. Instead they thought the crisis would be caused by a collapse in the dollar, and a jump in Treasury-bond yields, as foreigners balked at funding America's current-account deficit.

Now the recession has caused a rapid improvement in America's trade position. But ironically the resulting fall in the current-account deficit has been accompanied by a renewed downturn in the greenback. On a trade-weighted basis, the dollar has fallen by around 10% over the past six months.

That hardly constitutes a collapse. But if the decline accelerates, it could cause problems for the Federal Reserve, not to mention concern among America's creditors and trading partners.

The simplest explanation for the dollar's decline is based on risk aversion. On the days when risky assets fall (like September 21st) the dollar tends to go up. When risky assets rise, the dollar falls. The dollar has fallen fairly steadily since March, a period which has seen stockmarkets enjoy a phenomenal rally. Domestic American investors may be driving the relationship, repatriating funds in 2008 when they were nervous about the state of financial markets and sending the money abroad again this summer because of a perception that the global economy is reviving.

But although risk aversion may be a factor, describing the dollar as a “safe haven” seems dubious. Indeed, the weakness of American fundamentals has revived the longstanding bearish case against the currency. Some cite the American budget deficit, expected to be 13.5% of GDP this year. There is little sign that the Obama administration has a plan to reduce it, and health-care reform may add to it. In addition, there have been several comments from Chinese and Russian officials expressing a desire to diversify their reserves away from the dollar, or implying that the American government needed to do more to support its currency.

But if foreign investors are so concerned, why hasn't the dollar's decline been accompanied by a sharp rise in bond yields? One reason may be that the Federal Reserve has been buying so much of the year's debt issuance, as part of its quantitative easing (QE) programme. That has helped keep yields down.

Indeed, it is noticeable that the other big currency to have shown significant weakness is the pound. Like the Fed, the Bank of England has been pursuing an aggressive QE programme. Investors seem to prefer the monetary approach of the European Central Bank and the Bank of Japan.

David Woo, a currency strategist at Barclays Capital, says a very simple dynamic is at work: supply and demand. Last year the market was short of dollars because investors needed the American currency to meet their liquidity needs. This year QE is creating a surplus of dollars (and pounds) and is thus driving both currencies down.

The use of QE also creates a problem for central banks as they contemplate their exit strategies. An early abandonment of the approach could cause bond yields to rise sharply, unless there is an unexpectedly dramatic improvement in the fiscal position. But continuing QE could cause further currency weakness.

It is hard to see what the American authorities could do to bolster their currency even if they wanted to (exporters are happy about the decline and higher import prices are not causing inflationary pressures). Low yields offer little support to the dollar. The Fed seems highly unlikely to raise interest rates from their near-zero levels over the next 12 months or so.

As a result, some commentators think that the dollar is being driven down because it is replacing the yen as a focus of the “carry trade”, a common strategy in foreign-exchange markets in which investors borrow in a low-yielding currency and invest in a high-yielding one. But Adam Cole, the head of foreign-exchange strategy at Royal Bank of Canada, argues that the causation has been the other way round—the fall in the dollar makes it attractive to investors as a funding currency.

It is hard to think of a parallel in history. A country heavily in debt to foreigners, with a government deficit it is making little attempt to control, is creating vast amounts of additional currency. Yet it is allowed to get away with very low interest rates. Eventually such an arrangement must surely break down and a new currency system will come into being, just as Bretton Woods emerged in the 1940s.