The dollar's recent decline on foreign exchange markets has prompted investors to worry about a further, more significant drop. Though a simple extrapolation of recent trends is unfounded, there are indeed reasons to worry over the dollar's longer-term prospects. Because the flood of liquidity pouring into markets and the huge federal budget deficits both speak to deteriorating national finances and a strong, possibly inflationary, pressure; they both also point eventually to currency problems.

Of course, currency is always a relative game. And, since many other countries also face similar and equally severe problems, the dollar may not suffer as much as it might. Even so, circumstances surrounding the dollar are precarious enough to recommend currency diversification in any investment strategy.

The greenback's recent slide, however ominous to some, really has very little to do with these longer-term issues. Instead, it likely reflects an adjustment to the improving financial environment. The dollar had risen back in late 2008, largely because the financial crisis drove so many into U.S. Treasury securities and so unavoidably into the dollar. That movement of funds at once bid up the prices of Treasuries, drove down their yields relative to every other asset class and drove up the dollar's value. The currency effects were impressive. Between July 2008 and the opening months of this year, before the crisis began to lift, the dollar rose by some 21% against the euro, 32% against sterling, 30% against the Canadian dollar and 30% against the Australian dollar. The only exception of note was the Japanese yen, which also presented a haven since Japanese banks and that country's financial system seemed insulated from the financial crisis. The yen actually gained 20% against the dollar during this time.

But now that the worst financial fears have started to dissipate, this process has begun to work in reverse. Funds have flowed out of the Treasury havens, Treasury yields have backed up, credit spreads have narrowed and the dollar's temporary strength has reversed.

Accordingly, the yields on 10-year Treasury bonds have risen by some 150 basis points during these past few weeks, reversing all but 50 basis points of their drop late last year. Spreads on junk yields have come in by some 700 basis points, reversing about half their former widening. And, the spread between the rate on 3-month Treasury bills and overnight interbank lending rates has collapsed from 460 basis points last October to less than 50 basis points.

In concert, the dollar has lost some 12% against the euro, about half the ground it had gained; 17% against sterling, a little over a third of the ground it had gained; 14% against the Canadian dollar, about half the ground it had gained; and some 36% against the Australian dollar, a touch more than half the gain it made in late 2008. The Japanese yen, too, lost its haven status and has actually slid some 13% against the dollar so far this year and, of course, much more against these other currencies.

In this immediate adjustment, it is not likely that the dollar will fall much beyond the old lows it hit less than a year ago, which in the grand scheme of currency movements, is not very severe at all. But possibilities for a dollar move widen over the longer-term horizon, which, as already indicated, carries the inflationary risk implicit in both the huge Federal Reserve-created flows of liquidity and the equally huge budget deficits put in train by the Obama administration.

There is ample time for the Fed to take remedial action, as it has promised, and so head off the inflationary effect.

But though inflationary pressure remains more of a risk than a probability, it is significant enough to keep investors sensitive to the possibilities.

Even if matters were to get out of hand, however, there is enough ambiguity to frustrate any easy currency forecast. To be sure, a nation's currency typically collapses under inflationary pressure. But today, so many other nations find themselves in similarly difficult spots, it is not so easy to rely on these standard rules of thumb. More than usual, a complex of influences has created an array of currency crosscurrents.

The dollar could defend well, for instance, despite the inflationary threat, because many European nations have also injected tremendous amounts of liquidity into their own financial markets.

What's more, Europe faces a deeper recession than the United States and will probably exit it later than this country. Japan not only faces a difficult economy, but it has failed to make many necessary fundamental reforms.

Still, counterbalancing such considerations, bond as well as stock valuations abroad are that much lower than in America and may well, as a consequence, offer some compensation for the problematic economic outlooks there.