Eventually, it’s time to pay the piper. For America, that time seems to be today. Years of unsustainable trade deficits and growing debt loads have resulted in a dollar with a long-term trend that is decidedly downward. Unfortunately for America, the weak dollar is starting to aggravate its trade partners, namely Europe—and could have grave consequences for the world economy.

In September, the U.S. monthly trade deficit came in at a huge $56.5 billion—but as large as that was, it was actually a slight improvement over last year. Averaging more than $2 billion per day in trade losses, the U.S. trade deficit totaled $764 billion in 2006, setting a new record. Last year was the fifth consecutive year that America’s trade imbalance worsened.

At 5.76 percent of gross domestic product, 2006’s trade losses are at similar levels to those in other nations that have experienced economic and currency crisis.

Unsurprisingly, the dollar is sinking faster than a waterlogged rowboat with a shipment of 100-pound dumbbells.

Over the past seven years, the dollar has fallen by 40 percent against the world’s major currencies. Sixteen percent of that loss has come during just the past year and a half. Against gold, the dollar has faired even worse, losing 19 percent so far this year.

However, the rapid fall in the dollar’s value is drastically changing global trade dynamics. And the immediate impacts are being felt most dramatically in Europe.

The startling fall in the dollar’s value this year will benefit America in the short run. For example, it has made U.S. goods much cheaper when compared to foreign competition, thus boosting exports and dampening foreign imports. This is why the trade deficit is beginning to improve and U.S. exporters are beginning to reap higher profits.

In Europe, things are quite the opposite. European exporters are getting hammered.

The weak dollar means that Europeans are selling fewer goods to America, and America is purchasing fewer products from Europe. But Europe is actually getting hit doubly hard because China loosely links its currency to the dollar.

As the dollar has fallen, so has the Chinese yuan—the result being that European exports have become more expensive in China too, and Chinese goods have become cheaper in Europe—the result being that Europeans are selling fewer goods to, but purchasing more from China—the result being that Europe is now losing billions in trade with China. During just the first eight months of this year, the EU’s trade deficit with China has ballooned 25 percent.

But it doesn’t stop there.

Saudi Arabia also links its currency to the dollar. So as the dollar has fallen, so has the riyal—the result being that European exports have become more expensive in Saudi Arabia and Saudi Arabians are purchasing fewer European products—the result being that Europe is experiencing more trade losses—the result being … you get the picture.

And China and Saudi Arabia are not the only countries that link their currencies to the dollar. Twelve nations, including El Salvador, Ecuador and Panama, actually use the U.S. dollar as currency. Twenty-one other nations including Jordan, Venezuela, Belize, Qatar, Oman and Hong Kong officially link their currencies to the dollar. Additionally, other nations not officially linking their currencies to the dollar still have currencies that tend to parallel the dollar’s value.

In other words, America’s dollar problem is also Europe’s problem. A huge chunk of the world’s currencies are depreciating against the euro.

No wonder Europe is beginning to get fed up with the dollar’s slide.

“We consider that the euro area is not creating these global imbalances. … We cannot be the only ones that have to support the burden of adjustment,” says Joaquín Almunia, European commissioner for monetary affairs. Almunia is not alone; rhetoric from other European leaders confirms that economic conditions are approaching critical levels on the Continent.

There is a dangerous side effect to this trend: The odds of a trade war are becoming very real.

As European businesses suffer, pressure on politicians to take legislative action to protect trade will intensify. Airbus boss Tom Enders says the dollar’s fall is a “life-threatening” event for the company. France-headquartered Airbus, the world’s biggest plane maker, loses about €1 billion (us$1.5 billion) for every 10-cent rise in the euro versus the dollar. Munich-based bmw says it lost €666 million (us$983.5 million) last year because of the weak dollar. Multiply those losses by thousands of other companies that are in the same boat, and the trade losses get huge really fast.

Even in Germany, a nation whose many high-tech corporations are more insulated against currency fluctuations, tension is mounting. According to Stratfor, Germany is considering a French proposal to levy tariffs under the guise of environmental “green taxes” in order to pressure China to unlink the yuan from the dollar and allow it to rise (November 29).

“The fact that the Chinese currency is depreciating against the euro and appreciating against the dollar is creating a lot of problems for the European economy, and we could have as a result protectionism occurring in Europe,” said Jean-Claude Juncker, head of the Eurogroup of finance ministers. Peter Mandelson, the EU trade commissioner, has also warned that protectionist pressures in Europe are looming.

But perhaps the strongest warning about a looming trade war comes from America’s new ally, French President Nicolas Sarkozy. Sarkozy, in a speech to the U.S. Congress, warned that America risked triggering “economic war” with Europe if it attempted to devalue its way out of economic trouble by allowing the dollar to plunge in value. Sarkozy noted that although the relentless decline in the dollar may be a blow to the prestige of the U.S., which has pledged to uphold a “strong-dollar policy,” the real pain was being felt by Europeans.

“Those who admire the nation that has built the world’s greatest economy and has never ceased trying to persuade the world of the advantages of free trade expect her to be the first to promote fair exchange rates,” Sarkozy said.

“The dollar cannot remain solely the problem of others. If we’re not careful, monetary disarray could morph into economic war. We would all be its victims”

But the falling greenback, while stimulating exports, is also increasing calls for trade protectionism in America.

When the dollar falls, U.S.-denominated assets become cheaper, and foreigners are now beginning to take full advantage of the markdown sale in America—not just of toys and trinkets, but of strategic assets as well.

Europeans, Chinese and Arabs are grabbing U.S. infrastructure at a rapid pace. Stuffed to the brim with depreciating dollars, many investors are seeking to spend them before they become worth even less.

Sovereign wealth funds (swfs) are the new rage by which foreign governments are converting their depreciating U.S. debt holdings (e.g. U.S. treasuries) into investment funds to take advantage of other investment opportunities.

China holds around $1 trillion worth of these depreciating dollars and has set up its first swf that is currently capitalized at $200 billion. Middle Eastern nations also hold hundreds of billions of dollars. So do the Russians. And the Europeans—well, they have a euro that now buys one-and-a-half dollars, which is 80 percent more than it did at its low seven years ago.

It is estimated that current swfs hold $2.5 trillion available to be deployed. Just China’s “$1 trillion on hand … is enough to buy a controlling interest in all 30 of the Dow Jones industrials,” notes the Daily Reckoning (May 29). That includes Boeing, ExxonMobil, Citigroup, General Electric, Microsoft, JP Morgan Chase, Wal-Mart, General Motors, plus 22 more of America’s biggest and best companies.

Because the dollar has fallen so much, American companies and infrastructure have become favorite targets of these swfs.

During 2006, foreigners spent $147.8 billion snapping up U.S. businesses, up 77 percent from 2005. According to the United States Department of Commerce, Europeans led the way, spending an astounding $109.9 billion—almost twice what they did in 2005.

Although year-end data for 2007 is not yet available, with the dollar falling as fast as it has, the takeover trend probably has continued.

Just last week, Abu Dhabi spent $7.5 billion purchasing a 4.9 percent stake in America’s largest banking conglomerate (Citigroup) becoming Citi’s largest shareholder. Saudi billionaire Prince Alwaleed Bin Tala is said to be Citigroup’s third-largest shareholder.

In October, China’s Citic Securities announced it had acquired a 6 percent stake in America’s fifth-biggest securities firm—Bear Stearns Cos. In May, the state-controlled Saudi Basic Industries Corp. agreed to buy the plastic unit of General Electric Inc. (an essential supplier to the U.S. military). The list goes on and on.

All told so far this year, some 800 U.S.-owned companies were subject to foreign buyouts.

As America has witnessed the foreign nationalizing of corporate usa, voter angst has grown, and politicians have come under pressure to stem the tide. Going into an election year, pressure to legislate protections for American assets and trade is sure to increase. Calls to levy tariffs, duties, quotas, subsidies, and even to outright prohibit foreign ownership are almost sure to abound.

But trade protectionism in America or Europe could easily escalate into an economic arms race where nations turn inward and erect barriers to benefit local businesses and prevent foreign entities from competing. In such a scenario, global trade would immediately begin to regress, taking stock markets with it as well.

The last large-scale trade war America experienced was in the 1930s, with the Smoot-Hawley Tariff Act. That one law is credited for helping plunge America and the world into a decade of depression and despair.

Then again, how much strategic infrastructure does America want to be foreign-owned? When times are good and everyone is at peace, foreign ownership of strategic industry may not matter. But given the rising global tide of anti-Americanism, is it wise for America to allow foreign nations to have unrestricted access to American assets?

Unfortunately, America is now legislating from a position of weakness, and any protectionist measures may break the economy.

Trade war is probably the last thing America needs at the moment. With trade wars, everybody loses. The question just becomes who loses the most.

The economy is already teetering on the edge of recession. America’s manufacturing industry is atrophied, the housing market is collapsing, the banking industry is experiencing losses that will probably number in the hundreds of billions, and real inflation is far higher than government statistics suggest. A trade war would quickly put an end to any short-term economic stimulus that a falling dollar might provide.

“The dollar is a basket case,” says Peter Schiff, president of Euro Pacific Capital Inc. “We are going to pay the piper for years of having the underlying fundamentals of our economy disintegrate beneath our feet.”

If you don’t know what trade wars are like, the last major one in the 1930s saw industrial production and the national income fall by half, automobile and machine tool production fall to less than 9 percent of former levels, and one in four workers become unemployed.

Nobody wants a trade war. But will the weak dollar trigger one? It could.