SACRAMENTO -- As if they don't have enough to agonize over, California budget writers might want to add the shrinking U.S. dollar to their list of economic bogeymen.

After appreciating 5% in 2000 and another 6% last year, the dollar peaked in February. Since then, it has been falling against both the Japanese yen and the euro. As of last week, the dollar had declined by more than 14% from its February peak against the two currencies and by greater than 7% against the British pound.

Most observers believe the dollar will continue its slide. The only question seems to be whether its eventual landing will be hard or soft. So, how will this affect California's budget?

Shouldn't a cheaper dollar stimulate economic growth (and generate more tax revenue) by boosting overseas demand for U.S. goods? Shouldn't it make California a more desirable vacation destination for foreigners, as well as for Americans whose dollars don't purchases as much abroad as they did last year?

Well, yes, but ....

Barring another terrorist offensive, California's travel and tourism industry should benefit from a shrinking dollar. For everyone else--including exporters--the fallout is apt to range from mixed to undesirable. As a result, the economic expansion that California's political leaders are banking on to help bridge the chasm between revenues and expenditures may prove far less robust than hoped.

Last February, the Legislative Analyst's Office cautioned that the state faced not only an unprecedented revenue shortfall in the 2002-03 fiscal year but "an operating deficit in the range of $7 billion [that] would likely persist for some time." Since then, the state's fiscal picture has darkened substantially, forcing Gov. Gray Davis and the Legislature to adopt measures that effectively spread a portion of today's deficit into future years. The scheme will work only if California's economy recovers enough to generate the tax revenues needed to cover the burden.

The economic forecast underlying the governor's May budget revision contains a number of assumptions: that California's economy has already emerged from the 2001 recession; that consumer spending will continue to increase gradually; that businesses will resume capital investment toward the end of this year; that the colossal dollops of dollars the Bush administration wants to spend on defense and homeland security will spur California industry to higher rates of expansion in 2003 and thereafter.

There is no question that tens of billions of dollars of defense and security spending will help revive important parts of California's economy, especially the electronics, aerospace and biotechnology sectors. There is less certainty about future consumer and business spending, the real driving forces of a capitalist economy.

While U.S. fiscal policy may be turning more expansionary, the nation's monetary policy could move sharply in the opposite direction as a direct consequence of the dollar's continued deterioration. A weaker dollar makes imported goods more expensive, and given our immoderate dependence on imports--from luxury cars to bargain-basement clothing and toys--any drop in the dollar's value implies another import: inflation.

As inflationary pressures grow, the Federal Reserve Board can be expected to push up interest rates, which will increase the cost of corporate and consumer borrowing. Higher rates will retard economic expansion. Even worse, they also drive up the cost of bonds issued by state and local governments.

The dollar's decline represents a two-edged sword for California exporters. Because a diminished dollar should spur export growth by making our goods and services cheaper abroad, many smaller exporters should benefit.

However, the majority of California's export trade is conducted by large multinational corporations that sit at the nexus of intricate global supply chains. More than half of the state's merchandise exports are shipped to parties within the same corporate family as the shipper. Similarly, about 40% of California's imports come from parties related to the importer.

With so much trade conducted intramurally, the effect of a declining dollar on state exports will probably be less stimulating than standard economic models would predict. What is more certain is that companies in California will see the earnings of their overseas subsidiaries yield fewer dollars when repatriated.

The dollar need not plummet suddenly for the worst to happen. One commonly used definition of a hard landing is a currency correction that undermines confidence in other classes of dollar-denominated assets. Analysts at Morgan Stanley, for example, refer to a possible "sell America scenario" in which investors, spooked by undisciplined currency markets, precipitously divest themselves of U.S. stocks, bonds and real property. While few analysts think this a likely scenario, even a milder version could further shake the U.S. securities markets, undermine the value of U.S. companies and raise the cost of both public and private borrowing.

A weaker greenback would also have some local effects, especially for businesses reliant on imports. Thus, the ports of Los Angeles and Long Beach would probably see a significant falloff in activity. Together, they constitute the nation's premier maritime trade gateway. Yet both are primarily funnels for imported goods, handling $166.4 billion worth, versus just $33.3 billion in exports in 2000.

All these factors add up to (or subtract from) the likelihood that state tax revenues will recover as briskly as those crafting the state budget in Sacramento may hope. As long as the dollar continues its decline, betting on tax revenues to grow substantially over the next few years is a dicey proposition.

There's one other thing. Much to the annoyance of real nations, the state's political leaders regularly boast that California, with its $1.3-trillion economy, tops France and Italy and is rapidly closing in on Britain. A TV ad sponsored by Davis' reelection campaign questioning Republican challenger Bill Simon Jr.'s business acumen concludes by asking whether Simon is up to running "the world's fifth-largest economy." Well, as luck would have it, the sliding dollar could well ensure that, come election day, whoever wins will find himself presiding over an economy that has dropped a peg or two in the standings.