The dollar plunged to a two-year low versus Japan's yen Tuesday, and retreated against other major currencies, on fears the U.S. economy has fallen into a recession, Bloomberg News reported.

The dollar fell 1.26 yen to 106.90 versus the yen. Meanwhile, the British pound rose about 1.5 cents to $1.9704 in mid-day Tuesday trading. The dollar was virtually unchanged versus the euro at $1.4862.

Economists and analysts say a recession in the United States would invariably drive the dollar lower, due to foreign investors' reduced demand for dollar-denominated U.S assets, many of which would underperform during a recession. The dollar also would be hurt by lower interest rates, a near-certainty in the months ahead, with the U.S. Federal Reserve widely expected to again cut benchmark, short-term interest rates to jump start the U.S. economy.

The U.S. dollar's decline is having the predicted effect on sales of U.S. goods abroad - - but it's a positive metric that may draw more international debate, if the current dollar-lower trend continues.

The U.S. trade deficit narrowed 0.6% to $56.4 billion in September 2007, as international demand for goods like aircraft engines and machines increased, the U.S. Commerce Department announced. In September 2007 imports totaled $196.6 billion; exports, $140.2 billion. Further, through September, the trade deficit is running at an annual rate of $703.4 billion, down 7.4% from the same period a year ago.

The euro and pound have risen to $1.4677 and $2.0905 against the dollar - - a trend that has reduced the cost of American products purchased by foreign companies. The lower dollar also lowers the cost for Europeans to travel and buy goods in the states. Each has helped narrow the trade deficit, the Commerce Department noted.

Is our thirst for foreign capital about to bite us? According to a report in the U.K.'s Telegraph, officials of the Chinese government warn that they are prepared to dump their U.S. reserves onto the market should the U.S. government impose trade restrictions in an effort to persuade China to correct the Yuan/dollar imbalance.

China currently holds an estimated $900 billion in American bonds, and a total of $1.3 trillion worldwide. The warning is apparently a response to a bill backed by the Senate's Finance Committee that would impose tariffs to penalize China for currency manipulation.

This 'nuclear option', in the Telegraph's words, could be devastating to the already-weak dollar. However, as China's sugar daddy, such a blow to the U.S. economy would have vast repercussions on the Chinese economy as well. Any sane regime wouldn't take such a suicidal course of action.

So the question here, is one of sanity. Over the past decade, the Chinese leadership has shown many signs of economic savvy. One can only hope that the cooler heads prevail, and that this is simply brinksmanship aimed to carve out a better position in trade and monetary negotiations.