President Reagan told Congress yesterday that the American dollar is strong "because investors around the world have bid up" the price of U.S. currency as an expression of confidence "in our economy."

"That confidence is an asset and not a liability," the president said in his Economic Report, acknowledging that the strong dollar "and subsidized foreign competition" were injuring American farmers and some other U.S. exporters.

But his Council of Economic Advisers -- now down to one member, William Niskanen -- in a longer, supplemental report, laid most of the blame for last year's $110 billion trade deficit at the door of the unusually strong dollar. The report was prepared by Niskanen and former CEA member William Poole.

The CEA report also:

* Said that many Third World countries had shown dramatic improvement in their external debt balances, largely through better export growth in 1984. But it stopped short of declaring the debt crisis over, noting that most borrowers still are increasing their net indebtedness to the rest of the world.

* Warned flatly that the large U.S. current-account deficit, now exceeding $100 billion annually, and the corresponding capital-account surpluses, cannot go on indefinitely.

* Noted that economic recovery in Europe is accelerating at less than half of the average rate in the United States, Japan and Canada. The hope that curbing welfare expenditures would give Europe a significant forward thrust "by releasing resources to the private sector has not been fully met," the report said.

* Predicted that efforts for new multilateral trade negotiations will be shunned by Third World countries unless the United States and other big powers relax the restrictions they place on textile exports from the poorer nations.

The report's chapter on international economic affairs focused on the case for free trade, including "a rebuttal of the myths of protectionism." Niskanen and Poole cited U.S. trade restraints as well as restrictions imposed by other countries, and the document especially attempted to debunk the theory that "protection can provide a breathing period for an industry to modernize and to become more competitive."

This was an argument presented to justify the imposition of "voluntary" quotas limiting the importation of Japanese cars four years ago, and the argument has been restated by the United Auto Workers union and others now urging the administration to use its influence for a fifth quota year.

Quotas on Japanese car imports are scheduled to expire on March 31. The U.S. position in the matter is now being considered by a Cabinet-level committee.

The CEA report did not deal explicitly with the auto question, but made two generalized statements that dovetail with the views expressed by opponents of continued auto quotas:

* These curbs "paradoxically . . . help foreign producers by enabling them to charge higher prices for restricted exports." (For example, the report calculated that U.S. protection of the steel industry in the 1970s had fattened Japanese steel producers' profits by $200 million.)

* Voluntary restraint agreements "transfer implicit tax revenues from consumers in the importing country which would be collected domestically if tariffs were used instead to producers in the exporting countries" through the effect of restricted sales on prices.

And parrying the argument that imports must be restricted to protect "basic industries" -- the CEA said this line of reasoning "mistakes the prospects for continued vitality of the economy as a whole with the prospects of particular industries . . . The hallmark of a dynamic economy is that basic industries can change."

Although the U.S. bilateral trade deficit with Japan expanded to more than $33 billion last year, the CEA report said that "emphasis on the bilateral balance in a multilateral trading system is misplaced . . . and can be misleading -- just as would inferences about a person's financial standing based on his or her relationship with only one creditor."

To halt the slide toward protectionism, the CEA urged that the United States commit itself to "comprehensive trade liberalization" at the same time that it pushes for a new round of multilateral trade negotiations under the auspices of the General Agreement on Tariffs and Trade.

In his own report, the president was less specific, but said "our goal is a system of free and fair trade in goods and services, and capital. We will work toward this goal through both bilateral and multilateral agreements."