Sky Falling

“You could rattle the stars. You could do anything, if you only dared. And deep down, you know it too, and that’s what scares you the most.”
—Sarah J. Maas, Throne of Glass

U.S. Dollar Collapse: Causes, Impact, and When It Would Happen

Are We in for a U.S. Dollar Collapse or Is That Just Alarmist Thinking?

By Kimberly Amadeo
January 14, 2015

What Is a Dollar Collapse?

A dollar collapse is when the value of the dollar falls so fast that all those who hold dollars panic, and sell them at any cost. In this scenario, sellers would include: foreign governments who hold U.S. Treasuries, traders in exchange rate futures who trade the dollar versus other currencies, and individual investors who demand assets denominated in anything other than dollars.

The collapse of the dollar means that everyone is trying to sell their dollar-denominated assets, and no one wants to buy them, driving the value of the dollar down to near zero.

What Would Cause This to Happen?

Several conditions must be in place before the dollar could collapse. First, there must be an underlying weakness. Second, there must be a viable currency alternative for everyone to stampede into. Third, a triggering event would need to occur.

The first condition does exist. The dollar declined 54.7% against the euro between 2002 and 2012. Why? The U.S. debt nearly tripled during that time period, from $5.9 trillion to $15 trillion. This increases the chance the U.S. will let the dollar's value slide, allowing it to repay the debt with cheaper money.

Is There a Viable Alternative to the Dollar?

The dollar became the world's reserve currency when President Nixon abandoned the gold standard in the 1970s. The dollar is used for 43% of all cross-border transactions. The dollar's value is strong as measured by central bank reserves -- 61% of the these foreign currency reserves are in dollars.

The next most popular currency? The euro, which comprises less than 30% of reserves. The eurozone debt crisis has only weakened the euro as a viable alternative to the dollar as a global currency.

China and others have argued for a new global currency. China's central banker argues that the yuan should replace the dollar to maintain China's economic growth. However, replacing the dollar would be a massive undertaking, would require great global resolve and not happen quickly. 

Some see Bitcoin as a new world currency. That's because it is not managed by any one country's central bank. Instead, it is created, managed and spent online, although it can be used at brick-and-mortar stores that accept it.

What Event Could Trigger a Collapse?

Altogether, foreign countries own more than $5 trillion in U.S. debt. If China, Japan or other major holders started dumping these holdings of Treasury notes on the secondary market, this could cause a panic leading to collapse. China owns more than $1 trillion in U.S. Treasuries. That's because China pegs its currency, the yuan, to the dollar. This keeps the prices of its exports to the U.S. relatively cheap. Japan owns more than $800 billion in Treasuries, also keeping its currency, the yen, low to stimulate exports to the U.S. Japan is trying to move out of a 15 year deflationary cycle, and the 2011 earthquake and nuclear disaster hasn't helped.

China and Japan Can, But Won't, Trigger a Collapse

Would China and Japan ever really do this? Only if they saw their holdings declining in value too fast AND they had another market to sell their products to. The economies of Japan and China are dependent on U.S. consumers. They know that if they sell their dollars, their products will cost more in the U.S., and their economies will suffer. Right now, it's still in their best interest to hold onto their dollar reserves.

China and Japan are selling more to other Asian countries, who are gradually becoming wealthier. However, the U.S. is still the best market in the world. (See Demand in the U.S. Economy)

If It Did Occur, What Would Happen Next?

A sudden dollar collapse would create global economic turmoil as investors rush to other currencies, such as the euro, or other assets, such as gold or other commodities. Demand for Treasuries would plummet, driving up interest rates. U.S. import prices would skyrocket, causing inflation.

U.S. exports would be dirt cheap, boosting the economy briefly. Unfortunately, uncertainty, inflation and high interest rates would strangle possible business growth. Unemployment would worsen, sending the U.S. back into recession or even creating a depression.

How to Protect Yourself

Protect yourself from a dollar collapse by first defending yourself from a gradual dollar decline. Keep your assets well-diversified by holding foreign mutual funds, gold and other commodities. A dollar collapse would create global economic turmoil. To respond to this kind of uncertainty, you must be mobile. Keep your assets liquid, so you can shift them as needed. Make sure your job skills are transferable. Update your passport, in case things get so bad for so long that you need to move quickly to another country.

When Will It Happen?

A dollar collapse is not imminent. In fact, it's highly unlikely that it will collapse at all. That's because any of the countries who have the power to make that happen (China, Japan and other foreign dollar holders) don't want it to occur. It's not in their best interest. Why bankrupt your best customer? Instead, the dollar will probably continue to decline gradually, as these countries slowly find other markets. For more, see Dollar Decline or Dollar Collapse?

Dollar Decline or Dollar Collapse?

A Dollar Decline Is Inevitable, While a Collapse Is Unimaginable

By Kimberly Amadeo
March 17, 2015

Definition: The U.S. dollar declines when the dollar value is lower when compared to other currencies in the foreign exchange market. That means the dollar index falls. It also means the euro to dollar conversion is higher, since euros get stronger and can buy more dollars when the U.S. currency weakens.  It could also threaten the yen carry trade, because a weaker dollar usually means a stronger yen.

A declining dollar can also mean that the value of U.S. Treasuries falls. This drives up Treasury yields, and therefore interest rates. For more, see What Is the Relationship Between Treasury Notes and Mortgage Rates?

It can also mean that foreign central banks and sovereign wealth funds are holding fewer dollars, thereby lowering the demand for dollars. For more, see 3 Ways the Dollar's Value Is Measured.

Effects

A weaker dollar buys less in foreign goods. This increases the price for imports, contributing to inflation.  As the dollar weakens, investors in the benchmark 10-year Treasury and other bonds sell their dollar-denominated holdings. A weaker dollar will also drive up oil prices, since oil and many other foreign contracts are denominated in dollars, and oil-exporting countries need to maintain their profit margins. For more, see 3 Factors That Determine Oil Prices.

On the plus side, a weakening dollar helps U.S. exports, since their goods seem cheaper to foreigners. This boosts U.S.  economic growth, thus attracting foreign investors to U.S. stocks. However, if enough investors leave the dollar for other currencies, it could cause a dollar collapse. For more on this, see Dollar Collapse: Causes, Impact, and When It Would Happen.

Causes 

On July 1, 2014, FATCA (the Foreign Account Tax Compliance Act) required foreign banks and other financial institutions to disclose information about income and assets held by U.S. customers. Its goals is to root out wealthy U.S. taxpayers that are deliberately hiding money offshore. It also want to stop foreign banks who are using tax evasion as a profitable line of business. Many were worried that foreign banks will drop U.S. customers, to avoid compliance, thereby pushing them away from dollar-denominated assets. 

On October 16, 2013, China allowed British investors to pour $13.1 billion into its tightly restricted capital markets.This makes London the first trading hub for the yuan outside of Asia. This is one more way that China is trying to encourage central banks to increase their holdings of Chinese yuan. This is the biggest potential threat to the value of the dollar. For more, see Is the Yuan Replacing the Dollar as the World's Reserve Currency.

However, since then China has been devaluing the yuan against the dollar. That's because the world's third largest economy is worried that its economy is growing too slowing. However, trouble in China would strengthen, not weaken, the dollar because the Chinese central bank buys dollars to keep it strong and the yuan weak. For more, see Could a China Slump Drag the World Into Recession?

The yield on the 10-year Treasury note hit its lower point in 200 years on June 7, 2012. This indicates dollar strength as measured by Treasuries. 

China's currency, the yuan, rose to 6.4167 against the dollar, a 17-year high, on August 10, 2011.  This showed further dollar weakness as a result of the debt ceiling crisis.

Background

The dollar declined 40% between 2002-2008, partly because of the (at that time) $700 billion U.S. current account deficit. Over half of the current account deficit is owed to foreign countries and hedge funds. (Source: U.S. Treasury Dept.) 

The dollar strengthened during the recession, as investors sought a relatively safe haven. In March 2009, the dollar resumed its decline. That's thanks to the (now) $18 trillion U.S. debt. Creditor nations, like China and Japan worry that the U.S. government won't really support the value of dollar. Why not? A weaker dollar means that the deficit will not cost the government as much to pay back. Creditors have been gradually changing their assets to other currencies to stem their losses. Many fear that this could turn into a run on the dollar. That's what would quickly erode the value of your U.S. investments and drive inflation.. 

How to Protect Yourself From a Declining Dollar

The steps you take to protect yourself from inflation also protect you from a dollar decline. The best way, of course, is to increase your earning potential through education and training. You should also invest part of your portfolio in the stock market. Even though it's risky, the risk-adjusted returns usually outpace inflation. You can also purchase Treasury Inflated Protected Securities and Series I Bonds from the U.S. Treasury. For more, see How Can I Protect Myself from Inflation?

You can also purchase euros, yen or other currencies that will rise in value as the dollar falls. You can either purchase them outright at a bank, or buy an exchange-traded fund that tracks their value. 

If the dollar falls faster, prompting hyperinflation, then you would benefit from buying gold, precious metals and shares in gold mining companies. This the recommendation of The Coming Collapse of the Dollar. However, the authors also recommend short-selling stocks of companies that will be hurt by a falling dollar. That's not a good idea, because a) you don't really know which companies will be hurt the most and b) you don't know how fast the dollar will fall. If you did, you'd be better off buying foreign currency futures contracts that would use leverage to reward you for that knowledge. 

If the dollar absolutely collapses, the devastation upon the world's economy would be hard to imagine. Since no one really knows what would happen, you must be ready to move at a moment's notice. Keep your assets liquid, so you can buy and sell as needed. That means as little as possible in real estate, large volumes of physical gold, or other difficult-to-sell goods. Make sure you have skills that are needed everywhere, like cooking, farming or repairs. Get a passport, in case you need to move to another country.

Of course, the best defense against any uncertain future is a well-diversified portfolio. Rebalance your asset allocation if it looks like the business cycle is going to shift. You can tell that by following key leading economic indicators. 

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