How Can the Dollar Collapse?
“The collapse of the dollar means that everyone is trying to sell their dollar-backed assets, and no one wants to buy them, driving the value of the dollar down to near zero.” ...About.com/US Economy
Holdings that are owned by countries make this scenario even more sensitive. For example, if a country catches wind that a nation is selling off their dollar holdings or, if it is even thought that one may be planning to sell, this would be enough to start a panic sale. This is why countries would sell-off dollar investments in small amounts and over time.
What Conditions Would Cause the Dollar to Collapse?
Several conditions MUST be in place before the dollar could collapse.
- First, the dollar must already be weak.
- Second, there must be a viable currency alternative that everyone can turn to quickly in an emergency.
- Third, an event would have to trigger a stampede to a sell-off before a collapse could occur.
The dollar is already week so the first condition exists right now. The dollar has been declining against the euro by 40% between 2002 and 2009. Why? The U.S. debt more than doubled during that time period, from $5.9 trillion to $13 trillion. This increases the chance the U.S. will let the dollar’s value slide, allowing it to repay the debt with cheaper money.
An event or a cascade of events would be enough to cause the dollar to collapse. An event would be anything that investors consider worrisome. Investors will sell-off their holdings with dollars at a panic rate that cause the value of the dollar to fall quickly and crash.
When the value of the dollar falls quickly, investors with holdings in dollars react in panic and try to sell at any cost. Sellers affected by this type of scenario “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.” ...About.com/US Economy
The dollar became the world’s dominant reserve currency after World War II, and used globally to fix the rate of exchange for all foreign currencies to the U.S. dollar.
The world’s developed countries made a decision to create a plan in Bretton Woods, New Hampshire, that fixes the rate of exchange for all foreign currencies to the U.S. dollar.
The Bretton Woods agreement backed the dollar by its value in gold. By the early 1970’s, countries began demanding gold for their dollars in order to deal with inflation. However, by the time President Nixon realized that connecting gold to the dollar would deplete the gold reserve in Fort Knox, it was too late because the dollar had already become the world’s dominant reserve currency. (Source: Chicago Fed, Strong Dollar, Weak Dollar)
“In essence the dollar is like the Gold Standard. Most global contracts, especially those for oil, are denominated in dollars. Many large economies, such as China, Hong Kong, Malaysia and Singapore, peg their currency to the dollar.”
“When the dollar weakens, so do the profits of their exporters. These countries also hold large deposits of U.S. Treasuries, and could conceivably sell their holdings and cause a dollar collapse. However, it is not in their best interest.” … About.com/Dollar Power
During the decline of the dollar in the 1970’s, the early 80’s, and 1991-1993, there were concerns of a dollar collapse. As a result, countries discussed removing their currencies’ pegs to the dollar. There was no real substitute for the dollar as a global currency, so collapse did not occur.
Is There a Viable Alternative to the Dollar?
What Event Could Trigger a Dollar Collapse?
China and Japan Can, But Won’t, Trigger a Dollar 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. Right now 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 is 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 the Dollar Collapses, What Will Happen?
A sudden dollar collapse will 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 will plummet, driving up interest rates. Import prices will skyrocket, causing inflation.
U.S. exports will be dirt cheap, boosting the economy briefly. Unfortunately, uncertainty, inflation and high interest rates will strangle possible business growth. Unemployment will worsen, deepening the recession or even creating a depression.
How Can I Protect Myself from a Dollar Collapse?
Is a Dollar Collapse Imminent?
Could the Euro Replace the Dollar as a Global Currency?
However, even if the euro is destined to replace the dollar, it will happen slowly, and not cause a dollar collapse. That’s because it is in no one’s best interest for the dollar to collapse since it would completely destroy the global economy. Furthermore, the U.S. is the world’s best customer. Therefore, the very countries that could cause a dollar collapse are those who need us to keep buying their products. Therefore, they have no incentive. (See Not With a Bang But a Whimper)
Another reason why the shift to the euro, if it occurs, would happen slowly is because the euro is a relatively new currency. This revaluation – the strength of the euro and the weakness of the dollar – is seen by many as a natural correction of currency values. The euro’s value is being supported by the European Central Bank (ECB), which is keeping its interest rate high to fight inflation. However, as the U.S. economy slows, the EU’s will too, and the ECB will have to lower its rate. At this point, the euro will decline relative to the dollar, and the true relative value of the two currencies will stabilize.