What It Would Take for the U.S. Dollar to Collapse

Over time, investors have wondered whether or not the U.S. dollar will collapse. This has been more of a question as the global economic landscape has changed since the early 2000s, primarily with China becoming an economic powerhouse over the last two decades, and some nations considering trading oil without the petrodollar. It is an interesting question that might superficially appear plausible, but a currency crisis in the United States is unlikely.

Key Takeaways

  • Currencies collapse when faith in the stability or usefulness of the currency as a store of value or medium of exchange ceases.
  • This lack of faith or usefulness comes about for many reasons, such as improper valuations, pegging, sustained periods of low growth in the nation, and inflation.
  • The value of a currency is determined by the demand for it.
  • The demand for the U.S. dollar is high, primarily as the U.S. is the largest economy in the world and the country is considered to be a stable nation, both politically and economically.
  • Demand for the U.S. dollar is also high because it is the world's most prevalent reserve currency; many nations hold large reserves of the dollar.
  • For these reasons, among many others, the likelihood of the U.S. dollar collapsing is zero.

Why Currencies Collapse

History is full of sudden currency collapses. Argentina, Hungary, Chile, Angola, Zimbabwe, and Germany have all experienced terrible currency crises since 1900. Depending on the definition of "collapse," the Russian currency calamity in 2014 could be considered another example.

The root of any collapse stems from a lack of faith in the stability or usefulness of money to serve as an effective store of value or medium of exchange. As soon as users stop believing that a currency is useful, that currency is in trouble. This can be brought about through improper valuations, pegging, chronic low growth, or inflation.

Strengths of the U.S. Dollar

Ever since the Bretton Woods Agreement in 1944, other major governments and central banks have relied on the U.S. dollar to back up the value of their own currencies. Through its reserve currency status, the dollar receives extra legitimacy in the eyes of domestic users, currency traders, and participants in international transactions.

Most global oil transactions are conducted in petrodollars, meaning sales and revenues of oil transactions are denominated in U.S. dollars.

The U.S. dollar is not the only reserve currency in the world, though it is the most prevalent. The International Monetary Fund (IMF) has approved four other reserve currencies: the euro, the British pound sterling, the Japanese yen, and the Chinese yuan.

It is important that the dollar has competitors as an international reserve currency because it creates a theoretical alternative for the rest of the world in case American policymakers lead the dollar down a damaging path.

Finally, the American economy is still the largest and most important economy in the world. Even though growth has slowed significantly since 2001, the American economy still regularly outperforms its peers in Europe and Japan. The dollar is backed up by the productivity of American workers, or at least so long as American workers continue to use the dollar almost exclusively.

Weaknesses of the U.S. Dollar

The fundamental weakness of the U.S. dollar is that it is only valuable through government fiat. This weakness is shared by every other major national currency in the world and is perceived as normal in the modern age; however, as recently as the 1970s, it was considered a somewhat radical proposition. Without the discipline imposed by a commodity-based currency standard (such as gold), the worry is that governments might print too much money for political purposes or to conduct wars.

In fact, one reason the IMF was formed was to monitor the Federal Reserve and its commitment to Bretton Woods. Today, the IMF uses the other reserves as a discipline on Fed activity. If foreign governments or investors decided to switch away from the U.S. dollar en masse, the flood of short positions could significantly hurt anyone with assets denominated in dollars.

If the Federal Reserve creates money and the U.S. government assumes and monetizes debt faster than the U.S. economy grows, the future value of the currency could fall in absolute terms. Fortunately for the United States, virtually every alternative currency is backed by similar economic policies. Even if the dollar faltered in absolute terms, it may still be stronger globally, due to its strength relative to the alternatives.

Will the U.S. Dollar Collapse?

There are some conceivable scenarios that might cause a sudden crisis for the dollar. The most realistic is the dual threat of high inflation and high debt, a scenario in which rising consumer prices force the Fed to sharply raise interest rates.

Much of the national debt is made up of relatively short-term instruments, so a spike in rates would act like an adjustable-rate mortgage after the teaser period ends. If the U.S. government struggled to afford its interest payments, foreign creditors could dump the dollar and trigger a collapse.

If the U.S. entered a steep recession or depression without dragging the rest of the world with it, users might leave the dollar. Another option would involve some major power, such as China or a post-European Union Germany, reinstating a commodity-based standard and monopolizing the reserve currency space; however, even in these scenarios, it is not clear that the dollar necessarily would collapse.

The collapse of the dollar remains highly unlikely. Of the preconditions necessary to force a collapse, only the prospect of higher inflation appears reasonable. Foreign exporters such as China and Japan do not want a dollar collapse because the United States is too important a customer.

And even if the United States had to renegotiate or default on some debt obligations, there is little evidence that the world would let the dollar collapse and risk possible contagion.

What Would Happen if the U.S. Dollar Collapses?

If the U.S. dollar collapses, the cost of imports will become more expensive, the government will not be able to borrow at current rates, resulting in a deficit that will need to be filled by increasing taxes or printing money, inflation will skyrocket due to the higher cost of imports and the printing of money, resulting in an overall collapse of the economy.

What Would Happen to My 401(k) if the Dollar Collapses?

If the dollar collapses, your 401(k) would lose a significant amount of value, possibly even becoming worthless. Inflation would result if the dollar collapsed, decreasing the real value of the dollar when compared to other global currencies, which in effect would reduce the value of your 401(k).

What to Do Before the Dollar Collapses?

Though the U.S. dollar collapsing is unlikely, ways to hedge against it include purchasing the currencies of other nations, investing in mutual funds and ETFs based in other countries, and purchasing the shares of domestic stocks that have large international operations.

The Bottom Line

Though the U.S. dollar may have a lower value than other currencies, the commercial viability of the U.S. is unchallenged. The dollar is used globally as a currency in worldwide transactions, the majority of oil trades are done in U.S. dollars, and the country itself is the largest economy in the world and a politically and economically stable nation. There is no reason to expect the U.S. dollar to collapse in the near future.

Article Sources
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