Ever since the launch of quantitative easing (QE), worried investors have asked: "Will the U.S. dollar collapse?" It is an interesting question that might superficially appear plausible, but a currency crisis in the United States is unlikely.
Why Currencies Collapse
History is full of sudden currency collapses. Argentina, Hungary, Ukraine, Iceland, Venezuela, Zimbabwe and Germany have all experienced terrible currency crises since 1900. Depending on the definition of "collapse," the Russian currency calamity during 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 or pegging, chronic low growth, or inflation.
Currency collapses are caused by a lack of faith in the stability or usefulness of money—either as a way to store value or as a medium of exchange.
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.
The U.S. dollar is not the only reserve currency in the world, though it is the most prevalent. As of October 2016, the International Monetary Fund (IMF) approved four other reserve currencies: the euro, British pound sterling, Japanese yen, and 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.