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

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

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Reviewed by Thomas J. CatalanoFact checked by Suzanne KvilhaugReviewed by Thomas J. CatalanoFact checked by Suzanne Kvilhaug

Imagine waking up to a world where the U.S. dollar (USD), the bedrock of global finance, has collapsed. This scenario may seem far-fetched, but it’s a narrative often found on dubious platforms pushing gold, crypto, and extremist political views, and it occasionally creeps into mainstream discourse. The greenback has always had its external foes during the long period of its dominance—from the communist bloc and anti-colonialists to contemporary adversaries like China, Russia, and other emerging powers. Meanwhile, critics argue that mounting inflation, the rising U.S. federal deficit, and government entitlements could bring down the USD’s dominance from within.

Key Takeaways

  • Currencies collapse when there is a sustained loss of faith in their stability or usefulness as a store of value or medium of exchange, often because of economic mismanagement, political instability, or a significant shift in global market conditions.
  • The value of a currency is determined by the demand for it, which is very high for the U.S. dollar, given the U.S.’s position as the world’s largest economy and perceived political stability.
  • The U.S. dollar’s prevalence as the world’s primary reserve currency, making up 58% of worldwide currency reserves, further contributes to its high demand and stability.
  • Despite occasional challenges and concerns, the likelihood of the U.S. dollar collapsing is considered to be extremely low, given its strong global position and the underlying strength of the U.S. economy.

Given the ever-present economic and political uncertainty of geopolitics, pundits have predicted the dollar’s collapse ever since the greenback gained worldwide supremacy. They’ve been wrong each time—though a prognosticator needs to be right just once to gain fame in financial circles. Nevertheless, we shouldn’t be too sanguine: history shows that even the sturdiest of human edifices crumble, becoming ruins future generations barely notice as they trammel them underfoot.

To be clear, there are no such signs on the horizon. While about a fifth of the foreign currency reserves of the world’s central banks have moved away over the last quarter century, from 71% to 58%, that’s still a dominant position of strength for the greenback worldwide, let alone as a worthwhile currency within the U.S. In this article, we’ll explore the calamitous coincidence of events needed to dethrone the dollar, examining historical precedents, contemporary vulnerabilities, and potential scenarios.

Why Currencies Collapse

A currency collapse is a severe and sudden decline in the value of a nation’s currency, leading to economic instability, financial distress, and often political turmoil. This phenomenon includes skyrocketing inflation, vastly increased prices for imports, and a mass movement of investors out of the currency, if not the home country itself. In simple terms, a currency collapse means that the money people use every day loses its value rapidly, making it difficult to buy goods and services, repay debts, and maintain economic stability.

Argentina, Hungary, Chile, Angola, Zimbabwe, and Germany have all experienced horrific currency crises since 1900. 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.

The End Comes Quick

History is full of such currency collapses. Paraphrasing Ernest Hemingway’s line in “A Sun Also Rises” about bankruptcy, such catastrophes happen “gradually, then suddenly.” Events slowly build, but the collapse itself will be swift as everyone races for the exits.

What Is a Currency Crisis?

To start off, we can borrow from a now-classic paper by Graciela Kaminsky in the wake of the major currency crises in Mexico and across Asia in the 1990s, which provides the often-used categories for how economists have defined what a currency collapse is. Here are the types of crises (the examples are our own):

1. Crises with current account problems: These crises are marked by a loss of competitiveness, often because of real exchange rate appreciations. This can happen because of various factors, including overvaluation of the currency, rising production costs, or trade policies that disadvantage domestic producers. When a country’s goods and services become too expensive for foreign buyers, the demand for its currency falls, leading to devaluation and potential collapse.

Example: Argentina’s currency crisis in 2001 was partly because of a significant loss of competitiveness. The fixed exchange rate regime led to an overvalued peso, resulting in a severe current account deficit and, ultimately, a currency collapse.

2. Crises of financial excesses: These arise from booms in financial markets, characterized by a previous and unsustainable growth in domestic credit.

Example: In 2008, Iceland experienced a financial crisis characterized by a rapid expansion in credit and financial markets. The country’s banks accumulated significant foreign debt, and when the global financial crisis hit, these financial excesses led to a collapse of the Icelandic krona.

3. Crises of sovereign debt problems: These are linked to “unsustainable” foreign debt levels.

Example: In the early 2010s, Greece’s debt crisis was driven by catastrophic levels of foreign debt. The country’s inability to service its debt led to severe austerity measures and a dramatic devaluation of its economic stability within the eurozone.

Important

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

4. Crises with fiscal deficits: These result from expansionary fiscal policies. When investors perceive that a government is unable to manage its economy effectively, they may withdraw their investments, leading to a currency collapse. 

Example: Brazil faced a currency crisis in 1999, exacerbated by large fiscal deficits. The government’s expansionary fiscal policies led to a loss of confidence, resulting in a sharp devaluation of the Brazilian real.

5. Sudden-stop crises: These occur because of sudden reversals in capital flows, typically triggered by sharp increases in global interest rates. These crises, then, are externally driven. Countries heavily reliant on commodity exports, like oil or metals, can see their currencies plummet if global prices for these commodities fall sharply. 

Example: In 1994, Mexico sustained a sudden stop in capital inflows triggered by a sharp rise in U.S. interest rates. This external shock caused a massive outflow of capital, leading to a severe devaluation of the peso.

6. Self-fulfilling crises: These occur without any apparent domestic or external vulnerabilities.

Example: In 1997, the Thai government took the baht off its peg to the dollar, given the currency trading pressure that had suddenly appeared in the previous months. This marked the beginning of the Asian Financial Crisis an example of a self-fulfilling crisis. Initially, there were no clear signs of vulnerability, but speculative attacks on the baht led to a loss of confidence and a dramatic devaluation.

How a U.S. Dollar Currency Collapse Could Happen

Now that we know how a currency could go under, let’s imagine a scenario not too far from those depicted in the jump cuts at the beginning of post-apocalyptic movies. The dollar collapsing would require the convergence of improbable events that would tear much of society apart. The scenario is heuristic, not predictive.

  1. Trigger event: A combination of escalating geopolitical tensions and a major cyberattack on U.S. financial institutions severely disrupts global markets.
  2. Loss of confidence: Investors panic, rapidly selling off U.S. Treasurys and other dollar-denominated assets, triggering a steep decline in the dollar’s value.
  3. Inflationary spiral: The weakened dollar makes imports more expensive, fueling already high inflation rates. The U.S. Federal Reserve raises interest rates aggressively to combat inflation, but this has little effect, even as domestic businesses can’t find the dollars to pay for materials and keep workers on. Economic activity now collapses.
  4. Debt crisis: The combination of higher interest rates and a sliding economy makes it difficult for the U.S. government to service its massive debt. Concerns about a potential default rise, further eroding confidence in the dollar.
  5. Economic Crisis: The U.S. economy plunges into a deep recession, marked by high unemployment, business failures, and a collapse in consumer spending. Anyone who can move their money abroad is doing so.
  6. Loss of reserve status: Foreign governments take the cue, and central banks, alarmed by the dollar’s instability and the U.S.’s economic woes, begin a race to get themselves out of USD before everyone else does. This breakdown in demand for the USD is self-fulfilling: no one wants to be the last ones holding increasingly worthless greenbacks.
  7. Search for alternatives: Countries and investors shift into alternative currencies, such as the euro, Chinese yuan, or a basket of currencies, for international trade and investment. The world economy is reeling, too, as currencies pegged to the dollar are in free fall, and the declining dollar is wiping out much of the value in central banks worldwide.
  8. Social unrest: Economic hardship and growing inequality fuel widespread social unrest, further destabilizing the country and undermining any calming messages representatives put out to quell the damage.
  9. Dollar collapse: The dollar loses its status as a viable currency and gets no takers for international transactions. The U.S. faces a prolonged period of economic and political tumult.

Strengths of the U.S. Dollar

Since the Bretton Woods Agreement in 1944, many of the world’s central banks have relied on the U.S. dollar to back up the value of their 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. The International Monetary Fund (IMF) has approved four other reserve currencies: the euro, the British pound sterling, the Japanese yen, and the Chinese yuan.

Below is a table of advantages the USD has as a globally dominant currency.

Strength Description
Global Reserve Currency The USD is the primary reserve currency, held by central banks and financial institutions for international transactions and as a safeguard against economic instability.
Economic Stability and Size The U.S. has the largest and most diversified economy, with strong legal and political frameworks that instill confidence in the USD, making it a safe haven during global uncertainty.
Deep and Liquid Financial Markets The U.S. has highly developed and liquid financial markets, including the largest stock and bond markets, making the USD attractive for reliable investment prospects.
Trade and Investment The USD is the preferred currency for global trade and investment, with many commodities priced in dollars and substantial foreign direct investment flowing into the U.S.
Technology and Financial Industries The U.S. often leads in technology and finance, keeping the USD relevant and competitive in the global economy.
Military and Political Influence The U.S. has substantial military and political clout, which helps keep the USD in use by allies and those in line with U.S. policies.
Trust and Confidence The USD benefits from high trust and confidence due to credible U.S. monetary policy managed by the Federal Reserve.
Network Effects The widespread use of the USD creates a self-reinforcing cycle of increased liquidity and utility, making it more attractive for future transactions and holdings. Even adversaries would face substantial problems should the USD face a crisis.

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.

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 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 U.S., virtually every alternative currency is backed by similar economic policies. Even if the dollar faltered in absolute terms, it would still be strong relative to all other currencies.

Potential Threats to the Dollar’s Status

U.S. Fiscal and Monetary Policy

America’s fiscal and monetary policy can make the long-term purchasing power of the U.S. dollar uncertain. Large budget deficits of just over 6% of gross domestic product (GDP) and trade deficits of about 3% of GDP, funded by foreign investors through dollar-denominated securities, often raise concerns, especially with those critical of expansionary fiscal policy. Against gold, for example, the dollar’s purchasing power has fallen by 99% since 1972. If these imbalances grow and erode faith in the dollar’s future value, its status could be jeopardized.

The Federal Reserve’s unprecedented monetary expansion in response to recent economic crises, such as the 2008 financial crisis and the COVID-19 pandemic, has led to concerns about inflation and the dollar’s stability. The Fed’s balance sheet has ballooned because of massive asset purchases (quantitative easing) and low interest rates, which some argue could debase the currency over time.

If the U.S. continues to run large deficits and the Fed maintains an accommodative monetary stance for an extended period, it could lead to a loss of confidence in the dollar. Investors might fear that the U.S. will resort to inflation to erode the real value of its debts or that the dollar will depreciate significantly against other currencies.

Rising Strength of Foreign Currencies

While the dollar remains dominant, other national currencies are vying for a greater role in global trade and reserves. Despite challenges within the eurozone, the euro is the second most widely held reserve currency. The Chinese renminbi, bolstered by China’s economic might, is gradually gaining wider use, though it remains less than 3% of worldwide central bank foreign reserve currencies. Some central banks are also increasing holdings of the Japanese yen, British pound, and Swiss franc to diversify reserves. However, as you can see below, there has been no significant rise among any other leading currency in the past decade.

In addition, some countries are exploring bilateral trade in local currencies to bypass the dollar. China has currency swap lines with several nations to facilitate renminbi trade. The BRICS nations (Brazil, Russia, India, China, South Africa, and others) are discussing a shared currency. Rising powers may also forge new monetary alliances.

Moreover, countries facing U.S. sanctions, like Russia and Iran, are working to circumvent the dollar’s dominance. In response to sanctions, Russia has significantly reduced its dollar holdings and increased its gold reserves. It has also promoted using the ruble and other currencies for international transactions, particularly in the energy sector.

Efforts by Russia, Iran, and other nations to de-dollarize their economies and build alternative financial networks could, if successful, chip away at the dollar’s global dominance over time. They underscore how U.S. foreign policy, while powerful, can also give incentives to targeted countries to seek workarounds that could gradually erode the dollar’s universal standing.

Trade Wars and Geopolitical Tensions

Escalating trade wars and geopolitical tensions, particularly between the U.S. and China, could also threaten the dollar. If conflicts intensify and lead to a decoupling of the world’s two largest economies, efforts to reduce reliance on the dollar might be accelerated.

As America’s largest creditor and trading partner, China has significant leverage. In a worst-case scenario, China could dump its trillion-plus dollar holdings of U.S. Treasurys, sending shock waves through global markets. However, this would destroy the value of China’s own reserves and export-driven economy, making it a risky move to say the least.

More realistically, trade wars could spur China and other nations to hasten the development of alternative trade and financial channels that bypass the dollar. For example, China’s Cross-Border Interbank Payment System aims to internationalize the renminbi and cut its dependence on dollar transactions.

If trade friction splinters the global economy into rival blocs and alternative spheres of influence, it could fragment the monetary order and erode the dollar’s universality. Much depends on how the U.S. engages in economic and political diplomacy in a multipolar world. Finding a modus vivendi with rising powers while reassuring allies will be vital to maintaining global trust in the dollar amid geopolitical flux.

Fallout from the Global “Weaponization” of the Dollar

The dollar has become, in the words of some, America’s “weapon of choice” to further political objectives and preserve its global position. The U.S. has historically used dollar dominance to apply its policies and laws extraterritorially, undermine transactions contrary to U.S. interests (even if legal in other countries), exclude parties from dollar-based payment systems, and freeze or seize foreign dollar assets.

This runs the risk of making foreign institutions more reluctant to transact in dollars or hold dollar assets. Some countries are already reducing U.S. Treasury holdings, favoring alternative assets and trade arrangements. A shift away from dollars could undermine the U.S. ability to fund deficits, leading to higher interest rates and a devaluation of the dollar.

Can the U.S. Dollar Collapse?

There are 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, reinstating a commodity-based standard and monopolizing the reserve currency space. However, even in these worst-case 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 U.S. is too important a customer.

And even if the U.S. 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 wouldn’t be able to borrow at current rates, resulting in a deficit that would need to be paid by increasing taxes or printing money.
  • Inflation will spike because of the higher cost of imports and the printing of money, resulting in an overall accelerating collapse of the economy.

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

If the dollar collapses, your 401(k) would lose significant value. Exponential inflation would result if the dollar collapsed, decreasing the real value of the dollar compared with other global currencies, which, in effect, would reduce the value of your 401(k).

What Can Be Done 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 exchange-traded funds based in other countries, and purchasing the shares of domestic stocks that have large international operations.

Can Cryptocurrencies Replace the Dollar?

Some have speculated that the rise of cryptocurrencies like bitcoin could impact the dollar’s status. While their role is limited, crypto may eventually gain traction as alternative stores of value or payment methods.

However, despite their growth, cryptocurrencies remain highly volatile and lack the scalability, stability, and widespread acceptance needed to replace a significant fiat currency like the dollar. Their decentralized nature also poses challenges for large-scale monetary policy and financial regulation.

The Bottom Line

The commercial viability of the U.S. dollar is unchallenged. The dollar is used globally as a currency in worldwide transactions, most 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.

Some countries aim to de-dollarize or reduce their dependency on the U.S. dollar, but it is still essential for global business and is a widely held reserve currency. There is no reason to expect the U.S. dollar to collapse in the near future. Such a change would require the entire world to change its adherence to an international monetary system that has the greenback at its center. As yet, no replacement is anywhere on the horizon.

Read the original article on Investopedia.

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