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Why Not to Worry about a US Dollar Collapse

September 16, 2015

Will the US dollar collapse? Eventually, yes... but not anytime soon. At Mauldin Economics, we don’t worry about a dollar collapse. We think you shouldn’t worry, either.

However, we’re not saying that the dollar is as solid as the Rock of Gibraltar. The greenback is part of a world monetary system that reflects a giant set of political compromises. Given a choice, no one would design the system we have. It is a big, rickety contraption held together with duct tape and glue. It isn’t pretty, but at present, it’s intact.

 John Mauldin, our chairman, often says the world will “muddle through” its various problems. Extreme optimism and extreme pessimism are usually wrong. Reality lies somewhere in between.

  • We have real problems, but…
     
  • The problems have solutions.

We see the US dollar this way, too. It’s s not an ideal currency. It has many flaws. Eventually we will transition to something better. For now, though, it works well enough to keep the world spinning.

What will happen to the dollar? To understand this, we first need to review what got us here.

How the Dollar Became the World’s Reserve Currency

The US dollar’s position as the world’s leading currency grew out of World War II. In 1944, delegates from all the Allied nations met in Bretton Woods, New Hampshire, to plan the post-war world economy.

They agreed to set up a system where the US would control most of the world’s gold reserves, and other currencies would have ties to the dollar. It took effect when the war ended the following year.

From 1945 to 1971, the Bretton Woods system of “pegged” exchange rates ruled global commerce. The US fixed the dollar’s value at $35 per ounce of gold.

The resulting American supremacy opened the door for the country’s postwar economic dominance. The dollar was literally “as good as gold” in those years and empowered the US to rebuild the world’s war-shattered economy on its own terms.

However, this system had flaws and by the 1960s was already breaking down. On August 15, 1971, President Nixon issued an executive order to “close the gold window” and stop official conversions between the dollar and gold. This rendered the greenback a fiat currency whose value rested completely in the US government’s word. That remains the case today.

Now, currency exchange rates rise and fall based on global trade flows. Governments occasionally try to gain an advantage by devaluing their currencies. Financial markets impose some discipline, but critics compare it to a house of cards that could collapse any time.

Why Fear of a US Dollar Collapse is Rising

The fiat currency, dollar-dominated world has had several narrow escapes from collapse. The most recent was in 2008-2009 when massive debt defaults caused a global financial crisis. The Federal Reserve injected huge amounts of dollar liquidity into the economy, averting an imminent disaster but sparking other fears.

Events since 2009 gave investors more reasons to be nervous.

  • Faced with a sovereign debt crisis, the European Central Bank launched its own “quantitative easing” program and pushed short-term interest rates below zero.
     
  • The Bank of Japan tried to jolt its economy out of two “lost decades” with a multi-trillion yen stimulus program.
     
  • China’s economic growth began slowing, causing the People’s Bank of China to loosen its currency’s dollar trading band.
     
  • A plunge in energy and commodity prices threatened to destabilize emerging-market nations (like Brazil, Russia, Malaysia, Venezuela, Iraq, and even Saudi Arabia), which are heavily reliant on revenues from resources.

Against this precarious background, millions of Americans saw their own economy’s feeble growth and imagined that this economic tornado would hit the US next. The dollar was toast, they thought.

In hindsight, it’s easy to see why people would think this way. Currency investing is more complicated than stocks or mutual funds. The interplay between currencies and economic trends isn’t always obvious, and people fall prey to common myths like these:

Myth #1: Huge government debt will kill the dollar. The US has carried huge debts for decades, and the dollar is still with us. Yes, there is a connection between the government’s financial health and the dollar’s global value, but it’s one of many factors.

Myth # 2: China will sell all its T-bonds and crash the markets. It is true that Chinese institutions own a lot of US Treasury debt, but they know better than to sell it all at once. Even if they wanted to, who would buy it, and what would the US give to China in exchange? 

Myth #3: China will stop buying dollars. China can’t stop buying dollars as long as American consumers are buying Chinese exports. It has to do something with the money we pay. As long as we pay China in dollars, there will continue to be dollars in Chinese banks.

Myth #4: Higher interest rates will help the dollar. Higher interest rates might help the dollar by making it more attractive than other currencies, but yield is not the only factor. Trade flows and economic trends are just as important as interest rates.

When Will the Dollar Collapse? It Won’t!

In a world without fixed exchange rates, a nation can gain an advantage by manipulating its currency so that the value appears lower. This makes exports seem less expensive to foreign buyers while discouraging imports.

The US has played this game masterfully in recent decades—keeping the dollar low while still importing mass quantities of goods from abroad. Something changed in the last few years, though.

The chart below shows the US Dollar Index, which tracks the dollar’s value against a basket of other major currencies. Notice how it shot higher in the last half of 2014 and then stabilized in a much higher range in 2015.

What caused this? A combination of events, including:

  • The US Federal Reserve’s decision to end its “QE3” stimulus program,
     
  • A major reduction in US oil imports as domestic shale production soared,
     
  • The European Central Bank’s move to ease the continent’s debt crisis with new stimulus, and
     
  • A massive devaluation of the Japanese yen.

Compared to other world currencies, the US dollar is hardly collapsing. It is strengthening, and no other currency shows signs of catching up. Some currencies, no doubt, will collapse in the coming decades, but the dollar is way down the list.

How can this be? Ironically, cutting all ties to gold actually helps the dollar. Currency values are always relative to another currency. That means it is mathematically impossible for every currency to lose value. When you sell currency A (whatever it is), you must simultaneously buy currency B. That means some currency will always be on top of the pile... even if the pile is sinking.

The dollar has stayed relatively strong, despite US economic problems, because other currencies look even worse. Many foreign investors see the US as an island of stability in a storm-tossed world. They want to own dollar-denominated assets. That keeps the dollar strong.

For example, look at this chart showing the US dollar exchange rate against the Japanese yen over the last five years. In 2012, before the Bank of Japan launched its latest stimulus program, it only took around 80 yen to buy a dollar. By mid-2015, the rate was over 120 yen to the dollar.

If you are an American investor worried about the dollar, imagine how this must look to  Japanese investors. They might gladly trade places with you, if they could get dollars in exchange.

The same applies, more or less, to all other currencies. The dollar looks more attractive than the home currencies of many foreign investors. Anything can happen in the short term, of course, but a dollar collapse is unlikely in this environment.

Why the Dollar Could Strengthen Even More

Every fiat currency in history has eventually collapsed. The US dollar will collapse too, but we think that day is many years away. Meanwhile, our analysis says the dollar could get much stronger.

In John Mauldin’s latest Five-Year Global Financial Forecast released January 12, 2015, he explained what he thinks will happen. Here are four excerpted outlooks from what John called his “Tsunami Warning.”

  1. Japan will continue its experiment with the most radical quantitative easing attempted by a major country in the history of the world… and the experiment is getting dangerous.

The Bank of Japan is trying to end a deflationary malaise that dates back to the late 1980s. To do this, it must convince the rest of the world to buy more Japanese exports. Its best tool is a weaker yen—and not just against the dollar. Japan competes against Germany, China, and South Korea... so it needs to push the yen down against those currencies, too.

Why it’s a bullish sign for the dollar

From all appearances, Japan’s leadership is fully prepared to push the yen much lower than it is now. That will help owners of dollars and dollar-denominated assets.

  1. Europe is headed for a crisis at least as severe as the Grexit scare was in 2012—and for the resulting run-up in interest rates and a sovereign debt scare in the peripheral countries.

Excessive debt in the so-called PIIGS nations (Portugal, Italy, Ireland, Greece, and Spain) is holding back growth in much of Europe. The main exception is Germany. The euro common currency can’t work as intended while some member countries are booming and others are stuck in recession.

The European Central Bank is trying to restore balance with a gigantic asset purchase program and by pushing some short-term interest rates below zero. That’s right—if you have money to lend, you pay somebody to borrow it from you.

Why it’s a bullish sign for the dollar

As you might imagine, no one who owns euros is happy with this situation. Dollar interest rates may not be very high, but they are better than the euro alternative. We think euro currency holders will continue to buy dollars as their own currency remains stagnant... or drops even further.

  1. China is approaching its day of reckoning as it tries to reduce its dependency on debt in its bid for growth, while creating a consumer society.

China’s breathtaking economic transformation is like nothing else in human history. In just one generation, over a billion people have moved (or watched relatives move) from subsistence farming to modern industry.

At the same time, a big chunk of the world economy reorganized itself to accommodate China. Emerging market countries sold China fuel and raw materials. Chinese factories cranked out finished products— some for export and some to build China a modern infrastructure.

China managed its huge trade surplus with the US by keeping its renminbi currency tied to a trading band with the dollar. Rising debt and falling exports are making this system difficult to sustain. China wants the renminbi to be another “reserve currency” on par with the dollar, yen, euro, and pound. That means China must let its value “float” so market forces will determine its rise or fall.

Why it’s a bullish sign for the dollar

Beijing has to make a very difficult transition in the next few years. To maintain economic growth and loosen government control will be very difficult. There is a strong chance China will experience either a hard landing or a long period of very slow growth.

While we expect much volatility, China’s transition should be bullish for the dollar as the trade balance moves closer to equilibrium.

  1. All of the above will tend to be bullish for the dollar, which will make dollar-denominated debt in emerging-market countries more difficult to pay back.

Continued dollar strength will probably hurt many emerging-market currencies. Those with heavy dollar-denominated debts will find repayment more expensive. This will happen while slowing commodity demand reduces their export revenues from China.

Depending on how these trends develop, we see high potential for social disorder and even military conflicts as countries struggle to adapt. These could certainly affect the US, both economically and politically.

In other words, Americans will have plenty of things to worry about in the next few years, but a crashing dollar isn’t one of them. Most scenarios are either neutral or positive for the dollar. We could still see plenty of volatility, though, so you need to be ready for anything.

How to Protect Your Savings from Currency Volatility

How can you prepare for this uncertain future?

  • Stay Liquid. Avoid tying up capital in investments that will be hard to exit. We are entering a time of unpredictable volatility. Stay in dollars, but be ready to “hedge” or shift direction if necessary.
     
  • Minimize debt. Carrying a heavy debt load is the opposite of staying liquid. It ties you down and keeps you from capitalizing on opportunities. If you must borrow, try to do it in some currency other than the dollar. This will reduce your real repayment cost if the dollar continues to strengthen.
     
  • Own Gold for Insurance. Gold has been the “currency of last resort” for decades. Unlike fiat currencies—the dollar and all others—it will hold some value indefinitely. Don’t invest in gold to the exclusion of other assets, but have some as an emergency reserve.

John Mauldin and Jonathan Tepper offer more answers and actionable advice in their 2014 book, Code Red: How to Protect Your Savings from the Coming Crisis. The three steps above are recommended as an important starting point to safeguard your wealth.

The most important point is simple: Don’t panic. Whatever happens, it won’t be the end of the world. Don’t fret over mistakes or missed opportunities. You’ll have other chances.

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John Mauldin and his expert team watch the global currency markets with a unique, big-picture perspective. Each week in his free e-letter, Thoughts from the Frontline, John Mauldin shares the latest economic perspective from his well-placed contacts around the globe. Readers have a front row seat to the best financial and currency analysis. You can receive it at no charge by following this link: Subscribe to Mauldin Economics Newsletters.