The Independent Market Observer

Worried About a Dollar Collapse? Don't Be . . . Yet

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Dec 29, 2014 11:30:00 AM

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dollar collapseThis post previously appeared in mid-2013, but given the Fed’s ongoing monetary policies over the last few years, and the recent volatility in the currency markets, it makes sense to revisit today.

In my role as chief investment officer at an independent broker/dealer–RIA, I often receive questions from advisors, their clients, and the media about the potential for a dollar collapse and, more important, what currency would replace the dollar in that (in my belief) unlikely event.

The Special Drawing Rights (SDRs) developed by the International Monetary Fund (IMF) seem to be everyone’s first choice. Are they a suitable replacement? Unequivocally, no. And the reason is simple: SDRs are not a tradable currency but rather a basket of currencies used as an accounting tool by the IMF. (Read this fact sheet for more information.) Because they’re not a currency, SDRs cannot replace the dollar.

So what would be a suitable replacement? And what would need to happen to the dollar to bring about such a scenario?

Criteria for dollar replacement

Any replacement would need to have the following characteristics:

  1. It would have to be available in sufficient volume to support world trade.
  2. It would have to be freely tradable, so buyers and sellers could do transactions anywhere.
  3. It would have to be investable—again, in quantity, so excess reserves wouldn’t just sit there.
  4. To justify the costs of the change, it would have to be more appealing than the current dollar-centric system.

In many ways, the first test is the toughest. Given the sheer size of the world trading system, there simply aren’t enough, say, Canadian dollars or Swiss francs to go around. The only candidates that come close to passing this test are the U.S. dollar, the euro, the yen, and, increasingly, the Chinese yuan/renminbi. The Chinese currency, however, fails both the second and third tests—being freely convertible and investable in quantity. The dollar, euro, and yen do pass, however.

So, under current conditions, the euro and yen are the possibilities for dollar replacement. Any change would depend on whether the euro or the yen could become better suited for use as the reserve currency. Whether such a change could actually occur would depend on the dollar underperforming all of the alternatives for an extended period of time. To make any change worthwhile, the costs of staying with the dollar would have to exceed the costs of changing.

Given the euro’s well-documented troubles, and the financial issues surrounding many European countries, it doesn’t seem that the currency will become systemically more desirable than the dollar in the near to medium-term future, if ever. Although it’s certainly possible to invest excess reserves in Japanese assets, that likely wouldn’t be considered preferable given the very high level of Japanese government deficits and debt—well in excess of those of the U.S. and Europe. At this point, there’s simply no available alternative to the U.S. dollar that is sufficiently better to drive a change.

In theory and practice

Consider the dollar as equivalent to Amazon.com. Would it be possible for another Internet retailer to seize the dominant spot? In theory, certainly. In practice, any such contender would not only have to be better but enough better to make it worth everyone switching. I, for example, have an Amazon account already set up with my information and have prepaid for free shipping. I’m happy with the service, and it would be tough to make me switch, almost regardless of the incentives. Could I be enticed to switch? Yes, probably, but Amazon would have to screw up for a long time to make it worth the aggravation.

The upshot is that there’s no real alternative to the dollar in the short to medium term. Over the longer term, possible alternatives include the Chinese currency, should it become freely convertible and develop large liquid capital markets, or the euro, should it survive the current crisis. At that point, the U.S. dollar would have to perform so badly that the pain of keeping it as the reserve currency would exceed the pain of change.

Which brings us to the last point: Underperformance in a currency equates to high inflation or other losses in purchasing power, and many would point to that as a reason the U.S. dollar is doomed in the long run.

That might be the case. Yet, though the loss of purchasing power might be large in an absolute sense, it must be evaluated with respect to the alternatives. All countries, including China, have been trying to suppress their currency value to encourage exports. All countries, including China, have ramped up debt-driven spending to stimulate their economies. We can debate the relative weaknesses here, but there is no real standout currency that would meet the tests outlined above and provide a markedly superior alternative to the dollar.

A worry for another day

I’m certainly not ruling out an erosion of the dollar’s commanding position in the world economy over time. But not only will it take a while, it will also require some substantial changes in government policy—particularly China’s. This will probably be a problem in the 2020s, but it’s not one today.

                                     

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