Is the Collapse of the U.S. Dollar Imminent?

By Kimberly Amadeo, About.com Guide

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• u.s. debt
• treasury bonds
• exchange rates
• dollar

A dollar collapse is when the value of the dollar falls so fast that all those who hold dollars panic, and sell them at any cost. In this scenario, sellers would include: foreign governments who hold U.S. Treasuries, traders in exchange rate futures who trade the dollar versus other currencies, and individual investors who demand assets denominated in anything other than dollars. The collapse of the dollar means that everyone is trying to sell their dollar-denominated assets, and no one wants to buy them, driving the value of the dollar down to near zero.

Several conditions must be in place before the dollar could collapse. First, there must be an underlying weakness. Second, there must be a viable currency alternative for everyone to stampede into. Third, a triggering event would need to occur.

The first condition does exist. The dollar declined 40% against the euro between 2002 and 2009. Why? The U.S. debt more than doubled during that time period, from $5.9 trillion to $12 trillion. This increases the chance the U.S. will let the dollar's value slide, allowing it to repay the debt with cheaper money.

The dollar became the world's reserve currency when President Nixon abandoned the gold standard in the 1970's. The dollar is used for 43% of all cross-border transactions, and 63% the world's central bank foreign currency reserves are in dollars. The next most popular currency? The euro, which comprises only 30% of reserves. Although it is increasing rapidly, it is still less than half the amount held in dollars. China and others have argued for a new global currency. However, replacing the dollar would be a massive undertaking, would require great global resolve and not happen quickly (Source: IMF, COFER Table)

Altogether, foreign countries own $2.4 trillion in U.S. Treasuries. If China, Japan or other major holders started dumping dollars on the secondary market, this could cause a panic leading to collapse. China owns $800 billion in U.S. Treasuries. That's because China pegs its currency, the yuan, to the dollar. This keeps the prices of its exports to the U.S. relatively cheap. Japan owns $750 billion in Treasuries, also keeping its currency, the yen, low to stimulate exports to the U.S. Japan is trying to move out of a 15 year deflationary cycle. (Source: U.S. Treasury, Major Foreign Holders of Treasury Securities)

Would China and Japan ever really do this? Only if they saw their holdings declining in value too fast AND they had another market to sell their products to. Right now the economies of Japan and China are dependent on U.S. consumers. They know that if they sell their dollars, their products will cost more in the U.S., and their economies will suffer. Right now, it is still in their best interest to hold onto their dollar reserves.

China and Japan are selling more to other Asian countries, who are gradually becoming wealthier. However, the U.S. is still the best market in the world. (See Demand in the U.S. Economy)

A sudden dollar collapse will create global economic turmoil as investors rush to other currencies, such as the euro, or other assets, such as gold or other commodities. Demand for Treasuries will plummet, driving up interest rates. Import prices will skyrocket, causing inflation.

U.S. exports will be dirt cheap, boosting the economy briefly. Unfortunately, uncertainty, inflation and high interest rates will strangle possible business growth. Unemployment will worsen, deepening the recession or even creating a depression.

Protect yourself from a dollar collapse by first defending yourself from a gradual dollar decline. Keep your assets well-diversified by holding foreign mutual funds, gold and other commodities. A dollar collapse will also create global economic turmoil. To respond to this kind of uncertainty, you must be mobile. Keep your assets liquid, so you can shift them as needed. Make sure your job skills are transferable. Update your passport, in case things get so bad for so long that you need to move quickly to another country.

Fortunately, it is highly unlikely that the dollar will collapse. That is because no one who has the power to make that happen - China, Japan and other foreign dollar-holders - wants it to happen. It is not in their best interest. Why bankrupt your best customer? Instead, the dollar will probably continue to decline gradually, as these countries slowly find other markets. For more, see Dollar Decline or Dollar Collapse? (Updated December 30, 2009)