What Is a Dollar Collapse?:
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. This would include foreign governments who hold U.S. Treasuries, traders in exchange rate futures who trade the dollar versus other currencies, and even individual investors, who will 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.
What Would Cause the Dollar to Collapse?:
Over the last six years, the dollar has declined 40% relative to the euro and 30% relative to the yen. That means that Europeans who hold U.S. stock market funds have lost 40% of the value just because of the dollar decline. However, since the decline has been over a six year period, and since the global economy has been growing over this period, European investors have only gradually been moving out of the dollar and into the euro-denominated investments. (Source: St. Louis Fed)
The Japanese government, which owns $586 billion in U.S. Treasuries, lost $150 billion in relative value in the last six years. Japan bought dollars to keep the value of the yen low to make Japanese cars relatively cheaper in the U.S. market, helping Japan's economy to escape a 10-year deflationary cycle. Japan has been slowing selling Treasury bonds as its economy improves. Unfortunately, the recent dollar decline will weaken its economy by making its exports more expensive. (Source: U.S. Treasury, Major Foreign Holders of Treasury Securities)
China owns $492 billion in U.S. Treasuries, a 12% increase over last year. That's because China has pegged its currency, the yuan, to the dollar, so they need to buy dollars and hold as reserves to keep that exchange rate where they want it. As a result, the dollar's relative value has only declined 15% in the last six years against the yuan.
Altogether, foreign countries own $2.4 trillion in U.S. Treasuries. If China, Japan or other major holders begin selling a lot of Treasuries on the secondary market, it could start a panic amongst all sellers, causing a dollar collapse.
Why would they do this? Only if they really felt their holdings were 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 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 both trying to sell 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)
If the Dollar Collapses, What Will Happen?:
Demand for Treasuries will fall, which will cause interest rates to rise. Imports will become relatively expensive, which will spur inflation. Money previously invested in dollars will go to gold, real estate and other commodities, further spurring inflation. High interest rates will make homes even more expensive.
However, U.S. exports will be dirt cheap, helping the economy. Unfortunately, the high interest rates will prevent businesses from adding capacity. That could lead to unemployment, a recession and stagflation.
How Can I Protect Myself from a Dollar Collapse?:
The best way to protect yourself from a dollar collapse is to protect yourself from a gradual dollar decline. That is to have a well-diversified portfolio that includes foreign mutual funds, gold and other commodities. The equity in your home counts as part of this diversification. In addition, a dollar collapse would mean global economic turmoil of unknown proportions. The best defense against that is to have plenty of liquid assets that can be switched if necessary. Be ready to move to another country if needed. Make sure your job skills are transferable. Be mobile. This requires a dramatic change to your lifestyle.
Is a Dollar Collapse Imminent?:
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 decline gradually, as these countries gradually find other customers. (See Not With a Bang But a Whimper)
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