Is the Dollar Going to Collapse in Value?

The financial crisis of 2008 has been described as the worst financial crisis the world has seen since the great depression, but there are now murmurings of the potential for an even greater financial crisis, a currency crisis, caused by the demise of the US Dollar. The Dollar has been the reserve currency of the world since it took over from the Pound at the end of world war two, but we examine if it is about to crash spectacularly?

At the end of World War Two, the Bretton Woods system was established for world currencies. This system involved countries fixing their currencies to the US Dollar, which in turn was tied to the value of gold at a fixed exchange rate of $35 per ounce. As this was a fixed exchange rate system it effectively forced countries to pursue a certain monetary policy, in order to keep their currency pegged to the Dollar and in turn the value of gold.

However, during the post war era, and particularly in the 1960s the US was spending vast sums of money on warfare (Cold war, Vietnam War), and on improved welfare. The US was financing this by increasing the money supply through 'monetising debt' - the US government was issuing debt to finance its spending and the Federal Reserve was purchasing the debt, and holding it, until it became due. As a result not all US Dollars were backed up by gold, meaning the value of each Dollar in real terms was falling. As the money supply increased, gold reserves fell from 20,000 tonnes at the start of the Bretton Woods system to around 8,000 tonnes by 1971. Countries around the world were exchanging Dollars for gold, due to its declining value.

To meet the living standards US citizens demanded and the increased levels of government expenditure the Bretton Woods system became unsustainable for the US, and on August 15th 1971 President Richard Nixon officially ended the relationship. Since the demise of the Bretton Woods system the US has run a budget deficit every single year, right up to the current day. US gross debt (Federal, State and Local) stands at around $18 trillion, and the forecast is only for it to keep rising.
Even President Carter who only became President 3 years after Nixon left office, appears to allude to the problem that was developing in his famous 'Crisis of Confidence' speech in 1979; 'In a nation that was proud of hard work, strong families, close knit communities, and our faith in God, too many of us now tend to worship self-indulgence and consumption. Human identity is no longer defined by what one does, but what one owns. But we've discovered that owning things and consuming things does not satisfy our long term meaning... '

So why do people think the Dollar is going to Collapse?

When the Bretton Woods system was first introduced and the Dollar became the world's reserve currency the US economy had a sizeable advantage over the rest of the world. Europe and Japan were recovering from World War Two and there was the Soviet bloc behind the iron curtain. At one point over 80% of transactions around the world were performed in US dollars. However in the decades that followed Europe resurged, with the single market and European Union being created, Japan expanded rapidly throughout the 1980s, and more recently there has been the rise of China. The US economy no longer has the complete dominance over the world economy it once had.

US Government Debt is currently at around $18 trillion, with a trade deficit of around $800 billion a year. Including the debt of US businesses, and US citizens this figure is more like $60 trillion! This trade deficit is being funded by other countries, and investors around the world, which are buying US Government bonds. Along with the fact so many of the world's transactions are made in US Dollars its value is being supported. Asian countries in particular have wanted to support the value of the Dollar, so US consumers can continue to buy their goods.

However the Asian countries that grew so rapidly throughout the 1990s and 2000s, have recently been making suggestions they are going to move away from the US dollar. Just on Monday November 30th, it was announced that China's Yuan (also known as the Renminbi) is to join the IMF's Special Drawings Rights basket (SDR), alongside the Dollar, Pound, Euro and Yen, effectively making it another reserve currency in the world.

With the rebalancing of Asian economies towards an increase in domestic consumption, along with increased trade in Europe (recent UK - China trade agreements), Asian investors may no longer feel comfortable holding so much of their foreign reserves in Dollars. If the number of worldwide transactions in Dollars continues to fall, and US debt continues to climb, we will eventually reach a tipping point. Investors will no longer buy US Government bonds, as they won't believe the US Government is solvent (same issue which is currently effecting Greece), and if the number of Dollar transactions declines, there will be excess dollars all around the world, triggering rampant inflation in America, as the purchasing power of each Dollar declines. There will be a currency crisis, triggering a global recession on a much larger scale compared to the 2008 financial crisis.

There is one key reason though why any of this is highly unlikely to happen, at least in the short term. There simply isn't another currency to replace the Dollar with. There are significant issues still within the Eurozone, and although China recently joined the SDR, it has also seen a significant slowdown in growth. The US Dollar makes up 41.9% of the global reserve value under SDR, while the Chinese Yuan will make up only around 10%. The markets still view the US Dollar as risk free. The crisis in Greece occurred because investors believed the Greek Government could not afford to pay its debts, whereas if the US Government were to stop paying its debt, it would be because of unwillingness not an inability to pay. The Dollar is safe for now!

Is the time of the Dollar as the world's reserve currency coming to an end? Since the end of the Bretton Woods system in 1971, USA government debt has continually increased, and there are now serious fears this may trigger the collapse of the Dollar. Is an even worse financial crisis just around the corner?