How a Reserve Currency Can Collapse – An Extrapolation of Current Trends

January 22, 2009 · Posted in Strategic Insight · 14 Comments

There has been great debate about the fate of the dollar as we move through the crisis. A fiat currency like the dollar relies on the belief of investors in its stability and solidity. Trust in the financial solvency and security of the government is paramount. Once that trust comes into question currency moves away from that nation depressing its value. With the US dollar we are faced with a special dilemma for the US is both the world’s reserve currency and the US is the worlds largest consumer. On the surface it is in no ones best interest for the dollar to collapse. Some would argue that until the flight to quality factor somehow vanishes, that there is no plausible mechanism for the dollar to lapse into crisis. Indeed we see only strengthening lately as European nations face banking crises, debt downgrades, and devaluations.

Murdock Global Insight has taken the position that our fiscal situation is nearing a point where it can deteriorate rapidly resulting in a dollar crisis. As currencies are a zero sum game though, how exactly does a reserve currency collapse? The sequence of events described below portray a plausible scenario based on current trends including the comments that Chairman Bernanke made in London a few weeks ago and Secretary Geithner’s comments during his confirmation hearing. Both stated that substantially greater sums would be required to support the banking sector.

Assuming current trends continue…

• The US has $3 trillion in debt to sell this year (this assumes a good trillion extra for additional bank relief)

• France announces they will issue dollar denominated bonds – the stated reason is that it expands the range of buyers, the real reason is a reasonable bet that the dollar will be a lot lower than the Euro when it’s time to pay back. Others begin to follow.

• First shots of the coming currency wars are fired by US, Britain, China and others.

• US economy contracts more than forecast raising this year’s deficit above the $3 trillion point and sending future projections higher.

• US government successively extends credit support to larger and larger segments of the economy including automobile, credit card, state and municipal debt. Systemic risk is transferred increasingly from the private to the public sector.

• A world wide flood of sovereign debt forces interest rates up substantially as investors become increasingly uneasy about the volume of fiat currency being created. Though the Fed exercises quantitative easing in an attempt to keep rates low they continue to rise.

• US corporate pension defaults occur because of corporate bond defaults. Government is again lender of last resort.

• Sovereign debt defaults begin in those countries that could not secure additional debt financing. Multiple currencies collapse in smaller countries.

• Gold continues to rise as a growing number of investors seek a safe haven that is not a currency. Market sees increasing physical gold buying in America and elsewhere.

• The volume of US debt and obligations rises exponentially as federal government backing is extended to larger swaths of the economy. Interest rates continue to rise as the bond market begins to buckle under the volume. Investor uneasiness with the US dollar increases domestically and worldwide.

• There is a growing clamor in America for a stop to the bailouts but Washington continues.

• Ratings agencies finally cut the US government bond rating shocking the market.

• China and the other exporter nations continue to suffer economic contraction. China and others are forced to begin selling US treasuries to fund domestic spending as the bond market for new debt is becoming increasingly un-reliable, export revenues have collapsed and domestic spending must be boosted to maintain internal stability. Bond auctions fail regularly around the world.

• US – China tension mount as the US accuses China of undermining the dollar for political ends. Protectionism rises in the US leading to a trade war with China and other Asian nations.

• China announces that they will back their currency with gold (having become the largest gold producer in the world in 2008). This provides a measure of internal and regional stability. Asian nations begin to peg their currencies to China’s.

• Foreign investors begin to repatriate money to home currencies from the US in a reverse flight to safety. Many convert to physical gold and silver. Paper assets continue to languish globally. Commodities also continue to languish except for precious metals and agricultural commodities.

• The dollar begins to drop rapidly. Domestic news coverage begins unceasing discussion about a currency crisis in the same way that they currently are talking about deflation. The US stock market begins the final leg down. Bond market prices collapse.

• US inflation begins to head up as all things imported increase in cost and companies worried about the currencies emerging lack of buying power seek a risk premium through price increases. Hard assets of any form go up in price – land, antiques, food, machinery, anything that can be a store of value.

• US investors panic as inflation talk and currency collapse talk finally take hold. CNBC fans the flames.

• The US Government officially defaults on most of the bad assets and debt they have taken on reluctantly recognizing that is the only way to break the cycle. The Fed finally stops adding liquidity and frantically tries to remove it rapidly to restore confidence but succeeds only in further compromising the economy through the attendant spike in interest rates.

• By the end, the US dollar’s buying power is a fraction of what it was and is no longer a reserve currency - no one wants it. Asia regains stability first.

We have completed the first three items.

This is not so much a prediction as a roadmap that shows how a very bad end state can arise. If we see that we are following this course, or one very similar, then it can be a tool to guide our actions. If, on the other hand, we find ourselves on a much better path, then that too can guide our decisions. 2009 is a critical year as all of the global bond market events cited above are set to be tested.