Betting on a USD collapse might just be a losing bet. Despite the fact that the US debt clock keeps clocking up debt, last count the national debt stood at an eye-watering amount, 17.8 trillion US dollars, which amounts to approximately 56,000 USD per citizen. While a debt of that staggering magnitude would bankrupt most nations, the US can probably get away with it. There are several reasons why investors are unlikely to lose trust in the US dollar, despite the fact that it is a fiat currency. Like all other modern day currencies the US dollar has no intrinsic value and it is not backed by anything tangible such as gold.
To understand the dollar's global dominance we need to go back in history and examine how the dollar tackled its most recent crisis. Back in 1971 when Richard Nixon took the dollar off the gold standard the impact was almost immediate. The dollar rapidly devalued against most currencies, the dollar bear trend continued, albeit to a lesser extent over the following decade. Additionally, the dollar declined 95 percent against gold as the price of gold shot up from 35 US dollars per ounce to as high as 850 USD per ounce in 1981. The situation finally stabilized when the US Federal Reserve raised interest rates to 18 percent, halting further declines in the dollar and triggering a 20-year bear market in gold.
But there was another major factor at play which halted the dollar crashing further, which had a lot to do with President Nixon striking a deal with the House of Saud. The bones of the deal went something like this; the US would provide the Saudi Kingdom with US military protection and arms. In-exchange for US protection the Kingdom would denominate their prized commodity, oil, in US dollars. It became known as the petrodollar deal, which many believe may have saved the economy from inflation and the US dollar.
With oil now denominated in US dollars the Federal Reserve simply creates the currency to buy the oil with merely a few taps on a keyboard. Like magic the US then has access to oil in exchange for US dollars, a fiat currency, and US arms together with its military as the protectorate.
When other economies want to buy oil they need to buy US dollars. But unlike the US these economies don't have the privilege of creating US dollars out of thin air. Instead they need to labour and sell tangible goods and services to earn US dollars, which they then use to buy oil.
It is no coincidence that the world's most prized commodities, oil, gold, silver, copper, diamonds and anything of value are quoted in US dollars. While the world's most valuable commodities are denominated in dollars, global demand for the currency will be buoyant. When energy hungry China needs to buy oil, on the foreign currency market, this represents selling Chinese Yuan and buying US dollars. To earn US dollars China needs to export tangible goods to the US in-exchange for paper money. It's no surprise then that Americans have relatively higher living standards than anyone else.
Indeed, being the world's reserve currency has great privileges, this is known as the dollar hegemony, which is an economic and political phenomenon in which the US has decisive influence over the functions of the international monetary system. Did we not see this during the first quarter of 2014 when talks about tapering from the Fed, which implied a interest rate rise, sent emerging currencies into a tailspin?
Being the world's reserve currency is a kin to engineering a software programme with a back-door entrance. The programmer can hack into the computer and take control, even shut the computer down when he or she wishes. Similarly, the proprietors of the world's reserve currency can do the same to any economy as and when they wish. When the US wants to export inflation it just appreciates the dollar, which it is doing to the euro bloc countries right now. Likewise, if they want to reduce earnings of oil exporting countries, they just devalue the dollar.
Like it or not the US dollar continues to underpin the world economy and is the key currency medium of international exchange, unit of account and a unit of storage (e.g. treasury bills and bonds). Despite arguments to the contrary the US is not in a state of hegemonic decline.
China remains the largest buyer of US foreign debt and probably will remain so. Despite a growing middle class, China still relies on foreign demand for exports to fuel its economic growth. The US is China's second largest export market,the EU being China's number one trading partner. The likelihood of the Chinese suddenly dumping US debt to crash the dollar is unreal. The Chinese need a foreign market to unload their goods. It is an export reliant economy, its domestic demand is not big enough. So why would they kill the goose that lays the golden egg?
Is it mere coincidence that every foreign leader that tried to move away from pricing their oil in another currency has ended up with a shortened lifespan. It is as if the eye on the dollar has cursed any leader with such ambitions. Look at what happened to Gaddafi who had proposed "a single African military force, a single currency and a launch of the African Union". Saddam Hussein had similar ambitions.
But we are now in a precarious situation. Pumping money into a system without productive gains leads to inflation. The market is worried about rate rises, but that is unlikely to happen for the foreseeable future. Possible sell off is likely to occur when the Fed continues its round of quantitative easing and investors lose confidence in the policy. The first sign of a financial collapse would then be a loss of confidence in the US dollar as a store of value, then it is game over.
But the probability of a major conflict occurring before then is regretfully more likely. When the only strength a super power has left is to show the world it is still powerful through its military fighting machine, it might just flex its muscles and pick a fight.
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