Evaluating the Arguments for the Dollar's Demise
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From the great financial crisis (GFC) and the massive escalation of sovereign debt and quantitative easing (QE) to the threat of currency wars to cries from pundits to exit the dollar and buy gold, it requires a discerning advisor to sift through the din and decide whether the dollar's reserve status is slipping. Could the dollar look strong and still be in danger? Several recent books, and papers from the Bank for International Settlements (BIS), International Monetary Fund (IMF) and Federal Reserve (Fed) delineate the noise from the reality.
As a former regional director for a top-50 RIA now managing a family investment company, I have viewed the loss of reserve status – and a currency collapse – as a remote possibility for the next decade. Recent developments, however, have challenged my thinking. In the last ten-plus years, the global economy has undergone a remarkable transformation. Because of these transitions – in technology, finance, connectedness and geo-politics – the world will face the risk of unique shocks arriving at faster rates than we have before. The development of the internet and the metamorphosis and ubiquity of the smartphone were two of the many harbingers for this. Information makes leaps faster now, speeding up communication, accelerating actions and reactions and increasing levels of mobilization. In spite of the fact that the dollar increased 12% percent in 2014 and will likely be stronger short-term, we now have broader participation with wider risks.
Some have argued, in this context and others, that there is a greater likelihood that the dollar will collapse. Either debt and QE will cause hyperinflation, China will replace the dollar with the renminbi, the IMF will replace the dollar with the Special Drawing Right (SDR) or some other disaster will cause a crash.
After all, the dollar has been the global reserve currency for about as long as the historical average; it seems like its time is up.
Yet, there are weaknesses in the above assertions. Is it possible the dollar could crash? Yes. Later in this article I will suggest cause and scenario. Is it probable? The real danger probably won't be imminent for years. A review of recent posts from experts explains why.
If the dollar is replaced as the global reserve currency, one argument is its devaluation will occur swiftly because at least half of all dollars, approximately $650 billion of the $1.29 trillion in circulation (as of October 2014), are held outside of the U.S. When these dollars come flooding back into the country inflation will skyrocket, the dollar will devalue and parts of the U.S. will be reduced to third-world status in a short space of time.
It is important, therefore, to understand the arguments and the probability for each predicted scenario of the dollar's demise. I will examine the likelihood of these scenarios in the context of some recent books and research papers.
Is the dollar in danger?
According to “The International Monetary System: Where Are We and Where Do We Need to Go?”, an IMF working paper, though the dollar has maintained its dominance in spite of the GFC, developments since then continue to challenge its pre-eminence. The authors argue, “Any disruption of confidence in the sustainability of the U.S. economy would make it difficult for the dollar to play its role as the international reserve currency.” The paper reflects a developing market perspective, but also concludes that, apart from another U.S. crisis, internationalization of another currency will be difficult.
Still, a paper from the BIS, “The international monetary and financial system: its Achilles heel and what to do about it,” highlighted the weaknesses of the international monetary system (IMS) and made recommendations for reform, also pointing to replacement of the dollar as reserve. According to the conclusion, the risks of inaction on monetary reform should not be underestimated, and include returning to divisive, global currency wars and, ultimately, "triggering an epoch-defining seismic rupture in policy regimes."
The above papers and others examined specific scenarios relative to international currency reform. It is clear that the dollar is not favored like it once was. Currency Wars and The Death of Money, two books by James Rickards, and The Dollar Trapby Eswar S. Prasad, which stands in opposition, examined the issue of a dollar crash comprehensively. Rickards is an industry executive and Department of Defense consultant on financial dangers. Prasad is an influential academic who has worked for the IMF.
I will focus on those books, although there are others who warn that a crash is imminent – a tangential body of theories in the ether.
Prasad's book is an erudite and academic treatment that describes intricately balanced global forces not only holding back a dollar collapse, but also preventing it. Prasad offers only two "tipping points." Rickards' books are the Trap's potential foil; where Prasad is logical and measured, Rickards is passionate and apocalyptic, certain that a dollar collapse is coming and eager to explain why.
A simple reading of Prasad's arguments is that emerging markets' desire to increase exports and self-insure are pushing capital flows in need of safe assets increasingly towards supporting the dollar. There is a paradoxical, uphill capital flow from poorer countries to the U.S. This is the dollar trap: volatility created by U.S. central bank easing creates the need for emerging market reserves. Since there are so few large, liquid, safe bond markets, investments must flow towards the U.S. Ironically, this will likely prop up the dollar for years.
Rickard's approach in Money, and especially the earlier Wars, is more alarmist. His basic thesis is that in spite of all sane attempts to the contrary, the global system will come unglued and a crisis will bring down the dollar. He focuses on high sovereign debt and central bank liability, the interconnectedness of bank derivatives, currency wars, correlations and complexity theory relative to the global financial system to make his points. According to the theory of self-organized criticality, it only takes one snowflake to start an avalanche in a complex system.