A dollar collapse is when the value of the U.S. dollar plummets. In that scenario, anyone who holds dollar-denominated assets will sell them at any cost. That includes foreign governments that own U.S. Treasurys. It also affects foreign exchange futures traders. Last but not least, it will hit individual investors.

When the crash occurs, these parties 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. This will drive the value of the dollar down to near zero. It would make hyperinflation look like a day in the park.

Two Conditions That Could Lead to a Collapse

Two conditions must be in place before the dollar could collapse. There must be an underlying weakness in the value of the U.S. dollar, and there must be a viable alternative. In other words, there must be a reason people are fleeing the dollar and there must be somewhere for them to go. Otherwise, the dollar will remain the world's global currency. The majority of international contracts demand a dollar payment, so that also adds to its stability.

Underlying Weakness

The dollar is not exhibiting an underlying weakness. Between January 2008 and 2020, the dollar has strengthened by 30%, from 89.2 to 115. The coronavirus pandemic strengthened it a further 10%, rising as high as 126.4 on March 23, 2020.﻿﻿

Why? The U.S. economy is still seen as the strongest in the world. Investors trust the U.S. government will back its currency. The dollar's strength is based on its use as the world's reserve currency. The dollar became the reserve currency in 1971 when President Richard Nixon abandoned the gold standard.﻿﻿﻿﻿

As a global currency, the dollar is used for half of all cross-border transactions.﻿﻿ That requires central banks to hold the dollar in their reserves to pay for these transactions. As a result, 61% of these foreign currency reserves are in dollars.﻿﻿

Viable Currency Alternative

There is no viable currency alternative for everyone to buy. The next most popular currency after the dollar is the euro. But it comprises only 21% of central bank reserves.

China and others argue that a new currency should be created and used as the global currency. China would like it to be its currency, the yuan.﻿﻿ That would boost China's economic growth. China has not taken enough steps to make its currency widely traded. It's only 2% of central bank foreign currency reserves.﻿﻿

It's unlikely bitcoin could replace the dollar as the new world currency.

Bitcoin's value is highly volatile because there's no central bank to manage it. It's also become the coin of choice for the black economy.﻿﻿ That makes it vulnerable to tampering by unknown forces.﻿﻿

Economic Event that Could Trigger a Collapse

A collapse couldn't occur without a triggering event that destroys confidence in the dollar.

Altogether, foreign countries own more than $6 trillion in U.S. debt. The two largest are China and Japan. If they dump their holdings of Treasury notes, they could cause a panic leading to collapse. China owns nearly $1 trillion in U.S. Treasurys.﻿﻿ China pegs the yuan to the dollar.﻿﻿ This keeps the prices of its exports to the United States relatively cheap.

Japan, in turn, owns more than $1.2 trillion in Treasurys. It also wants to keep the yen low to stimulate exports to the United States. Japan is moving out of a 15-year deflationary cycle. The 2011 earthquake and nuclear disaster didn't help.﻿﻿

Would China or Japan ever really dump their dollars? Only if they saw their holdings declining in value too fast.

The economies of Japan and China are dependent on U.S. consumers. They know that if they sell their dollars, their action would further depress the value of the dollar. So their products, still priced in yuan and yen, would cost relatively more in the United States. Their economies would suffer. Right now, it's still in their best interest to hold on to their dollar reserves.

China and Japan are aware of their vulnerability. They are selling more to other Asian countries that are gradually becoming wealthier. But the United States is still the best market in the world.

© The Balance, 2018

When Will the Dollar Collapse?

It's unlikely that the U.S. dollar will collapse at all. Countries that have the power to make that happen, such as China, Japan, and other foreign dollar holders, don't want it to occur. It's not in their best interest. Why bankrupt your best customer? Instead, the dollar will eventually resume its gradual decline as these countries find other markets.

Effects of a Dollar Collapse

A sudden dollar collapse would create global economic turmoil. Investors would rush to other currencies, such as the euro, or other assets, such as gold and commodities. Demand for Treasurys would plummet, and interest rates would rise. U.S. import prices would skyrocket, causing inflation.

U.S. exports would be dirt cheap. This would give the economy a brief boost. But in the long run, inflation, high interest rates, and volatility would strangle possible business growth. Unemployment would worsen, sending the United States back into recession or even a depression.

How to Protect Yourself

Protect yourself from a dollar collapse by first defending yourself from a gradual dollar decline.

Keep your assets well-diversified by holding foreign mutual funds, gold, and other commodities.

A dollar collapse would create global economic turmoil. To respond to this kind of uncertainty, you must be mobile. Keep your assets liquid, so you can shift them as needed. Make sure your job skills are transferable. Update your passport, in case things get so bad for so long that you need to move quickly to another country. These are just a few ways to protect yourself and survive a dollar collapse.