US Dollar Collapse Predictions: The Dollar is on its way out

US Dollar Collapse Predictions: Here are many reasons why the Dollar is on its way out

Updates: Renowned investor Warren Buffett, along with his business partner Charlie Munger, has expressed confidence in the US dollar’s continued dominance as the world’s reserve currency despite experts warning about potential de-dollarization. Buffett attributes this belief to many countries holding large amounts of dollar reserves for safety and international commerce. However, both Buffett and Munger have warned against the US government flooding the economy with excess money

China’s state-owned banks are selling dollars to buy yuan in the offshore market to mitigate the yuan’s decline. This action aligns with the central bank’s easing of cross-border financing rules, which aims to reduce the depreciation pressure on the yuan. Despite this, the yuan remains down by about 4% against the dollar for the year.

US Dollar Collapse Predictions: Bretton Woods and Petrodollar System History

Today most of the world’s trade is conducted in USD (U.S Dollars). This is the “defacto” global reserve currency for trading between most nations. Around the end of WW2 (World War 2), the “Bretton Woods” system was set up by a group of 44 nations in a conference held at Bretton Woods, New Hampshire (USA). This monetary system established the rules for commercial and financial relations among the participant nations which included the United States, European nations, Australia, and many others. Member nations would peg their currencies to the U.S. dollar, and the U.S. would peg the US dollar to gold, at a price of $35 an ounce.

Will the Dollar Lose its Reserve Status? Read here

Vietnam War and the Gold Peg: The central role of the dollar in world trade eventually forced the US to run a persistent trade deficit. By the early 1960s, the U.S. dollar’s fixed value against gold (35$ per ounce) was seen as overvalued. The profligate spending due to the Vietnam War and the welfare programs during the 1960s meant that the dollar was seen as being overvalued against its gold reserves. A few countries tried to withdraw the gold that they had sent to the United States for safekeeping. After a run on its gold reserves, in August 1971 then-President Nixon declared a temporary suspension of the dollar’s convertibility into gold and thus the original Bretton Woods system collapsed. By 1973, the Bretton Woods system was replaced by freely floating fiat currencies. The dollar subsequently lost 20% of its value (devalued against gold)

The Oil Shock of 1973: Unconditional support by the United States for Israel during the 1973 Yom Kippur War angered the Middle Eastern Arab states. These oil-producing OPEC states placed an oil embargo on the United States. As a result of this, the price of oil quadrupled causing a severe economic shock for the US and other oil-importing nations. This added to the stagflation of the 1970s increasing economic misery in the United States. To improve its relationship with the Saudis and bring down oil prices, President Nixon in July 1974 sent his Treasury Secretary William Simon on a secret mission to negotiate a deal with the Saudis. As per the agreement,

The U.S. would buy oil from Saudi Arabia and provide the kingdom with military aid/hardware
In return, the Saudis would use their oil wealth (which had gone up a lot especially given the price rise) to buy US Treasuries (i.e. Debt)

This mechanism (of pricing oil in just US dollars) was soon adopted by other OPEC countries

This once again confirmed the hegemony of the US dollar as the mechanism for global trade [for example, oil purchases in the British pound fell from 20% to 6% in just a couple of years post this event]. This was referred as to the “Petrodollar” system where oil was exclusively priced in US dollars and the oil-producing nations in return plowed their oil revenue money back into the United States.

The purchase of US Treasuries with the oil revenue helped keep the US dollar strong and the US debt cheap. The US government due to these foreign purchases of US debt was able to keep borrowing costs lower and was unencumbered to generate even larger sums of debt which it used to finance wars, social welfare programs, etc. over the next few decades. For the OPEC nations, it allowed them to park their excess money in US Treasuries which were considered one of the safest investment products around given the long-term stability of the dollar system and the US govt creditworthiness (i.e., implicit understanding of not defaulting on their debt obligations).

US Dollar Collapse Predictions: Russian Sanctions & its Implications

Russia’s invasion of Ukraine in February 2022 resulted in the Western nations (including the USA and Europe) employing some of the toughest sanctions to date, some of which were previously only employed against pariah nations like North Korea, Venezuela, Iran, etc. Russia was removed from the SWIFT banking system (a messaging system that is used for faster and quicker cross-border trade/payments between trade partners).

Various banks & financial institutions have ceased operations inside Russia and also refuse to do any transactions with entities inside Russia. However, in an unprecedented move, the US led a move to freeze Russian Central Bank forex assets. As per reports around half of Russia’s $600B worth of forex reserves which were outside Russia have now been frozen. Traditionally in the Petrodollar system, many Central Banks also parked their Forex reserves and gold with the US and other Western nations for safekeeping. Many preferred to keep their assets overseas in the West to prevent them from falling into the wrong hands due to corruption or local unrest and also keep them in safer US Treasuries which are less affected due to the vagaries of fluctuating local currencies.

US Dollar Collapse Predictions 2022: Dollar Index Performance

While there is limited causality, Across 5 Presidential Terms each of Republicans and Democrats, The Dollar Index fell lower in 7 Terms

Reagan (R, 1 Term)
Bush Sr (R, 1 Term)
Clinton (D, 1 Term)
Bush Jr (R, 2 Terms)
Obama (D, 1 Term)
Trump (R, 1 Term)

The Index rose under

Clinton (D, 1 Term)
Obama (D, 1 Term)
Biden (D, 1 Term)

Here is the data by years

Jan 1st, 1986 – 122.2
Jan 1st, 1993 – 93.0 [Reagan + Bush, -29.2]
Jan 1st, 2001 – 110.4 [Clinton, +17.4]
Jan 1st, 2009 – 84.6 [Bush, -25.8]
Jan 1st, 2017 – 100.9 [Obama, +16.3]
Jan 1st, 2021 – 90.6 [Trump, -10.3]
July 21st, 2023 – 100.8 [Biden, +10.2]

US Dollar Collapse Predictions: The Morality of Freezing Central Bank’s Reserves

Now in the space of a year, both the Afghan and Russian forex reserves overseas have been frozen with a proverbial “single click of a button”.

Already a portion of the $7B of the Afghan reserves is going to be split among the 9/11 families and humanitarian assistance. So, in Afghanistan’s case even if relations normalize with the ruling Taliban elite or even if they are overthrown by a friendly democratic regime some of the money will never come back as it is already being given away.

Something similar where the frozen Russian central bank reserves are given to the Ukrainians would not be too farfetched at this point. Keeping aside the moral question of the money helping the Russians and the Taliban this has opened Pandora’s box on whether the money in US Treasuries and dollars especially parked overseas is safe or not. Even the venerable Wall Street Journal in its recent op-ed opined with the headline “If Russian Currency Reserves Aren’t Really Money, the World Is in for a Shock”.

The unwritten principle from the past few decades that central bank reserves are sacrosanct has been thrown out of the window in a flash. Any country that threatens the West/US alliance or dares to cross them could have itself on the wrong end of sanctions including being pushed out of the dollar-based global monetary order. Nations that have gradually earned their forex reserves with years of traded surpluses will be wary of putting their wealth at the mercy of other powers. It’s not just about the principal amounts they’ve saved, but also about the potential growth of these reserves over time. The best compound interest can significantly magnify the value of these reserves, making them even more critical to safeguard. In the current geopolitical climate, the challenge is not just to earn and compound these reserves but to ensure they remain untouchable by external forces.”

The Russian ruble after getting devalued a lot versus the US dollar has now somewhat stabilized but it is still ~40+% lower than before the Ukraine invasion. With Russia being frozen from the Western banking system it will be hard to get dollars to transact with the rest of the world. Russian central bank to stabilize their local currency (ruble) prevented citizens from exchanging rubles for dollars. Russia even before 2022 had been gradually increasing its trade with China in yuan/rubles (i.e., moving away from the dollar).

Russia on a daily basis exports around $1B of natural gas to the rest of Europe. They are now asking the European gas importers to pay in rubles instead of dollars. This forces European nations to exchange their dollars and euros for rubles to fulfill their energy payments to Russia. This creates more demand for rubles helping stabilize their currency against the dollar/euro.

India also has been using the rupee-ruble pair to avoid CAATSA sanctions and now with Russia being cut out of the financial system, this trade is bound to grow given India’s dependence on Russian military hardware/spares. If more nations to de-risk themselves from ending up in a position like Russia start moving away from the dollar system, it chips away at dollar hegemony in the long run. Already OPEC nations such as Saudi Arabia have sought to explore deals to sell oil to China in yuan (vs. dollars).

US Dollar Collapse Predictions: Foreigners have been selling US Treasuries

For the past 7+ years, foreigners have been net sellers of US Treasuries (vs being net buyers pre-2015).

Note: Image courtesy of hedgopia.com

Now if other nations start to more aggressively selling US Treasuries (on a net basis) than ever before, this will increase the cost of borrowing for the US government which is already facing high levels of debt. To keep interest rates low, the Federal Reserve would have to step in as a measure of last resort for buying these Treasuries. Otherwise, with very high interest rates it risks bringing down the whole highly leveraged and indebted financial system.

China gave its huge US Treasuries portfolio (in excess of $1T reportedly) if it has plans for reunification with Taiwan it will want to sell these Treasuries before making any move on Taiwan. Any country by itself selling US Treasuries might not have a massive impact but if a significant number of countries follow through there would be long-term issues for the dollar and the United States.

Many smaller countries that have dollar-denominated debt can’t print out of a crisis like the US does. Being the reserve currency US can print more of its own currency which combined with the foreign buyers of US Treasuries allows the US to print its way out of any financial crisis. However, the cost of all this printing of US dollars comes with bad consequences for other nations who now are mired even deeper in financial repression.

US Dollar Collapse Predictions: Could the Chinese Yuan replace the Dollar?

In 1944, during the Bretton Woods conference British economist, John Maynard Keynes proposed BANCOR a new neutral reserve currency that would be used for settling international accounts. However, the US overruled this proposal in favor of a system of fixed exchange rates using the U.S. dollar (which was a gold standard currency for central banks) as a reserve currency.

Now if commodity-rich nations such as Saudi Arabia and Russia suddenly decide to not use the dollar for global trade, then the trillion-dollar question is what would be the next global reserve currency? Looking back at the history over the past few centuries, one has seen that the global reserve currency has changed hands every ~80-100 years. The dollar is nearing the 80-year mark also so a change of the guard in the next few years would not mean a deviation from the historical norm.

Note: Image courtesy of https://medium.com/road-less-ventured/why-bitcoin-could-become-the-world-reserve-asset-4100f54b1093

The global reserve currency has been closely aligned with the overarching power in the world at that moment in history. China being a rising power sees itself as a Great Power (in its own mind at least) and would be in the mind of many as “calling the shots” in what the next global currency would be. While in theory, China would not mind having most of the world trade be conducted in yuan given the Triffin dilemma that the US faces today this would be an obstacle.

The Triffin dilemma is the conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies. The use of the US dollar for global trade creates a big demand for dollars from all around the world leading to the dollar strengthening relative to other global currencies. This dollar strength made US exports become uncompetitive compared to their peers overseas. This has led to the hollowing out of the US manufacturing sector and a flight of jobs over the past few decades. This has imposed heavy costs on those who worked in blue-collar jobs across many areas of the US including the so-called “Rust Belt”.

China being an export-led economy would not want to fall into the same trap as the United States. While they would like to have global trade denominated in yuan in principle (as a matter of national pride) one doubts if they want their exports (which are a big part of their economy) to become more expensive. Also, for all trade to settle in yuan China would have to export yuan to many other nations that would need yuan to settle trade with their trading partners. Given the strict capital controls in China, it would be surprising if China allowed a lot of yuan to go out of the country to foreign shores.

China has benefitted from the dollar system (running up trade surpluses year after year) where they can have their exports cheaper due to dollar strength so they would not mind having the reserve currency as something other than their own currency. Even if China wanted to set up the yuan as a default reserve currency the question is would other states fully embrace it?

Today due to tensions with the West, Russia is forced into a friendship with China but they were not on the best of terms always including a military skirmish in 1969. Chinese from time to time bring up their territorial claims in the Russian Far East including Vladivostok which they say were given up by China as part of unequal treaties during their “150 years of humiliation” with foreign powers and now they want it back. Many other Asian neighbors including India, Vietnam, South Korea, Japan, etc. with which China has adversarial relations would also be wary of adopting a yuan-based reserve currency where they would be dependent on China to obtain yuan for their trading.

Also, in the event of military hostilities with China or its allies, they (like what Russia is facing right now) could be “cut off” from the reserve currency yuan which would be determinantal to them.

A return to a system like BANCOR (neutral reserve currency) proposed by Keynes in 1944 would require active cooperation between many nations across the world. With active geopolitical tensions among various sets of nation pairs: Russia and USA, USA and China, Europe and Russia, Saudi Arabia/UAE and Iran, etc. the chances of another “Bretton Woods” kind of consensus are next to nil.

US Dollar Collapse Predictions: Gold and Bitcoin to Replace US Dollar?

Many macroeconomics watchers Luke Gromen macro analyst and founder and president, of Forest for the Trees (FFTT) have mentioned that in the future world-neutral assets like Gold or even Bitcoin might be used to settle transactions for cross-border trade. Gold and Bitcoin being neutral assets removes the Triffin dilemmas for nations while also providing options that are also to an extent free of counterparty risk.

GOLD has been around for centuries and was used as a medium of exchange in older times. Gold reserves can be kept locally which eliminates depending on other nations to purchase let’s say dollars or yuan or some other currency to affect trade. Russia already is reportedly considering accepting payment for natural gas from “unfriendly nations” in gold. This eliminates the need to convert the dollars into rubles they get for oil/gas payments which are now harder given the sanctions. Russia has one of the highest gold reserves in the world at $130B+ which they can use as collateral to trade (in lieu of now hard-to-come dollars).

Greater adoption of gold-backed trading is bound to increase the price of gold in which case given their large reserves is going to benefit them the most. Nations could directly trade with each other in gold eliminating the threat of sanctions via 3rd parties. However, transporting huge amounts of gold between nations would have its unique challenges in terms of transportation, security, and insurance for such transfers. Gold also requires a strenuous audit for its weight and quality/purity which would be other overheads added in this kind of monetary system. One can in theory settle the trade between 2 nations on a “net basis” (vs. trying to pay by gold for every small transaction between both) but this would entail the government having to pay the individual entities till the overall trade is settled as one final transaction.

BITCOIN: The other possibility for the next global reserve currency floated by some (especially by Bitcoin enthusiasts) is Bitcoin. Unlike gold which is physically hard to move given its weight and the cost of security/transportation Bitcoin has no such challenges. The amount of Bitcoin on the open ledger can easily be verified and there is no counterparty risk if it is held securely by individuals/nations. Also, gold requires large-scale auditing of gold and verification of the gold itself (i.e., purity) which Bitcoin does not. Russia recently has indicated its willingness to even accept Bitcoin for its oil and gas.

Accepting Bitcoin for all global trade right now would be a Bitcoin purist’s ultimate dream but given the amount of liquidity in the Bitcoin market, it would interesting to see how such a thing would play out. More development in the L2 (Layer 2) application space like Lightning Network could help overcome this challenge. While with the passage of time, the volatility in Bitcoin is reducing (on a relative basis) for some traders, the volatility might be unappealing to transact in. A mitigation mechanism like instantly converting the Bitcoin transactions back into local fiat currencies would help overcome the volatility issue. Bitcoin either on the main chain or via L2 applications like the Lightning network with its low fees would be cheaper in terms of costs to move money from buyer to seller compared to traditional finance channels.

An example of this is the Lightning network used by El Salvadorian expatriates sending money to relatives back home via the Lightning network vs. traditional methods such as Western Union. The money is sent back home at a fraction of the cost compared to Western Union there is no need for their family members to make an arduous trek to the nearest Western Union office which could not only be time-consuming but also prone to interdiction by criminal gangs who could ask for their “cut” in lieu of safe passage.

Bitcoin network is decentralized would make it exceedingly hard for nation-states to block other nations from trading in it making it highly censorship and sanction-resistant. A nation does not have to remain in fear that antagonizing Nation A where it parks its forex reserves or angering Nation B which has the global reserve currency can inflict economic pain if it does not do the bidding of the other nation. With Bitcoin, no government or a set of actors can inflate the currency away or manipulate it to the detriment of other nations.

US Dollar Collapse Predictions: Epilogue

The recent events have brought into focus the pitfalls of a reserve currency where other nations can’t control their own reserves and hence their own economic destiny. Once friendly nations could in the future turn on one another leading to sanctions on the smaller nation and/or it being cut off from the global economic system. A bigger nation could use the threat of sanctions to “mold the behavior” of a smaller state to its own liking. This has brought into focus neutral assets that are harder to sanction, block, and seize such as Gold and Bitcoin. Once derided as flights of fantasy of “gold bugs” and “bitcoin maxis” a transition to them being used to settling cross-border payments does not seem as outlandish as just a few months ago.

Russia and even other states might opt out of the current system by in the future explicitly denominating a barrel of oil in ounces of gold or a cubic foot of natural gas in Satoshi’s (i.e., a smaller unit of Bitcoin). Given the current commodity price spikes, many nations (unless they diversify quickly to other sources which take some time and cost) might be forced to pay Russia by these new mechanisms due to the lack of choices. [i.e. forced to the new payment system “kicking and screaming” vs gradually adopting it voluntarily]

This does not mean that the US dollar will lose its reserve assets tomorrow, but it is on the way out. On the geopolitical front as the world moves from a unipolar America to a multipolar world, there could be something similar in the economic sphere where we could have multiple reserve currencies operating at the same time!

Legendary investor and billionaire Stanley Druckenmiller in an interview last summer said that he does not expect the dollar to be the reserve asset within 15 years. The 2020 decade has been one of massive upheaval with all sorts of problems: pandemic, supply chain issues, massive central bank printing, inflation, geopolitical tensions, great power rivalry, war, commodity price shocks, etc. Given the events of the past couple of years in this decade, it would be hard to say what the future holds in terms of the next reserve currency be it Gold or Bitcoin or something else but it would not be surprising that the if the dollar does not have global reserve currency status by end of this decade.

Is the Dollar Collapse a Myth?

In recent times, there have been several claims about the US dollar losing its market share as a reserve currency at a faster rate than commonly believed. However, Brad Setser, an economist and expert on international finance, disagrees with these claims, arguing that the dollar’s share of reserves didn’t actually change at all in 2022.

Setser explains that the immobilization of Russia’s reserves actually froze far more euro than dollar reserves, indicating that shifting reserves to Europe wasn’t sufficient to offer real protection from coordinated sanctions. He also emphasizes that while global reserve accumulation stopped in 2022, this was not a result of the US dollar’s decline.

The data on reserve holdings adjusted for changes in US bond market valuation does not show any significant US dollar sales. In fact, no currency experienced large reserve inflows in 2022. Setser points out that it is essential to consider the foreign assets of state banks and sovereign wealth funds when analyzing reserve trends, as they provide a more comprehensive view of the global financial system.

Although the dollar’s share of all official flows may have decreased slightly, this is likely due to the dollar’s share of sovereign wealth funds being lower than its share of reserves. Moreover, countries often buy euros and yen to maintain their currency shares constant with the US dollar.

Setser argues that there wasn’t a significant shift out of US dollar reserves in 2022, despite the claims made by some analysts. He does not deny that the global financial system is evolving in response to sanctions, but he believes that the alleged decline in the US dollar’s status as a reserve currency is not supported by evidence.

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