I’m something of a Ron Paul fan but sometimes he says something that really grates. In the car this morning I was listening to a Ron Paul podcast in which he said he feared the collapse of the US dollar. He went on to say that when currency collapse comes it generally comes very quickly. This grated  because it seems quite counter intuitive. The USA is one of the biggest economies in the world. In spite of recession they are still a power house with nearly 25% of all global production occuring within the USA. However I decided I’d give this question some more thought.

Firstly I should say that I’m not a recognised expert on monetary policy. I know enough to say that most economists have only a modest grasp on the issues. And beyond currency traders (and even including a lot of them) those in the finance sector generally only have a microeconomic understanding of money. As such I feel quite comfortable sticking my nose into this domain.  

So could the US dollar collapse? Firstly we need to decide what a collapse might mean. If collapse merely means losing 5% of value in a year relative to the EURO then collapse sometime during the next decade is probably inevitable. Of course the prospect of recovery from such a position is also probably also inevitable. If collapse means losing 99% of it’s value eventually anytime in the next 1000 years then obviously this is also probably inevitable. For the sake of a sensible definition we might assume collapse means losing 80% of it’s value within a 2 year period and a subsequent general inability to recover. And again for the sake of argument I’ll assume that the benchmark for value is the exchange rate relative to the EURO. We could choose Yen or gold or Pounds but simply for the sake of a conversation I’ll choose the EURO.

The value of a currency is determined by two factors and two factors alone. They are the demand for that currency and the supply of that currency. And supply and demand are merely flip sides of the same coin (excuse the pun) depending on your vantage point in a transaction. We can complicate things by looking at credit multipliers and the like but at the end of the day credit merely effects the value of currency by acting as a product substitute in some instances and so it may effectively dampen demand. In the final analysis it is just supply and demand that operate. Our modern fiat currencies are generally managed by central banks and the US dollar is no exception. Managing a currency generally means working to avoid collapse or a painful inflation or deflation.

So how does a central bank “defend” the value of a currency.  If a large number of people decide to dump your currency on the market the value will decline and ultimately the only thing a central bank can do in that situation is to let the value fall or to start buying back the currency. It may buy under the banner of increasing interest rates but this is merely symantics, the mechanics still entails buying through what they call open market operations. Of course it is possible that a central bank will simply allow the currency to fall but I won’t be so petty as to suppose that the central bankers might all leave on vacation on the same day. I’m assuming they don’t want the currency to collapse and will act according. I’m interested in knowing if things can occur that will take the avoidance of collapse out of their hands entirely.

How does a central bank buy currency? There is only one way a central bank, including the US central bank, can buy back it’s currency and that entails selling it’s assets in exchange for the currency. If it holds gold it might sell gold in exchange for US dollars. In so doing it provides demand for the dollar, or seen another way it reduces the supply of dollars in circulation. So it would seem that as long as it holds assets the central bank can keep on buying back currency and arrest even the most vicious dumping of the currency by other parties without any significant consequence for the value of the currency. In fact this is the case, so long as it holds enough assets.

So what are the assets of the US central bank? Well I had to dig a little but primarily they are securities (ie bonds). Primarily US government securities. Unlike our central bank they don’t appear to hold a lot of foreign currency or gold. The gold in Fort Knox belongs to treasury not the central bank. So mostly their assets are mostly piece of paper from the US treasury that say IOU so many dollars. And it has a lot of these. Slightly more in fact than it has US dollar notes in circulation (including the esoteric electronic version of notes it stores for commercial banks – don’t tie yourself in knots worrying about the distinction). So for the US dollar to collapse it would seem that the value of these assets would also need to collapse. This is where it gets interesting.

If I have an IOU that says “Fred owes Terje three goats” then the value of that IOU is determined by two things. One is the value of goats. The other is the financial credibility of Fred. Perhaps you can see where this is leading but let me spell it out a little using the terms in this example.

We have these things called goats that have value. If people dump goats on the market we can defend their value by buying up lots of goats. To buy the goats we sell these assets called ”IOU goats”. However if the value of goats is declining so is the value of “IOU goats”, and in fact they are losing value in direct proportion. This may seem odd but in spite of this circular relationship we must admit that the game of defending the value of such goats in such a manner generally does work and has worked for a very, very long time. Much of the worlds trade is done using currencies built on such circular constructs. Perhaps it looks flawed but empiracly it works.

However lets imagine now that Fred owes too many goats and his business has stagnated and he decides that he will default on his debts. Now those “IOU goats” will be worth next to nothing because Fred is no longer credible financially. And if those assets are worth next to nothing then suddenly we have no assets with which to defend the value of goats. Suddenly the game is up and all it takes is a slight breeze and the house collapses, along with the currency.

In summary and putting it back into real world terminology I’d say that given the asset profile of the US central bank the collapse of the US dollar is possible on two counts. One is if the dollar declines rapidly and as it does so it takes down the value of the assets in a vicious circular decline. Perhaps it would be prudent for the US central bank to have a more diversified asset base. Some gold perhaps. Maybe some more EUROs. However ultimately I don’t think the long standing game of defending the value of dollars with “IOU dollars” is suddenly going to stop working on this basis. It is a robust well tested technique in spite of it’s apparent circular nature.

The second way the dollar could collapse is if the US government can’t repay it’s debts. If this happens then on reflection I’d be inclined to agree with Ron Paul. Currency collapse could come extremely rapidly. And in this situation the central bank, in spite of all the best intentions in the world, and even if they employed the best brains in the world, couldn’t then escape such a vortex. Certainly not with US bonds as a primary asset base.

A counter point might be that if the US dollar collapses in this way then so will the other currencies of the world if the respective central banks hold primarily US dollar assets as their backup. So maybe we have a synchronised collapse and the US dollar doesn’t fall 80% against the EURO because the EURO also collapses. None the less the collapse would be felt relative to real goods in the form of extreme inflation.

Is any of this likely? Personally I think the USA can avoid default on it’s debts. It is AAA rated so not likely if ratings still mean anything. Also as I said in the beginning they have a huge proportion of the worlds production. They have enormous scope to cut government spending (eg military expenditure) to turn their government finances around. They have lots of smart people. I’d like to think that smart people with lots of resources can avoid impoverishing themselves through excessive government debt.