The Coming Collapse of the US Dollar

When central bankers interfere with currencies they harm not just the economic interests of their own country but also create global imbalances. The world’s most important currency is, at least for the foreseeable future, the US dollar. The head of America's central bank is Ben Bernanke. Mr. Bernanke has been criticizing China for its currency manipulation at the same time as he has been manipulating the value of US currency by printing trillions of dollars.

The US bond market has been rallying for 30 years. The most important short term interest rate is set at 0-0.25%. Long term interest rates are at a record low. This is clearly not the configuration of interest rates that would be set by a free market in an economy that is still in the midst of a crisis. There are several factors which are maintaining interest rates at such low levels and none of them are the product of capitalism.

Firstly, the reserve currency status of the US dollar has meant that since the end of WWII nations have found security and a steady return in US government bonds. This privilege has meant that for decades savings have been flowing into the United States, so American citizens haven't had to produce anything in order to generate their own savings. This accounts for the decline in manufacturing in the US over the years. The US has now become a country that uses the savings of other countries to purchase the goods that other countries produce! This has contributed to a massive trade deficit, budget deficit and has contributed to America's looming sovereign debt crisis.

Secondly, interventionist philosophy in China has guided policymakers into pegging the yuan to the US dollar at a rate below that which would be determined by a free market, in the hope of gaining  an edge in export markets. But in order to maintain the currency peg, China must devalue their currency in line with  the devaluation of the US dollar. To do this, the Chinese central bank prints yuan and uses them to purchase US government bonds. The pace of currency devaluation has been intensifying in recent years as Chairman Bernanke, following the principles of interventionism, attempts to revive the ailing US economy through quantitative easing.

Thus, in order to maintain the peg, China has been increasing their holdings of US government bonds and decreasing the value of their currency. This, and not burgeoning demand, is the cause of the current Chinese  inflation. China now holds almost $US1 trillion of American government bonds. Note that these bonds are denominated in US dollars and so lose value as Bernanke prints more dollars.

Now let's bring Japan into the picture. Japan, like the US, has maintained their most important short term interest rate at 0% for years. This undervaluation of the yen has been exacerbated by investors who borrow from Japan at 0% and invest the money elsewhere for a profit. This has the effect of increasing the supply of yen in the foreign exchange market and helps to maintain an undervalued currency. Importantly, Japan (like China) has used its excess yen to purchase US government bonds and has accumulated nearly $US1 trillion worth of them.

Japanese policy makers are guided by a philosophy which tells  them that a stronger currency will weaken the economy by reducing their  competitiveness in export markets. But as we have seen earlier, increased exports is not what Japan needs right now. They need to be able to import goods from abroad. Regardless, in order to maintain the wrongheaded policy of currency devaluation, the Bank of Japan must continue recycling freshly printed yen into US government debt.

If Japan stays on their current policy path they will shortly be confronted with intensifying inflation and this will make the necessary imports unaffordable. The only cure for these issues is a stronger currency. So, a scenario is currently developing whereby the Bank of Japan will eventually have no choice but to strengthen the yen by selling US  government bonds.

When Japan - the world’s third biggest holder of US government bonds - begins selling US dollars, the yen will rise but conversely the US dollar will fall. Simultaneously, a massive hole in the US government bond market will open up. Finding investors to fill this hole is highly unlikely given the structural imbalances in the US economy and the decreasing value of the US dollar. In fact, this is the reason that the Federal Reserve is involved in buying US government bonds in the first place. The Fed is now the world’s largest holder of US government bonds and will shortly own more bonds than China and Japan combined.

This means that interest rates in America will begin to rise as Japan’s  savings are withdrawn from the market. To appreciate the impact of this, consider the precarious position of the US economy even now at record low interest rates and imagine where the US economy would be if rates were higher. The US economy will begin to tank. In a last  ditch attempt to maintain 0% interest rates the Federal  Reserve may step in with a third round of quantitative easing to buy up  the bonds that Japan sells. But the Fed can only purchase bonds with money it creates out of thin air so this procedure would intensify US inflation.

As America's inflation intensifies and US dollar denominated assets such as government bonds become worthless, there will be strong incentives for China to follow Japans lead, de-peg their currency from  the US dollar and dump their US government bonds.

Once this happens, the United States will face the most important decision  in its history: due to their low savings and the reluctance  of foreigners to continue to supply savings, America will  either have to default on its national debt or inflate their way out of debt. The ultimate result of these choices are deflation and hyperinflation (think Zimbabwe) respectively.

When the crisis occurs, the blame should be directed squarely at interventionism. Free market capitalism would have prevented this crisis in the same way it would have prevented all crises throughout history.