Can We Avoid the Coming Dollar Collapse?

 |  Includes: UDN, UUP
by: Howard Richman

There has been increasing concern in American foreign policy circles lately about the coming dollar collapse. The writers often point to "Triffin's Dilemma" as an explanation of why the crash is inevitable and why only delaying actions are possible. Here's Wikipedia's summary of that dilemma:

The Triffin dilemma (less commonly the Triffin paradox) is the observation that when a national currency also serves as an international reserve currency (as the US dollar does today), there are fundamental conflicts of interest between short-term domestic and long-term international economic objectives. This dilemma was first identified by Belgian-American economist Robert Triffin in the 1960s, who pointed out that the country issuing the global reserve currency must be willing to run large trade deficits in order to supply the world with enough of its currency to fulfill world demand for foreign exchange reserves.

In a June 2010 paper (How Dangerous Is U.S. Government Debt? The Risks of a Sudden Spike in U.S. Interest Rates), CFR's Francis E. Warnock argued that we are now nearing the endgame in which the flight from the dollar produces a dollar collapse. In fact, he even claimed that we almost experienced that crash in 2009:

Late last year, this potential danger came close to becoming reality. Largely thanks to homegrown pressures, unrelated to Triffin’s dilemma, the world’s risk-free asset, the ten-year U.S. Treasury bond, was sagging. With sizeable budget deficits, the prospects of an ever-increasing amount of government debt, the end of the Federal Reserve’s crisis-driven program of accumulating Treasury bonds, and an uptick in inflation expectations, the ten-year Treasury yield increased by fifty basis points from 3.25 percent to 3.75 percent. And further increases were likely. Such increases would not only substantially raise the cost of future government borrowing, but would also threaten any recovery in housing and other interest-rate-sensitive sectors.

Triffin was correct that, as world trade grows, increasing amounts of the reserve currency must be available to finance the international financial transactions. This is a valid monetary principle: there must be enough money available to pay for things. If the currency used in the transactions deflates quickly (i.e., goes up in cost) that causes debtors to have severe problems.

Take the South Korean experience of October 2008, just after the Federal Reserve foolishly closed Lehman Brothers without protecting its creditors, causing a worldwide liquidity crunch which caused the dollar to spike upwards in currency markets. Due to this international deflation of the dollar, many South Korean businesses that had borrowed money in dollar-denominated loans, couldn’t make their payments. Fortunately, the Federal Reserve offered dollar-won currency swaps to the South Korean Central Bank which strengthened the won relative to the dollar while making dollars available to South Korean businesses so that they could avoid bankruptcy.

It was Bernanke’s finest hour. He faced the situation that Greenspan had blown in 1997, and came up with the correct solution. Greenspan had let the won (and the currencies of the other Asian Tigers) collapse without providing any help whatsoever.

The Solution to Triffin’s Dilemma

Bernanke’s currency swaps in October 2008 demonstrates the solution to Triffin’s Dilemma. A country does not need to run trade deficits in order to make increasing amounts of its currency available to other countries. Its central bank can also trade currencies with foreign central banks. Let me explain. There are two ways enough dollars can build up abroad to finance trade:

  1. One Sided Flows. One way occurs when a foreign central bank builds up its dollar reserves without the Federal Reserve building up reserves in that foreign currency. This method causes the dollar to strengthen versus the foreign currency in foreign exchange markets and causes the foreign currency to weaken versus the dollar in foreign exchange markets. The Peoples Bank of China currently builds up dollar reserves, not because it needs them, but in order to keep its currency weak versus the dollar in order to steal market share from U.S. Industries. As a result, China gets investment in tradable industries while the United States does not.
  2. Two Sided Flows. The other way occurs when two central banks swap each others currencies. This method does not cause any change in the relative value of the two currencies. If foreign central banks do not cooperate with the Federal Reserve, then the Federal Reserve can simply buy the same value of their currency reserves that they buy of our reserves. The Federal Reserve already has the authority to buy foreign currency reserves on its own account with or without the approval of the U.S. Treasury.

There is still a way to restore full faith in the dollar as the world's reserve currency and avoid the crash. All we need is to do is:

  1. Balance Trade. Trade deficits cause the dollar to build up abroad and prevent the United States from getting needed investment in its tradable goods sectors. We can easily balance trade with a WTO-legal scaled tariff
  2. Balance Budgets. Our imbalanced budgets threaten the confidence that is needed for investors to put their money in U.S. Treasury bonds. The budget would quickly get balanced if House Republicans stick to their guns and refuse to raise the debt limit this May.
  3. Balance International Money Flows Instead of buying its own treasury bonds (QE2), the Federal Reserve should right now be buying foreign reserves in order to balance trade. If China won’t let them buy reserves, they can make a tidy profit by establishing a Sovereign Wealth Fund to buy Chinese stocks.

Unfortunately, our economic and political leaders are doing none of the above. The eventual dollar crash, spike in U.S. interest rates, and high U.S. inflation is virtually inevitable. All because our economic leaders can't see their way out of Triffin’s Dilemma.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.