My favorite game as a child growing up was to mess around with a deck of cards and try to stack them to build a house. You have to carefully place your card in a certain manner because it is so delicate and unstable, the whole house can fall down in an instant. This unstable and fake house made of cards would never be thought of as a comparison to the money we all spend on a daily basis. More over we all believe it has meaning and importance. As a result of our belief, it does have meaning and purpose. This example is the definition of a fiat currency. The dollar is not backed by gold anymore, instead it is now backed by something not so tangible: confidence. Through our debt, lack of international faith, and global competition I believe there is possibility of a currency crisis in our near future.
What is a currency crisis exactly? To understand what a currency crisis is we should make sense of Balance of Payment accounts. These are accounts of financial transactions between one country and the rest of the world. A currency crisis occurs when a currency is suddenly devalued usually caused by persistent balance-of-payments deficits. It is a type of financial crisis that affects a broad part of an economy. The value of the currency changes in a blink of an eye because it is undermined to serve as a store of value or medium of exchange.
A reserve currency is a currency that is held in large amounts by many different governments for their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market and various commodities. The main world reserve currency is and has been the US dollar for decades. Barry Eichengreen of The Wall Street Journal reports, “More than 60% of the foreign reserves of central banks and governments are in dollars.” When countries trade with other countries, it is common practice that one country asks for the others currency converted into dollars. For example if a country is dealing with Mexico, they'll ask for dollars instead of pesos. The dollar is held its reign as the world reserve currency for many reasons. The dollars faith has come from such a strong growth in our economy in the past decades. It is also highly convenient for other countries to use. The amount of derivative tools to hedge against changes in the dollar is a far greater amount than most currencies. It has also been a type of safe haven from having investors turn to it in times of crisis. The U.S. Treasury securities is a very popular asset bought by international governments. This is all fine and dandy however the situation is not as bright and shiny as it seems...
Any bum off the street can tell you that if you owe money, others probably will not have faith in you. One reason for a sudden devaluation in our currency is simple enough: debt. According to usdebtclock.org, our country is approaching 16 trillion dollars in debt. Even through using kindergarden logic you can conclude the US dollar is screwed. According to Credit Suisse economist Dana Saporta of The New York Times, “Getting rid of debt could be a long and slow process.To get back to a 1990s debt-to-income ratio of 84%, households would either need to pay down another $3.3 trillion of debt, or see their incomes rise $3.9 trillion. That’s equivalent to about nine years’ worth of income growth in normal times.” Therefore solely because of consumer debt our economy could stay like this for a good nine years, if Saportas estimate holds true. As our debt grows exponentially, the question of holding onto it or deflating it away still remains; either way we're doomed.
Another argument for why there could be a currency crisis on the loom is because countries are ceasing to accept dollars in trades. The countries that have stopped using the dollar in currency trades are not some uninvolved, no-name countries, but they're big players in the world economy such as China and Russia. Wen Jiabao and Russian counter-part Vladmir Putin have decided to abandon the US dollar for bilateral trade and plan on using their own currencies. They claim they are not intending to devalue the dollar in doing so but to protect their domestic economies. However, whether they're intending to or not, they will devalue the dollar as a result. The value of the dollar is based on the confidence of our economy; because China and Russia are starting to loose faith in the dollar, the demand of the US dollar around the world has shrunk significantly.
Another issue validating the inevitable devaluation of the dollar is economic competition. This is the first time in 50 years America is seeing real competition in the world economy. More competing currencies for being the worlds reserve currency is the last thing we need. China is currently moving rapidly to internationalize the Yuan. “The last year has seen a quadrupling of the share of bank deposits in Hong Kong denominated in yuan.” (Eichengreen) Chinese companies that do international trade in the Yuan as appose to dollar will free themselves from costly foreign transactions. As a result, China will have a bigger hand in the global economy. China's growing currency will affect the dollar inversely and we may be number two before we even know it.
Say were not the world's reserve currency... so what? The currency crisis would mean all the hours you spend as a mindless worker drone will be for nothing. If/when a currency crisis happens to the dollar, the standard of living for everyone will shoot up dramatically. The cost of oil will rise, even the cost of your favorite Abercrombie sweater will skyrocket. It would be a huge slap in the face and wake up call for all Americans. There will not be such cockiness in Americans because of our standard of living anymore when we won't be able to feed ourselves.
Economic news is not a topic many people are enthused to discuss. This is mainly due to the fact that, in the eyes of Americans, it is not fun to talk about the reality of our grim financial situation. But the facts are clear. Through our debt, competition, and lack of confidence, a US currency crisis will occur, unless serious preemptive motions are put in place.
Disclosure: I am long SNDXF.PK.
Additional disclosure: ...In my money and banking Economic class we were allowed to write an essay on anything related to today's economy...