The USA $ is the worlds reserve currency. Where ever you travel, they'll take your USA dollars. And every country keeps USA dollars in reserve. When ever there is a crisis in the world, the term "flight to safety" is synonymous with the purchase of Treasury Bills. And while the dollar has weakened against the UK pound and the euro, we remain the worlds most trusted currency. But what if that were to change? What if a flight to safety were not to translate into Treasury Bill purchases? Or what if countries like China decided the "mighty dollar" wasn't so mighty after-all and started to reduce their holdings?
These questions are hardly improbable! To the contrary, there are economists around the world who are warning of this possibility. If it were not for the fact that there are huge problems with euro member countries finances too, the dollar would be even weaker against the euro than it already is! China which funds our debt, does so because American imports are critical to their factories. But as their massive population raises its level of consumption the need for USA imports will diminish and the potential desire to finance our debt may wain. The Chinese may be planning for this which may explain why that they've been staying much shorter in their T-bill terms they purchase (e.g. more 2 yr, 5 yr. and less 20 yr. and 30 yr.).
Rumors have been circulating for years about the collapse of the USA dollar and its replacement with a new currency that would join the USA and Canadian dollar and the Mexican peso. That seems unlikely to me, but the mighty dollar doesn't have to collapse altogether for us to have some very serious problems. All that has to happen is for the USA dollar to lose its luster.
If the world starts to favor other currencies and shy away from USA T-Bills. Rising T-Bill interest rates would push up interest rates and USA borrowing costs. In turn, our massive budget deficit and debt would be far more expensive to carry. This effect would compound the challenge of balancing our budget!
Put it all together and this is a possible sequence of events: Interest rates on T-Bills rise to attract their sale causing Federal debt costs to rise. The government is forced to dramatically raise taxes and cut even more spending. The combination of higher interest rates and higher taxes and large fiscal spending cuts would represent an enormous drag on GDP. As the economy slips so would tax revenues. At that point we've created a terrible negative spiral! Add in the expectant massive stock market reaction. Add in the likelihood that consumer and business spending would cease up. Add it all up and we have an economic disaster! But this disaster would make the last "financial crisis" and recession look like the preview to the real show, a depression!
Far fetched? Not really. It could literally begin overnight. All it would take is for the collective concern that already exists over the way the USA is dealing with its deficit, to morph into collective fear over our ability to deal with our debt. Fear often turns into panic. Panic turns into over-reaction. Over-reaction results in a sell-off. If that happens, then we're off to races!
There is an alternative scenario. A much more positive one, thank goodness. But I'll save that for another time.
NOTE: Since publishing this post I find it interesting that this last week in February, despite world tensions that rippled through the world and USA stock market, there was not the classic strengthening in the US Dollar that we typically see.
Related articles:
Three Investing Gurus See Dark Days Ahead for the Dollar
Traders 'Short' Dollars As Currency Loses Attraction
Debt Facts
The Dollar: Safe haven no more
Truth-0-Meter: USA Debt Compared to Other Countries