What It Would Take for the U.S. Dollar To Collapse

Imagine waking up to a world where the U.S. dollar (USD), the bedrock of global finance, has collapsed. This scenario may seem far-fetched, but it’s a narrative often found on dubious platforms pushing gold, crypto, and extremist political views, and it occasionally creeps into mainstream discourse. The greenback has always had its external foes during the long period of its dominance—from the communist bloc and anti-colonialists to contemporary adversaries like China, Russia, and other emerging powers. Meanwhile, critics argue that mounting inflation, the rising U.S. federal deficit, and government entitlements could bring down the USD’s dominance from within.

Given the ever-present economic and political uncertainty of geopolitics, pundits have predicted the dollar’s collapse ever since the greenback gained worldwide supremacy. They’ve been wrong each time—though a prognosticator needs to be right just once to gain fame in financial circles. Nevertheless, we shouldn’t be too sanguine: history shows that even the sturdiest of human edifices crumble, becoming ruins future generations barely notice as they trammel them underfoot.

To be clear, there are no such signs on the horizon. While about a fifth of the foreign currency reserves of the world’s central banks have moved away over the last quarter century, from 71% to 58%, that’s still a dominant position of strength for the greenback worldwide, let alone as a worthwhile currency within the U.S. In this article, we’ll explore the calamitous coincidence of events needed to dethrone the dollar, examining historical precedents, contemporary vulnerabilities, and potential scenarios.

Why Currencies Collapse

A currency collapse is a severe and sudden decline in the value of a nation’s currency, leading to economic instability, financial distress, and often political turmoil. This phenomenon includes skyrocketing inflation, vastly increased prices for imports, and a mass movement of investors out of the currency, if not the home country itself. In simple terms, a currency collapse means that the money people use every day loses its value rapidly, making it difficult to buy goods and services, repay debts, and maintain economic stability.

Argentina, Hungary, Chile, Angola, Zimbabwe, and Germany have all experienced horrific currency crises since 1900. The root of any collapse stems from a lack of faith in the stability or usefulness of money to serve as an effective store of value or medium of exchange. As soon as users stop believing that a currency is useful, that currency is in trouble.

What Is a Currency Crisis?

To start off, we can borrow from a now-classic paper by Graciela Kaminsky in the wake of the major currency crises in Mexico and across Asia in the 1990s, which provides the often-used categories for how economists have defined what a currency collapse is. Here are the types of crises (the examples are our own):

1. Crises with current account problems: These crises are marked by a loss of competitiveness, often because of real exchange rate appreciations. This can happen because of various factors, including overvaluation of the currency, rising production costs, or trade policies that disadvantage domestic producers. When a country’s goods and services become too expensive for foreign buyers, the demand for its currency falls, leading to devaluation and potential collapse.

Example: Argentina’s currency crisis in 2001 was partly because of a significant loss of competitiveness. The fixed exchange rate regime led to an overvalued peso, resulting in a severe current account deficit and, ultimately, a currency collapse.

2. Crises of financial excesses: These arise from booms in financial markets, characterized by a previous and unsustainable growth in domestic credit.

Example: In 2008, Iceland experienced a financial crisis characterized by a rapid expansion in credit and financial markets. The country’s banks accumulated significant foreign debt, and when the global financial crisis hit, these financial excesses led to a collapse of the Icelandic krona.

3. Crises of sovereign debt problems: These are linked to “unsustainable” foreign debt levels.

Example: In the early 2010s, Greece’s debt crisis was driven by catastrophic levels of foreign debt. The country’s inability to service its debt led to severe austerity measures and a dramatic devaluation of its economic stability within the eurozone.

4. Crises with fiscal deficits: These result from expansionary fiscal policies. When investors perceive that a government is unable to manage its economy effectively, they may withdraw their investments, leading to a currency collapse. 

Example: Brazil faced a currency crisis in 1999, exacerbated by large fiscal deficits. The government’s expansionary fiscal policies led to a loss of confidence, resulting in a sharp devaluation of the Brazilian real.

5. Sudden-stop crises: These occur because of sudden reversals in capital flows, typically triggered by sharp increases in global interest rates. These crises, then, are externally driven. Countries heavily reliant on commodity exports, like oil or metals, can see their currencies plummet if global prices for these commodities fall sharply. 

Example: In 1994, Mexico sustained a sudden stop in capital inflows triggered by a sharp rise in U.S. interest rates. This external shock caused a massive outflow of capital, leading to a severe devaluation of the peso.

6. Self-fulfilling crises: These occur without any apparent domestic or external vulnerabilities.

Example: In 1997, the Thai government took the baht off its peg to the dollar, given the currency trading pressure that had suddenly appeared in the previous months. This marked the beginning of the Asian Financial Crisis an example of a self-fulfilling crisis. Initially, there were no clear signs of vulnerability, but speculative attacks on the baht led to a loss of confidence and a dramatic devaluation.

How a U.S. Dollar Currency Collapse Could Happen

Now that we know how a currency could go under, let’s imagine a scenario not too far from those depicted in the jump cuts at the beginning of post-apocalyptic movies. The dollar collapsing would require the convergence of improbable events that would tear much of society apart. The scenario is heuristic, not predictive.

1. Trigger event: A combination of escalating geopolitical tensions and a major cyberattack on U.S. financial institutions severely disrupts global markets.
2. Loss of confidence: Investors panic, rapidly selling off U.S. Treasurys and other dollar-denominated assets, triggering a steep decline in the dollar’s value.
3. Inflationary spiral: The weakened dollar makes imports more expensive, fueling already high inflation rates. The U.S. Federal Reserve raises interest rates aggressively to combat inflation, but this has little effect, even as domestic businesses can’t find the dollars to pay for materials and keep workers on. Economic activity now collapses.
4. Debt crisis: The combination of higher interest rates and a sliding economy makes it difficult for the U.S. government to service its massive debt. Concerns about a potential default rise, further eroding confidence in the dollar.
5. Economic Crisis: The U.S. economy plunges into a deep recession, marked by high unemployment, business failures, and a collapse in consumer spending. Anyone who can move their money abroad is doing so.
6. Loss of reserve status: Foreign governments take the cue, and central banks, alarmed by the dollar’s instability and the U.S.’s economic woes, begin a race to get themselves out of USD before everyone else does. This breakdown in demand for the USD is self-fulfilling: no one wants to be the last ones holding increasingly worthless greenbacks.
7. Search for alternatives: Countries and investors shift into alternative currencies, such as the euro, Chinese yuan, or a basket of currencies, for international trade and investment. The world economy is reeling, too, as currencies pegged to the dollar are in free fall, and the declining dollar is wiping out much of the value in central banks worldwide.
8. Social unrest: Economic hardship and growing inequality fuel widespread social unrest, further destabilizing the country and undermining any calming messages representatives put out to quell the damage.
9. Dollar collapse: The dollar loses its status as a viable currency and gets no takers for international transactions. The U.S. faces a prolonged period of economic and political tumult.

Strengths of the U.S. Dollar

Since the Bretton Woods Agreement in 1944, many of the world’s central banks have relied on the U.S. dollar to back up the value of their currencies. Through its reserve currency status, the dollar receives extra legitimacy in the eyes of domestic users, currency traders, and participants in international transactions.

The U.S. dollar is not the only reserve currency in the world, though it is the most prevalent. The International Monetary Fund (IMF) has approved four other reserve currencies: the euro, the British pound sterling, the Japanese yen, and the Chinese yuan.

Below is a table of advantages the USD has as a globally dominant currency.