Wednesday, 25 March 2009

So when exactly will the dollar collapse?

It seems that many economists are predicting the collapse of the US dollar. The argument goes something like this: The U.S. government is in huge debt. It maintains its borrowings by selling bonds. These bonds have to compete on the open market with other types of investments, so they have to offer a competitive balance of interest rate, security (against default) and protection against inflation. At the moment, the US is clinging on to the edge of the cliff for some rather temporary reasons...
  1. People are still holding on to the (perhaps irrational) belief that the U.S. government could never conceivably default on its bonds and so the "risk premium" the US needs to offer on the bonds is negligible.
  2. The rest of the world is in such a dire state that they don't know where else to put their money.
  3. There is not much (obvious) inflation in the US.
Now many of the people who believe in the Armageddon scenario are being ridiculed by others who point to the relative strength of the dollar compared to so many other countries. But these three conditions can not remain favorable forever. I have been thinking about when exactly the dollar bubble will burst and it just occurred to me that there will be an upper limit - and that is when the first few countries start to pull out of this recession. As soon as that happens then there will be a new place for investors to put their money. The result of this is that US bonds will now have a serious competitor and the only way that the US can compete would be to raise the interest on their bonds... now this would quickly become very painful for the US and all their options would be horrid... they would fall off the cliff.

This is of course just an upper limit... the dollar collapse could be triggered before then at almost any time... including tomorrow.

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