Dollar Collapse: Why is it taking so long and what does it mean for crypto?

Research
• May 28, 2024
Dollar Collapse: Why is it taking so long and what does it mean for crypto?

by Ryan Shea, Trakx cryptoeconomist

Key Take-aways

  • Calling for the collapse of the US dollar is a popular sport in the world of crypto. But just like warning that the end of the world is nigh it is a long-standing forecast fail.
  • This naturally leads one to question what is driving these persistent forecasts of dollar decline, why have they been so wrong and what does it mean for crypto?
  • Delving into the underlying macroeconomics it is clear the global financial system is stuck on a path of increasing disequilibrium but there is no obvious Plan B, at least not in the fiat world.
  • In many ways, it is just like the final showdown in the movie The Good, the Bad and the Ugly: it ends, as everyone expects, in a hail of bullets but no one wants to shoot first.
  • For many crypto bros the inevitable transition away from the US dollar as the world’s leading reserve currency is unambiguously bullish for their asset class of choice. However, there is an equally plausible alternative pathway, one that could extend the US dollar’s longevity.

Predicting the demise of the US dollar has a lot in common with warning that the end of the world is nigh. Both are long-standing forecasts fails1. Take the following headline from the Wall Street Journal (see below). It was not written by some gold bug or crypto bro with an investment to shill but instead was written by the esteemed US academic economist Barry Eichengreen, who has forgotten more about the history of the international monetary system than most people can ever hope to learn. It also wasn’t written recently, he made his prognostication over a decade ago. So, despite all his knowledge, like many others before and since Eichengreen succumbed to temptation by predicting (incorrectly) the downfall of the US dollar.

Two Common Forecast Fails

Dollar Collapse: Why is it taking so long and what does it mean for crypto?
Dollar Collapse: Why is it taking so long and what does it mean for crypto?

Source: The Wall Street Journal and The Simpsons

Despite the woeful record of this particular economic prediction it remains very popular, especially in the wonderful world of crypto. The question is what is driving these persistent forecasts of the US dollar’s fall from grace, and why have they been so wrong? In answering these questions we will delve into the crypto implications because this is, after all, the primary focus of these research notes.

Dethroning The Dollar

First to clarify, when talking about the demise of the US dollar what people are really talking about is the greenback losing its status as the world’s leading reserve currency, a mantle it formally assumed from Sterling in 1944 with the birth of the Bretton Woods system.

Attaining reserve currency status requires several things, although economists disagree on the extent to which each of these various factors are important. They include economic dominance, substantial international trade flows and deep and liquid capital markets where investors' property rights are protected by the rule of law (meaning governments are subject to a fixed set of rules that limits the scope for coercion).

In essence, these requirements boil down to the same requirements of all sound monies, namely that they are stable, safe, trusted2 and widely accepted. Monies that satisfy all of these conditions will tend to be held in significant quantities by the central banks and monetary institutions of nation-states, monies that don’t won’t.

With the UK economically and politically weakened by two world wars it’s ability to satisfy the aforementioned conditions was seriously undermined, leading to the US dollar usurping Sterling as the world’s leading reserve currency.

Even today, and despite all the long-running doom predictions, the US dollar remains the most widely owned reserve currency in the world and by some considerable margin. The latest IMF data shows the US dollar accounts for 58% of global FX reserves – roughly 3X that of the next most widely owned reserve currency – the Euro.

Global Allocated Foreign Reserves (% total, Q4 2023)

Dollar Collapse: Why is it taking so long and what does it mean for crypto?

Source: IMF

Exorbitant What Exactly?

One consequence of being the world’s leading reserve currency, and the reason why deep liquid capital markets are required, is that there is demand from the rest of the world to hold the currency, typically in the form of government bonds and other presumed “safe” assets. To absorb these sustained capital inflows, the country with the reserve currency has to run persistent current account deficits, the bulk of which is in the form of trade deficits. This observation was first made by the economist Robert Triffin, which is why this phenomenon is known as the Triffin dilemma or paradox.

Commenting on the US position in the 1960s the French finance minister Valéry Giscard d'Estaing called it the privilège exorbitant because it implied the US and its citizen’s could live beyond their means, meaning they could consume more than they earned vis-à-vis the rest of the world. The other advantage the US gains by having the world’s premier reserve currency is that it provides a financial mechanism to pursue its political objectives beyond its national borders – the 2022 decision to ban Russia from the SWIFT clearing system being a recent example of this soft power being exercised.

However, as compelling as those positives are, having the world’s leading reserve currency is not cost-free. Running persistent current account deficits has an impact not only on the external-focused part of the economy but also on the inward-facing domestic economy. To understand why we need to delve into a bit of macroeconomics, but don’t worry it is not very complex.

One of the most important but least well-understood macroeconomic identities is the sector financial balances. In simple terms, it states that a country’s current account deficit is equivalent to the difference between investment and savings of the private sector (household and corporate) and the government.

Current Account Balance = Net Corporate Saving + Net Household Saving + Government Budget Balance

What follows from this identity3 is that to absorb the capital inflows from the rest of the world – the counterbalance of the US current account deficit - either US households, corporates and/or the government also have to run a deficit.

As can be observed in the following chart showing the evolution of the US sector financial balances over the past 30-odd years, the vast majority of the time it is the government that runs the deficit. Indeed, there have only been two occasions when the private sector went into deficit over this time frame; corporates in the late 1990s and households in the mid-2000s.

US Financial Sector Balances

Dollar Collapse: Why is it taking so long and what does it mean for crypto?

Source: Fred Economic Database

For much of the post-war period, the US economy was able to absorb these capital inflows without too much of an issue4. There was a modicum of concern in the first half of the 1980’s when the “twin deficits” first emerged, but these concerns abated in the decade after as the corporate sector replaced the government as the absorber of foreign capital inflows because the internet-led surge in productivity triggered a boom in US business investment. However, this improvement in the US fiscal position proved short-lived. The budget deficit quickly re-emerged when the dotcom bubble burst and the US economy fell into recession and it has remained pretty sizeable in the two decades since.

The Chicken Or The Egg?

While the sector financial balances identity unambiguously shows that a country’s fiscal and external balances are connected, it says nothing about the causal direction. This “chicken versus egg” debate has been a long-standing bone of contention in the economics profession and a source of great confusion for investors. However, it really shouldn’t be.

Since 1995 there has been a 10X increase in global foreign reserves – see chart below - and, as already stated, the majority is denominated in US dollars. (NB: These reserves are overwhelmingly non-US because US foreign reserves are a paltry $35bn.)

Global Foreign Exchange Reserves (USD tr)

Dollar Collapse: Why is it taking so long and what does it mean for crypto?

Source: Statistica

The growth in global foreign reserves accelerated after the Asian crisis in 1997 when Thailand stopped defending its currency, a move that triggered a wave of devaluations around East Asia. In response to the crisis, supranational organizations like the IMF and the World Bank provided financial support but only in return for these countries implementing substantial domestic structural reforms. The lessons learned by these countries from the crisis and the draconian reforms demanded in return for external financial assistance led many emerging and developing economies to build up foreign reserves as a form of self-insurance against future crises.

However, this precautionary motive was not the only factor that drove the increase. Many nations (especially China) decided to bootstrap their economic growth by running trade surpluses versus the US and the rest of the world and used foreign reserve purchases to stymie the natural tendency of the exchange rate to appreciate – effectively short-circuiting the market’s self-correcting mechanism. Such mercantilist policies allowed these nations to grow at a much faster rate than the US. As a measure of their success the US economy now represents only 25% of global GDP down from 40% in 1960.

The natural consequence of the relative decline is that foreign capital inflows now have a correspondingly larger impact on the US economy, as is clearly shown in the chart below. Since the mid-1990s, the US current account deficit has been consistently greater than two percentage points of GDP, and even went as high as 6% in the mid-2000s. These numbers may not appear to be very high at first glance. However, in reality the economic distortion is considerable. A developed, high-income economy like the US would typically be expected to be a net exporter of capital (meaning a surplus on the current account) because underdeveloped economies tend to grow more quickly than mature economies due to the catch-up effect, implying a higher relative rate of return, making them attractive to investors in more mature slower growing economies5.

US Current Account Balance (% GDP)

Dollar Collapse: Why is it taking so long and what does it mean for crypto?

Source: Fred Economic Database

Between A Rock And A Hard Place

To fully appreciate the nature of this economic distortion consider what would happen if the US chose not to accommodate these foreign capital inflows via the budget deficit. One possibility is that either US households or corporates would have to run sustained deficits (don’t forget its an identity so these balances must sum to zero at all times6). Both of these things actually occurred during the past three decades and led to exactly the same result: a financial bubble (dotcom in 2000, housing in 2007) quickly followed by recession when the inevitable burst came. The second possibility is US unemployment would be forced higher because there would be insufficient domestic demand for American products to make up for the lack of foreign demand due to an overvalued US dollar - a point made by Professor Michael Pettis on numerous occasions.

Neither of these options are politically appealing.

So, even though blaming US politicians for their fiscal largesse is a very popular sport (which I readily confess to participating in from time-to-time), one must acknowledge that successive US administrations have found themselves in a difficult position directly as a result of the US dollar being the reserve currency of choice for the rest of the world. Short of imposing, or rather reimposing7, capital controls – the financial equivalent of the nuclear option - there is not much US politicians can do to correct the situation.

Even President Biden’s recent announcement of punitive tariffs on certain Chinese imports, while headline grabbing, will not really move the dial. First, the changes are only projected to impact $18bn of current US annual imports, and second, as I will go on to show, it will not discourage China from continuing to run trade surpluses, which must be exported either directly or indirectly into US asset markets. In effect, the US government is coerced into running sustained fiscal deficits because of the way other nation-states choose to invest their foreign reserves.

Plan B?

With the US political establishment seeming unable to alter the status quo unilaterally, an obvious alternative solution is for reserve-accumulating nations to either reduce their external surpluses – thereby lowering capital exports to the US – or switch to using another currency to hold their reserves in. Unfortunately, neither of these options are viable either, at least not for the two largest official holders of foreign reserves, namely oil exporting nations and China.

Obviously, it is impossible for oil exporting nations to consume their natural resources domestically so they have to be sold overseas. And, if their sizeable trade surpluses were not recycled via central bank or sovereign wealth fund purchases of foreign assets, their currencies would experience a substantial appreciation that would severely impinge the competitiveness of the non-oil based part of their economies – a phenomenon known by economists as the Dutch disease.

China is similarly reliant on perpetuating its trade surplus, albeit for different reasons. China’s economic miracle – the transformation from a low to middle-income country - has been driven by decades of robust investment. As alluded to above, typically, such large scale investment would be financed by investors in more mature, higher-income countries because of the relatively higher anticipated returns. However, China chose a different route. Its capital account was, and remains, effectively closed so as to ensure the political leadership remains firmly in control of the economy8. As a result, the investment boom had to be (recall its an identity not a theory) financed from domestic sources, primarily households. The direct consequence of this decision is that China has one of the lowest consumption/GDP shares in the world, some 15 percentage points lower than seen in the US and other economies.

Chinese Consumption Share of GDP

Dollar Collapse: Why is it taking so long and what does it mean for crypto?

Source: Statistica

If China rebalanced the structure of its economy9 such that consumption rose to levels more typical of other economies, its trade surplus would decline, its appetite for foreign reserves and demand for the US dollar would decline, leaving it and the US (not to mention the entire global financial system given the importance of the US currency) in a much better shape.

Sounds good, no?

This is hardly a radical or innovative thought. Indeed, many economists (myself included) have been calling for this structural change to the Chinese economy for a decade or more. The problem though, and the reason why such a change has never been implemented, is that transferring a greater share of GDP to households would undermine the political, financial and bureaucratic structures the Chinese leadership has grown to rely on over the past several decades and there is absolutely no guarantee transitioning would be smooth10. Even though it represents the first-best solution globally, for a nation-state whose political model is based on centralized control and where social stability is paramount, this risk makes it a complete non-starter.

Desperately Seeking…. Alternatives

What about alternative currencies to replace the US dollar?

Earlier in this research note, I included a pie chart showing the currency split of global foreign reserves. Aside from the US dollar, there are seven other currencies that nation-states choose to hold their foreign reserves in. Of those, the EUR, CNY and JPY appear to be the most viable alternatives to the US dollar because they are the currencies of large economies, with substantial international trade flows and reasonably deep capital markets. The problem with them replacing the US dollar though is clear when one looks at the table below.

Current Account Balance (% GDP)

20132023
United States-2.6-3.8
Euro zone2.11.9
United Kingdom-3.1-3.1
Japan1.02.0
China1.51.5
Australia-4.31.1
Canada-3.5-0.4
Switzerland8.99.4
Source: IMF

All three of these economies run sustained current account surpluses (and in China’s case, as mentioned, their capital account is closed). Replacing the US dollar as the leading reserve currency would, as per the Triffin dilemma, mean they would have to run sustained deficits instead, something they are unwilling to do11. So, even though superficially they seem plausible alternatives to the US dollar, the reality is that they aren’t.

Of the remainder, the UK is pretty much as tapped out as the US given it has an equally dire external balance position, whereas the final three economies are simply too small with insufficiently deep capital markets to absorb sustained foreign purchases of their assets. In short, there is no practical alternative to the US dollar in the world of fiat money.

Houston We Have A Problem

The conclusion that flows from this is clear. Perpetuating the reserve status quo only ends one way – fiscal crisis in the world’s largest economy. Domestic asset bubbles in the US like those we saw in the 2000’s could extend things for a while, but they cannot change the ultimate destination. As Herb Stein, a senior fellow at the American Enterprise Institute, once observed:

If something cannot go on forever, it will stop”.

This inevitability is the reason why predictions of the US dollar’s demise are so popular.

However, once it becomes abundantly clear that the US is no longer able to carry the economic burden of being the world’s reserve currency, the race would be on to exit, but exit where? As I have explained at length, no other fiat currency is viable as an alternative to the US dollar. Moreover, given the US dollar is the bedrock of the international monetary system, abandoning it would force the entire global economy to adjust in chaotic and disorderly ways – a far from appealing prospect. That is why despite the inevitability of the US dollar’s fall from grace, forecasts of its demise have so far proved to be wrong. The global financial system is stuck on a path of increasing disequilibrium.

In many ways, it is just like the final showdown in the movie The Good, the Bad and the Ugly: it ends, as everyone expects, in a hail of bullets but no one wants to shoot first.

Mexican Standoff

Dollar Collapse: Why is it taking so long and what does it mean for crypto?

Source: The Good, the Bad and the Ugly:

The Ecstasy of Gold

I didn’t know this when I wrote the above but the showdown in the film is accompanied by the Ennio Morricone-penned song The Ecstasy of Gold, and quite frankly I don’t think I could have chosen – albeit inadvertently - a better metaphor for the current state of the international monetary system.

As I pointed out in a prior research note, central bank purchases of gold have surged over recent years. According to the World Gold Council the trend continued this year, led by Turkey and China12 (quelle surprise!). This is an unambiguous sign of growing concern that the US dollar’s days as the leading reserve currency are numbered.

Writing about this trend in central bank gold purchases last March I said…

...[g]iven their natural inclination towards conservatism, it makes sense that central banks’ first choice would be to purchase a fiat money hedge they are very familiar with and have the infrastructure in place to handle.”

Central banks have the infrastructure to deal with gold bullion because it was historically the only form of debt-free money available and it is this characteristic that makes it a good fiat hedge. The arrival of Bitcoin changes this because there is now a second form of debt-free money – a point made recently by Ray Dalio founder of the world’s largest hedge fund Bridgewater (see the previous Monthly update).

I readily acknowledge that it may take them some time to get fully onboard with this notion, but with each passing month crypto is becoming less of a fringe asset class. As we saw with last month’s SEC 13F filings, over 700 large tradfi asset managers (including one US state pension fund) have holdings of spot Bitcoin ETFs - a product championed by no less than BlackRock, the world’s largest tradfi asset manager. Bitcoin is becoming respectable and increasingly credible as a US dollar off-ramp in the same way that gold has been historically.

Once central banks (and foreign reserve managers more broadly13) understand and get comfortable with this digital version of the yellow metal, it is extremely likely in my opinion they will begin to allocate greater amounts to Bitcoin. After all, there are not many other ways available to them to protect themselves from the inevitable fall from grace of the US dollar (and certainly none when the choice is limited to other fiat monies). Indeed, one could argue that Bitcoin could be just the catalyst the US dollar bears have been in search of all these years.

And, if reserve holders begin allocating to Bitcoin it would be a very bullish development. After all, their increased purchases of gold have contributed to pushing up the price 22% over the past year (making new record highs in the process). Just imagine what would happen to Bitcoin’s price given it has a market cap barely one-tenth of that of gold?

Stablecoins – A Twist

Of course, nothing is ever set in stone when it comes to finance – what would be the fun in that? There is another path that could be taken, and it too involves cryptocurrency, specifically fiat-backed stablecoins.

The total market capitalization of stablecoins – the vast majority (99%) of which are pegged to the US dollar - is $160bn give or take, so modest relative to the size of foreign reserves, but the sector is expanding rapidly. In a recent blog post, which I highly recommend reading, Nic Carter made the following comment:

stables are becoming a truly dominant global settlement infrastructure, and one that is increasingly integrated into the existing financial system. As I have laid out, I believe stables are the new Eurodollars, and once they reach critical mass (perhaps in the $300-$500b range (versus their $160b float today), the Federal Reserve and other major central banks will be forced to integrate them into their financial toolkit, rather than impolitely ignoring them as they do today. This would mirror the transition that Eurodollars went through in the early ‘70s.”

For those who are fortunate enough not to know what Eurodollars are, they are offshore US dollar deposits that are not subject to the legal jurisdiction of the US. In many respects, USD-pegged stablecoins14 are similar to Eurodollars because they too are US dollar liabilities that originate outside the regulated banking system. Moreover, like the Eurodollar market back in the 1970s there is strong growth potential because they display much less price volatility than unbacked cryptocurrencies like Bitcoin and Ether, which enhances their ability to serve as a medium-of-exchange.

If, as Nic Carter, believes stablecoins have a bright future it is quite plausible that central banks will seek to acquire then in order to be able to continue to satisfy their financial stability objectives, which for a central bank is the primary job function, even surpassing price stability objectives15. Moreover, because stablecoins are deployed on decentralized blockchains, once minted they become bearer instruments whose usage does not require an intermediary. Although this does not put them totally beyond the reach of the US government i.e. make them sanction-proof, it does make them less readily accessible, which some reserve holders are likely to view as a positive relative to plain old fiat holdings.

By providing a new source of demand for US dollars, the widespread adoption of stablecoins could extend the US dollar’s longevity as the world’s leading reserve currency. That said, and I reiterate, it cannot overcome the inevitable decline, only postpone it. Nevertheless, postponement of a problem is indistinguishable from avoidance of a problem for a politician whose time horizon rarely exceeds the four-yearly election cycle, so it is perfectly possible that Washington decides to embrace stablecoins as no one wants the collapse of the US dollar’s reserve hegemony on their watch.

Until next time.


1Fingers crossed it stays that way in terms of the latter

2A money designed to operate in a trust-minimizing manner is even better *wink*.

3Because it is an identity it means that the relationship holds no matter what macroeconomic theory one favours be it keynesian, monetarist, neoclassical, MMT or any other kind.

4Despite what many people, especially those within the crypto space, think there is no problem with a government running a sustained budget deficit. In fact, if the rate of interest paid on the outstanding stock of debt is below nominal GDP growth a government can run a budget deficit ad infinitum in theory because the country’s debt-to-GDP trajectory is not on an explosive trajectory. However, this is very much not the case today. I outlined the equation used in debt sustainability analysis in an earlier research note – see: https://trakx.io/resources/research/cryptocurrencies-store-of-value/

5This was what happened in the US in the 19th century. Foreign capital played a substantial and beneficial role in US economic development – see: https://www.jstor.org/stable/1047318.

6Excluding small statistical discrepancies that occur in all macroeconomic data.

7Capital controls in some shape of form were only repealed in the US in the mid 1980s – a mere blink of the eye in the grand scheme of things.

8Most economists and investors spend the vast majority of their time thinking about cyclical changes in economic growth to assess the likely impact on financial asset prices and largely ignore structural aspects. That is a grave mistake when trying to look at the longer-term picture.

9For those interested in hearing more on this please check out this a Macro block podcast last year with the aforementioned Professor Pettis - https://www.youtube.com/watch?v=XO8o0TO-rfg .

10The added wrinkle in the case of the Euro zone is that there is no fiscal union, meaning each government’s bonds are not perfect substitutes.

11These are confirmed purchases. China has a habit of revising up their official gold holdings a long time after the fact probably in order to minimize the market price impact – see: https://www.ft.com/content/2c67f078-2c6d-11e5-8613-e7aedbb7bdb7

12Sovereign wealth funds being the other popular investment vehicle for managing a country’s surplus foreign earnings.

13Not all stablecoins are backed by fiat holdings, some are backed by commodities, including other unbacked cryptocurrencies, others by maths (so-called algorithmic stablecoins). However, in this note I am strictly referring to fiat-backed stablecoins whose valuation is depends upon US dollar deposits.

14If domestic financial systems adopt USD stablecoins, the ability to provide liquidity backstops would necessitate them holding stablecoins as well.

15 This decision continues to discourage diversification away from the US dollar. Indeed, a Bloomberg article published last year discussed the impact of China’s closed capital account for oil-producing nations - see: https://www.bloomberg.com/opinion/articles/2023-02-27/pricing-petroleum-in-china-s-yuan-sounds-inevitable-not-for-saudi-arabia?sref=wOrDP8KX

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