What Is a Dollar Collapse?:
A dollar collapse is when the value of the dollar falls so fast that all those who hold dollars panic, and sell them at any cost. In this scenario, sellers would include: foreign governments who hold U.S. Treasuries, traders in exchange rate futures who trade the dollar versus other currencies, and individual investors who demand assets denominated in anything other than dollars. The collapse of the dollar means that everyone is trying to sell their dollar-denominated assets, and no one wants to buy them, driving the value of the dollar down to near zero.
What Would Cause This to Happen?:
Several conditions must be in place before the dollar could collapse. First, there must be an underlying weakness. Second, there must be a viable currency alternative for everyone to stampede into. Third, a triggering event would need to occur.
The first condition does exist. The dollar declined 54.7% against the euro between 2002 and 2012. Why? The U.S. debt nearly tripled during that time period, from $5.9 trillion to $15 trillion. This increases the chance the U.S. will let the dollar's value slide, allowing it to repay the debt with cheaper money.
Is There a Viable Alternative to the Dollar?:
The dollar became the world's reserve currency when President Nixon abandoned the gold standard in the 1970s. The dollar is used for 43% of all cross-border transactions. The dollar's value is strong as measured by central bank reserves -- 61% of the these foreign currency reserves are in dollars.
The next most popular currency? The euro, which comprises less than 30% of reserves. The eurozone debt crisis has only weakened the euro as a viable alternative to the dollar as a global currency.
China and others have argued for a new global currency. China's central banker argues that the yuan should replace the dollar to maintain China's economic growth. However, replacing the dollar would be a massive undertaking, would require great global resolve and not happen quickly.
Some see Bitcoin as a new world currency. That's because it is not managed by any one country's central bank. Instead, it is created, managed and spent online, although it can be used at brick-and-mortar stores that accept it.
What Event Could Trigger a Collapse?:
Altogether, foreign countries own more than $5 trillion in U.S. debt. If China, Japan or other major holders started dumping these holdings of Treasury notes on the secondary market, this could cause a panic leading to collapse. China owns more than $1 trillion in U.S. Treasuries. That's because China pegs its currency, the yuan, to the dollar. This keeps the prices of its exports to the U.S. relatively cheap. Japan owns more than $800 billion in Treasuries, also keeping its currency, the yen, low to stimulate exports to the U.S. Japan is trying to move out of a 15 year deflationary cycle, and the 2011 earthquake and nuclear disaster hasn't helped.
China and Japan Can, But Won't, Trigger a Collapse:
Would China and Japan ever really do this? Only if they saw their holdings declining in value too fast AND they had another market to sell their products to. The economies of Japan and China are dependent on U.S. consumers. They know that if they sell their dollars, their products will cost more in the U.S., and their economies will suffer. Right now, it's still in their best interest to hold onto their dollar reserves.
China and Japan are selling more to other Asian countries, who are gradually becoming wealthier. However, the U.S. is still the best market in the world. (See Demand in the U.S. Economy)
If it Did Occur, What Would Happen Next?:
A sudden dollar collapse would create global economic turmoil as investors rush to other currencies, such as the euro, or other assets, such as gold or other commodities. Demand for Treasuries would plummet, driving up interest rates. Import prices would skyrocket, causing inflation.
U.S. exports would be dirt cheap, boosting the economy briefly. Unfortunately, uncertainty, inflation and high interest rates would strangle possible business growth. Unemployment would worsen, sending the U.S. back into recession or even creating a depression.
How to Protect Yourself:
Protect yourself from a dollar collapse by first defending yourself from a gradual dollar decline. Keep your assets well-diversified by holding foreign mutual funds, gold and other commodities. A dollar collapse would create global economic turmoil. To respond to this kind of uncertainty, you must be mobile. Keep your assets liquid, so you can shift them as needed. Make sure your job skills are transferable. Update your passport, in case things get so bad for so long that you need to move quickly to another country.
When Will It Happen?:
Fortunately, it's highly unlikely that the dollar will collapse. That's because any of the countries who have the power to make that happen (China, Japan and other foreign dollar-holders) don't want it to occur. It's not in their best interest. Why bankrupt your best customer? Instead, the dollar will probably continue to decline gradually, as these countries slowly find other markets. For more, see Dollar Decline or Dollar Collapse? (Article updated November 20, 2013)