Is the U.S. Dollar on the Verge of Collapse?

Devaluation of the Petrodollar

The Fed as the Regulator

Historically, the Federal Reserve has had two tools at its disposal: interest rate (also known as Federal Funds Rate) and quantitative easing. Interest rates relate to the borrowing rate at which commercial banks accept loans from Central Banks. Quantitative easing refers to “printing money” or injecting additional currency into circulation via accounting transaction. The functionality of these tools is to maintain the value of the U.S. currency through unilateral equalization. In this case increasing and maintaining the value of the dollar. Each tool functions to exaggerate a specific parameter responsible for driving the currency’s market value. The idea is that the interest rate stimulates an extreme while quantitative easing stimulates another extreme — whereby the result is a value that is relatively stable and central to these two polarities. Similar to pulling two ends of a string — with the currency value resting at the point of tension. Historically, the federal funds rate has been set to be inversely tied to the monetary supply in circulation. If more currency is issued through quantitative easing, the interest rate is increased to function as a counter-weight — hedging inflation.

The traits that give a currency value are buying power/spend-ability (indicated by level inflation) and amount of money in circulation (supply). A foundational concept in economics is that the most valuable commodities are those that are most rare or scarce in quantity. If there is so much of a commodity in circulation to the point where anyone can get it, then its value drops. For value is maintained through scarcity — if something is abundant then there is no need to pay for it — you may simply obtain it through natural means. Quantitative easing has an inverse effect relative to the interest rates (relating to action of the Federal Reserve). Quantitative easing or increasing the monetary supply raises inflation. To balance this out, the Fed historically would raise interest rates. The increase in the interest rate would cause Gross Domestic Product (GDP) to drop as people are not taking out as much loans and spending money on houses and cars, this in turn would reduce the amount of currency that is in circulation — as people are focused on saving money. However, since the economic and housing-market crash in 2008, GDP has become stagnant for the most part, so raising interest rates is no longer feasible. When we say interest rates we are not referring to the Annual Percentage Rate (APR) that the consumer pays but rather the interest rates in which commercial banks can borrow money from the Central Banks. The way it works is commercial banks borrow their money and then pass down the interest savings or expenses down to the consumer. Currently, Interest rates are near zero and yet more money is being inserted into circulation. As a result of government-imposed lock-downs on businesses and communities pursuant the coronavirus outbreaks, unemployment has increased. This further adds to the pressure of the high levels of debt held by the U.S. Quantitative easing is resorted to as a means to offer some form of alleviation to the economy.

Federal Funds Rate — 62 Year Historical Chart: The chart below shows the daily level of the federal funds rate back to 1954. The fed funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. The current federal funds rate as of August 21, 2020 is 0.09%.

Preceding Caption and Image Source: macrotrends.net

The Consumer Price Index (CPI) is a metric used for assessing inflation. The figures in the chart below reflect the overall change in buying power of consumers relative to the decade between 2010–2020. Consumers are required to pay more money for the same goods, indicating a decrease in buying power or an overall increase in inflation for the U.S. dollar.

CPI Reflecting Inflation Over Time. Image Source: bls.gov

Current Position of the U.S. Relative to the World

Since the outbreak, the U.S. has been isolated from the rest of the world as a result of countries issuing travel suspensions to U.S. citizens. The suspensions were issued in reaction to the statistics reported relative to the number of coronavirus cases. In the view of the world economy, this isolates the United States to an extent relative to specific industries — mainly travel. This may or may not diminish financial returns the United States acquires through exports. This would be determinate upon whether the travel suspensions push countries to extend these measures to imports/exports over time.

Crude Oil Surplus & Reduction of the Petrodollar

Pursuant to the world-wide government imposed lock-downs, the majority of the population has been quarantining at home. Staying indoors, and conducting only minimal and essential travel. Local commutes have been reduced to the purchase of groceries and supplies. This reduces the demand for petrol in general as people are no longer commuting to work (majority are working virtually from home) with air travel being virtually non-existent.

Since the abolition of the gold standard in the 1930’s, the U.S. dollar has since become a fiat currency based on a free-floating system. This means that the overall global perception determines the wealth of the dollar as it is not backed by any actual collateral. Since then, the United States has used petroleum as its collateral, by pegging crude oil to the dollar (in certain oil-producing nations) — maintaining that crude oil contracted be executed through the U.S. dollar. This is particularly in reference to the relationship between the United States and Saudi Arabia — one of the largest exporters of crude oil. By maintaining a hegemony over crude oil exchanges, the United States was able to regulate the value of its currency by mitigating any inherent risk associated with the lack of collateral to back its currency.

Earlier we mentioned that scarce resources are considered the most valuable and therefore worth paying the highest price. Given the current state of world travel and the amount of people staying at home, this points to a looming surplus in crude oil. If there is a high supply of something with little demand, this drives the price of the commodity down. If the price of oil drops, then there are of course possibilities that it may directly proportionately affect the value of the U.S. dollar (petrodollar). This effect may be further amplified by the world’s shift from nonrenewable energy to renewable energy. This however does not to be considered as something bad, but rather seen as change — with a potential outcome of something very positive

The below charts reflect the supply and demand for crude oil over the last five years. We can see a sharp reduction in production of crude oil starting in the second quarter of 2020. However, the reduction in production of crude oil is surpassed by the drop in consumer demand.

Source: eia.gov

Coin Shortages

All across the U.S. have been reported coin shortages, and the policy-adoption of retail establishments only accepting exact change, credit, or otherwise not returning the remaining change. This hints towards a preparation or deviation towards the possibility of fully credit-based transactions. Most of us already use credit all the time anyway, with limited uses for hard cash. The coin shortages further direct us towards a transition to a cashless society. With the outbreak, this becomes a greater possibility. If it is perceived as a health risk, hard cash (or at least coins) will likely be done away with — eliminating exchange of paper money to reduce the circulation of germs. I am not vouching for or promoting the idea, simply presenting it. A cashless society would further pave the way for the rise of electronic cryptocurrencies such as Bitcoin — solidifying their practical usage in the world economy.

There are potential risks, which must be considered, relative to the removal of cash from circulation. For one, many people who are homeless rely on cash donations as their source of income. If cash were to be removed this may present issues for these people, making it more difficult for them to acquire donations. Another thing we must give consideration is the idea that if we transition to fully cashless are potential risks with cyber security. The potential for electronic balances to be hacked or usage restricted from vendors based on imposed regulations (or even social credit ratings for that matter — this is already a thing in China).

Asset Diversification

Being able to grow your own food is of course the best form of asset diversification, but if that is not an option then of course making good financial decisions to hedge risk may be considered. The best way to hedge risk is always asset diversification (land, commodities, etc.). Given the current status of the world economy due to the outbreak and the fact that the petrodollar is utilized as the standard for purchasing crude oil throughout most parts of the world, it becomes evident that a devaluation of the U.S. dollar would have a ripple effect of consequences. This would likely lead to a full re-structuring of the world economy and how financial markets operate. So investing in liquid assets (i.e. other cash currencies) may not be the most effective method of risk mitigation. Historically, people have always reverted to purchasing gold when concerns regarding cash currency arise. Although cash currencies are the most liquid, they may carry more inherent risk.

The Bottom Line and the Psychology Behind Currency Valuation

One may theorize that the U.S. military is enough to preserve the strength of its currency. However, given the consensual global stance towards the United States from other countries, it is apparent that the U.S. military perceptively will not be sufficient means as most attrition is due to the perceived manner in which the coronavirus outbreak has been address in the United States. The United States is currently isolated from the rest of the world and may have to rely on itself to preserve its well-being. However, given the amount of world debt incurred by the U.S. government and its inability to pay it all off, this begins to add even more resistance towards its currency.

Judging by the charts, it does not really look like anything too crazy (although it is too soon to tell). Travel bans do not necessarily imply American export bans, and the inflation does not appear too extreme relative to the Consumer Price Index. However, one must also account for the federal funds rate nearing zero and the potential for negative interest rates to become a normality. Negative interest rates would likely further increase inflation and completely re-haul the structure of the U.S. economy. If retained, the value of the U.S. dollar may purely be based on reliance, speculation, and good-will.

I simply present the facts, you decide for yourself. If we do approach a new system where we have negative interest rates, then we basically have a working incentive for people to use (and borrow) money — in other words, banks will, in a way, be paying consumers interest to borrow money. If negative interest rates do become a thing, then it is a good practice to stop and ask why. For people who are not consumerists and do not rely on the system to produce their goods, they may prefer to return to some form of tangible barter system. After all, a barter system (although less convenient) removes the hand of the middle-man and converts exchanges between buyers and sellers into trades — allowing the interaction to become an intimate exchange of value rather than simply a business transaction.

Regardless of what happens, the outcome is unknowable at this point in time — it can go either way. Therefore, the best practice is to be mindful and to plan for the future as best as you can but without dwelling on it and becoming anxiety-ridden. A restructuring of debt is taking place, meaning that all the debt the U.S. owes will likely be refunded. In other words, it will not be paid back.

Asset diversification is a good way to hedge risk — financial strategies such as investing in tangible collateral, such as gold and silver. But don’t go purchasing a load of precious metals just yet. Although gold and silver generally retain their value, the issue comes down to their usefulness and practicality. Precious metals are heavy and an inconvenience to carry around. So the odds of us reverting to such a method of exchange is unlikely (in my unqualified opinion). It does not hurt to have some, but do not bank everything you own on precious metals. A switch to some alternative form of free-floating cryptocurrency is more likely (i.e. Bitcoin). In this day and age, people for the most part know what money is and that it is simply a means of exchange and holds no real world value outside of that. So the perception that it is for convenience and functions as a means of exchange — that all recognize and participate in — is what truly holds the value of a currency. In other words, money is a collective hallucination — and this is known. People use money for its practicality, not because they perceive it to be useful as a stand-alone tangible good.

The best practice still to this day is owning things that hold their value (due to their usefulness) such as land and buildings. Another good practice is ensuring you have the essentials for well-being and survival — just making sure that you have enough food available in your home if a drastic change were to occur. I am not telling you to hoard or stockpile, but rather to just give yourself a little bit of cushion. You may take these things into account when diversifying your assets. Risk is greatly minimized by a broad diversification in many different asset classes: both currencies of exchange and stand-alone tangible goods.

Suggested Assets & Examples for Diversification

  1. Liquid Assets: Cash — Include foreign currencies that behave inversely to the U.S. Dollar. *Investing in assets that behave inversely to one another (and relative to the market) is an effective method of hedging risk*
  2. Commodities: Gold, Platinum, Silver
  3. Securities: Stocks (Equities), Index Funds (e.g. S&P 500), and Exchange-Traded Funds (ETFs).
  4. Cryptocurrencies: Bitcoin
  5. Buildings and Land: Home Property — Place of Residence
  6. Survival Essentials: Food and Supplies

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