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The Process

The exit from the dollar will run on two tracks, both of which lead to trouble for the United States. One track is for the dollars themselves. The other is for Treasury bills and other IOUs denominated in dollars. Whether it happens rapidly or slowly, here is how the process works.

Foreigners hold over $600 billion in hand-to-hand U.S. currency (e.g ., $100 bills) and over $1 trillion in checking deposits at U.S. banks— about 65 percent and 30 percent, respectively, of the two items. When they decide they no longer need most of it because other currencies are serving well for international trade, they'll unload the excess by selling dollars for those other currencies.

The immediate effect will be a drop in the foreign-exchange value of the dollar; a dollar won't buy as many Russian rubles, Chinese yuan, Brazilian reals, or units of any other currency as it once did, which will translate into higher prices for goods imported into the United States. All that stuff from China that you can buy at Walmart won't be so cheap anymore, nor will cars from Germany or South Korea, or coffee from South America, or cocoa from Africa, or shirts from a dozen poor countries that today crave dollars. In other words, an early result of the world distancing itself from U.S. currency will be price inflation in the United States.

A separate vector feeding price inflation will come into play. The dollars that foreigners are unloading will find their way to the wallets of individuals and businesses in the United States—the dollars will have nowhere else to go. That extra cash will reinforce the inflationary process already under way.

Foreigners hold over $5 trillion in U.S. Treasury securities and bank certificates of deposit (CDs), about 47 percent of the total outstanding. As the dollar's hold on reserve currency status slips away, the primary motive for owning those assets will slip away with it. The U.S. Treasury and commercial banks in the United States will be forced to offer higher yields to persuade foreigners to roll over their investments as they mature, which will push up interest rates throughout U.S. credit markets. Prices of existing dollar-denominated bonds will fall.

Then the two tracks—the effects of dumping dollars themselves and the effects of diminished demand for dollar-denominated IOUs— will meet. Higher rates of price inflation will operate as a second-stage booster for interest rates, as savers and lenders insist on being compensated for the purchasing power that is draining out of their dollars.

The process won't just be financial news. It will change the way Americans live, and it will change the U.S. government's notion of what is possible and what is not.

For most Americans, it will mean a period of stagnant or declining living standards. Imported goods will become more expensive, as will borrowing to buy a house or for anything else. It will be a hard lesson that tomorrow is not inevitably better than today.

For the U.S. government, it will mean learning to live as just one more borrower in the international capital markets. Letting debt grow faster than the economy will no longer be an option. The politicians will be forced to decide what not to spend money on.

On the Fast Tracks

For most Americans, it's not going to be good times. Whether the unwinding of the dollar's hegemony turns into a depression and a truly painful experience for millions of people depends on how rapid and abrupt the process is.

What happens if the petrodollar system breaks down relatively rapidly, over the course of a year or two, instead of slowly fading away? This is the worst-case scenario for the Colder War—not a withdrawal but a flight from the dollar. You wouldn't want it to happen, but you shouldn't assume it won't.

The past six years of ultralow interest rates have pushed bond prices higher and higher. A flight from the dollar would send interest rates at least up to the highs of the 1970s and early 1980s (when the rate on the 30-year Treasury bond peaked near 15 percent) and slash the trading prices of existing bonds by 35 percent to 55 percent. Homeowners with adjustable-rate mortgages would get crushed. Results for the stock market would be even more violent.

The Federal Reserve could forestall the process temporarily by creating even more trillions of fiat dollars out of thin air to buy up the bonds being dumped by foreigners. But the bond dumpers would quickly trade the newly minted bucks for more immediately useful currencies, which would further depress the exchange value of the dollar, which means imported goods would become even more expensive for Americans and price inflation would get even worse. And as the newly created but unwanted dollars returned to the United States, they would become yet another force driving inflation.

Rapidly rising interest rates would have nasty consequences throughout the U.S. economy.

U.S. banks would be in trouble. The fall in the value of their bond holdings and the gap between yields on old loans and the higher rates they would need to pay to retain deposits would push many institutions toward insolvency. The Federal Deposit Insurance Corporation (FDIC)'s puny insurance fund wouldn't be enough to buy even a Band-Aid for the problem. You could count on the Federal Reserve to deal with the problem by printing still more money—which would pay for still more inflation, which would exceed the rates suffered in the 1970s. A 20 percent annual inflation rate would be within reach.

And something even worse could happen to the financial system. The daisy chain of derivative investments that runs in and out of the world's biggest banks, insurance companies, brokerages, and hedge funds could come apart, with truly apocalyptic consequences, as explained nearby in "The Bomb in Your Basement."

The U.S. government's option of last resort would be to default on debt held by foreigners, which would produce the most interesting day ever in the history of global financial markets. Panic, chaos, pandemonium—no word would be adequate to describe it. But a default with lipstick and makeup, such as surprising foreign investors with a high rate of withholding tax on their interest earnings, is a possibility. Other countries have weaseled out of debt they couldn't pay and then climbed out of the deep pile of wreckage that resulted, although it has never been done on the scale that a U.S. default would represent.

It is more likely that the U.S. government will raid individual retirement accounts (IRAs) and 401 (k)s by requiring them to hold a minimum percentage in Treasuries—for the account owner's supposed protection, of course.

Rising interest rates would cripple the economy. Not only do they harm the housing industry, but they discourage people from borrowing money. Business start-ups would become rare, as would any expansion of existing businesses. Frightened consumers would slow their spending. Unemployment would reach depression levels.

At best, it would be stagflation, a state of high unemployment, snail-paced or negative economic growth, and rapid price inflation. The combination of higher prices for necessities and lower wages would demote much of the middle class to working poor status and impoverish those creeping along on fixed incomes.

The U.S. government would be forced to slash expenditures— drastically. It wouldn't be able to continue borrowing 46 percent of what it spends, at least not for long, since at high interest rates the interest on the debt would quickly become ruinous. Cutting spending would mean a much smaller military and a big decline in the services and handouts that a wide swath of the population now takes for granted.

Americans living on government largesse would be hit hard, and they'd be joined by millions of newly unemployed. When the ranks of the disgruntled begin to swell, things could get very noisy very fast, and the noise could turn into street violence. Members of the Occupy movement would be remembered for their nice manners. Episodes of martial law are a possibility.

International trade wouldn't cease, but it would switch to alternative currencies. The ruble and the yuan are the top candidates. I'm sure that in his dreams Vladimir Putin envisions the ruble as the world's new reserve currency, but there's no guarantee that any one currency would replace the dollar.

Another possibility is that gold would recover its historical role in international trade. Russia, China, India, and others have been buying gold over the past decade and would be ready for such a development. In fact, this may be where Putin is trying to go, since Russia is now the world's number-three gold producer and its output is growing rapidly. A gold ruble has already been proposed for use within Russia.

The Bomb in your Basement

A simple derivative is a financial contract that derives its value from the performance of another, underlying asset—such as a particular stock, a bond issue, a defined basket of stocks or bonds, an interest rate, or other financial index. Other derivatives are more complex; their value depends on whether the underlying asset outperforms or underperforms a given standard. Some of them are inverts; their value rises when the value of the underlying asset declines.

Imagine a laboratory where a mad scientist dismembers animals of different species and reassembles the parts into novel structures. That's how strange the world of derivatives gets. And it gets even stranger. The asset underlying a derivative may itself be a derivative whose underlying asset is or includes still other derivatives. The chains can be very long and complex, a tangle of claims and obligations by the many banks and other institutions involved.

The financial mathematics customarily used for valuing derivatives and assessing their risk levels assume that the behavior of the ultimate underlying assets and financial indexes will never stray too far from normal. Generally that assumption works nicely. But if a truly abnormal event occurs, something that might not happen more than once in a century, something like the world rejecting yesterday's international reserve currency, the only answer you'll get from the math for estimating value and risk will be "Duh."

That result would be worse than a wave of catastrophic losses by banks and insurance companies. It would be catastrophic losses with lights out, since the complexity of many derivatives would prevent the participants from quickly assessing who lost what. All the participants (including, most likely, the bank where you keep your money) would look bankrupt, as many of them would in fact be.

Depending on who's doing the measuring, the notional value of all derivatives currently outstanding is $600 trillion. In a dollar meltdown, that would make for a lot of confusion. During the 2008-2009 financial crisis, the markets got a taste of how bad it can get. If there is a rapid flight from the dollar, they'll get a banquet's worth.

In 2008 and 2009, trust evaporated. Banks refused to lend to other banks because no one knew what the other guy's collateral might be worth. The financial system seized up, and we came within a whisker of finding out what could happen in the event of a dollar meltdown.

Banks would fail, brokerages would fail, credit would dry up, debtors would default en masse, and individual investors would see their accounts swept away, their life savings lost. A global depression would ensue.

There is no financial event in history to compare this with.

 
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