At MoneyShow San Francisco, Peter Schiff: The problems I saw leading up to the financial crisis of 2008-9 are dwarfed by the problems that I see now under Bernake and Yellen. The bubble that they created is far bigger. This thing is probably going to blow up on Donald Trump. I wish he hadn’t claimed ownership when he put his brand on this stock market bubble, on this phony economy. They’re going to have the rename the Great Recession because this one is going to be worse. We are going to have a dollar crisis this time. The average American is going to suffer much more this time. That’s why I’m here at the MoneyShow to tell people how to profit on the events that are about to unfold.
The basic reason for believing that the dollar is overvalued is, of course, that the United States is running very large current account deficits, and that the possessors of other major currencies – especially the yen – are correspondingly running large current surpluses.
Now current account imbalances are not necessarily a warning sign. Indeed, they are the necessary counterpart of any transfer of funds from places with excess saving (Japan) to places with high returns on investment (the U.S.). Still, massive current account imbalances mean that the surplus countries are holding an ever growing share of their wealth in the deficit countries, a process that cannot go on forever; and (Herbert) Stein’s Law reminds us that things that cannot go on forever, don’t. Eventually the U.S. deficit and the rest-of-world surplus must be sharply reduced, perhaps even reversed; and while this adjustment could take place in other ways, it is likely that much of it will occur via a decline in the value of the dollar vis-a-vis the yen, the euro, and so on.
The “sustainability” question – which as far as I know I first posed back in 1985, in a paper titled “Is the strong dollar sustainable?” – is whether the market seems to be properly allowing for that required future currency decline. If not, the dollar is doing a Wile E. Coyote, and is destined to plunge as soon as investors take a hard look at the numbers. (For those without a proper cultural education, Mr. Coyote was the hapless pursuer in the Road Runner cartoons. He had the habit of running five or six steps horizontally off the edge of a cliff before looking down, realizing there was nothing but air beneath, and only then plunging suddenly to the ground).
And the numbers do have a definitely Coyoteish feel. True, interest rates in the United States are higher than those in Japan or Europe, which means that the market is in effect predicting gradual dollar decline. But inflation is also a bit higher in the United States; the real interest differential on long-term bonds is probably only about 2 percent vis-a-vis Japan, less vis-a-vis Europe. Thus investors are implicitly expecting only a 2 percent per annum real depreciation of the dollar against the yen over the long term; given the size of the current account imbalance, that just isn’t enough.
To understand why, bear in mind that a currency depreciation (or, more strictly, a revision of expectations leading to a currency depreciation – the exchange rate is, of course, an endogenous variable) constitutes a positive demand shock and a negative supply shock to the depreciated country. It is a positive demand shock because the country’s goods become more competitive on world markets; it is a negative supply shock because import prices increase. And conversely, of course, a currency appreciation is a negative demand shock and a positive supply shock.
The reason to be concerned about a sudden dollar decline, then, is that it so happens that the United States is currently a supply-constrained economy, while much of the rest of the world is demand-constrained. So the net effect is negative almost everywhere.
In the United States, where wages are finally beginning to reflect a more-than-full-employment labor market, a sudden dollar decline would at least threaten to produce a wage-price spiral – and the mere threat would mean that the Fed would likely be forced to raise rates. Whether this would lead to a substantial contraction is unclear – who the heck understands aggregate supply behavior these days? – but a dollar decline is certainly not positive for the U.S. right now.
As for the rest of the world, demand shocks from a currency appreciation are normally easy to deal with: just cut interest rates, which among other things limits the appreciation. But of course Japan is firmly in a liquidity trap, and cannot cut rates; the euro-zone is not in a liquidity trap, but a sufficiently sharp dollar decline could put it into one. The only places that clearly benefit from a weaker dollar are demand-constrained economies pegged to the dollar; and Argentina and Hong Kong are just not big enough to change the general picture.
Simple textbook open-economy macroeconomics, then, tells us that startingfrom where we are right now – a U.S. economy at or beyond capacity, a large part of the rest of the world well below capacity, and in or near a liquidity trap – a drop in the dollar will be a global contractionary force. How strong a force? Well, it depends on the drop; if markets were to force the U.S. to move rapidly to current account balance or beyond, the numbers would be very troubling. This is unlikely, I think; but then serious crises usually are, ex ante.
Three events that could trigger a collapse
These two situations make a collapse possible. But, it won’t occur without a third condition. That’s a huge economic triggering event that destroys confidence in the dollar.
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 $1 trillion in U.S. Treasurys. That’s because China pegs the yuan to the dollar. This keeps the prices of its exports to the United States relatively cheap. Japan also owns more than $1 trillion in Treasurys. It also wants to keep the yen low to stimulate exports to the United States.
Would China and Japan ever dump their dollars? Only if they saw their holdings declining in value too fast and they had another export market to replace the United States. The economies of Japan and China are dependent on U.S. consumers. They know that if they sell their dollars, that would further depress the value of the dollar. That means their products, still priced in yuan and yen, will cost relatively more in the United States. Their economies would suffer. Right now, it’s still in their best interest to hold onto their dollar reserves.
China and Japan are aware of their vulnerability. They are selling more to other Asian countries that are gradually becoming wealthier. But the United States is still the best market in the world.
What would happen after a collapse
A sudden dollar collapse would create global economic turmoil. Investors would rush to other currencies, such as the euro, or other assets, such as gold and commodities. Demand for Treasurys would plummet, and interest rates would rise. U.S. import prices would skyrocket, causing inflation.
U.S. exports would be dirt cheap, given the economy a brief boost. In the long run, inflation, high interest rates, and volatility would strangle possible business growth. Unemployment would worsen, sending the United States back into recession or even 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. These are just a few ways to protect yourself and survive a dollar collapse.