Economic bubbles are weird because they seem so obvious in hindsight, and yet most people don’t see them while they’re happening.
There’s almost always one somewhere. When one deflates, the next one comes along like clockwork.
The most educated and experienced among us all, those in the central banks, in the prestigious investment firms, in high government office, are often caught blindsided by each one.
Even people who do spot the bubbles are often wrong in a way.
There are many perma-bears that regularly predict economic collapse, and are wrong year after year, and then they get a brief spotlight for an inevitable right call they make right before a recession. Then they go on being wrong for more years saying everything is going to keep getting worse, as the economy recovers.
I have a page dedicated to tracking economic bubbles building in the United States, but even that won’t catch them all. I ignore some of the small/localized ones like Bitcoin or high valuations on cannabis stocks, and just focus on ones that have larger impacts on the national economy.
Some of the growing bubbles aren’t being given enough credit, in my opinion, like the massive current $800 billion U.S. federal deficit during a booming peacetime economy. A deficit of 4% of GDP with full employment is unprecedented. Imagine what the deficit will be like during the next recession when tax revenues fall.
Every once in a while I like to ask myself, “What am I missing? What aren’t people seeing? What will investors years or decades from now look back on as being obvious?”
And in this article, I want to outline something that is mostly under the radar in mainstream finance, and may or may not impact us during this next recession or the one after that. But it seems like it will one day be a problem.
And that’s the fiat currency of the United States.
What is Fiat Currency?
Fiat is from the Latin for, “Let it be done.” An absolute decree from a person or institution in command.
Fiat currency is a monetary system whereby there is nothing of value in the currency itself; it’s just paper, cheap metal coins, or digital bits of information. It has value because the government declares it to have value, and that it is legal tender to pay all things including taxes.
A Brief History
For much of human existence, economies were based on trade. Furs for oysters, olive oil for spices, labor for bread, etc.
The mining of precious metals like gold and silver made that simpler, and these metals have been considered money for thousands of years. With precious metals, you could turn a specific commodity (like furs) into a universal commodity (like gold and silver, which are malleable, long-lasting, and able to be broken into small measurable units), to buy whatever you want at a later date.
Precious metals preserve wealth very well and have natural value due to their scarcity and unique chemical properties. A gold coin could buy you a nice suit 2,000 years ago, and it can buy you a nice suit today. Not much more, and not much less.
(Silver is a more industrial metal, with extraordinarily high conductivity, which gives it several applications in electronics, electric vehicles, solar panels, and more.)
For most times in recent centuries, paper money was linked to a gold standard in various currencies, redeemable in some way for gold.
Eventually, in the post-WWII era, many currencies instead pegged their value to the U.S. dollar. And starting in 1971, the United States ended the gold standard. This made the dollar a fiat currency; something that has value simply because the U.S. Treasury Department says that it has value.
Since then, the U.S. dollar has lost most of its value compared to gold (from 35 dollars for an ounce of gold back then to over 1,200 dollars for an ounce of gold today), but savers holding their dollars in savings accounts have made enough interest to make up for that de-valuation.
For almost 50 years now, that has worked pretty well. The U.S. briefly had major inflation in the late 1970’s, but since then has had stable low inflation and strong economic growth.
And the dollar is used around the world for payment of goods and held by central banks as the dominant currency for foreign-exchange reserves:
Chart Source: Bloomberg
But will this last forever? And what happens if it doesn’t?
It’s not like it’s been that long, as though it’s a permanent institution. Probably half of the people reading this were alive longer than the U.S. has had fiat currency. So it’s not like this situation can’t change or become a problem; it’s a fairly recent and novel concept.
I’m not one of those investors advocating for a return to the gold standard. However, there are other defenses a country can take to defend its fiat currency that the United States doesn’t do at all, and it’s worth being aware of.
The U.S. Has No Foreign-Exchange Reserves
In the current age, every major government currency in the world is a fiat currency. However, many central banks can defend their own currency with foreign-exchange reserves when needed. The United States is unique in that it has virtually none. We have no defenses.
Foreign-exchange reserves mainly consist of foreign currencies and gold. The most popular foreign-exchange currency held by central banks by far is the U.S. dollar, but the Euro, Japanese Yen, Swiss Franc, and a few others are popular as well.
Foreign-exchange reserves held by central banks around the world have multiple purposes:
- They act as savings; a way for a central bank to be able to pay external obligations if necessary.
- If a country’s own currency weakens (which makes imports more expensive, and in crisis situations can lead to major devaluation), their central bank can sell some of its foreign-exchange reserves and buy its own currency. This reduces supply and increases demand for their own currency, strengthening it. The bigger the reserves compared to the country’s monetary supply or GDP, the more “ammunition” they have to defend the value of their currency if needed.
- If a country’s own currency strengthens too much (which can be bad for export-driven countries), their central bank can print units of their own currency and use it to buy foreign-exchange reserves. This weakens their currency a bit and increases their reserves going forward.
Here is a map by Visual Capitalist, using data from Howmuch.net, to show how large various countries’ reserves are:
Chart Source: Visual Capitalist
This chart isn’t perfect because it excludes gold and only counts actual currency. However, it’s a great visual.
As you can see, China, Japan, Switzerland, Saudi Arabia, Hong Kong, Brazil, Singapore, South Korea, and Russia have among the biggest foreign-exchange reserves. The United States has almost nothing.
Data for foreign reserves generally comes from central bank websites. More simply, you can also get info on worldwide foreign-exchange reserves from the CIA World Factbook (moderately up-to-date), Trading Economics (quite up-to-date) and Wikipedia (also quite up-to-date and well-sourced).
The United States foreign reserves counting gold is actually on the order of about $400-$500 billion. This is much higher than any of those sources state, even among the sources that include gold.
This is because in addition to their puny ~$44 billion currency reserves and special drawing rights, the Federal Reserve has over 260 million ounces of gold certificates, and their book value is listed as $42/ounce because that’s what the value was in the 1970’s. Virtually all of that gold is held and owned by the U.S Treasury.
Currently gold is worth over $1,500/ounce but the Fed books it based on the old price rather than current market price, and sources use the official book value rather than the actual value today.
When the actual market price of the United States’ gold is considered, in addition to their currency reserves and special drawing rights, the Fed and Treasury combined has in the ballpark of $400-$500 billion in reserves. Gold is about three-quarters of the value.
Reserves Relative to Economic Size
More important than the sheer amount of reserves a country has, is how much reserves it has compared to its amount of currency in circulation (M2 money supply), or compared to its annual economic output (GDP).
After all, if a central bank has to defend its currency, it has to sell foreign reserves in an amount relative to the size and scope of the currency it is defending.
For example, during the summer of 2018, Turkey and Argentina had major currency crises, which hurt them badly because they have so much foreign-denominated debt. Both of those countries had less than 10% of GDP worth of currency reserves, while most countries have much more. They couldn’t adequately defend their currencies.
Here are some rough figures, give or take a few percent, for how much a few major countries have in foreign reserves relative to their GDP and M2 money supply:
|Country||% of GDP||% of Money Supply|
|United States Reserves||2%||3%|
The United States has foreign-exchange reserves including gold equal to about 2% of its GDP and about 3% of its M2 money supply. And that’s using the current price of the United States’ gold; not the low book value they state.
This is far smaller than just about any country.
Basically, the United States has zero ammunition to defend its currency if a dollar crisis occurs. There’s nothing it can sell to buy a significant amount of dollars to improve the supply/demand balance of dollars.
Even countries that have had currency crises recently, like Argentina and Turkey, in part because their reserves were not large enough to defend their currencies, have proportionally far more reserves than the United States. We are a major outlier in how very little reserves we have.
And this is ironically due to historical strength of the U.S. dollar. We’ve never had a need for currency reserves. Other countries hold reserves in dollars, while we hold nothing.
As the world’s sole superpower after World War 2, with vast natural resources, a free economy, and in great location connected to and defended by two oceans, the United States has been the most robust and diversified economy in the world for decades.
The dollar is the default currency for global payments and various central bank foreign reserves. Other countries hold our dollars for reserves; we don’t need to hold anything. Our dollar is the axiom to which other currencies are compared, and which commodities are priced in.
Or at least, that’s historically been the case.
One of the driving factors that led to the 2007/2008 subprime mortgage crisis (“the Great Recession”) in the United States was the belief that real estate always goes up in value. So you could leverage 30-to-1 against it. You could bundle a bunch of subprime mortgages together for diversification and slap a high credit rating on it. Because it’s real estate. It’s safe. It doesn’t go down.
But then it did go down by 20% or more. And that wouldn’t have been so bad if not for all the leverage based on the belief that it can’t go down that much.
And the dollar is basically the same. It doesn’t go down. It doesn’t need foreign-exchange reserves. Until, one day, what if it does?
What Could Cause a Dollar Crisis?
There are a lot of things in the favor of the U.S. dollar that makes a dollar crisis unlikely. Something big would have to overtake those in-built advantages.
U.S. dollar entrenched advantages:
- Most commodities are priced in dollars globally. So, for example, if country A sells oil to country B (and neither of those countries are the United States, and they both have their own currencies), they often still price that transaction in U.S. dollars.
- The U.S. dollar is a safe-haven currency. In times of crisis, people globally buy dollars. Even if the crisis originates in the United States, like the 2008 subprime financial crisis mostly did, people still buy dollars for safety.
- There’s no major fiat currency alternative. The euro is close, but the European Union doesn’t have the same centralized governance, taxation, and unity of the United States. The Chinese renminbi is another contender as the currency of the world’s second largest economy, but the country is not open enough yet for its currency to become the world’s leading reserve standard. Japan’s yen is another big one, but that country has the highest sovereign debt in the world as a percentage of GDP, and a shrinking population. The Swiss franc, British pound sterling, Canadian dollar, and other stable currencies just aren’t quite widespread enough.
- The U.S. is the world’s largest importer. We’re a major consumption-oriented economy. A major reason why so many countries hold dollars is because they already have so many dollars from selling goods to the United States.
- At the current time, the United States has higher real interest rates than most other developed countries. There’s more incentive to hold dollars, and therefore for the dollar to strengthen.
In order for the U.S. dollar to not be so heavily bought around the world, central banks would need to diversify their holdings more, commodities would have to be priced in other currencies more often, and the U.S. dollar would have to lose its perception as a safe haven currency.
What could be different in the future compared to the past, which could cause a dollar crisis which has not been seen in the nearly 50-year history of U.S. fiat currency?
Here are a few things that could destabilize the U.S. dollar:
- Increasing federal debt and deficits
- Large and long-term trade deficits
- A significantly weakening middle class
Let’s quantify them one at a time.
Potential 1) U.S. Federal Debt
The United States has historically had fairly low government debt as a percentage of GDP. Only during WWII did it spike to high levels, but that was quickly paid off (mostly by keeping the debt stable while GDP grew quickly, rather than actually paying off debt).
By the time the U.S. left the gold standard and the dollar became a fiat currency in the 1970’s, the United States had very low debt relative to its GDP. During the 1980’s and early 1990’s the U.S. started to rack up debt more quickly, but that was temporarily turned around in the late 1990’s.
However, in the aftermath of the 2008 subprime mortgage crisis, the United States racked up a ton of debt. Going forward, the United States currently has massive fiscal deficits even during peacetime at the top of a bull market, and so projections are that unless government taxation or spending substantially changes, the U.S. debt as a percentage of GDP is going to skyrocket:
Source: Congressional Budget Office
Frighteningly, that chart assumes no recessions over the next decade or two. When the CBO releases projections like this, they assume constant smooth GDP growth.
Will Congress improve this dire debt forecast? Perhaps. Several European countries racked up a ton of debt after the 2008 global financial crisis and European sovereign debt crisis, but many of them like Germany were successful in reducing that debt substantially over the next few years.
If U.S. debt stabilizes, the fiat currency of the country has a better chance of remaining the global reserve currency. But if U.S. debt keeps increasing relative to GDP, central banks and institutions around the world will be more likely to diversify their currency holdings away from the U.S. dollar.
Potential 2) U.S. Trade Deficit
The United States has a trade deficit of over $550 billion per year.
The goods deficit is over $800 billion, while the services surplus is over $250 billion, and the net total deficit is over $550 billion.
Normally, trade deficits have a self-correcting mechanism in the form of currency fluctuations. If a country has a large trade deficit for a long time, it eventually has a weakening economy or its currency tends to weaken relative to other currencies.
A weakening currency ironically tends to improve (reduce) a country’s trade deficits. For example, if the U.S. dollar weakens relative to other currencies, it means exports to the U.S. become a lot more expensive for U.S. consumers paying in dollars, and means U.S. exports to other countries are a lot more competitive and appealing (cheaper) to buy. Imports would go down and/or exports would go up.
The United States however is never allowed to encounter this self-correcting mechanism to reduce its trade deficit. Because the U.S. dollar is bought around the world by central banks, it can maintain a large and growing trade deficit and so far its currency hasn’t paid the price for that. There’s enough global demand and liquidity for U.S. dollars and Treasuries that we can have a half-trillion dollar deficit every year and still maintain a strong currency.
However, we’ve only had a big trade deficit since the mid/late-90’s. Just over 20 years:
Chart Source: Trading Economics
The 2008 subprime mortgage crisis considerably weakened our economy, and served as a self-correcting mechanism for the trade deficit even though our currency remained strong.
However, with 20+ years of large trade deficits under our belt, what will happen when we go 30 years with a large trade deficit? 40 years? 50? How long is this sustainable?
Many economists view the trade deficit as beneficial to the United States in the near-term and intermediate-term, and raises the standard of living for U.S. citizens. But can it continue forever?
Most likely, either the economy has to weaken, or the currency has to weaken, for this to correct itself to any significant degree.
Potential 3) U.S. Polarization and Weakening Middle Class
Credit rating agencies started downgrading U.S. Treasuries in 2011 due to political polarization and brinkmanship within the U.S. government. Debt is rising, and government is more divided than almost any time in U.S. history.
Political polarization and partisanship, measured in terms of members of Congress voting in line with their party, is at record highs over the past century:
Chart Source: Ray Dalio and Bridgewater Associates
Gone are the days when Representatives and Senators would reach across the aisle on a regular basis and work together to govern the country. Politics have always been brutal, but the last time it was this polarized was in the first decade of the 1900’s, a century ago.
Starting from the late 1970’s and up, we’ve had a clear trend of political polarization. At 96% voting among party lines, it can’t go much higher than it is now.
Likely related, American confidence in Congress, media, and banks is at multi-decade lows :
Chart Source: Ray Dalio and Bridgewater Associates
In addition, due to increasing wealth concentration, the wealth of the average U.S. citizen is a lot higher than the more relevant median citizen.
(“Mean” refers to the average; all wealth divided by the number of citizens, which means the top 1% pulls the average up quite a bit. “Median” refers to the actual middle person example, so if you line up all adult Americans, the median net worth is the net worth of the person who is richer than 50% of them and poorer than the other 50%.)
According to the 2018 Credit Suisse Wealth Report, although the mean American citizen is one of the richest in the world with over $400k in wealth, the median American has less than $62k. Thus, although the American mean is higher than the Japanese mean, UK mean, Canadian mean, South Korean mean, and so forth, the American median is below all of those countries’ medians.
In this case, due to wealth concentration, the average is a lot higher than the median. In other words, the middle class is not very well off. The typical middle class American has less wealth than their counterparts in many other developed countries. The top 0.1% wealthiest people in the United States have roughly the same wealth as the bottom 90% combined.
A 2014 working paper by the Federal Reserve Bank of Dallas found that higher degrees of wealth inequality were strongly correlated with political polarization over nine decades of recent U.S. data:
Chart Source: John Duca and Jason Saving, Dallas Fed Working Paper 1408
With so many people being left behind for a variety of reasons, it’s no surprise that politics can get more polarized.
People accept a certain level of wealth inequality and concentration. It gives them an incentive to work harder and rise through class levels in society. But when it hits extremes, people start to feel like they are cheated, that the system is stacked against them.
Automation, foreign labor, tax structures, central bank actions, extreme health care costs- all of these things and more can contribute to a large portion of the population not benefiting from the economy. And when wealth is so concentrated, the money moves around less. The consumer spending engine of the economy starts to sputter.
Summary, and How to Stay Protected
A significantly weaker U.S. dollar seems a far-off scenario, but there are building factors in favor of it happening at some point.
The United States has had a fiat currency for less than 50 years. It’s a fairly short-lived experiment in the grand scheme of things, especially considering we have virtually no foreign exchange reserves to support the dollar should it be necessary to do so, unlike every other major fiat currency on Earth.
And in those 50 years, the United States has grown a massive trade deficit, built up high federal government debts, and encountered record political polarization. We’re not in the same situation as we were 50 years ago, so we shouldn’t assume that just because something has worked for nearly five decades that it means it will continue to work forever.
Either the United States will correct some of its deficits, or the currency may weaken and self-correct some of them itself.
And from the big picture viewpoint, a weakening currency is not so bad. Economies regularly self-correct in various ways.
If our currency were to notably weaken compared to other currencies, it would make imports more expensive and exports more competitive. Holders of U.S. cash would lose some global purchasing power, but domestic U.S. businesses may see a boost over the long run. It would kind of force us to spend less and produce more.
Diversification is Key
The way to hedge against a weak dollar is simple: hold some foreign-denominated assets and/or precious metals as part of a diversified portfolio. If the dollar goes down, these things give disproportionate returns for U.S.-based investors.
I have some specific articles with tips on how to invest in those asset classes:
- International Stocks and ETFs: Where I’m Focusing This Year
- How to Invest in Gold and Silver: Precious Metals Investing Guide
- Demystifying Emerging Markets: How to Invest Wisely Abroad
That’s not to say avoid U.S. stocks or cash. I have plenty of U.S. equities and short-term dollar-denominated bonds, cash, and cash-equivalents. It’s just that, as part of a diversified portfolio, I’m not 100% in dollar-denominated assets like some U.S. investors are.
You also have to consider that if you are a U.S. investor, your primary income is likely in dollars, your home is priced in dollars, and your bank account is in dollars. Combined with the U.S. equities and U.S. bonds portion of your portfolio, you are likely very, very long the United States and its currency.
Having a portion of your portfolio dedicated to international equities, precious metals, commodity producers, or other non-dollar assets is not a bad move in my opinion. During months or years where the U.S. dollar strengthens relative to other currencies, the foreign part of your portfolio won’t feel great. But during times when the U.S. dollar weakens, or we have some domestic recession, those assets can be big outperformers.
If you want to see an example, I have a real-money diversified model portfolio for readers of my free investment newsletter. You’ll also get a detailed update on market conditions and investment opportunities every 6 weeks or so.