Key Takeaways
- A currency collapse is when a country's currency loses all its value and becomes practically worthless in day to day use
- This is generally as a result of political or economic upheaval, hyperinflation or war
- It’s not a common occurrence, but we’ve seen it happen before in various places around the world
- For investors, it’s a risk to be aware of, though luckily it’s fairly easy to protect yourself against it
- While technically the U.S. dollar could collapse, it’s backing from the largest economy in the world and its status as the global reserve currency, makes that highly unlikely
Whoa, that’s a big statement. If you're someone from Argentina, Venezuela or Russia, you understand the realities of what can happen when your home currency fails. It’s a big deal, and it can cause immense financial damage to the economy and individuals.
But is it actually realistic to think that the U.S. Dollar, the world's reserve currency, could collapse too?
Look, we’ll cut to the chase. It’s unlikely. But, it’s not impossible. Nothing is in the world of money and finance. For investors, it’s important to understand the potential outcomes that could impact their finances, even if they’re unlikely.
So in this article, we’re going to walk you through what actually happens when a currency collapses, how it could impact investors, and what they can do to protect against it.
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What is a currency collapse?
A currency collapse is when a currency loses all of its value. This might seem crazy, but it makes more sense when you consider that money is simply an IOU from the government. It used to be that paper money, coins and even numbers on a bank statement represented an amount of gold in reserve.
In those days, money represented an IOU for that amount of gold. Now, the system isn’t fully backed by gold, but the concept remains the same. Now, they’re backed by the weight of the United States, reflecting everything within the economy.
So in order for a dollar to have value, society needs to believe that the United States has value. Given how many taxpayers, businesses and valuable assets are in the US, it’s hard to argue that it doesn’t have value. In fact, the reason why the U.S. was able to move off the gold standard was because it had so much economic value.
So, a currency collapse is when there is no longer any trust that the asset, country or organization has sufficient value to reflect the currency.
This can happen for a number of reasons.
Hyperinflation
When hyperinflation occurs, every dollar becomes less valuable. $10 might buy you a 12 case of Pepsi today, and then tomorrow that same $10 only buys you six Pepsi’s. The currency’s value becomes less and less, and this can create a spiral that ends up in it becoming practically worthless.
We’ve seen an example of this in Zimbabwe in the early 2000’s.
Political Instability
While not something we expect to see in the U.S., governments can be overthrown. When there is a military coup, a war or another event resulting in political upheaval, a country’s currency can often be a casualty.
High Debt
Many countries have high levels of debt these days, but this is all relative to the strength of the underlying economy. When a country has very high debt and a shrinking economy, this can cause a flight of assets and a collapse of the currency.
These are just
The U.S. dollar’s special status
Unlike any other country in the world, the U.S. dollar has a special place in the global financial system. That’s because it is the global reserve currency. That means that it’s considered as the safest currency there is, with many other countries keeping U.S. dollars in reserve.
This isn’t just a theoretical detail, it’s a practical one too. For example, many global financial contracts are denominated in U.S. dollars, and many countries who have struggled to maintain a stable currency use U.S. dollars as their own national currency.
Right now there are 11 foreign countries that use the U.S. dollar as their official currency. These include Panama, El Salvador, Zimbabwe and Timor Leste.
The U.S. dollar has been able to gain and maintain this special status because of the strength of the economy. The U.S. is still the biggest economy in the world by far, with an annual GDP of $23 trillion. Second is China with $17.7 trillion, and way back in third is Japan with $4.9 trillion.
All of this is to say, for the U.S. dollar to collapse would take something pretty major. Like, a WWIII type situation.
And despite all of the uncertainty around the world, the U.S. still remains one of the most stable countries there is. The chances that we see a collapse of the U.S. dollar are very slim, and if it did happen, we'd probably have bigger problems to worry about than our investments.
Like where to get clean water and what to hunt for our dinner.
How does currency collapse impact investors?
Investments are inherently tied to the currency they’re held in. If you hold U.S. stocks which are denominated in dollars, you need dollars to buy and sell them. That’s fine if the currency remains stable and you live in the United States, but it can cause havoc if it doesn’t or you don’t.
When a currency collapses, investors can see their assets plummet in value, purely on the exchange rate alone. Not only that, but during times of economic and political crisis, governments will often restrict the movement of currency in an attempt to limit the damage.
So currency risk is a really important factor for investors. Anyone looking to invest in assets denominated in a ‘risky’ currency, should understand the additional risks involved, and expect the potential for additional returns for taking that higher risk.
The bottom line
Currencies can and do collapse, but it’s not a minor event. When a currency collapses, it’s down to a significant economic or political event in a country that has a huge impact on its citizens.
It’s not a likely outcome at all in most countries around the world, and that’s particularly true for the United States. This is down to the U.S. dollar's status as the global reserve currency.
So while technically the U.S. dollar could collapse, the chances of that happening any time soon are incredibly slim.
For investors, currency collapses can impact their portfolios if they invest globally (as they should be). The best way to protect against this is through sufficient diversification. By having assets spread across different industries and in different currencies, it limits the potential damage of a currency collapse on a portfolio.
Jason Mountford is a Forbes Contributor and Trend Analyst at Q.ai
