Preparing for a Lengthy and Unpredictable US Dollar Crisis

“On the threshold of a crisis,” we observed in our essay “Investing Ahead of the Curve” in the July 19, 2011 edition of The Daily Reckoning, “a fertile imagination can be an investor’s most valuable asset.”

“During normal times,” we continued, “investors can focus only on buying quality stocks one by one from the bottom up, without also trying to envision what tragedies might befall them from the top down… But it may be time to begin imagining the unimaginable.

“It may be time, in other words, to begin considering that the next phase of the global monetary system might not include the US dollar as its reserve currency…or that the next two decades of life in America might not look anything like the last two decades.”

Here in the US of A, life is still pretty good, even if the economy isn’t perfect. A true crisis seems unimaginable. After all, even the 2008 crisis wasn’t that bad. Today, the Apple store in the mall is always packed, most of the restaurants in town are full…and the dollar is still strong enough to buy a nice vacation almost anywhere in the world.

A currency crisis that triggers an economic crisis — or vice versa — just feels like a bunch of wacky doom-and-gloom stuff. And it may well be. In the context of America’s legendary resilience and economic might, a catastrophic currency crisis seems almost unimaginable… But the time has arrived to begin imagining it…not because it is certain, but because it has become less unimaginable.

The best way to defend against a currency crisis is as obvious as it is emotionally difficult: Don’t hold the currency that is hurtling toward a crisis.

There is nothing mechanically difficult about this remedy, but it can be very difficult emotionally…and tactically. An individual who trades dollars for some sort of “safer” currency, for example, risks looking like a fool for a long period of time. Not even gold is a sure bet over short-to-medium-term timeframes. This safe-haven asset tumbled about 40% against the dollar during the 2008 crisis.

In short, being “safe” can sometimes feel very dangerous…and foolish. And no one wants to look as foolish as Noah building his Ark…unless, of course, it starts raining.

When the rain started falling on Brazil in 1990…or Thailand in 1997…or Russia in 1998, investors who had traded their local currencies for US dollars or gold were able to sail through the crises relatively unscathed. As their economies tumbled into deep recessions and asset values collapsed, the folks who had parked their wealth in dollars or gold were able to preserve their wealth…and also to take advantage of the resulting bargains.

But these folks had to be both forward-looking and patient if they were to succeed in protecting their wealth. Even so, their mission was infinitely easier than the one we Americans face today.

Throughout the serial currency crises of the last several decades, individuals everywhere throughout the world knew they could protect their wealth simply by trading their local currencies for US dollars. They didn’t even have to think about it. Just a wee bit of imagination enabled some investors to steer clear of these crises. The dollar was a sure thing.

But now that the “sure thing” itself is the thing that is becoming less sure, the appropriate course of action is very difficult to determine. Today, the looming potential crises are not unfolding in banana republics or in chronic economic basket cases, but in the world’s largest economies.

Investors required almost no imagination to envision the Argentine currency crisis of 2002. Argentina, Brazil and Russia all possessed a rich history of monetary incompetence and chicanery. Today, however, investors will require an imagination so vivid and wild that it would border on hallucinogenic. They must not merely imagine that an Argentina might have a currency crisis…again…but they must try to imagine that the euro might splinter apart…or that the dollar might suffer a disastrous hyperinflation.

If, in fact, the foundations supporting the dollar’s strength are eroding, how should the forward-looking dollar-holders protect themselves? Should they swap dollars for a few select foreign currencies? Maybe, but what if they select the wrong “select” currencies?

Singapore, Norway and Chile, to name just three examples, issue currencies that have been appreciating against the US dollar for many years. Broadly speaking, their currencies are strong because these nations operate in a much more fiscally responsible manner than the US government. Yet, when the euro crisis reached a boil last summer, the US dollar was still the world’s go-to currency. The Singapore dollar, Norwegian krone and Chilean peso all fell at least 10% against the US dollar.

All three of those currencies have since recovered most of their losses. But the point remains: Trying to preserve wealth by swapping US dollars for some other currency is a terrifying and risky quest…even if that strategy may be absolutely correct over the long run.

Eric Fry
for The Daily Reckoning