The American economy is possibly sliding back into recession, yet at the same time the U.S. greenback is soaring in currency exchange markets, and other currencies are falling. The Canadian dollar, for example, slid into the 95-cent range early on Friday morning, and that came after a reassuring report from Statistics Canada that our economy expanded at a comfortable rate in July.

More than a few observers are perplexed by this apparent contradiction. How is it that the U.S. economy is at the epicenter of the current global slowdown, yet its currency is strengthening?

A Safe Haven

The first (and most common) explanation is the U.S. dollar as a safe haven. Banks, insurance companies, pension funds, individual investors, and governments around the world hold their financial assets in any number of investment vehicles. Stocks, commodities (such as oil or gold), corporate or government bonds, and money market instruments (such as Treasury bills) are the most common.

But when there is greater risk-adversity among investors, they run and duck for cover in investments with the greatest degree of certainty, and that is still government bonds issued by the U.S. government.

But isn’t the U.S. economy tanking? And isn’t Washington bankrupt? Why would American government debt be considered a safe haven?

The U.S. government ultimately has the wherewithal to meet its debt obligations.

By purchasing U.S. bonds and Treasury bills, investors are indeed lending money to Washington, which needs to borrow a lot of money these days just to pay its bills. This was brought to a head in July with the debt-ceiling crisis in the United States, which was more of a political gong show than a truly fiscal meltdown.

Americans are among the least taxed people in the industrialized world—there is a lot of room to raise tax revenue if they had to. As well, the U.S. government spends an incredible amount of money, particularly on the military and social security entitlements. The problem is politicians can’t agree on what to do: raise taxes or cut spending.

America’s debt problem is very serious, but it is nothing like the problems in Greece in 2011, or even Lehman Brothers in 2008, both of which were out of money and out of options. Investors know that despite the credit rating downgrades this summer, the U.S. government ultimately has the wherewithal to meet its debt obligations. And because of that, they are still willing to park their cash in U.S. Treasury bills, knowing it is safe.

A second and related explanation is what happens when investors grow fearful of a stock market downturn and start selling their equity stakes in companies. The financial proceeds from the sale of these stocks has to go somewhere, and often it just ends up on the investors’ balance sheets as cash (or as Treasury bills). If that cash is in U.S.-dollar denominated accounts it puts upward pressure on demand for the U.S. dollar—and because of this, the price (or exchange rate) rises.

The U.S. Federal Reserve Board—which is partially a privately owned operation—acts as the central bank for the United States. It issues the U.S. dollar and controls monetary policy (through adjustments to the amount of dollars in circulation and through interest rates). But the U.S. government, in essence, backs the legitimacy of those dollars. It is “fiat money”—a legally decreed medium of exchange, validated entirely by the backing of some government or crown.

When investors run to the safe haven of U.S. government Treasury bills or park it in U.S.-dollar denominated cash bank accounts, they are not necessarily casting a vote of confidence in the U.S. economy, but rather confidence that the U.S. government will be around in three months, a year, or 10 years—and will honor its commitment to back the dollar.

Other currencies (such as the Canadian dollar, the Australian dollar, or the Norwegian krone) are riskier because they are exposed to volatile commodity prices, and their national economies are smaller.

The Chinese yuan is controlled by that country’s government and is not a fully tradable currency.

Other emerging economies (Russia, India, Brazil) do not have the same track record of political stability. And because of the European situation at the moment, the future of the euro is questionable.

As paradoxical as it seems, that leaves Washington as the last remaining bastion of stability. Investors may be losing confidence in the U.S. economy, but they remain solidly confident the U.S. government will pay them back—at least for now.

Todd Hirsch is Senior Economist with ATB Financial and Alberta Business columnist for Troy Media. Copyright Troy Media Corporation.