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Page added on March 8, 2015
Why It Matters If the Dollar Is the Reserve Currency
We refer to the dollar as a “reserve currency” when referring to its use by other countries when settling their international trade accounts.
For example, if Canada buys goods from China, China may prefer to be paid in US dollars rather than Canadian dollars. The US dollar is the more “marketable” money internationally, meaning that most countries will accept it in payment, so China can use its dollars to buy goods from other countries, not solely the US. Such might not be the case with the Canadian dollar, and China would have to hold its Canadian dollars until it found something to buy from Canada. Multiply this scenario by all the countries of the world who print their own money and one can see that without a currency accepted widely in the world, international trade would slow down and become more expensive. In some ways, its effect would be similar to that of erecting trade barriers, such as the infamous Smoot-Hawley Tariff of 1930 that contributed to the Great Depression.
There are many who draw a link between the collapse of international trade and war. The great French economist Frédéric Bastiat said that “when goods do not cross borders, soldiers will.” No nation can achieve a decent standard of living with a completely autarkic economy, meaning completely self-sufficient in all things. If it cannot trade for the goods that it needs, it feels forced to invade its neighbors to steal them. Thus, a near-universally-accepted currency can be as vital to world peace as it is to world prosperity.
What “Reserve Currency” Really Means
However, the foundation from which the term “reserve currency” originated no longer exists. Originally, the term “reserve” referred to the promise that the currency was backed by and could be redeemed for a commodity, usually gold, at a promised exchange ratio. The first truly global reserve currency was the British pound sterling. Because the Pound was “good as gold,” many countries found it more convenient to hold pounds rather than gold itself during the age of the gold standard. The world’s great trading nations settled their trade in gold, but they might accept pounds rather than gold, with the confidence that the Bank of England would hand over the gold at a fixed exchange rate upon presentment. Toward the end of World War II, the US dollar was given this status by treaty following the Bretton Woods Agreement. The US accumulated the lion’s share of the world’s gold as the “arsenal of democracy” for the allies even before we entered the war. (The US still owns more gold than any other country by a wide margin, with 8,133.5 tons compared to number two Germany with 3,384.2 tons.)
The International Monetary Fund (IMF) was formed with the express purpose of monitoring the Federal Reserve’s commitment to Bretton Woods by ensuring that the Fed did not inflate the dollar and stood ready to exchange dollars for gold at $35 per ounce. Thusly, countries had confidence that their dollars held for trading purposes were as “good as gold,” as had been the British pound at one time.
The Advent of the Fiat Reserve Currency
However, the Fed did not maintain its commitment to the Bretton Woods Agreement and the IMF did not attempt to force it to hold enough gold to honor all its outstanding currency in gold at $35 per ounce. During the 1960s, the US funded the War in Vietnam and President Lyndon Johnson’s War on Poverty with printed money. The volume of outstanding dollars exceeded the US’s store of gold at $35 per ounce. The Fed was called to account in the late 1960s first by the Bank of France and then by others.
Central banks around the world, who had been content to hold dollars instead of gold, grew concerned that the US had sufficient gold reserves to honor its redemption promise. During the 1960s the run on the Fed, led by France, caused the US’s gold stock to shrink dramatically from over 20,000 tons in 1958 to just over 8,000 tons in 1970. At the accelerating rate that these redemptions were occurring, the US had no choice but to revalue the dollar at some higher exchange rate or abrogate its responsibilities to honor dollars for gold entirely. To its everlasting shame, the US chose the latter and “went off the gold standard” in September 1971. (I have calculated that in 1971 the US would have needed to devalue the dollar from $35 per ounce to $400 per ounce in order to have sufficient gold stock to redeem all its currency for gold.) Nevertheless, the dollar was still held by the great trading nations, because it still performed the useful function of settling international trading accounts. There was no other currency that could match the dollar, despite the fact that it was “delinked” from gold.
Why the Dollar Continued To Be a Reserve Currency
There are two characteristics of a currency that make it useful in international trade: one, it is issued by a large trading nation itself, and, two, the currency holds its value over time. These two factors create a demand for holding a currency in reserve. Although the dollar was being inflated by the Fed, thus losing its value vis-à-vis other commodities over time, there was no real competition. The German Deutsche mark held its value better, but the German economy and its trade was a fraction that of the US, meaning that holders of marks would find less to buy in Germany than holders of dollars would find in the US. So demand for the mark was lower than demand for the dollar. Of course, psychological factors entered the demand for dollars, too, since the US was the military protector of all the Western nations against the communist countries.
Today we are seeing the beginnings of a change. The Fed has been inflating the dollar massively, reducing its purchasing power and creating an opportunity for the world’s great trading nations to use other, better monies. This is important, because a loss of demand for holding the US dollar as a reserve currency would mean that trillions of dollars held overseas could flow back into the US, causing either inflation, recession, or both. For example, the US dollar global share of central bank holdings currently is 62 percent, mostly in the form of US Treasury debt. (Central banks hold interest-bearing Treasury debt rather than the dollars themselves.) Foreign holdings of US debt is currently $6.154 trillion. Compare this to the US monetary base of $3.839 trillion.
Should foreign demand to hold US dollar denominated assets diminish, the Treasury could fund their redemption in only three ways. One, the US could increase taxes in order to redeem its foreign held debt. Two, it could raise interest rates to refinance its foreign held debt. Or, three, it could simply print money. Of course, it could use all three to varying degrees. If the US refused to raise taxes or increase the interest rate and relied upon money printing (the most likely scenario, barring a complete repudiation of Keynesian doctrine and an embrace of Austrian economics), the monetary base would rise by the amount of the redemptions. For example, should demand to hold US dollar denominated assets fall by 50 percent ($3.077 trillion) the US monetary base would increase by 75 percent, which undoubtedly would lead to very high price inflation and dramatically hurt us here at home. Our standard of living is at stake here.
So we see that it is in the interest of many that the dollar remain in high demand around the world as a unit of trade settlement. It is necessary in order to prevent price inflation and to prevent American business from being saddled with increased costs that would come from being forced to settle their import/export accounts in a currency other than the dollar.
Threats To the Dollar as Reserve Currency
The causes of this threat to the dollar as a reserve currency are the policies of the Fed itself. There is no conspiracy to “attack” the dollar by other countries, in my opinion. There is, however, a rising realization by the rest of the world that the US is weakening the dollar through its ZIRP and QE programs. Consequently, other countries are aware that they may need to seek a better means of settling world trade accounts than using the US dollar. One factor that has helped the dollar retain its reserve currency demand in the short run, despite the Fed’s inflationist policies, is that the other currencies have been inflated, too.
For example, Japan has inflated the yen to a greater extent than the dollar in its foolish attempt to revive its stagnant economy by cheapening its currency. Now even the European Central Bank will proceed with a form of QE, apparently despite Germany’s objections. All the world’s central banks seem to subscribe to the fallacious belief that increasing the money supply will bring prosperity without the threat of inflation. This defies economic law and economic reality. They cannot print their way to recovery or prosperity. Increasing the money supply does not and cannot ever create prosperity for all. What is more, this mistaken belief compounds a second mistake; i.e., that savings is not the foundation of prosperity, but rather spending is the key. This mistake puts the cart before the horse.
A third mistake is believing that driving their currencies’ exchange rate lower vis-à-vis other currencies will lead to an export-driven recovery or some mysteriously generated shot in the arm that will lead to a sustainable recovery. Such is not the case. Without delving too deeply into Austrian economic and capital theory, just let me point out that money printing disrupts the structure of production by fraudulently changing the “price discovery process” of capitalism. When this happens, capital is allocated to projects that will never be profitably completed. Bubbles get created and collapse and businesses are suddenly damaged en masse, thus, destroying scarce capital.
Possible Future Scenarios
Because of this money-printing philosophy, the dollar is very susceptible to losing its vaunted reserve currency position to the first major trading country that stops inflating its currency. There is evidence that China understands what is at stake; it has increased its gold holdings and has instituted controls to prevent gold from leaving China. Should the world’s second largest economy and one of the world’s greatest trading nations tie its currency to gold, demand for the yuan would increase and demand for the dollar would decrease overnight.
Or, the long festering crisis in Europe may drive Germany to leave the eurozone and reinstate the Deutsch mark. I have long advocated that Germany do just this, which undoubtedly would reveal the rot embodied in the euro, the commonly held currency that has been plundered by half the nations of the continent to finance their unsustainable welfare states. The European continent outside the UK could become a mostly Deutsch mark zone, and the mark might eventually supplant the dollar as the world’s premier reserve currency.
The underlying problem, though, lies in the ability of all central banks to print fiat money; i.e., money that is backed by nothing other than the coercive power of the state via its legal tender laws. Central banks are really little more than legal counterfeiters of their own currencies. The pressure to print money comes from the political establishment that desires both warfare and welfare. Both are strictly capital consumption activities; they are not “investments” that can pay a return.
In a sound money environment, where the money supply cannot be inflated, the true nature of warfare and welfare spending is revealed, providing a natural check on the amount of funds a society is willing to devote to each. But in a fiat money environment both war and welfare spending can expand unchecked in the short run, because their adverse consequences are felt later and the link between consumptive spending and its harm to the economy is poorly understood. Thus, both can be expanded beyond the recuperative and sustainable powers of the economy.
The best antidote is to abolish central banks altogether and allow private institutions to engage in money production subject only to normal commercial law. Sound money would be backed 100 percent by commodities of intrinsic value — gold, silver, etc. Any money producer issuing money certificates or book entry accounts (checking accounts) in excess of their promised exchange ratio to the underlying commodity would be guilty of fraud and punished as such by both the commercial and criminal law, just as we currently punish counterfeiters. Legal tender laws, which prohibit the use (in many cases) of any currency other than the one endorsed by the state, would be abolished and competing currencies would be encouraged. The market would discover the better monies and drive out less marketable ones; i.e., better monies would drive out the bad or less-good monies.
We need to look at the concept of a reserve currency differently, because it is important. We need to look at it as a privilege and a responsibility and not as a weapon we can use against the rest of the world. If we abolish, or even lessen, legal tender laws and allow the process of price discovery to reveal the best sound money, if we allow our US dollar to become the best money it can — a truly sound money — then the chances of our personal and collective prosperity are greatly enhanced.
16 Comments on "Why It Matters If the Dollar Is the Reserve Currency"
Rodster on Sun, 8th Mar 2015 9:26 am
I read this article posted on ZH last week. It matters a whole lot that the US retains the worlds reserve currency. The US Govt’s entitlement programs are being funded by the green back.
Without the reserve currency we’d be just another turd world nation…oh wait!
Davy on Sun, 8th Mar 2015 10:21 am
Rodstar, there is not one other major power that is not broke from debt, unfounded liabilies, and overshoot issues. The U.S. is currently a first, second, and third world country. All countries are on a journey of decent. Let’s make that clear when we are acknowledging the descent of the American empire.
There are no viable BAU alternatives other than regionalization and localization globally. I love how people preach winners and losers with a decouple of rising powers. I say that is a Cat Piss agenda seek.
penury on Sun, 8th Mar 2015 10:33 am
I will repeat what I said before. The U.S. uses the Reserve Currency status also as a weapon of control for nations which utilize the dollar. The IRS and other agencies use the pretext of tax evasion to monitor bank accounts around the world. The U.S. uses sanctions on countries that we have a tiff with and strictly control imports and exports which depend on”dollar”transactions. The U.S. uses devaluation and value inflation of the currency as a weapon of currency warfare. All nations which utilize the dollar for trade must buy or borrow dollars to buy or trade with other nations. Currently nations owe the U.S. in excess of 18 trillion dollars because of this trade. The interest generated covers a lot of items. I will not mention MIC sales to these nations. With the “Reserve Currency” the U.S. is able to maintain control of large numbers of nations who presume themselves to be independent, but are effectively vassel states.
Dredd on Sun, 8th Mar 2015 10:39 am
One man’s erect currency is another man’s viagra (Economic War Of The Pacific – 5).
That mafia does silly a lot, but rather seriously.
Rodster on Sun, 8th Mar 2015 10:55 am
penury- “I will repeat what I said before. The U.S. uses the Reserve Currency status also as a weapon of control for nations which utilize the dollar.”
Well said and stated!
The USSA thru the manipulation of it’s Swift system has used it’s status as reserve currency as a financial weapon to hurt other countries, Russia has been the latest. Then you have the credit rating agencies who are just shadow agencies for the US Gubmint who also use it’s credit rating as financial weapons against other nations so as to destabilize them. Russia has a lower GDP to Debt ration than the USSA and yet their status was downgraded to just a tad above junk.
You can only use financial weapons of mass destruction when you have the worlds reserve currency.
So Russia along with China have quickly moved to get away from Swift and setup their own version, they are quickly eliminating the USD in trade between countries and they have begun to setup their own version of the IMF.
Davy on Sun, 8th Mar 2015 11:41 am
Many nations benefit and also manipulate the U.S. reserve currency. China in particular has gutted the U.S. manufacturing base through currency manipulation and globalization practices like labor at slave labor levels. While the U.S. has benefited hugely the reserve currency status was one of the primary causes of run away consumerism and the sprawl economy.
This currency situation has primarily benefited a few at the expense of the many. IMA globally because the global plutocracy Russians and Chinese included have benefited. The demise of the dollar based BAU financial system is welcome in this respect. Unfortunately the consequences will be a dangerous vacuum of a BAU world in financial descent.
It’s so refreshing to listen to the anti-Americans who live in a winner loser world of agenda and selective facts. Resentment and hatred are wonder lusts enjoyments. It’s nice to compare oneself to this lower intellectual level so as to know what is closer to the truth and what is agenda goal seek of personal vendetta.
shortonoil on Sun, 8th Mar 2015 12:31 pm
To its everlasting shame, the US chose the latter and “went off the gold standard” in September 1971.
The US went off the “gold standard”, and went on the “the oil standard”. Prior to 1971 the US was one of the largest exporters of oil in the world, and to buy oil from the US required dollars; and everyone needs oil! After ’71 the US, with a little demonstration of its military machine, convinced the Saudis, and the rest of the Middle East that it was a whole lot more profitable, and safer to sell its oil in dollars. Those that decided to do otherwise got “shocked, and awed”.
As long as the world needs oil, and there is a soldier to pull the trigger when necessary, the dollar will remain the world’s reserve currency. The only problem with this methodology is that the oil age is ending. Without the reserve currency the US can’t pay its bills. The war birds in DC are going to have to find someplace else to roast! Don’t let them perch in “your” back yard.
BobInget on Sun, 8th Mar 2015 12:44 pm
Before Zimbabwe adopted the dollar, (as currency) inflation was out of control.
A former British Commonwealth Colony,
Zimbabwe’s lingua franca is English, not Chinese.
Panama uses USD’s for the same reason.
OPEC member, Ecuador’s currency is the USD.
Bahamas (Bahamian dollar always = $1 US)
Belize (Belize dollar always = 50¢ US)
Bermuda (Bermudian dollar always = $1 US)
Cambodia (quasi official in major cities)
Cayman Islands (Cayman dollar always = $1.20 US)
East Timor (tiny island country between Indonesia and Darwin Australia)
Federated States of Micronesia (South Pacific)
Marshall Islands (near Micronesia actually)
Organization of Eastern Caribbean States (OECS dollar always = 37¢ US)
Palau (east of the Philippines)
The above article is full of opinions. Never
does this paid propagandist mention ‘oil’.
Golds, silver, copper, palladium, platinum, combined can’t match USD $ volume of oil trading, coffee, also traded in USD, comes closer.
Rank of DOLLAR traded commodities;
Crude Oil and derivatives – The most commonly traded commodity is Crude Oil, and its various derivatives such as heating oil and gasoline.
Coffee – The second most traded commodity is Coffee [value wise]. Coffee is mainly traded through the New York Board of Trade [NYBOT], the Kansai Commodities Exchange [in Osaka, Japan], the Singapore Commodities Exchange [SICOM] and Euronext [London].
Agriculture – Common commodities in agriculture include wheat, corn, maize, oats, rice, soybeans and they are traded in the Chicago Board of Trade [CBOT], the Kansai Commodities Exchange [in Osaka, Japan], the Risk Management Exchange [RMX-in Hannover], the Minneapolis Grain Exchange, the Winnipeg Commodity Exchange [WCE], The Tokyo Grain Exchange [TGE] and Euronext.
Animals and Animal Products – Animals and animal products such as live and feeder cattle, beef, frozen and fresh pork bellies, and eggs are mainly traded in the Chicago Mercantile
Cocoa, Butter, Orange juice and Sugar – Items like cocoa, butter, orange juice and sugar are also commonly traded in the New York Board of trade.
Metals – Metals such as aluminum, nickel, copper, lead and ferrous scrap are mainly traded in the New York Mercantile Exchange [NYMEX], the London Metal Exchange [LME], the Shangai Futures Exchange [SFE], the Central Japan Commodities Exchange, Hedgestreet Exchange [in California], and the Tokyo Commodities Exchange [TOCOM].
Precious Metals – The other commonly traded commodities are precious metals such as gold, silver and platinum and they are traded in the New York Mercantile Exchange [NYMEX], the Brazilian Mercantile and Futures Exchange [BMF], the Dubai Gold and Commodities Exchange [DGCX], the National Commodity Exchange Limited [in Karachi, Pakistan] and the Tokyo Commodities Exchange [TOCOM].
Plastic – Plastic is traded in the London Metal Exchange [LME] and the Dalian Community Exchange [DCE-China]
Natural Gas – Natural gas is traded in the New York Mercantile Exchange [NYMEX] and ICE Futures.
Bio-fuels – Bio-fuels is another upcoming commodity and is now being traded in the Brazilian Mercantile and Futures Exchange [BMF], the Bursa Malaysia [MDEX], the Chicago Board of Trade [CBOT], the Chicago Mercantile Exchange [CME] and the New York Board of trade [NYBOT]
http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude_contract_specifications.html
BobInget on Sun, 8th Mar 2015 1:18 pm
I’ll offer one traveler’s example.
Banks in Nicaragua Only accept euros and dollars in exchange for local currency.
Even bordering Costa Rican currency is shunned. At the same time ANY store or vendor
will take dollars with a big smile.
Some visitors in Nicaragua and Costa Rica who never bother to exchange dollars for local money.
One quick tale:
Ecuador uses only USD’s and a few half dollar
and quarters minted in country.
Paper ones are so shredded and dirty tourists
feel the need to wash (all over) after handling.
The USD coin, an entirely different matter.
Most Americans (NOT Canadians or Mexicans)
have never spent a USD dollar coin.
Where are your Sacagaweas? And where are all those John Quincy Adams presidential coins?
Go to Panama or Ecuador, fill your pockets.
Here’s the punch line;
Standing in line at an US international airport
restaurant, a fellow ex Ecuadorian tourist and airline passenger showed me her USD one dollar coin and asked me if it was legal in Texas. To be fair, I’ve been asked the same
question about US dollars in San Juan, P.R.
Not on the dollar list above because Puerto Rico, along with VI, Guam, that one where all the huge line backers come from, are US colonies.
Outcast_Searcher on Sun, 8th Mar 2015 1:25 pm
OK. I don’t get this, so I’m going to ask in hopes someone with real insight can explain this.
WHY does the US reserve currency status actually compel, or even make desirable, foreign countries to hold more dollar reserves than they want?
There is a FOREX exchange where the Bank of Settlements recently said an average of $5.3 TRILLION of currency futures is exchanged daily.
So, for example, Japan needs to buy lots of oil. It doesn’t want to hold dollars. So, when it needs to buy oil, right before it buys the oil it sells Yen (which for this example it wants to hold instead of dollars), buys dollars, and then buys the oil with those dollars it just bought. No risky dollar holding period. No muss, no fuss. And all at electronic speeds.
This is NOT 1930 when Smoot Hawley was an issue and computers weren’t even invented.
So please – tell me. Why doesn’t the modern FOREX market make the whole supposed “power” and “advantage” of being the world’s reserve currency a moot point?
(Obviously countries could hold gold or copper or any physical commodity they wanted, instead of their own currency. The thing is if they fear a relative decaluation in the US dollar, with modern electronic markets, they can hold ANY highly liquid alternative(s) they prefer. Problem solved.)
Perk Earl on Sun, 8th Mar 2015 1:38 pm
“There is evidence that China understands what is at stake; it has increased its gold holdings and has instituted controls to prevent gold from leaving China. Should the world’s second largest economy and one of the world’s greatest trading nations tie its currency to gold, demand for the yuan would increase and demand for the dollar would decrease overnight.”
I like how that starts out; “There is evidence China understands what is at stake.” Yeah, pretty obvious since they are now advertising their currency on billboards near airports!
That quoted paragraph above is what I was trying to get across in an earlier discussion a day or so ago. Real simple; if China continues to accumulate gold, then tie the Yuan to that gold, while the US continues to debase it’s currency, then a greater shift to using Chinese currency for exchange is likely.
Short writes: “As long as the world needs oil, and there is a soldier to pull the trigger when necessary, the dollar will remain the world’s reserve currency. The only problem with this methodology is that the oil age is ending. Without the reserve currency the US can’t pay its bills.”
That’s not going to help the USD either. Someone has to pay the piper and some day that payment may be made by Yuan’s. Who woulda thunk it even just 10 years ago, but here we are with the trend moving in that direction.
American Idiot on Sun, 8th Mar 2015 3:56 pm
It’s amazing just how desperate these Idiots sound.They can’t justify their existence.
The World is doing fine without Jews and they will do fine when this Idiot country collapses on it’s own debt.
Makati1 on Sun, 8th Mar 2015 6:59 pm
“…The above article is full of opinions.” BINGO! The dollar is NOT necessary for trade if there are other currencies in use. And there are.
As Perk said, all it would take is for China to back their Yuan with gold. An event not too far in the future, I think. The flood out of USDs would be a sight to behold, and the death knell for America.
And, no, Short, neither the US military or oil will determine the world’s reserve currency. Already, countries selling oil are switching to other currencies. The Empire tried to prevent it by killing Saddam and Gahdafy but they over stepped their bounds with Russia when they tried to use USD’s as a weapon to take them down. Now China is Russia’s backup. A fact that scares the shit out of Washington.
Give the Chinese another few years and the dollar will be so weak it will no longer threaten the rest of the world. Wait and see. If there is not a world war sooner.
clueless on Sun, 8th Mar 2015 10:13 pm
It matters…otherwise, we ( i’m american via virtue of petition) belong to the 4th world…errr 3rd world. Period. Nothing follows.
Makati1 on Mon, 9th Mar 2015 3:54 am
clueless, better to step down the ladder voluntarily than to have it pulled out from under you. I’m better then half way from the 1st to the 3rd world now. Another year or so, and the transformation will be complete.
I keep less then 100 USDs in my bank accounts. Only enough to keep them open. My income gets converted to Philippine Pesos quickly each month. Stores will not accept dollars here.
Brian on Tue, 10th Mar 2015 3:51 am
This article has two current fallacies:
1) Printing money leads to inflation
2) The dollar is weakening
Our experience since 2008 is that we have very low inflation in the US. Inflation requires not just an expansion of the monetary base, but a certain velocity of money. That’s not happening yet, and there’s so much slack in the labor market (see the U-6 unemployment numbers) that significant inflation seems years away.
And the US dollar is strengthening, due to the potential for the Fed to raise interest rates. This is in addition to all the other currencies being basket cases. Additionally the US economy is doing a reasonably good job recovering, and a lot of foreign capital is moving into US markets seeking a solid return.
The author didn’t mention the coolest thing about reserve currency status & QE. The US sells debt in its own currency. The Fed bought it with dollars it created. The Treasury pays interest to the Fed, and the Fed is required by law to turn over all profits from its operation to the Treasury. Basically QE was an interest-free loan to the US government, which also lowered everyone else’s interest rates in the US and let homeowners & corporations refinance all their debt too. The Fed’s QE benefitted everyone, except people relying on savings accounts or money market accounts.