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How would you tell your grandma why the USA dollar is the world reserve currency and what main consequences it has for the US and the world?

Concerning why the dollar is the global reserve currency, you should explain both the historical reason and the political (including perhaps economical, social, and military) causes why the dollar still is the reserve currency.

As for the consequences, how would the US and the world (especially Europe and BRICS) be affected if the dollar were not the dominant reserve currency anymore?

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Why is the Dollar the Reserve Currency

The U.S. dollar is the reserve currency for historical and practical reasons:

Historical Reasons

At the conclusion of WWII, the U.S. and other western countries established a currency system called the Bretton Woods Accord, where all currencies were pegged to the Dollar, and the Dollar was pegged to gold. Essentially, every currency was denominated directly or indirectly in gold, making international trade easier. What made sense in 1945, because the U.S. had 50% of the global economy, was unsustainable in 1973, and Bretton Woods (really Bretton Woods II) collapsed. Countries still had large Dollar reserves, however, and the Dollar has continued as the reserve currency.

Two possible opportunities to change the reserve currency have occurred: the end of the Cold War and the beginning of the Euro. The end of the Cold War actually strengthened the Dollar as the reserve currency, because the U.S. economy was even more important globally that before. The Euro was thought by some to be a meaningful challenge to the Dollar, and a potential candidate for alternate reserve currency, but the lack of political union in the EU, and the resulting problems, combined with the political instability caused by groups like AfD, BNP and so on agitating for EU exit make that an insufficiently stable choice for reserve currency.

Practical Reasons

  1. The U.S. has the largest economy by far, and it was even larger in the past, meaning that most countries have significant trade in Dollars. They can always, therefore, use their Dollars.
  2. Oil is denominated in Dollars in most markets, and it has been since the early 20th Century, when the U.S. was the major producer of oil.
  3. The U.S. reserve system is committed to a stable currency value, with little history of rampant inflation, and it is mostly capable of maintaining that stability.
  4. The U.S. is the most secure country in the world, meaning that its currency is unlikely to suddenly be devalued or destroyed by war.
  5. The Dollar is plentiful, reducing supply issues a non-issue. Part of this is a function of history—the Dollar has been the reserve currency for so long that there are a lot of Dollars available--and part of it is a function of the size of the economy. Smaller economies could not risk the quantity of currency abroad that the U.S. has, as a sudden rush of that currency home would destroy their economy.
  6. All other challengers have proven not up to the task for a variety of reasons. The Euros weakness is discussed above. The Chinese RMB is not traded on the open market. The Deutschmark no longer exists, and even when it did, W. Germany and United Germany were in precarious political positions. Japans Yen is too weak. The Ruble disintegrated in 1991, and has never really recovered its confidence.

Bottom Line

The easiest way to explain it to Grandma is to ask her what other currency could be the reserve currency. Is there any other organization that she would be willing to bet her entire life savings, and the welfare of her family for generations, will be around and similar enough to what it is now to be recognizable against all challengers? The U.S. may not be a 100% bet, but it is the best available bet, by far.

Main Consequences

  1. The U.S. has outsized economic power, due to the ability to influence the global economy, indirectly. That power is not granular at all—it cannot target a single country for example—but it allows the U.S. to control the overall temperature of the global economy, at least more than other countries.
  2. U.S. currency objectives dominate the currency market. The U.S. prefers a stable currency, with fungible monetary instruments to facilitate trade and economic growth. Other countries might prefer capital controls, or higher rates of inflation, but that is difficult to pull off while the Dollar is the reserve currency.
  3. Oil is cheaper in the U.S. than elsewhere, and the U.S. can afford to ship things or conduct military operations better because of it.
  4. Many international economic agreements are denominated in dollars, even when there is no U.S. party to the agreement. This makes it difficult for one party to inflate away debts, and some countries have a hard time buying on the international debt market (like Argentina, for example) because their currency vis-a-vis the dollar is so bad.
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One of the consequences of the dollar being the reserve currency is the United States' persistent trade deficit (the Triffin dilemma). In order for the world economy to function, the USA has to produce enough dollars to cover all the domestic and foreign uses. If it fails to do so, there will be deflation. A side effect of deflation is economic slowness, as there isn't enough money to support all the necessary transactions.

Domestically it's easy for the new dollars to make it into the economy. The government spends more money than it prints, so it just happens without further intervention.

Internationally, it's more difficult. The USA could loan money to other countries, but that would simply put off the decision. The two real possibilities are foreign aid and a trade deficit. Foreign aid is unpopular. So a trade deficit is all that's left. The USA sends dollars out into the world and the rest of the world sends back goods.

The USA having cheaper oil prices is a result of this dynamic, which also makes other goods cheaper in the USA.

  • I would love to give this a +1 because it is something I haven't heard before and it seems to make sense, but I'm skeptical in part because I've never heard it before. Can you provide any evidence for this beyond your own argument? – Readin May 5 '16 at 3:50
  • It would be nice to be able to merge answers, because this is something I hadn't heard of either, and was initially skeptical, but when I took a look at the U.S. accounts, it seems very plausible to me. – The Pompitous of Love May 5 '16 at 16:34

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