Have you ever wondered how the Federal Reserve is able to print our dollars without producing anything to back it up? It’s one of the advantages of being the world’s dominate reserve currency. But how does it all work?
Here’s a list of commonly asked questions about reserve currencies and my stab at simplifying the answers:
- What is a world reserve currency? And how does that affect the U.S.?
- Are other countries considered a reserve currency?
- How did the U.S. become the dominate reserve currency?
- What are the privileges of being the dominate reserve currency?
- Are there disadvantages to being a world reserve currency?
- What happens to other countries if our dollar weakens?
- How long will the U.S. be the dominate reserve currency?
- What might be the next reserve currency?
What is a world reserve currency? And how does that affect the U.S.?
A reserve currency is a currency that is held in significant amounts by governments and institutions to conduct transactions in the global market. The United States Dollar is currently the dominant reserve currency which means the dollar is used a majority of the time by countries when settling their international trade accounts.
As the world’s reserve currency the U.S. can trade directly with any country using its own dollars instead of exchanging dollars into the other country’s currency. Converting from one currency to another costs money, which is why many countries will simply stockpile reserve currencies like the US dollar to avoid these costs and then use those dollars for their international trades.
Below is an example graphic from Stansberry Research:
When South Korea wants to buy beef from Argentina or when Germany wants to buy oil from Saudi Arabia, the countries must first switch their home currency into U.S. dollars, before settling their payments.
The U.S. had nothing to do with these trades, but because we are the dominate reserve currency, we benefit from those trades since our dollars are in use.
In this example, South Korea and Germany must purchase our dollars to execute their trades. Multiply this example by countries across the globe and you can envision the tremendous benefit the U.S. receives from being a reserve currency.
Are other countries considered a reserve currency?
Yes, this chart shows all of the currencies that qualify for “reserve” status, and the percentages in which they’re held by governments and institutions around the world.
For example, when most central banks hold money in a currency other than their own, they may also hold 62% in US dollars, 23% in Euros, and about 4% each in Japanese Yen and British Pounds.
All this is predicted to change in October 2015 when the International Monetary Fund (IMF) will consider adding the Chinese Yuan to its basket of currencies called the Special Drawing Rights (SDR). If the yuan is added, then central banks around the world will also add the yuan to their foreign exchange reserves which will impact their percentage of dollars held in these central banks.
How did the U.S. become the dominate reserve currency?
After WWII, the major developed countries of the world met in Bretton Woods, New Hampshire and agreed to peg their currencies to the US dollar. At that time, the dollar was backed by its value in gold, and the U.S. held the largest gold reserves. This allowed other countries to back their currencies with dollars, rather than gold.
The US dollar became the dominate world’s reserve currency, replacing the British Pound Sterling which had taken a beating during WWI and WWII.
Also, around the time of the Bretton Woods Agreement, the IMF was formed to ensure that the Federal Reserve did not inflate the dollar and that the Fed stood ready to exchange dollars for gold at $35 per ounce. Other countries were satisfied to use dollars for their international trade because they knew those dollars could be traded back to the U.S. for gold at any time.
However, the Federal Reserve did not maintain its commitment to the Bretton Woods Agreement and by 1971 President Nixon went off the gold standard.
Although other countries around the globe were unhappy about this decoupling from gold, there was no other currency and economy at that time strong enough to replace the US dollar as the dominate reserve currency.
Currently, the value of our US dollar is based on faith and trust in the strength of our economy. As a fiat currency, our dollar (and all the currencies of the world) are nothing but an IOU, a promissory note that is not backed up with any tangible asset such as gold or silver – it’s just paper.
What are the privileges of being the dominate reserve currency?
The U.S. does not have to pay exchange rates when doing business with other countries. Because dollars are already in circulation world-wide, it allows the U.S. easy access to resources like oil in international markets.
Other countries need dollars to trade in the international market which creates a demand for the dollar.
When these countries export their goods to the U.S., they get dollars in return. But because it costs the U.S. so little to produce dollars (we can just print them), it’s kind of a “free lunch” on other countries’ exports.
Our reserve currency status also creates a strong market for U.S. debt. In essence, we can export our debt to other countries. Foreign countries buy United States Treasury debt not just as an investment, but because dollar-denominated assets are the best way to hold foreign exchange reserves.
The more international companies and individuals use the dollar it means more of them in circulation and thus more liquidity for the dollar. Liquidity means that financial assets can be priced more easily and loans are more easily provided.
The world’s need for dollars has allowed the U.S. government as well as American firms and individuals to borrow at lower costs, granting them an advantage estimated to be in excess of $100 billion per year.
Are there disadvantages to being a world reserve currency?
As the dominate reserve currency, our dollar is considered stronger than most other world currencies. This hurts the competitiveness of U.S. exports because our goods are too expensive for foreigners to purchase. Consequently, this means U.S. manufacturers scale back production and either lay off workers or close plants altogether.
As a result, this slows our economy and jobs growth.
What has enhanced our living, has also put the U.S. deeper into debt.
What happens to other countries if our dollar weakens?
Many large economies still peg their currency to the dollar. These countries stockpile dollars because they export more than they import. They receive dollars as payment. By holding onto these dollars, it keeps their currency values lower which is good for their countries exporters.
When the dollar weakens, so do the profits of their exporters and the value of their country’s currency reserves. As a result, they don’t want to hold on to as many of those weakened dollars.
These countries also hold large deposits of U.S. Treasuries, and could conceivably sell their holdings and cause a dollar collapse. Although, at this time, it is not in their best interest since it would destroy the global economy. In addition, the U.S. is the world’s best customer. The same countries that could cause a dollar collapse are those who need us to keep buying their products.
However, many countries are concerned over U.S. fiscal policy. These foreign investors and countries are slowly moving out of dollar-denominated investments. When they diversify into other currencies like the Euro or the Chinese yuan, this reduces the demand for the dollar and the value of our dollar continues to decline.
A few years ago, Brazil, Russia, India, China and South Africa (BRICS) signed pacts promoting intra-BRICS trading in their own currencies rather than using the US Dollar as settlement.
China and the United Arab Emirates agreed to bypass the US Dollar and instead use their own currencies for oil payments. India agreed to use gold as payment to Iran for oil. That’s not all…here are more examples of deals bypassing the US dollar.
How long will the U.S. be the dominate reserve currency?
Throughout history, the country that dominated global commerce during any given period was usually marked with the status of having the reserve currency. Spain and Portugal dominated the 15th and 16th centuries, the Netherlands the 17th century, France and Britain the 18th and 19th centuries, and the U.S. dominated the 20th century.
Image courtesy of JP Morgan
However, no country maintains reserve currency status forever. The global economy is dynamic and market shares shift. A transition of the reserve currencies has always brought about turmoil and uncertainty in financial markets.
The reserve currency transition is a cycle that has typically lasted in history somewhere between 80 to 110 years. Officially, the US dollar has been the reserve currency for 68 years. However, the US dollar was used in trade since the 1920s. That would put the US dollar over 90 years as the reserve currency.
What might be the next reserve currency?
A report released by the United Nations Conference on Trade and Development in 2010, called for abandoning the US dollar as the single major reserve currency.
Some countries, including China, have proposed making the International Monetary Fund‘s (IMF) special drawing rights (SDR) as a reserve currency.
In October 2015, the IMF will vote on adding the Chinese Yuan to its current basket of currencies – the US dollar, euro, yen and pounds.
The IMF released a report in February 2011, stating that using SDRs as a reserve currency “could help stabilize the global financial system.”
Most economists agree it’s not IF but WHEN the dollar loses its reserve currency status. What they don’t agree on is the process that will lead to the dollar’s decline as the reserve currency.
Many financial planners, wealthy investors, and central banks own a certain percentage of their hard assets in gold bullion as an insurance and a hedge against the dollar’s decline.
To quote James Rickards, best selling author of The Death of Money, The Coming Collapse of the International Monetary System:
“Gold is not digital, cannot be wiped out by hackers, and is immune to crashing stock markets and bank failures. Russia has increased its gold reserves 70% in the past five years. China has increased its gold reserves over 200% in the same time period. Do they know something you don’t?”
It’s time to start acquiring gold.
Let me show you how it’s done.
James “Lamont”
757-310-9175
jameslawson246@gmail.com
Independent Karatbars Affiliate