The United States Dollar as the World Reserve Currency

This is the twentieth post in a series entitled Currency, Money and the Economy.

Way back in the fourth post, we established the fact that the US dollar has served as the world reserve currency since World War II. Everything that is traded internationally is denominated in US dollars. However, with all the recent financial trouble the United States have wrought on the rest of the world, some have begun to wonder if the US dollar’s days are numbered as the world reserve currency.

Britain’s daily newspaper The Independent reported on October 6, 2009 that oil-exporting countries in the Middle East as well as China, Japan, Russia and France met in secret to begin work on a plan to replace the US dollar as the world reserve currency. Government officials from all countries denied that the story was true. The previous week, Iran had stated that it had already traded away its US dollars and was using the Euro as its reserve currency. The United Nations has released reports saying that it wants to replace the US dollar as the world reserve currency. So it is obvious there is concern about the strength of the US dollar. However, is there a reason for us to panic just yet?

The answer to this question is no. However, the reason does need some explaining. The United States has about $15 trillion in circulation that is being held by nearly every country in the world, including ourselves. If the world were to decide to replace the US dollar with something else, then there would be less of a reason to hold US dollars. That means that other countries would go to the FOREX market and exchange US dollars for either their own currency or whatever currency becomes the new standard.

With everybody selling US dollars, that would make the US dollar much weaker relative to every other currency and begin the onslaught of inflation here in the United States. However, by doing so, the other countries essentially shoot themselves in the foot two ways.

With their currencies now much stronger relative to the US dollar, other countries will discover that it is now more expensive to export to the United States. The American consumer will curb their spending with higher prices. Therefore, the export machines that these foreign countries have built will slow, stalling out their own economies.

Most countries hold US Treasury bonds. Let’s say that India purchased 10-year US Treasury notes two years ago. That means in eight years, the United States will return the US dollars back to India with interest. However, if dollars are no longer the world reserve currency and have weakened considerably because it was removed, then how valuable will that 10-year US Treasury Bond be eight years from now, even with interest? It will be a fraction of the return that India was expecting when it purchased the note initially. Every country holding US Treasury bonds would have the same problem.

Therefore, if other countries successfully removed the US dollar as the world reserve currency, they would be responsible for triggering the economic Armageddon that all central banks are trying to avoid. Since these countries are still trying to recover from this last economic downturn, I doubt they want to deliberately start another one. However, if the trend of printing endless currency does not stop soon, somewhere down the road there will be a breaking point and everyone will lose confidence in the US dollar.