What Is The Significance of a "Reserve Currency?"

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      Creigh Gordon

      Many people have opined that the dollar might stop being “the world’s reserve currency” and have speculated on what that might mean. It’s pretty hard to figure out what might happen if you don’t know what a dollar actually is, and most commentators don’t know what money really is.

      If you have a trading partner that you don’t trust, you’re forced into a barter situation. This is true even if you use an intermediate commodity, such as gold, as a medium of exchange. If you do trust your trading partner, you might be willing to accept a promissory note, but there’s not much you can do in a wider economic sense with such a promissory note because trust in that person will be limited. However, if there’s a third party that is widely trusted, say a government or a bank, you can use their promissory notes as a medium of exchange. And that’s what all modern economies use as money.

      When people in one country want to trade with people from another country and don’t find barter convenient they need to agree on a medium of exchange, or to put it another way, to agree on whose trusted promissory notes they will offer and accept. That agreement is made on an ad-hoc basis. (This is true for domestic trade too, although the domestic currency is usually the default choice.) Certain currencies enjoy wider acceptability than others, but there’s nothing magic about any currency. It’s all about liquidity (how easy is it to spend) and stability (does it hold its value).

      So how do you assure liquidity and stability? The size of your economy is probably the biggest factor. The rule of law is important; protection from powerful predators and arbitrary seizure is important.

      After the Bretton Woods international gold standard agreement folded, major central banks agreed to accept US dollars for international exchange, mostly due to the primacy of the US economy at that time. Dollars were referred to as a “reserve currency.” But that was about the extent of the magic. It’s all about liquidity and stability. Maintain the size of your economy and the integrity of your promises and all will be well.

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