Is Providing the World's Reserve Currency a Blessing or a Curse?

Why the rest of the world likes to stockpile U.S. dollars. And how lots of folks misunderstand the upsides and the downsides of this situation.

Photo by Jonathan Borba, downloaded from Pexels

What does it mean that the U.S. dollar is the world’s reserve currency? Do we even want it to be the world’s reserve currency?

Countries like China, India and Brazil might not. They’ve made noises about—or even taken the first incremental steps towards—getting off the U.S. dollar as their reserve currency of choice. Donald Trump feels differently: “Many countries are leaving the dollar,” he said at a recent rally. “They are not going to leave the dollar with me. I’ll say, you leave the dollar, you’re not doing business with the United States because we’re going to put a 100% tariff on your goods.”

I’ll let others discuss the merits—or demerits—of Trump’s specific proposal. I want to focus on the top two questions. Because everyone seems very confused on this topic.

For instance, my guess is Trump is just vaguely aware that important people say being the world’s premiere reserve currency is beneficial to United States. So losing that status would be bad. And Trump wants to be America’s strongman savior. Yet Trump’s own running mate, J.D. Vance, actually thinks it’s self-destructive to be the world’s dominant reserve currency.

So let’s try to sort things out.

What IS a Reserve Currency, Exactly?

A huge portion of international trade is done in U.S. dollars. If Mexico wants to buy oil from Venezuela, or Britain wants to buy cars from Japan, they won’t just do the deal in their own currencies. They’ll use the U.S. dollar as an intermediary. “Over the period 1999-2019, the dollar accounted for 96 percent of trade invoicing in the Americas, 74 percent in the Asia-Pacific region, and 79 percent in the rest of the world,” according to the U.S. Federal Reserve. “The only exception is Europe, where the euro is dominant with 66 percent.”

To put my “Annoying MMT Guy” hat on for a minute, every country’s government can create as much of its own currency as it wants; Mexico can never run out of Mexican pesos, Britain can never run out of British pounds, and so on. But for any given country, every other country’s currency is a scarce resource. For every country other than the United States, U.S. dollars are something they can run out of.

Thus, most countries find it useful to build up stockpiles of U.S. dollars—also known as reserves—for a rainy day. You never know when you might have an emergency, be in need of critical imports, and not be able to immediately sell the exports to afford them. As of 2022, approximately 58 percent of all foreign exchange reserves were U.S. dollars.¹ The euro was a distant second at 20 percent.

Hence, the U.S. dollar is the world’s reserve currency. Really, there are lots of different reserve currencies. But the United States’ is the overwhelmingly dominant one.

How did our currency wind up in this position?

At a practical level, it’s just very useful to have a single stable currency for international transactions. Otherwise, whenever Britain bought cars from Japan, Japanese carmakers would get a bunch of British pounds. But the only thing those pounds would be good for is buying stuff from Britain. Or the Japanese carmakers could trade those British pounds for Japanese yen or whatever other currency they needed for their next transaction.

Scale this logic up to a complex global level, with trade between lots of countries at once, and you can see how it would become horribly cumbersome very fast. Everyone agreeing on a common currency to use for international trade just makes things much more straightforward. If you sell exports in that currency, you can then use it to buy imports from anyone.

For a long time, that common currency was gold. Then it was the British pound. After World War II, economist John Maynard Keynes proposed creating a global currency specifically intended for international trade. But the Bretton Woods system was established instead, making the U.S. dollar the common currency for international trade. Bretton Woods officially ended in 1973, but by then the path dependency was set. And here we are.

The (Limited) Upsides of Providing the World’s Reserve Currency

The practical upshot of all this is that the U.S. doesn’t have to stockpile other currencies to engage in international trade. If we want to buy imports, we just pay with our own currency. And since our government can create an infinite supply of our own currency, we can never run out of it. Awesome! (Annoying MMT Guy strikes again.)

The United States does keep some foreign currency reserves on hand, but they’re minuscule: Measured in U.S. dollars, they’re about $12 billion in euros and $6.6 billion in Japanese yen—0.05 percent and 0.03 percent of our GDP, respectively—because we really don’t need them, except for marginal stuff. By contrast, China’s foreign exchange reserves are a little over $3 trillion in U.S. dollars, which is almost 17 percent of its GDP.

You may have heard that providing the world’s premiere reserve currency makes it easier for the U.S. government to borrow at low rates. Some people think that’s good (cheaper credit for us) while others think it’s bad (we’ll be tempted into borrowing too much). But in truth, it’s neither. Because that claim rests on a deeply confused and incoherent picture of how public and international finance works.

It’s true that foreign countries and businesses stockpile U.S. dollars by investing in financial assets denominated in U.S. dollars, just like you or I do in our savings portfolio. And a lot of the time, they’re buying up U.S. Treasury bonds. In effect, other countries stockpile their U.S. dollar reserves by lending those dollars back to the U.S. government.

But we don’t actually need countries to lend the federal government U.S. dollars. Because the federal government can create all the U.S. dollars it wants! (I know, I know, Annoying MMT Guy just won’t go away.) There are some practical uses to the U.S. government issuing bonds when it deficit spends. But none of them include getting its hands on U.S. dollars it otherwise wouldn’t have.

You often hear people worry about China selling off all the U.S. debt it’s holding to drive up our interest rates and fuck with our economy. But if it did that, then the Fed—an agency of the U.S. government—would just print up a bunch of U.S. dollars and buy those bonds, until it brought interest rates back down to where it wanted them to be. Other countries buying U.S. Treasury bonds is about as harmless an exchange as it gets.²

So no, providing the world’s reserve currency does not make it easier for the U.S. government to borrow in its own currency. Nor does it make it easier to borrow in foreign currencies; it makes it so we don’t need to borrow foreign currencies to begin with. So we run no risk of getting into a foreign currency debt crisis. That’s it.

How International Debt Crises Actually Work

For every country that isn’t the United States, a foreign currency debt crisis is at least a feasible possibility. (How likely a possibility depends on the country—a point we’ll return to shortly.) The obvious way for countries to get their hands on U.S. dollars is to sell exports. And the way to build up a surplus stockpile of U.S. dollars is to run a trade surplus in that currency; sell more in exports than you buy in imports.

This requires producing stuff the rest of the world wants to buy, and producing enough for your own domestic needs that you’re not too reliant on imports. For a lot of developing countries, that can be tough. They often wind up really needing key imports because their domestic industries are still building up and diversifying. Yet for that same reason, they struggle to sell enough exports to afford the imports they need.

That conundrum leads to countries borrowing U.S. dollars to maintain their reserves. But those loans eventually have to be paid back—and they have to be paid back in a currency the country can run out of. When you hear that a country like Mexico or Argentina is in a debt crisis, what happened is it borrowed too much in a currency other than its own. And 99 times out of 100, it’s borrowed too many U.S. dollars. Which is when organizations like the International Monetary Fund have to step in with emergency loans—but only on the condition that the country go through brutal austerity.

One of the most important distinctions in international economics is how much debt a country owes in its own currency versus foreign currencies; i.e. how much it’s borrowed in a currency that it controls versus a currency it doesn’t. Yet most analysts just mash the two types of debt together into a single category. Which is absolutely fucking maddening.

If America were a developing country, providing the world’s reserve currency would be a huge benefit. We’d have a limitless supply of the currency we needed to buy imports, unrestrained by how many exports we could sell or how much foreign currency we could borrow.

But we’re not a developing country; we’re a rich, diversified, prosperous and advanced one.

If You CAN Provide the World’s Reserve Currency, You Probably Don’t NEED To

The United States has exported more food than we import almost nonstop for decades.³ We’ve never imported more than a third of our energy. We usually import much less, and in the last several years we’ve actually been producing more energy than we consume. Besides energy, our other biggest exports are high-value, technologically-involved goods like cars, helicopters, gas turbines, integrated circuits, and medical instruments.

Imports are just 15.4 percent of our economy overall. And for all the genuine damage our trade deficit does to our social fabric, it’s just three percent of our economic output. The worst it got in the last few decades was six percent. That’s all we would lose if the rest of the world suddenly went away and we had to consume our own exports while doing without imports.

Being a rich and productive country with lots of diversified sectors and industries, there’s not really anything that we can’t make here if we put our minds to it. When we are dangerously reliant on imports for key resources—microchips come to mind—it’s because of stupid policy choices that serve rich capitalists at everyone else’s expense. It’s not because of any intrinsic inability to stand up the supply chains on our own soil.

Our prosperity also means our economy provides lots of opportunities and incentives for people to invest. And since the only currency you can use to invest in the U.S. economy is U.S. dollars, there’s a lot of demand in the world for U.S. dollars. So even if we weren’t providing a major reserve currency, it would be very easy for us to acquire foreign currencies, because investors on international markets would be eager to give us foreign currencies in exchange for U.S. dollars.

Thus, importing whatever we needed would still be smooth sailing.

Look around the world, and you’ll see this is exactly the situation for other countries—Britain, Australia, Canada, Japan, and so on—that have advanced, diversified economies like ours but that don’t provide a major reserve currency. Because they’re an attractive investment opportunity, they can affordably acquire the foreign currencies they need, so they can afford their imports. And they don’t suffer foreign currency debt crises. To lose that privilege, they’d have to first cease being an advanced, rich, diversified economy.

I’d wager that to become a provider of a major reserve currency in the first place, you must have the kind of economy that doesn’t actually need the benefits of doing so. If you did need those benefits, that would mean your country was heavily dependent on imports; that it was underdeveloped and at risk of instability. In which case, you’d probably never dominate global trade to begin with.

A Reserve Currency as a “Resource Curse”

So the upsides to providing the world’s dominant reserve currency are pretty “meh.” What about the downsides?

J.D. Vance is quite often a dangerous loon. But one thing he’s said that isn’t crazy is that providing the world’s dominant reserve currency is a lot like “resource curse.” (Though I think what he’s referring to in that link is closer to the concept of “Dutch disease.”)

When a country has a valuable natural resource, like oil or gas, it winds up exporting a lot of that resource, because the rest of the world wants it. That drives up the value of the country’s currency, which makes all the country’s other exports more expensive. So the domestic sectors and industries that don’t deal in that one key export sometimes wind up withered and underdeveloped. The country enters a kind of of codependent relationship with the rest of the world: its domestic economy focuses on producing that one export, and then uses the proceeds to import all the other needs it can’t produce for itself.

Of course, the second anything goes wrong with that one key export, the country is screwed.⁴

Now, the United States isn’t supplying one key export. Instead it’s supplying a key currency. And like I said, the safest way for countries to get surplus U.S. dollars is to run a trade surplus in that currency. But everyone’s trade surplus has to be mirrored by someone else’s trade deficit. And since America is the provider of U.S. dollars to the world, “someone else” usually winds up being us. So we just get trade deficits across the board, and hollowed-out industrial bases in sectors that tend to do a lot of exporting, like manufacturing.

While providing the world’s dominant reserve currency isn’t the sole reason the United States runs persistent trade deficits, it’s definitely a major factor. Which makes it highly amusing that Trump wants to browbeat other countries into retaining the U.S. dollar as their reserve currency, since he also hates the trade deficit.

A Problem We Can Live With (But Others Maybe Can’t)

But Trump’s stupidity aside, trade deficits come with real downsides. And the orthodox economics profession is far too blasé about those downsides. At the same time, those problem can be counteracted without upending the global economy. Using smart policy, we can live with a trade deficit indefinitely without suffering the ill side-effects. (More on that in a future post.)

The trouble is that we have not been smart; we’ve just let the trade deficit problem fester. And since nature abhors a vacuum, Donald Trump gets to steps in with the extremely clunky idea of a 10 percent tariff on all imports.

But for our purposes here, the point is that the benefits to the United States of providing the world’s dominant reserve currency are marginal to the point of uselessness. And the downsides, while totally manageable, are real. Just focusing on our own self-interest, this seems like a deal that’s somewhere between “meh” and “moderately bad.”

But you know who really gets screwed by the U.S. dollar being the world’s reserve currency? It’s not Americans. It’s the rest of the world.

Particularly developing countries.

They’re the one’s whose economies get stuck focusing on low-pay manufacturing to produce enough exports to bring in surplus dollars. And they’re the ones whose governments risk borrowing too many U.S. dollars, thus winding up in a foreign currency debt crisis. On top of all that, whenever the United States hikes its interest rates for purely domestic reasons—to deal with our recent bout of inflation, for example—that also screws other countries: Suddenly, through no fault of their own, U.S. dollars become harder to borrow, and the borrowing harder to pay back. Which makes a debt crisis even more likely.

The best solution to all this would be to resurrect Keynes’ old notion of a new currency designed specifically for international trade. We also need a complete revamp of global trade rules and norms, to help developing countries build up their own prosperity and resiliency again, rather than relying on advanced imports in exchange for operating as the sweatshops for well-off western consumers.

But in the meantime, the U.S. should try to manage the world’s reserve currency as humanely as possible. That means not being afraid to run plenty of budget deficits: That will counteract the drain on demand from our trade deficit, and keep our own economy at full employment. At the same time, it will provide the rest of the world an abundant supply of U.S. Treasury bonds to stockpile dollars in. More radically, we should also think about relying on tools other than interest rates to control inflation.

Lots more detail on all those points in future posts.

1. Which is down from roughly 70 percent a quarter century ago. So there’s been some limited move away from the dollar. But not much.

2. Countries buying U.S. financial assets other than our Treasury bonds is a different matter. Besides those bonds, foreign governments and business will usually invest their U.S. dollars in the stocks of American companies. Which often comes with the right to vote on who runs the company board, and to vote on major business governance decisions. Depending on the nature and ideology of a foreign government, maybe we don’t want them having that say-so in the running of our domestic firms?

3. That trend did reverse in the last few years, when we started running trade deficits in agriculture more often on a month-to-month basis. Yet those deficits remain quite small in comparison to the overall scale of our food production.

4. Not surprisingly, this often happens to developing countries that find themselves sitting on top of oil or gas reserves. Or they just decide to focus on low-cost manufacturing. It’s a way to solve the aforementioned problem of bringing in enough U.S. dollars. But it’s a solution that obviously comes with a lot of risks and long-term downsides.