Reserve Currency

Imagine you travel abroad and hold out Korean won to a market vendor. They won't want it, because they can't easily use won to buy other things back home. Big trade between countries works the same way. Every country needs a common means of payment that it can accept with confidence.

Toward the end of World War II, the United States, which held most of the world's gold, stepped up as the problem solver. At a 1944 conference in Bretton Woods in the U.S., America promised that any other country's central bank could bring $35 and swap it for one ounce of pure gold at any time. Thanks to that promise, countries began to trust dollars instead of gold when they traded, and the dollar became the firm standard currency for international deals.

In 1971 the promise to swap dollars for gold ended, but the dollar kept its position. In the 1970s, oil-producing countries such as Saudi Arabia took dollars as payment for oil and then invested that money back into U.S. Treasury bonds and the like (the "petrodollar" flow), which helped a lot. Add the huge size of the U.S. economy and its deep financial markets, and the dollar remains the world's most widely used money today.

A country with a reserve currency enjoys economic privileges that are hard to imagine. It only has to pay the tiny cost of putting ink on paper to print money, and it can easily buy expensive things from other countries, like luxury cars and raw materials. Economists call the huge profit from issuing money seigniorage.

When it borrows from abroad, it can issue bonds in its own currency instead of someone else's. So it worries far less than other countries about a currency crisis, where foreign money runs dry and the country risks defaulting. In fact, the worse a crisis gets, the more investors around the world rush toward the dollar, which they believe is the safest.

But behind these huge benefits hides a problem that's hard to escape. For world trade to flow smoothly, the U.S. has to keep pumping dollars out into the world. To do that, more dollars have to leave the country through imports and overseas investment than come in. In other words, it has to keep running a balance-of-payments deficit. When that deficit snowballs, it runs into a contradiction: the dollar's value and credibility start to wobble. It's named the "Triffin dilemma" after the economist who spotted it.

The U.S. dollar isn't the only reserve currency. The euro of the European Union, the Japanese yen, and the British pound are actively traded in international foreign exchange markets. They play a solid supporting role in the world economy, and they're usually called secondary reserve currencies.

Still, if you look at their actual share, the dollar's lead remains overwhelming. Of the foreign exchange reserves that central banks around the world keep in their vaults as emergency funds, the dollar's share is close to 60%. China's yuan and other currencies keep challenging the dollar's dominance, but in the convenience of its trading network and the transparency of its financial markets, it's very hard to overtake the dollar in a short time.

In the end, the key ingredient that makes a reserve currency isn't how impressive the money looks. It's firm trust across the whole international community. As long as the belief that "this money will hold its value tomorrow, and ten years from now" doesn't break, a reserve currency's strong position won't be shaken easily.