Categorized | economy

Reserve currency versus global currency

Michelle Bachmann, Congresswoman from Minnesota’s sixth district, has introduced panicked legislation outlawing the establishment of a “global currency.” The legislation was inspired by China’s overture to establish a single reserve currency and, quite possibly, make that standard, universal global reserve currency some other currency rather than American dollars. Timothy Geithner limpidly announced that the U.S. was open to the idea but soon backpedaled (a tiny bit) a few days later to affirm the centrality of dollars in central bank foreign reserves. But Bachmann, and a few other conservative commentators, have been fanning the flame of the possibility of a “global currency.” Normally I let misunderstandings (or posturings) like this pass, but I’ve already had six or more entrepreneur friends express grave concerns about Obama’s plans for a “global currency” and three people who follow this blog have asked me how much of a threat this imminent global currency is.

To which I say, calm down. Stop listening to Sean Hannity and Michele Bachmann. A standardized, universal reserve currency is not even in the same ballpark as a global currency. Adopting a standardized reserve currency is highly unlikely and, should it ever come to pass, that standard will almost certainly be American dollars. Unless the U.S. implodes, disappears down a black hole, or turns out to have been a hallucination for the past few centuries.

Bloggos are reacting to this new global currency nonsense by rolling their collective eyes, but it’s not like “reserve currency” is an active concern for folks trying to make a living or build a business. Do you know what a reserve currency is (if you do, then you have a bit more reason to get sarcastic). So, for all those folks who think that nefarious netherworlders are out to globalize a single currency, here’s a little primer on reserve currencies.

A “global” currency is one that is legal tender in all countries (with a few exceptions). The euro is similar to a global currency in that it is legal tender in all the countries that make up the European Union (along with the currencies printed within those countries). A global currency could completely replace country currencies or live peacefully with those currencies, as the euro has done for several years. A global currency does not and never has existed. Several economists have proposed something like a global currency, but it ain’t going to happen soon. The issues and obstacles involved are impossible to overcome. For instance, look at the overwhelmingly divergent monetary policy responses to the downturn between Europe and America. While the U.S. is firehosing money into the economy, the Europeans are holding back. Inflation is a bigger worry in Europe because they have a social safety net to cushion many of the effects of the recession. What about the euro? Well, even though Ireland and Spain, for instance, are suffering the recession as the U.S. is, euro policy is effectively at the mercy of France and Germany, the two biggest economic powerhouses in the union, both of which are doing okay in the recession and are responding highly conservatively.

A “reserve currency” is any foreign currency held by a foreign central bank (the Federal Reserve is the U.S.’s central bank). When, say, a Chinese company manufacures toilet seats for a U.S. company, the U.S. company pays in dollars. But the Chinese company can’t use dollars — they aren’t legal tender in China. So they exchange those dollars for renminbi a the local bank and the local bank exchanges those dollars for renminbi with the central bank. The central bank may sell those dollars back to the U.S. (exchanging them for renminbi or government debt) or they can just hold them. When the Chinese central bank holds dollars, then they have dollars in their reserve currency.

Now the same thing happens when the Chinese trade with the Canadians or the Mexicans. If the trade balance is uneven, that means more Canadian dollars and Mexican pesos are going into the Chinese central bank than renminbi are going out. So they pile up. But the Chinese don’t want to hold Canadian dollars and Mexican pesos, so they trade them on the foreign exchange (FOREX) markets for American dollars.

If every country does the same thing — trade the foreign currencies piling up in their vaults for American dollars — then dollars tend to be the de facto reserve currency.

(Now, before 1944, whenever countries traded with one another, they would exchange currencies using gold. If we were on the same system, the Chinese central bank would be piling up gold bars (and the U.S. would be steadily losing its store of gold), rather than American dollars.)

Without going into detail, central banks use foreign reserve currencies to help set the exchange rate of their own currency and affect the total amount of their own currency in circulation. For instance, the Chinese could start printing renminbi and buying dollars with it. This will decrease the value of the renminbi and corresponding increase the exports going out of the country (because Chinese goods will become cheaper in dollars). This will also increase the amount of renminbi in circulation.

Right now (and forgive me, because I’m doing this from memory), about 65% of the foreign currency reserves held by central banks around the world are American dollars. Another 25% are euros and another 12% or so are Japanese yen. (Americans, by definition, do not hold dollars in their foreign reserves and the Japanese does not hold yen in their foreign reserves — they aren’t foreign currencies in those countries).

This is a good deal for Americans (and Europeans and the Japanese). Since so many dollars are held as reserves, that means that Americans can buy things from other countries at a slight discount relative to other countries (because they don’t involve additional exchange fees).

The Chinese are proposing that most if not all central banks adopt one and only one foreign currency to hold in reserves. That currency will be the one against which all countries back and determine the exchange rate of their own currency. Some economists think this is a good deal, but I’m too ignorant to venture an opinion.

Should such a standard emerge, it’s highly unlikely that it would be any currency other than American dollars, on account of an economic phenomenon called the network effect or network externality (anyone who’s gone gaga over Malcom Gladwell’s “tipping point” has scrimmaged around in network externality land). Think of telephones — if I come up with a new way of calling people and it doesn’t work with telephones, then telephones win and I lose. Too many people use telephones and have used them for too long. The same applies to reserve currencies.

So, if you’re the kind of person who takes the Hannity’s and Bachmann’s seriously (and I’m not criticizing you for doing so), then understand this. When Geithner says that, no, absolutely not, the U.S. will not consider adopting a global currency when the day before he said that he was open to a standard, globally adopted reserve currency, he is, as Bachmann charges, giving two different answers. But they’re answers to two different and totally unrelated questions.

So, down a pound of Scotch, don’t worry, and be happy.

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4 Responses to “Reserve currency versus global currency”

  1. Chih Chen says:

    What China is talking about is an international reserve and trade settlement currency like IMF’s SDR or as gold in the ages of gold standard. It is a big deal for US since if, for example, every country demands gold for settling trades, the immediate effect is that US cannot run massive trade deficit, and American citizens will be forced to save to create seed money for its financial system to work, and American needs to dirty their hands again to produce in order to have something to consume. Consumption based American economy will be downsized substantially. Instead of buying 20 to 30 toys per child per holiday, only 2 to 3 toys will be bought just like all other major countries around the world.

Trackbacks/Pingbacks

  1. [...] key currency countries need watching,” China Daily, April 19) Since I’ve already done it before, I’m not going to go into the arcana of reserve currencies and SDR’s (which, [...]

  2. [...] and China eye plan to axe dollar,” Financial Times, May 18) We’ve already written about what this means in economic terms, but for entrepreneurs and small businesses, a gradual decline in the use of the dollar as an [...]

  3. [...] than Rep. Bachmann, with her multiple Ivy League PhDs in economics, global trade, and finance, how reserve currencies work. If you want to pain yourself with the economic details of reserve currencies, feel free to follow [...]


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