A reader asks: Does the U.S. get special advantages from the dollar's status as reserve currency, specifically, from pricing oil in dollars? The answer is, definitely, yes - but there disadvantages as well.
The advantage is that the dollar is more highly valued because it is used as the world's reserve currency. This means the dollar is used for 43% of all cross-border transactions. Since the dollar is the world's currency, other countries are more willing to buy U.S. Treasuries, which is just like buying dollars. In fact, the dollar makes up 66% of the world's central bank foreign currency reserves. High demand for the dollar, and Treasuries, means the U.S. government doesn't need as high a return, or yield. This lowers interest rates and allowed the U.S. to run up a $12 trillion debt.
Disadvantages
The disadvantage is that the U.S. has gone too far. Its debt is now 80% of total economic output. Many countries, like China, are worried the U.S. won't pay its debt back. As a result, the value of the dollar is declining.
Oil is priced in dollars. When the dollar declines, oil producing countries may raise the price of oil to maintain profit margins in their local currency. This can bump up the price of oil in the U.S.
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Comments
Dear Reader,
Kimberly is right in that the US has the enviable position of controlling the currency-of-choice among nations. Central banks, major financial institutions and private investors, on the whole, consider the US dollar a haven in times of global economic uncertainty. But, indeed, the US has gone too far — taking advantage of the “good will” its currency has enjoyed with only “good intentions” of debt repayment to back it.
If I may go a bit further regarding various country’s concern the US won’t repay its debt, it’s not so much the US won’t repay, but that when the time comes to repay, the dollar won’t be worth the dollar it was at the time of the loan. One billion dollars lent to the US five years ago may only be worth about $400 million today — a long-term loss. For the average price of oil in 2005, in dollar terms, was about $50 — now $84: 70% more that has to be paid for a barrel of oil; and the average price of gold was $445 — now $1,161: 161% more for an ounce of gold. Ouch!
The onus is on the US government to prove it is serious about its debt and deficits. Unless an earnest effort is made to right these wrongs, “good will” may turn into “ill will”, and all those dollars held by central banks, financial institutions and private investors come flooding back into the US, plunging the value of the dollar and causing prices to rocket into space due to escalating import costs.
My hope is that the US dollar, by action of its overseeing government, re-earns the right to be considered the world’s reserve currency.
Hi Tony,
Thanks for the clear explanation. You are right, there is a great deal of concern about whether the U.S. government will allow the dollar to weaken for the very reason you stated – the debt would be repaid in cheaper dollars.
However, it is in no one’s best interests to let the dollar collapse,which is what would happen if these other countries sold their dollars suddenly.
Instead, it is happening slowly, as these countries form trade agreements with each other and invest, bit by bit, in other currencies. Expect the dollar to continue its slow decline, over time.
Kimberly