What is a "reserve currency" anyway?

I just realised I don't really know; that's why I'm asking.

With the Eurozone troubles, the US dollar has been rising against the Euro. That's not so surprising. But the US dollar is rising not just against the Euro; it seems to be rising against other currencies as well, like the Canadian dollar. And gold is rising too, even against the US dollar. As Scott Sumner notes, it's looking a bit like a replay of late 2008. On a much smaller scale so far, but it's still worrying.

I can understand this at one level. In a financial crisis, there's a rush into money. And at a global level, the US dollar is the most "moneyish" of all moneys, so there's a rush into US dollars. But what does it really mean to say that the US dollar is the most "moneyish" of all monies?

Clower (teasing Patinkin): "Money buys goods and goods buy money, but goods do not buy goods". That's what makes money, understood as the medium of exchange, special. With n goods, including money, there are only n-1 markets in a monetary exchange economy. Money is traded in all n-1 markets; all the other goods are traded in one. Apples trade against money in the apple market. Bananas trade against money in the banana market. Etc. Every market is a money market. There is no market in which apples trade for bananas.

So, among moneys, what makes the US dollar special?

1.The US economy is a big proportion of the world economy. My guess is that a greater value of goods are bought and sold for US dollars than for any other single currency. And I'm talking about all transactions, not just GDP (which measures only final sales of newly-produced goods and services). Transactions of intermediate goods and services, and financial assets, count too. Plus, even outside the US, and even outside dollarised economies, my guess is that more traders will recognise and accept, at a pinch, the US dollar than any other foreign currency. The US dollar is a "bigger" money than any other money, because it buys and sells more stuff than any other money.

But I don't think that's the most important reason why the US dollar is special.

2. Is this true, and if so, in what exact sense is it true: "US dollars buy Canadian and Australian dollars, and Canadian and Australian dollars buy US dollars, but Canadian dollars do not buy Australian dollars, and Australian dollars do not buy Canadian dollars"? If this is true, and true in some useful and important sense, then the US dollar is to other moneys what the other moneys are to other goods. The US dollar is not just a bigger money; it's meta-money; it's the money's money.

In other words, if I want to sell my Canadian dollars and buy Australian dollars, do I first have to use my Canadian dollars to buy US dollars, then use those US dollars to buy Australian dollars? Because that's what seemed to happen to me in Australia once. I wanted to do a simple swap of Canadian into Australian dollars, but I think I got dinged for the buy/sell spread twice.

So, for all you guys wearing red suspenders on trading floors, or anyone else who knows more about this than me, is what I wrote above true? Please expand.

And if it's not true, in any useful and important sense, just what exactly does it mean to say that the US dollar is a "reserve currency", and why does it matter? I know that it is held as reserves by central banks around the world, but that only begs the questions: why? and so what?

I've ignored fixed exchange rates, where the US dollar is special because some countries peg their currency's exchange rate to the US dollar. That was much more important in the past in making the US dollar special; less so today. And I've ignored the role of the US dollar as medium of account -- "oil is priced in US dollars" -- because I can't see why it matters so much.

Today's dumb question.

Comments

[jg]

Nick, as a retail customer, if you buy AUD from CAD, the bank should not charge you twice with the spread as AUDCAD is a quoted exchange rate. That being said, in the interbank market, it is really the product of 2 rates, AUDUSD and USDCAD. AUDCAD does not really trade. The USD is money's money in that sense. There are some important exceptions related to Europe however. EURCHF - which is a very important exchange rate, and the scandinavian currencies do trade directly against the EUR (EURDKK, EURNOK etc...).

But otherwise, the USD is the other side of pretty much all exchanges. However, I dont think this causes the USD to be a reserve currency. The causal relationship is probably the reverse: Its reserve status probably meant that it evolved as the most important currency in FX markets.

[Mucus]

I was under the impression that the USD (and the Euro and Yen to lesser extents) is a "reserve currency" because the majority of world reserves are held in USD. As in : http://en.wikipedia.org/wiki/File:Reserve_currencies.svg
As above, I don't know if thats causal or a symptom though.

[E]

Yes, the USD is the most widely held Foreign Exchange Reserve currency. The USD being the predominate reserve currency is a causal effect of point #1, above.

[Nick Rowe]

Good comments. Thanks. I'm going to let them run for a bit, before trying to draw any conclusions.

[Neil]

Re: #2 - I've been told that there are 11 currencies that Visa (which probably handles the majority of international consumer exchanges) will directly exchange Canadian dollars for. That number may be wrong - I can't find a reliable source right now - but it is certainly greater than 1. I'm not sure of the complete list, but it definitely includes USDs, Euros, and GBPs, which is noticeable if you're a nerd like me who tracks his exchange spreads while traveling. For the hundred-and-change other currencies of the world, they will charge you the spread twice as they convert via USDs.

[Phil Koop]

It seems to me that you have asked similar finance questions before, had them answered by knowledgeable people, and rejected the answers on the grounds that they were inconvenient to your theories. A not uncommon reaction of economists.

Anyway, I agree with jg in every respect. Any currency pair that a trader refers to as a "cross" will be executed as 2 legs in the interdealer market. The buy side will be quoted an all-in spread derived from the interdealer spreads. In some cases there will be technical issues because of differing spot settlement terms, resulting in one leg being non-spot. However, all of these effects are minuscule compared to retail spreads; you definitely should not be charged 2X. Interdealer spreads are single digits versus over 200 for retail.

USD is not a cross with respect to any currency I am aware of; as you say, USD buys anything. It really is just all about the liquidity, which outside the classroom is a genuine, tangible, valuable commodity. "Valuable" as in, it costs money, and is visible in the prices of traded assets. Liquidity itself is a messy thing being compounded partly of psychological/network effects (assets are liquid because they are liquid) but also with some real underpinning (the sheer volume of US trade combined with lack of currency controls guarantees a degree of liquidity in its currency.) The psychological/network aspects of the reserve currency make the incumbent sticky; thus the gold standard hung around well after the UK economy ceased to be preeminent.

You should also be aware that for some purposes, USD cash is not the king of currencies; that title belongs to USD bills and bonds, which for legal and regulatory reasons are often preferable to cash when posting collateral. They are meta-meta-money. That is the chief reason that yields on bills in low-IR environments (USD, JPY) are occasionally negative (remember that bit about the value of liquidity being visible in asset prices?)

I see no way that you could simply deduce that USD should be the world's reserve currency by dint of thought and theory. It is an irreducibly empirical matter.

[Nick Rowe]

Phil: "It seems to me that you have asked similar finance questions before, had them answered by knowledgeable people, and rejected the answers on the grounds that they were inconvenient to your theories. A not uncommon reaction of economists."

Yep. Guilty! "If the facts don't fit the theory, check the facts!"

But I really, really like your answer, because it really, really, strongly agrees with all my somewhat inchoate theoretical notions of liquidity.

(Except that little bit at the end, about USD bills and bonds, which I am going to have to try to weasle around, or else ignore ;-)

[Nick Rowe]

For example, I was stunned to learn, a year or so ago, that "off the run" bonds trade at a discount (sometimes significant) to "on the run" bonds: a fact that makes no sense whatsoever from standard finance theory. But then I realised that fact made perfect sense from the perspective of the Mengerian theory of money -- liquidity and network effects. The on the run bonds trade at a premium because they are more liquid, and are more liquid because they trade more, and trade more because they are more liquid.

[Jon]

In volume, trading currency has almost no cost. Especially for a large banking organization like such as Visa, they need only trade on the market a fraction of the volume of their customers because the remainder nets out.

When a local bank deals with actual foreign notes, there is an understandable cost. Otherwise, the costs are minimal--and it must be, US$4 trillion equivalent is exchanged daily. I don't recall the local money changer offering a bid/ask spread that differed by the 4th decimal point!

80% of the forex market consists of dollar trades.

The special role of the dollar is legal in origin--Bretton woods spells out explicitly that all currencies are defined with respect to the dollar, and the dollar is equivalent to gold. In this way Bretton woods defined the dollar to replace gold as THE money.

Another observation:

Only in a handful of countries are you expected to pay in the local currency. Even 'Euro' countries such as Greece and Italy accept dollars in their stores. Admission fees to the government run tourist attractions in Sweden are priced in dollars. I've paid Canadian restaurant bills in dollars. In India, in China, and in Costa Rica I observed that dollars were accepted as payment everywhere. What's more in third-world countries, dollars are often accepted at highly favorable rates by local merchants.

[Determinant]

Jon, my brother worked at as waiter at a sit-down restaurant down by the major highway exit. It's one of the main routes to cottage country, and they see a lot of Americans in the summer. They accept US Dollars as a courtesy but don't provide anywhere near a fair exchange rate, and make no pretence to do so.

In many small retail cases it's all about customer service, not market exchange efficiency.

[Ed Seedhouse]

Well I think you answered your own question. A "Reserve Currency" is a currency that banks hold as a reserve. But then you go on to ask why is apparently is mostly the US dollar these days. Fine, but that's wasn't the question asked in the headline!

[Daniel]

Nope. You pretty much nailed it. The one you didn't 'list' because you can't see why it matters (oil) matter a lot.

#3 - Oil is priced and traded in USD worldwide. Oil is THE strategic resource. ALL of our economies are directly dependent upon access to oil, refining, and distribution of petroleum products. All of them. This is a big reason why nearly all countries keep USD as their reserve currency. Even if their own currency completely crashes they can keep the economy moving with the USD they have in reserve. That's simplifying things radically obviously (we won't get into political 'clout', etc. but it's there too) but does get to the heart of the matter.

The reason? World War II. After 1945 nearly every 'modern country' in the world had been involved in that war. All of these countries for many reasons did enormous amounts of 'business' with the USA. Many of these countries were provided financial aid to restore their infrastructure and economies by the USA all in USD. It just became a self-fulfilling equation. More and more USD were becoming the 'currency of trade' between other nations. Once our economy just exploded in the 1950-60s it was 'set in stone' if you will.

[Mike Sproul]

"I can't see why it matters so much"

Correct. I expect there are many banks around the world that maintain checking accounts denominated in euros, dollars, pounds, etc, and hold reserve stocks of each of those currencies. The denominations of those accounts could be changed for the trouble of making bookkeeping entries. Remember that British Merchant banks used to deal in pounds, until British restrictions on external sterling loans made the Merchant banks start denominating their deposits and loans in dollars.

[Panayotis]

Nick Rowe,

It may help to think the reserve currency as the 'currency of last resort", the one that in the presence pure uncertainty all payment settlements whether between central banks, other financial institutions and international trade counterparties can be completed. If ignorance regarding payment facility is present between counterparties, their last resort is to settle with the resrve currency. Ignorance bounds completion whether in lending, payment settlement or spending decisions.

[Nicolaas Smith]

"Even if their own currency completely crashes they can keep the economy moving with the USD they have in reserve."

Zimbabwe wiped out the real value of the country´s ZimDollar money supply by printing zillions of ZimDollar 100 Trillion notes - some on A4 photostat paper. They had to withdraw the ZimDollar from circulation.

They had no USD reserves.

The economy was still Dollarized using USD, SA Rands, Pounds, Euros and Botswana Pulas from balances of these items in the economy.

[Rohan Clarke]

Nick,

As a country who still swears allegiance to the Queen, we Australian's are proud of the fact that our currency is quoted AUDUSD. When you Canadian's abandoned ship, you lost all base currency privileges - ie. USDCAD. It's a throwback to a time when GBP was the world's reserve currency - hence that pair is also still quoted as GDPUSD (and called 'cable' by the old folk in recognition of the original way in which it was traded - over the cable).

The point being that by looking at how the world transitioned from GBP to USD as a reserve currency, you may find some colour to your answer.

(It speaks volumes about the creators of the EUR that they dictated that it would be quoted as the base currency.)

[casanova]

The dollar is exchangable for crude oil which is the essential ingredient for all forms of modernity.

All other trades in other markets are churning and noise to conceal dollar preference.

The USD is the reseve currency because all countries need it to buy oil.

As long as USA has the big guns, oil will be traded in dollars and USD will remain the reserve currency for decades to come.

[RSJ]

"I see no way that you could simply deduce that USD should be the world's reserve currency by dint of thought and theory. It is an irreducibly empirical matter."

Hmm, is that how thought and theory dints?

You would reason that there would be a dominant currency for international trade because of the network effects; a situation of multiple competing trade currencies is unstable. Then you would reason that if there was an economy that accounted for a plurality of the world's trade, then its currency would have a higher probability of being the reserve currency. If everything was equally balanced -- a dozen identical nations all trading in equal amounts with each other -- still something -- a sunspot -- would break the symmetry, and you would leave the unstable equilibrium and start heading towards the common reserve equilibrium.

The point about bonds is a good one. The U.S. is incredibly stingy in its monetary base, but liberal with bond issuance. Our bond markets are by far the deepest and most liquid in the world -- they are the real money, due to the same network effects as above: it's irrational (and frowned upon by the currency issuer) to hold currency -- it's much better to hold an interest bearing bond. So everyone holds something, in this case USG bonds, and that becomes the numenaire for international trade and finance.

[edeast]

I'm a gonna say, semi-continuous value holding item, with largest set of users. Set of users being determined, by taxation base (chartalism) and I guess, gov control(oil), and network effects. But now I'm going to have to read Menger.

[edeast]

Oh ya, i'm asserting that there is a market where apples trade for bananas.

[Determinant]

Rohan Clarke:

Canada has used the Canadian Dollar since 1871, and there were the Province of Canada Dollar, the New Brunswick Dollar and the Nova Scotia Dollar.

Canada was never part of the Sterling Area.

[Nick Rowe]

Here's my take on it now, having reflected on the comments.

My conjecture (point 2) was basically correct, but over-simplified.

I have an image of a hub-and-spoke model of money. To get from city Apples, to city Bananas, you have to change planes at the hub Money.

I saw each currency as a local hub, and the reserve currency (the USD) as a global hub, that connects all the local hubs together. But what I missed is that there are also regional hubs, that connect some but not all of the local hubs together. The USD is a global hub; the EURO is a regional hub. Take two cities A and B from anywhere in the world. Sometimes you can fly from A to B via a local hub. Sometimes you can fly from A to B via a regional hub. But you can always fly from A to B via the USD.

I also missed integrating the holding of reserves into my understanding. You can buy any currency directly with the USD. And central banks hold USD reserves. Those are two senses in which the USD is a reserve currency. Which causes which? My gut tells me that the first causes the second, but I have to recognise that causation goes both ways. I hold Loonies because I know I can buy things with them. But I can buy things with Loonies because other people around me are willing to hold Loonies.

As to *why* the USD is the reserve currency, my own views are vary similar to Phil Koop's. History is the main determinant on what currency wins the network externality game. Under Bretton Woods, all currencies had fixed exchange rates in terms of the USD, so the USD traded for all currencies, and each central bank had to keep USD reserves. Bretton Woods disappeared, but the equilibrium remains. But RSJ's point must also matter as well. Even if we forgot history, the fact that the USD economy is bigger than any other means the USD would probably re-emerge as the reserve currency.

I know liquidity is important, and I really wish I understood it better. Transactions costs (bid/ask spreads, commissions, etc.) are part of it. But so is the ability to buy or sell a lot of it quickly without turning prices against you. But I think there's still more to it than that. A big exit door helps me get out the theatre quickly, but if everybody else is rushing for the exit at the same time to get to the ATM, that won't help me as much.

My house is not very liquid.

1. There are transactions costs like realtor's fees, lawyer's fees, home inspections, etc.

2. Not many people come on the market each year wanting to buy a house exactly like mine. It's a thin market. If I were able to wait a year, I could wait for the buyer who really wanted a house exactly like mine, and get a high price. If I tried to sell it quickly, because I needed cash fast, I would have to lower the price a lot, to attract a buyer who really wanted to buy something quite different.

3. If I and everybody on my street wanted to sell our houses to raise cash at the same time, we would have to really lower the prices, because we would be trying to share that small flow of people who really want to buy a house on this street among all of us. Rush to the exits.

[Steve]

I just read the new Cochrane Op-Ed in the WSJ. Could you comment on that? Would be interesting to hear your view!

Thanks,

Steve

[GA]

As someone in finance, I'm continually astounded by the network/base effect of the 'original currency' issue in trade and finance.

Example: some company in Russia buys (using bank finance) a piece of highly specialised equipment from e.g. USA, Eurozone, or some other country (which we'll call 'Canada.)'

Now, obviously there are very few reasons that the originating market/producer should determine the purchaser's borrowing currency. Even if the purchaser is indirectly getting finance from the seller or seller's bank (like with a trade instrument with post-finance), the only important decision factors that should go into which currency will be borrowed (as opposed to used to pay for the equipment are risk (to the borrower) and cost of finance in that currency.

That scenario being put out there: it's my contention that empirically the currency in which the purchaser borrows is _heavily_ influenced by the preferred currency of the seller. There are only a few logical reasons where the decision to lend in the seller's currency makes sense (collateral value is in original currency, purchaser has income from seller's market/currency), but I have frequently heard the assertion 'borrow in Euros because that's where we got the stuff.'