Reserve currency, the words are everywhere these days when reading up on the Economic Collapse of the World. Most people do not understand its implications and effects on the economy. I am going to try and explain it the best I can for everyone who reads this thread.

First of all I would like to point out that even though I do use Wikipedia, I wish I didnt have too. Wikipedia just has the most information in one place that I could find. I will also site other places and even a High School text book I happen to have.

What is Reserve Currency?

Reserve Currency

A foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations, or to influence their domestic exchange rate.

Investopedia Commentary

Currently, the U.S. dollar is the primary reserve currency used by other countries. A very large percentage of commodities such as gold and oil are usually priced in U.S dollars, causing other countries to hold this currency to pay for these goods. A large debate still continues about whether or not the U.S. dollar will stay the main reserve currency or if it will shift over to the euro.

A reserve currency (or anchor currency) is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc.

This permits the issuing country to purchase the commodities at a marginally cheaper rate than other nations, which must exchange their currency with each purchase and pay a transaction cost. (For major currencies, this transaction cost is negligible with respect to the price of the commodity.) It also permits the government issuing the currency to borrow money at a better rate, as there will always be a larger market for that currency than others.

The United States dollar is the most widely-held reserve currency in the world today. Throughout the last decade, an average of two thirds of the total allocated foreign exchange reserves of countries have been in U.S. dollars. For this reason, the U.S. dollar is said to have "reserve-currency status", making it somewhat easier for the United States to run higher trade deficits with greatly postponed economic impact (see currency crisis). Central bank reserves held in dollar-denominated debt, however, are small compared to private holdings of such debt. In the event that non-United States holders of dollar-denominated assets decided to shift holdings to assets denominated in other currencies, there could be serious consequences for the U.S. economy. Changes of this kind are rare, and typically change takes place gradually over time; the markets involved adjust accordingly.

There are two principal causes behind the most recent development. Both have to do with the fact that Europe is becoming more attractive for international investors compared to the United States. On the one hand, interest rates in Europe and the United States are moving in opposite directions. "The ECB will continue to raise its key rates next year, whereas interest rates appear to have peaked in the USA," says Joachim Scheide, an expert on the economy at the Global Economic Institute (IFW) in the northern German city of Kiel. This means that financial investments denominated in euros are yielding higher interest and are in greater demand internationally, which in turn leads to a rise in the euro.

The prospects for growth are also shifting. The US economy is cooling off. The government recently lowered its 3.3 percent growth forecast for 2007. If Americans consume less as a result of a decline in foreign capital investment, the United States could even face a prolonged period of more modest growth.

Pessimists are quick to come out of the woodwork whenever a major shift in the financial markets approaches. Many economists and bank analysts, especially in the United States, believe that the correction will happen very suddenly, with the dollar depreciating by 10 to 30 percent within a short period of time.

This would inevitably cause an adjustment crisis. Growth rates would plunge worldwide and a global recession, coupled with a drastic jump in unemployment, could follow.

This doomsday scenario is by no means the majority view. Some experts, especially in Germany, are more optimistic. "The US trade deficit has grown in the course of a few years," says IFW expert Scheide. "It will also gradually decline over a period of several years."

Scheide expects the dollar to lose another 10 percent in value against the euro in the next five years, a scenario that would be much easier to handle for the German and European economies. Companies would have sufficient time to adjust to changes in exchange rates. "In that case even an exchange rate of 1.40 wouldn't be disastrous," said DIW analyst Steinherr.

The Soft Landing: This scenario doesn't involve any dramatic drop off in the dollar; rather the dollar would slowly depreciate to a more balanced level. Imported goods (particularly from the Far East) would be more costly for us to purchase. Meanwhile our export economy would slowly revitalize since our goods will become cheaper and be more in demand with the increased wealth that the people living in developing nations are beginning to experience. Our trade balance would slowly disappear and higher tax revenues would rebalance the deficit. The threat of outsourcing would slowly turn around. The domestic stock market would appreciate as a result, in particular large multinational corporations and those within the manufacturing sector. Smaller (non-multinational) foreign stocks would also do well along with bonds denominated in foreign currency. Larger, dollar reliant multi-national foreign companies wouldn't fare as well.

The Hard Landing: This would happen when one event creates a chain of events, leading to panic and crash in the financial markets. For instance, a geopolitical event such as China invading Taiwan could trigger this. Or sudden changes in the market makes a hedge fund go under; leaving exponential obligations and a huge sell off of assets around the world to fill the gap. Commodities, long term interest rates, and inflation would take off. Ironically, the rust belt would come alive and become a boom area of the country with its cheap manufacturing capability and attractive asset prices to overseas buyers. The domestic stock market would crash along with the housing market. Seeking safety, short term debt and money market accounts would be earning close to nothing. Foreign stocks and foreign denominated bonds would do exceptionally well in light of the immediate event. Eventually, the results will be the same within the soft landing, but this scenario would be accompanied by more extreme market conditions, panic, capitulation and pain that would amplify the situation.

Worst Case: This is what Lietaur suggested. This is where the U.S. government takes action that creates artificial market conditions with regulations and reneges on its obligations to its debt holders around the world. Essentially there would be two dollar's, a foreign and a domestic dollar. It would spark a new era of global protectionalism and currency restriction. The global economy and financial markets would in a prolonged recession or depression and the U.S. would experience higher interest rates, deficits, taxes, and the real estate market would bust. Wal-Mart wouldn't have anything on their shelves because all the foreign goods would be too expensive to buy.

Originally posted by Tentickles
reply to post by bismarcksea

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I am all for hitting the reset button but understanding our current system better can lead to changes.

Because if you really think about it, they wont allow the button to be reset.

Originally posted by Tentickles
reply to post by cpdaman

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Great to see someone with a grasp on the current situation. Any thoughts on China and Russia?

Originally posted by Rockpuck
reply to post by cpdaman

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70% of our gdp is consumer spending.. internally revolving "wealth"... take the reserve currency status from us and our currency crashes.. y
We cannot sustain an economy generating real wealth if our second greatest asset is the ability to spend our money...

Originally posted by Tentickles

Originally posted by Rockpuck
reply to post by cpdaman

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70% of our gdp is consumer spending.. internally revolving "wealth"... take the reserve currency status from us and our currency crashes.. y
We cannot sustain an economy generating real wealth if our second greatest asset is the ability to spend our money...

You sir, indeed have a godlike wisdom on this subject.

Hit the nail right on the head. A Consumer economy doesnt last if the consumers dont consume.