Imagine you want to buy 100 thousand barrel of oil. The oil is coming from Saudi Arabia. Are you paying Saudi Arabia in riyal? In other terms, are you going to go to your central bank, convert your euros to riyal, and with those ryial you buy the oil? This would seem to easiest thing to do.
No, you are paying Saudi Arabia in dollars.
Oil is traded in dollars worldwide since the early 70's. That's why we talk about petrodollars.
Ok, now you live in the Netherlands decide to buy a large amount of, let's say, TV screens from Japan. Are you going to pay them in euros? Yes, you can. They would accept euro in exchange for TV screens.
What does it happen if you live in Argentina and want to buy the same Japanese TV screens? well, unless you have yens, that is you convert your pesos in yen and buy Japanese goods, you cannot do that. You have to convert pesos in dollars, and with those dollars you buy the Japanese goods.
In other terms, from these two examples, you can already see that the dollar is used as a currency medium for trade exchange between two different countries.
The International Monetary Fund (IMF) considers a basket of five currency, to be used as reserves for international trade.
- US dollar (41%)
- Euro (31%)
- Chinese Yuan (11%)
- Japanese Yen (8%)
- Pound Sterling (8%)
(in light yellow the new entry: the Chinese Renmimbi)
As you can see, the dollar is by far the biggest weight in the IMF's basket. Recently (2015), Chinese Yuan was added in the basket at the expense of the Euro (mainly), the Yen and the Sterling. The dollar weight was unchanged.
So, let's recap: when two firms in two different countries decide to trade, they typically exchange goods or services paying in dollars.
Three important questions:
1. Why do they need to use a foreign currency?
2. Why is the dollar the most used foreign currency?
3. What are the consequences for the USA and all the other countries?
First question: Why is there the need to use a foreign currency if two countries decide to trade between themselves?
Answer: let's use an example. If I am Polish and I need to buy a Toyota, theoretically I could pay the Japanese firm in zloty. The Japanese could convert my zloty and get their yens. But if Japanese do not want any zloty, we should go for a barter. The Jap could buy some stuff from Poland in exchange for the Toyota car. Of course this is impractical. That's why they both decide to use a currency that everybody wants.
Of course nobody prevents Japan from accepting Polish zloty. If Japan has zloty as a currency reserve, they can accept a payment in zloty. But this would imply that that the Japanese Central Bank should hold reserves for all the currencies in the world, which is inconvinient. It is easier to have just a bunch of currencies to be used as reserve, possibly from the biggest economic areas in the planet.
Second question: ok, for international settlements of payments, we need a common currency which we all agree upon. But why the dollar and not, let's say, the argentinian peso or the canadian dollar?
The easy answer is: the USA are the biggest economy in the world, so everybody does business with them, and needs their currency.
The other answer is more complex: the USA won the Second World War, and, according to the Bretton Woods agreement in 1944, the dollar became de facto the global reserve currency, mainly replacing the Pound Sterling. Following the collapse of the gold standard in the period between 1969 and 1973, the USA created the petrodollar, making deals with Saudi Arabia and other OPEC countries: you want oil? pay in dollars. Who prints dollars? the USA. So, since everybody needs oil, everybody needs dollars. This has been keeping the demand for dollars high.
Third question: so, everybody needs to use dollars. What are the consequences for the USA and for the other countries?
The consequences, even if they are not known by the people, are huge: I am not exaggerating, the consequences are so important that they have shaped the world we know today. Since the abandonment of the gold standard, and with the raise of petrodollars, the US has been having an increasing trade deficits. They got goods and services from developing countries, and paid with money paper, ie dollars, in exchange for that. This has created:
1. raise in the economies of the Asian countries (Japan, Malaysia, Vietnam and nowadays China)
2. huge bubbles in the stock market
3. lowering interest rates in the cost of money for the US government, because the exporting countries, with all those dollars in excess, have reinvested the dollars in US treasuries: since the demand was high, the yield was lower and lower. So the US government could refinance with little expense, so increasing expenses on social welfare.
4. loss of jobs in industry in the US, because industry could pay a few euros a chinese worker instead of paying hundreds euros per day a worker in Michigan.
5. stagnating wages for middle class, since industry was disappearing and there were too many workers to be absorbed by industry and all the service companies working around industry.
6. surge of private debt (household debt) because, in order to keep the same quality of life, and thanks to low interest rates (point 3) families found it easy to increase their level of debt.
and many other things. In a nut shell, a huge acceleration of production worldwide, speed-up of globalization and huge increase of consumption (due to the low interest rates on loans), and net decrease in the savings rate (because you do not earn enough). All of this has led to a shrinking middle class in the US.
Bear in mind that everybody is accepting dollars in exchange for goods and services because they think that the dollar is stable and trustworthy. Now, you may say it is not true: due to inflation the dollar is losing purchasing power, the Fed has been printing trillions of dollars in the last 8 years and China is growing and piling up gold. Nevertheless, when I hear this objection, I raise an eyebrow and start to ask: what is the alternative? As far as I can see, in economics, there is not good or bad, there are better or worse solutions. Everything is relative, not absolute.
The euro zone is a disaster, China is an unknown (following the same steps of Japan in the 80's), Japan has been in stagnation for twenty years and the UK lives mainly with the finance industry.
And the same monetary policies that the Fed has been running through, are the same that other central banks are using! so, there is no clear winner. If dollar loses purchasing power, and governments may become wary of the US currency, what currency should they keep in their (electronic) vaults? everybody is trying to weaken their currency!
In such a bad scenario, it makes no surprise that currently the dollar is stronger with respect to all other currencies.