In past lot of economists have proposed change in reserve and trading currency. Once, President Musharraf along with Malaysian Prime Minister (Mahatir) proposed Islamic dinar as currency for trading amongst Muslim block (seems that it did not materialized). Nevertheless, all these proposals did not go much far. Recently Russia (Mr Putin) proposed Rouble as new trading and reserve currency. Talk is going on since long in many world capitals to change trading and reserve currency from dollar to basket of currencies, where Euro may play major role. Seems some countries have already taken practical step towards changing their reserves and trading currencies from dollar to Euro or other currency. Some of these countries are China, Iran, Syria, Venezuela, Cuba, Kuwait, Russia, UAE etc.
At present dollar is reserve and trading currency. If reserve and trading currency would change from Dollar to Euro (or any other currency, or basket of currencies, or Rouble as Russia is proposing), than that would be start of American economical decline (rather start of an end to America being an economical as well as military power, as once economical power disappears, military power disappears too).
Having dollar as reserve and world trading currency means giving a sort of tax to USA (One can call that Jagga tax). Because of this tax, American can live a luxurious way of life without much working, but on the work of others.
How it works and how USA benefits? There are two ways that make USA benefit form this situation.
Way one (and most important): America survives without paying real money for their imports. To understand that, let see the example: Let say that every one trusts me and believe that I can pay for whatever I like. Thus, whatever I need, I write a cheque and everyone accept my cheque. Funny thing is that, they accept my check but do not cash my cheque. They keep my check and consider that itself money. They pay my cheque to others and others also accept my cheque as money. Now, it does not matter if I really have money in the bank, as no one cash my cheque, so I buy whatever I like and spend whatever I like, as I just have to write as many cheque as I need and give to people. For me, cheque is a piece of paper that I write the amount and sign it, that’s all.
In economical world, it is called fiat money or money that is not backed by any real physical commodity or material. Fiat money has no real value or substance, but it is money backed by trust only.
Now, dollar is cheque that USA prints on piece of paper and distribute to others for whatever they need. Dollar has no real value or substance, but it is fiat money. World accepts dollar note and give USA whatever USA wants. That dollar note does not come back to USA for real payment. All who have that keep dollars as reserves, use dollars to trade with others, or invest dollars in USA.
Last year (2006) USA trade deficit was $857 billion (and that was no exceptional year). On top of this trade deficit USA has other expenses, like dishing out dollars to Israel, Egypt, and many other countries. USA is also spending billions of dollars on military ventures abroad. There are many foreign workers in USA that sends remittance to their home countries.
Apart of that, USA has within USA maybe around (or could be over) 20,000 billion dollars investment money belonging to foreigners (in properties, shares, Government bonds, and God knows what). All those investments are earning dollars for foreign residents. Return on investment in USA belonging to foreign residents could be over 1500 billion dollars every year (if one assumes 7.5 percent return).
USA exports goods worth around $ 1000 billion a year but imports goods worth around $ 2200 billion a year. Though America balance of payment in services is around $ 100 billion (earns around $ 460 billion from others and others earn around $ 360 billion from USA), it is insignificant as America trade deficit in goods is around $1200 billion. Now one can see that just investment income of foreign resident from USA is most likely more than what USA exports. So, even if USA keeps exporting goods and services without importing anything, still American debt would never decrease.
USA national debt is around 9000 billion dollars and a large chuck of that belongs to foreign residents. American national debt is increasing around 1.11 billion dollars daily. Every American man, woman, and child is indebted by over $ 29,000 just because of national debt (That excludes private debt belonging to foreign residents, as well as investment of foreign residents in USA).
Unfortunately, USA is not paying interest on debts nor repaying debt, but all interest every year is accumulating as further debt (because USA pay them in dollars and foreign lenders reinvest them back in USA). Unfortunately, foreign residents hold that American fiat money and consider that wealth, and that illusion is there because dollar is trading and reserve currency.
In reality, USA neither have that much wealth to pay foreign owned dollars neither they could. [Note: Even if USA stop importing anything and keep working free as donkey for foreign residents to export what they are exporting at the moment, still America wont be able to even pay interest (or investment income, or dividend) on the money invested in USA by foreigners].
Devaluation of dollars will not help, as devaluation means inflation and high interest in USA, that in turn means value of foreign investment in USA rising. Further, because of devaluation, Americans have to work harder to earn foreign currencies to pay back the debts USA has already accumulated. USA imports a lot and devaluation means American negative balance of payment would increase further.
Hence, for USA, dollar to stay as reserve and trading currency is important, else not only American way of life would go, but that they would start working as slaves. Obviously, if such would happen, that could make America to start war, and that is different matter. Anyhow, if weak countries would have initiated this change, USA would have given them a kick, but it seems that Russia has initiated that and persuading China and many other countries to follow.
If that would happen and succeeds, USA would start loosing their economical power but soon that would affect USA military power too, making USA weaker in both economic and military term (could even make the whole country collapse).
Way two: Many countries have dollar reserves but they have not even invested those dollars in USA economy. Because dollars is world reserves and trading currency, many individuals have kept dollars in their safe deposits without earning any return from dollars they hold, thinking that dollar is as safe as gold. Many countries also do that. Since there is inflation in USA (however small), dollar loses its purchasing power every year. Thus all that dollars that is sitting idle abroad with foreign resident, USA (effectively) earn interest on that equal to inflation.
Example: Let say that you bought something for 1000 dollars and issued a cheque of 1000 dollars to pay for that. You kept 1000 dollars in your bank account to cover that cheque. Bank pays you compound interest on your deposit equal to inflation, so that your 1000 dollars buy same amount of goods whenever you take that money out from bank. That means, bank is paying you interest equal to inflation, to cover the change in value of your deposit.
If cheque was cashed same day, 1000 dollar from your account would go and you won’t get any interest on 1000 dollars in your bank. But if inflation is 5 percent and bank is paying you compound interest of 5 percent to cover your inflationary losses, than if that cheque would come after one year, your 1000 dollar in bank would have become 1050 dollars and thus after paying that 1000 dollars cheque you are still left with 50 dollars. If cheque would come after 15 years than 1000 dollars by then would have become more than 2000 dollars. That means after paying $1000 dollars you are left with more than $1000 in your bank, thus your actual cost of that cheque become half to you. Just imagine that you issue the cheque and it never comes to your account to get cashed, than in reality cheque did not cost you anything. Nevertheless, if it comes after let say 140 years, than in reality that cheque would only cost you one dollar, even though you bought 1000 dollars worth of goods for that cheque.
‘Way two’ has no long term losses to USA as it is pure gain. USA only benefit from ‘way two’ mentioned above, though it is very little compare to ‘way one’. Nevertheless, apart of huge benefits that brought huge investment to USA, ‘way one’ also took USA into a pitfall of living on borrowed ‘fiat’ money, and from where it is almost impossible for USA to come out. As world finances increases, world reserves and trading increases, USA falls further deeper into the pitfall.
Actually, in earlier days dollar was linked to gold but time came when USA was unable to honour gold for dollars, and hence in 1971 (President Nixon) delinked dollar from gold. This gave American economy a boost but in the end, American started living beyond their means, relying on imports using fiat money ‘dollar’, resulting now in a situation where American economical situation is precarious, even though on surface it looks smooth.