Reserve Currency Theory

Reserve Currency Theory is a new term I just invented to describe why the US can issue so much debt. It is simply because the US Dollar is the world's reserve currency. So long as the dollar continues in this role, then the US can issue an almost infinite amount of debt.

MMT (Modern Monetary Theory) is the latest preferred term for theory that was previously called Keynesianism.  Keynesianism, if I understand it correctly, states that the government should run a surplus when times are good and a deficit when times are bad to counterbalance the economy.  MMT, if I understand it correctly, states that government debt is necessary for private savings, and to increase the money supply, and so government deficits are not bad per se.  However, even so, under MMT, there is a limit to how much debt a country can incur before it reaches the Keynesian endpoint.

Another version of it is called Monetary Sovereignty, and advocate it as the cure for whatever economic ails a country has.  So Monetary Sovereignty adherents would tell Greece to regain its monetary sovereignty and inflate away its debts.  However the truth is that nobody would want to use the Greek drachma unless they were forced to.

So under my theory, world currencies are split into 4 categories.  First, the dollar (which I will come back to).  Second, the currencies which are linked to the dollar and for all practical purposes are also dollars, just under a different name.  Third, the "normal" currencies, such as the Euro, Canadian dollar, etc. which are commonly traded on the Forex markets and to which MMT may have some relevance.  Fourth, the "local" currencies, such as the Botswana pula, or the proposed Greek drachma, which are used only as a local currency.  No foreigner would buy debt denominated in the local currency.

The dollar is exempt from the "laws of gravity".  The US can issue an almost infinite amount of dollars.  When the US issues enough dollars to deflate their value, then the other countries issue more of their currencies in turn in a process called competitive devaluation.

But what about a gold-backed currency?  Maybe it would make sense for some country to issue a gold-backed currency, like the gold dinar,  meant to be an alternative to the dollar.  But people wouldn't use it as a currency for most transactions simply because of Gresham's law ("bad money chases out good").  It would be used as a store of value, however.

What about the euro or yuan?  At the moment it appears that neither of these will replace the dollar.  For a currency to do so, it would have to have a Lender of Last Resort, and a well-developed centralized market for debt. 

So, assuming my theory is true, what should the US do?  It should use the power it has been given, issue more debt, and buy up debt of European countries (earning the interest that they pay), and invest in big infrastructure projects, like a tunnel under the Gibraltor straits.

I will be looking for arguments to further develop or to challenge this theory.

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Update: I am tagging this as a projection that the US economy can survive almost indefinitely or at least until 2099.

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Update 6/19/12.  This isn't a model, its an article on the almighty US dollar.  If the US runs into severe problems, there will be alternatives, even if we can't see what they would be right now.