Why do we have Money?
The purpose of money is to store our economic value (time, efforts, resources, etc.) Without money, a carpenter would have to find a chicken farmer that needed a new table if he or she ever wanted eggs. Because of monetary systems, the carpenter can produce a table, sell it to anyone, and use the money over time to buy groceries from various sources. Money greatly increase the efficiency of an economy.
Money comes in various forms. Commodity currency is money that has value in of itself. Salt has been used in Eastern Africa, tea bricks in Central Asia, Parmigiano cheese in Italy, cocoa bean in Central America, and pemmican in North America. Cattle, knives, and even potato mashers have been used as well. The most obvious example of commodity money is precious metal.
A lump of gold has substantial value no matter where or when you live. It is easily worked, carries a current, and is stunningly beautiful. To further ease transactions, the metal currency is often minted into coins or bars that are recognizable, standard in size, hard to counterfeit, and noticeable if shaved or clipped. This allows it to be exchanged without a scale and without fear of purity issues. The advantage of commodity currency is it will always be worth something. The disadvantage is that it is less portable and cannot be transported digitally.
Another type of money is representative currency. This is a certificate that can be redeemed for a commodity (something of value). Effectively, the object stays in place, but the title of ownership changes hands. The United States operated under this form of currency for nearly a hundred years. The United States’ paper money used to be exchangeable for actual silver at the Federal Reserve. An advantage to this method is the commodity doesn’t have to be continually packed by the owner and it doesn’t get worn or abused. A disadvantage is it masks the commodity and puts it in someone else’s control. If there is doubt that the certificate can be redeemed, the purchasing power of the certificate will plummet.
The final type of currency is what almost everyone carries today, fiat currency. This is currency that only has value because someone says it does. It is monopoly money when playing a game, tokens when at an arcade, stickers when paying the postage, fancy green paper with historical figures when paying in cash, and a blip on a computer screen when ordering online. In their own domain, they are each valid currency. If I were to pull out a checkbook while playing Monopoly, it would ruin the game and if I were to use Monopoly money at the grocery store, I wouldn't have any eggs for dinner.
If the rules within the domain are unchanging and fully backed, the system works. I’ve never had a hyperinflation problem while playing Monopoly, because I've never designated an official "game rule maker" who announced midgame that prices would double with each dice roll. The problem with the real world is there are "game rule makers": the US government, the US Federal Reserve, and other law makers or currency regulators throughout the world. They constantly play with currency supply, interest rates, commodity prices, taxes, tariffs, and treaties to meet their objectives. Unfortunately, this manipulation has caused the collapse of both the currency and the economy dozens of times in the past.
The US Dollar
The US dollar is even one step more convoluted. They are not owned by the US Government, but by the Federal Reserve System. If the US Government needs more dollars than what it collected in taxes, it sells government securities (government debt) in the form of Treasury bills, Government Bonds, and Government Notes. These are bought by other countries, investors, or the Federal Reserve and will eventually need to be paid back with interest. When the Federal Reserve buys the securities, it creates money out of thin air and is reffered to as "printing money", even when digitally created.
Reserve Currency Status
In 1944, 44 delegates from 44 Allied nations gathered together in Bretton Woods New Hampshire to discus global finances in the WWII aftermath. At the time of the Bretton Woods Conference, the United States was the leading exporter and creditor and the dollar was exchangeable for a fixed quantity of gold (representative currency). Because of the United States' strong currency, the delegates selected it to be the international reserve currency.
As the global reserve currency, other nations would have to first trade their money for dollars before exchanging with other countries to settle debts or purchase comodities. Countries also hoarde dollars as their own personal reserves the same way a household would hold some available cash for difficult times. It also serves as some protection against adverse exchange rates with their local currency. No one wants to scramble for dollars when they are needed because that is also likely when they are the most expensive.
Because countries need dollars, it creates an extra demand. This proping up of the dollar and gives the United States a huge advantage in power and prosperity. As the only legal producer of the US dollar, we also get a discount on transactions by avoiding exchanges. Much of the prosperity we experience today is directly dependent on holding the reserve currency status.
In 1771, the United States released a series of economic measures known as the Nixon Shock. It was in these monetary policies that the US dollar lost its representative currency status and fell to a true fiat currency. This should have plummeted the value, but other countries weren't willing to declare their dollar holdings worthless.
The US Petro Dollar
Knowing the dollar had to be backed by something, even if indirectly, in 1973 the United States made a brilliant deal to protect Saudi Arabian oil fields (specifically from Israel) on two conditions. They had to agree to only sell oil in US dollars and invest their excess profits in US government debt securities. By 1975, this deal was expanded to all OPEC nations, creating the US petrodollar. These deals forced other nations to buy US goods to obtain US dollars despite the physical worthlessness of the paper money. The deals also gave artificial demand to US government debt securities, lowering the interest rates significantly. Basically, the US is able to print money to buy oil, then have the oil producers buy the debt used to print the money! It is this circular system that allows the US to print nearly as much money as it wants.
In the past, some oil producers have tried to switch away from the petrodollar system and have felt the full force of the US military. In Iraq, Saddam Hussein traded his oil for Euros, so we searched for an excuse to take him out. With the 9/11 attacks, we chose to ignore the fact that most of the hijackers were Saudi (our petrodollar ally) and instead drew up plans against Iraq as the answer. Kaddafi sold oil in Dinars and met the same fate. Just about every military decision since the Industrial Revolution is oil dependent. Vietnam, Pearl Harbor, and even the assassination of Archduke Franz Ferdinand (triggering WWI) all have underlying oil motivations.
Basically, the United States of America, knows that oil rules the world. If the petrodollar system is threatened, the economy will collapse. Even President Franklin D. Roosevelt once said, “I hereby find that the defense of Saudi Arabia is vital to the defense of the United States”.
Unfortunately, China has a growing thirst for oil and is now Saudi Arabia's biggest customer. At the same time, the US oil orders are declining. Saudi Arabia feels somewhat betrayed by our relaxing of policy against their enemy, Iran, and is questioning the need to maintain the petrodollar system. In 2010, Russia and China struck a deal and now will exchange oil directly, skipping the dollar.
If oil is bought without the US dollar, nations will have much less tendency to hoard dollars and they may find their way back to the US, quickly. Countries will want to cash in on their US debt holdings and the dollar value will tank as the domestic money supply skyrockets into hyperinflation. The US dollar is in trouble.
Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast. Anything I recommend should be personally analyzed and discussed with your financial adviser.