However, this is not in itself enough to make the dollar valuable. Products and services must be available for those holding this currency. This too is true for all fiat currencies. Unless something is produced inside the political borders of a currency, the currency has no value.
What is unique about the US dollar, is that it is widely used outside the US. This means that the dollar derives it value, not only from the production of products and services in the US, but also from many products produced outside the US. In particular, the production of oil. Oil prices are set in US dollars.
Being a world reserve currency, the US dollar has more value than it otherwise would have had. Also, the US dollar derives its value in part from the US bond market.
Excess dollars are invested in US bonds. This pushes the price of bonds up. This in turn, attracts other investors who want to get in on the lucrative trade. They need US dollars to get in, which pushes up the price of dollars.
This has produced a virtuous cycle that has lasted since 1981. US bond prices go up due to international demand, which in turn attracts more investors and more demand. The result has been falling interest rates and a steady increase in debt.
However, there's a limit to how low interest rates can go, and we seem to have reached that limit. Furthermore, an increasing amount of international trade is now bypassing the dollar.
Buying US bonds at current prices, using US dollars that are more likely to go down in value than up, makes very little sense.
The result of this is that the virtuous cycle described above is about to reverse. US bond prices are about to go down. Demand for these bonds will fall, and the dollar will fall too. Interest rates will rise as a consequence. However, the higher interest rates will not attract investors to the dollar. As long as the medium to long term perspective is one in which bond prices are likely to fall, demand for dollars and bonds will remain weak.
Only a sharp shock in which interest rates are pushed aggressively higher will stop the decline in the dollar. This was done in 1981 to stop the dollar from falling. However, a repeat of that exercise seems unlikely today. There's too much debt in the system.
If interest rates go beyond 5%, the annual interest on the national debt goes to 1 trillion dollars. If interest rates go to 20%, as may be needed to prevent a complete meltdown in the dollar, interest payments go to 4 trillion.
There are in other words only two ways out of the mess. The US government will have to default on its debt, or it must allow the dollar to devalue radically against all other currencies.
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