Here are two defensible stories about why the dollar is a reserve currency issued by a country that can't balance its budget or produce more than it consumes:

1. This is primarily a function of external demand. The rest of the world needs that reserve currency, and as the rest of the world grows, and its financial system grows, too, it needs more and more reserves. The only way to get dollars is to sell something to Americans and then not spend the dollars on things Americans sell to you, or to outsource this relationship to some other trading partner. So that's what they do.

2. The US lives beyond its means, both in terms of consumption exceeding production and in terms of spending exceeding taxes. But it's also a rich country with plenty of investment opportunities, so it's historically been able to outgrow a little profligacy. But the result of this profligacy is that there are lots of USD-denominated assets owned by foreign investors, and these assets are liquid. The US's persistent deficit means that everyone else knows they can source dollars, so they're willing to borrow in USD, and that makes the US dollar the global reserve currency.

These stories both make sense, though they ignore some of the relevant historical contingencies: the US dollar was designed as a reserve currency by the Bretton Woods agreements, which pegged every currency to dollars and pegged the dollar to gold. When the US abandoned gold convertibility, the world's financial infrastructure still treated the dollar like a reserve currency—and now that precious metal reserves didn't constrain issuance, the US could offer the world as much currency as the world needed.

This has some interesting side effects. Historically, reserve currency status correlates with GDP, but more strongly with trade and with the size of a country's financial system. The US is a big player in global trade, but its share of global trade is actually smaller than its share of GDP (23% vs 26%). But the American financial system is so sprawling, and the dollar so important globally, that in effect every financial system that isn't actively under US sanctions or that doesn't have significant barriers to capital mobility is part of the US system.

A big financial system makes reserve currency status durable, as the example of the UK illustrates. The US had a bigger economy than the UK by the turn of the twentieth century, but a disproportionate share of global trade was priced in sterling, and there were plenty of global borrowers who'd tapped liquid markets in London and still needed to source pounds when they paid down debt. And because there were so many pound-denominated bonds outstanding, there was good infrastructure for borrowing against them and trading them, so it still made sense for borrowers to use pounds.

This effect is easier to describe today, because we have more data and more terminology. If there are more investors who want to denominate their wealth in US assets, it has several effects:

1. These assets become more liquid, and worth more.

2. At a given valuation, they have better risk-adjusted returns—you can be more confident that you can borrow against them, trade in and out rapidly, use derivatives to hedge, etc.

3. At an earlier stage of a company's existence, when it's a net consumer of capital and is mostly funded through venture capital or other non-publicly traded assets, there's a much stronger incentive for VCs to move money into the most promising companies, because they'll have bigger IPOs.

4. If talent is mobile, too, this ends up being a subsidy for skilled immigration—while it's a big hassle to move to the US from India or France or Brazil or wherever, it has an enormous payoff, so the US ends up with a disproportionate share of the right tail of the talent distribution.

In a way, the US economy has expanded the idea of a "reserve asset" from just the currency and short-term government obligations to the entire civilization. The US is the global backstop when there's either an economic or geopolitical crisis, and this means the US is more densely-networked with the rest of the world, which raises both the ability and need to perform that stabilizing function.

As the UK example illustrates, this is a hard equilibrium to break. Even if the US loses share of global economic activity, and even starts to lose share of the financial system, there's still a lot of dollar debt outstanding, and that means that there are still lots of companies that transact in dollars, which mean that for many of them, dollar debt is still a good idea. Since the US is a disproportionate share of global consumption relative to GDP—that gap being the only way to supply the world with the dollar assets it demands—economic shocks to the US tend to produce worse economic shocks to the rest of the world, leading to dollar scarcity and an even more US-centric financial system.

It could break eventually, and it would be a painful process if that happened—an America that consumes a little less than it produces in order to pay a crushing debt burden is simply a less fun place to be, and also one that wouldn't have nearly as robust a financial system and would thus miss out on capital allocation-driven growth. It would be in some ways a saner system—it's always been a bit peculiar that American consumption is indirectly subsidized by high savings rates in third-world countries—but most economic actors have incentives to keep the system going rather than to take it apart.

The Diff aims to cover the dollar's reserve currency status in the same way that a newspaper for fish would talk about water. It's so ubiquitous that you'd be forgiven for never thinking about it, but if you do think about it, you'll have a better understanding of the environment you're in. So we've looked at:

• Reserve currencies as Giffen Goods ($)

• How China might try to make its own reserve currency ($), and why that probably won't work

• Why a sudden increase in tariffs threatens, but doesn't end, the dollar's status ($)

• Volatility in a financialized economy ($)

• And Part 1 ($) and part 2 of a series on emerging market banking and why it's so challenging.

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