The History of U.S Dollar as a Reserve Currency

The dollar's reign as the global reserve currency of the world

For the past 78 years, the U.S has benefitted from being the issuer of the global reserve currency of the world. Commodity purchases are priced and settled using the dollar, meaning that the U.S has minimal exchange risk when purchasing goods around the world.

History suggests that this will not remain the case forever. In fact, most reserve currencies are only able to hold on to that title for about 100 years. In order to understand where the future is moving, I have often found it useful to study what has happened in the past.

So, here is the history of how the dollar earned its status as the global reserve currency and the events that have transpired leading to today:

Until World War I, it was not clear that United States would emerge as a financial hegemon of the world. The crisis, which started in July of 1914, led to multiple European countries becoming indebted to the United States.

By the time the U.S joined the war in 1916, the demand for dollars had surged across the world. The reason was simple - the U.S offered the most resources in terms of raw materials and industrial technology, two critical components of warfare.

The end of World War I marked the entrance of the U.S in designing the economic world order. Britain invited America to join in forgiving the debts of countries such as Russia, France, and Italy. The White House refused the offer.

Instead, the U.S took a much more isolationist approach to foreign policy. Ultimately, France and Britain defaulted on their wartime American debt. The economic collapse from indebtedness also led countries such as Germany and Italy to fall under authoritarian leadership.

Post World War II, the Bretton Woods Agreement aimed to remedy many of the issues. It wasn’t until the 1950s though that European economies were finally stable enough to transact with the U.S. Even then, it required Congress to pass the Marshall Plan in order to avoid collapse of European currencies.

Source: BullionByPost

The geopolitical tension against the Soviet Union forced the west to become economic allies. Most notably, the fixed rate exchange system of the world emerged during this time.

It was clear that if the dollar was allowed to trade freely on a market, it would have had a downward slope, especially compared to other exporting competitors such as Japan and Germany.

The world continued to abide by the newly created system, based on the anchor that the dollar was backed by gold. In 1971, this came to an end.

By the 60s, many countries had already started the process of cashing in their dollars for gold. Given that just $11 billion of gold backed almost $24 billion in dollar exchanges, the tension amongst other nations was clear. Eventually, President Richard Nixon was forced to end the convertibility of the dollar into gold in August of 1971, officially creating what is now known as the fiat money standard.

Source: NYT Cover on August 16, 1971

The credibility of the dollar was no longer based on gold or other precious metals, but rather on the authority of the state.

The dollar became an instrument for speculation, and the biggest beneficiary of this was change was Wall Street itself. The depth of the financial markets had increased significantly, and dollar denominated international lending led to faster boom and bust cycles than ever before. Debt crises emerged in Latin America during the 80s, Mexico in 1995, Asia in 1997, and Russia in 1998.

Source: IMF

The collapse of the Soviet Union in 1991 was the last straw that stabilized the dollar as the dominant currency of the world. But with each crisis, the world questioned the credibility of U.S as a debtor. It appeared that Washington was following an aggressive policy of financial expansion and restructuring.

Perhaps the most well known example of this was the bailout of LTCM, a hedge fund that blew up during the Russian Ruble crisis in 1998. (For people interested, I would highly recommend the book: “When Genius Failed”)

During the 2000s, the Euro emerged as a clear competitor to the dollar in Europe. In Asia, China’s cheap manufacturing costs challenged America’s ability to export international goods in the same way. Back home, U.S began to run on trade deficits, rather than surplus, as each administration seemed to care less and less about federal budgets.

The 2008 Financial Crisis brought these issues into the limelight once again. As banks collapsed around the world due to the interconnected nature of the financial system, economists and politicians questioned the structure laid out by Bretton Woods. In September of 2008, French President Nicolas Sarkozy said “we must rethink the financial system from scratch, as at Bretton Woods".

Source: The Balance

The crisis also signified the world’s dependence on America. The Federal Reserve pumped liquidity into the market and was able to protect the U.S balance sheet, but the same couldn’t be said about Europe. In fact, European government credit ratings were deteriorating faster than ever as the world was slowly losing faith in the Euro.

Source: Statista

At the wake of the Coronavirus crisis in 2020, the financial system of the world came into question once again. Central banks around the world became accommodative and embarked on quantitative easing. Interest rates came down along with it, leading to a boom in prices across all asset classes.

The Federal Reserve remained persistent on this path, claiming that inflation was transitory and mostly due to pandemic related supply disruptions. Despite this, the appetite for U.S treasuries remained strong.

In the late half of 2021, it became clear that inflation was not so transitory as Central Banks originally thought. In 2022, this became coupled with geopolitical tensions in Russia and Ukraine. As NATO countries shower Russia with sanctions and boot them off from the SWIFT payment system, the hegemony of the dollar comes into question once again today.

Money is now being used as a weapon more than ever before. It may be necessary for peaceful resolution of the situation at hand today, but it is without a doubt going to put a question mark on the reliability of fiat currency.

The Chinese Yuan is an obvious alternative to the dollar hegemony of the world today. The manufacturing prowess of China has become clear in the past decade, and China’s share of world GDP is expected to be about 20% by 2050.

To some extent, this transition has already begun. On March 15, 2022 Saudi Arabia announced that it will now consider being paid in yuan instead of dollars for Chinese oil purchases.

The lack of transparency of the Chinese government, however, make matters more complicated. Not many Central Banks would feel comfortable holding reserves of currencies from a censorship ridden government.

Many point to cryptocurrency as a potential solution, citing that it is immutable on the blockchain and cannot be seized by governments. It is important to note, however, that most users today buy their crypto through centralized exchanges, which can just as easily be regulated.

CBDCs, or Central Bank Digital Currencies, are another possibility. Both the U.S and China have expressed some interest around this concept.

Source: BIS Central Bank Survey

The reality is that war is the only modern model for the transition between reserve currencies. It was World War I and II that ultimately ended the British Empire’s dominance. Whether a peaceful transition is available this time around remains to be seen.

This post was inspired by Adam Tooze - “The Rise and Fall and Rise (and Fall) of the U.S Financial Empire”