HOW DID THE US DOLLAR BECOME THE WORLD’S RESERVE CURRENCY?

What is a world reserve currency? A world reserve currency is a currency that is held in large quantities by central banks across the globe and is globally accepted as a means of payment for goods and services. In this current day and age, only one currency fits closely into this definition: the US Dollar. In 2020, the US dollar accounted for around 60% of the world’s foreign exchange reserves. In all regions of the world, apart from Europe, the US Dollar accounts for 75% of trade. During the 2008 financial crisis, around 70% of international liabilities and claims are denominated in US Dollars. At a global level, no other currency meets the level of power the US Dollar has. Yet, why has this occurred? What led to the US Dollar being the world’s reserve currency?

In order to understand this, let us go back in history. During the 19^th and early 20^th Centuries, conversion of international currency used to occur via the Classical Gold Standard System. This meant that the currencies of the countries that follow this system are non-fiat currencies. Non-fiat currencies are currencies backed by a commodity, in this case gold. This meant that currencies had a fixed exchange rate to a certain quantity of gold e.g. £5 is fixed to 1 gram of gold or $20 is fixed to 1 gram of gold. In this example, this means that £1 equals $4. The central bank of countries that followed the Classical Gold Standard System had gold reserves that backed their currency and allowed them to maintain their currencies to the specified amount of gold. If they did not have enough gold reserves, they would be forced to devalue their currency or reduce the amount of money in circulation. Also, in a country that followed the Classical Gold Standard System, a person could go to the bank with paper currency and exchange it for gold e.g. if a person went to the bank with £5 to convert, the person would give £5 paper currency in exchange for £5 worth of gold. Furthermore, under the Classical Gold Standard System, trade between countries occurred using physical gold. For example, if the UK imports $5 million worth of products from the USA, the UK would give $5 million worth of gold to the USA. Or, if the UK exports £5 million worth of products to the USA, the USA would give £5 million worth of gold to the UK. This meant that countries with trade deficits saw their gold reserves decline since they were importing more than they were exporting. Whilst, countries with trade surpluses saw their gold reserves accumulating since they were exporting more than they were importing.

This Classical Gold Standard System was working well until the 1930s. During the 1930s, the Classical Gold Standard System collapsed due to the Great Depression. In the 1930s, the Great Depression caused many banks to fail which resulted in the overall money supply in countries to reduce. This significantly impacted many economies causing deflation and reduction in growth. In order to stop this, the amount of money circulated in economies needed to increase. Yet, under the Classical Gold Standard System, it was very difficult for countries to increase their money supply, since it was restricted by and dependent on the amount of gold reserves present in the country’s central bank. Therefore, in the early 1930s, many European nations including England abandoned the Classical Gold Standard System in order to stabilize their economy during the Great Depression. On the other hand, in the USA, Franklin D Roosevelt signed the Gold Reserve Act of 1934. With this act, Roosevelt transferred ownership of all monetary gold present in the USA to the US Treasury (e.g. gold from people and gold from banks) and stopped the conversion of paper currency into gold. And, this act also devalued the dollar to $35 per ounce of gold. Through this act, the money supply in the USA was able to increase, enabling the USA to recover from the Great Depression. But, also allowed the Federal Reserve Bank to increase its gold reserve significantly. This Act set out the path for the US dollar to become the world’s most powerful currency.

From 1939 to 1945, most of Europe was fighting during World War 2. But to finance the war, resources (e.g. tanks, ammunition, food) were required. Therefore, these European countries imported these resources from the USA. In return for these imports, countries would typically give gold to the USA. By the end of World War 2, Europe’s entire gold reserve had essentially depleted with most of the countries having trade deficits. By 1947, the USA had accumulated 70% of the world’s gold reserves, essentially placing the USA in an extremely powerful position to control the international monetary system post World War 2.

In July 1944, 44 countries met in Bretton Woods in the USA in order to establish a new global monetary exchange system to be used after World War 2. Since the USA had the most amount of gold reserves in the entire world, this new exchange system resulted in the currencies of the 44 countries being tied to the value of the US Dollar which would be pegged against the price of gold. In the Bretton Woods System, 1 ounce of gold is equivalent to $35. The value of the US dollar is tied to the value of foreign currencies. This essentially made the US dollar act as a middleman when converting foreign paper currencies into gold and also resulted in there being fixed currency exchange rates between the currencies of the 44 countries. e.g. if £1 is equal to $4 and 1 yen is equal to $2, then £1 is equal to 2 yen. The main purpose of the Bretton Woods System was to stabilise the global economy and to foster global economic growth.

Although this did occur, another significant impact of this system was that it led to the global dominance of the US dollar. Under the Bretton Woods System, the US dollar was given a tangible value as it was the only currency that was convertible into gold. Furthermore, due to the stability and huge nature of the US economy, many countries placed a lot of trust in the US dollar. Therefore, once the Bretton Woods System began working, it resulted in the US dollar to become the preferred means of payment for transactions between countries and also resulted in central banks having significant reserves of US dollars, since it was considered almost as safe as holding gold itself, which emphasises the confidence placed in the US dollar. Thus, it is clear to say that the Bretton Woods System played a significant role in enabling the US dollar to dominate global trade and global reserves.

Initially, when operational, the Bretton Woods System was working as planned. The 44 countries part of this system were having substantial amounts of economic growth and the demand for US dollars globally was high, with this system seeming to be very secure.

Yet, eventually, in the 1960s, this system began to start failing due to a major flaw in the system which was that it was the USA’s responsibility to maintain the fixed rate of converting gold into US dollars and to also provide enough US Dollars globally to facilitate for international transactions. To increase the supply of US dollars in the global economy, the USA began to run persistent trade deficits i.e. importing more than they are exporting. As a result, US dollars begin to outflow out of the US economy. Furthermore, at the same time, the USA were enforcing new social welfare programs and fighting in many wars across the globe due to the Cold War. To finance all these things, including the persistent trade deficits, the USA had to print out more US dollars which resulted in the global supply of US dollars increasing. Yet, the increase in the amount of gold reserve the USA had was not as high as the increase in the global supply of US dollars. Eventually, there was a major imbalance between these two and USA was failing to meet its responsibility in maintaining the fixed rate of $35 per ounce of gold. There were too many US dollars for the amount of gold backing it. This threatened the US dollar's stability and security and the entire Bretton Woods System.

Once the other 44 countries became aware of this situation, the confidence in the US dollar was reduced. This eventually resulted in the central banks of many countries converting their US dollars into gold in fear that the US dollar would be devalued (e.g. from $35 to $45 per ounce of gold). This led to a rapid depletion of US Gold Reserves which further threatened the stability of the US Dollar and also threatened the entire Bretton Woods System. To prevent this, in 1971, President Nixon had temporarily suspended the convertibility of the US dollar into gold and then eventually ended the entire Bretton Woods System. This led to the transition of exchange rates from fixed rates under the Bretton Woods System to floating exchange rates, which determine an exchange rate based on the demand and supply of that currency on the forex market.

Although you would think that the US dollar would lose its dominance after the collapse of the Bretton Woods System, this did not occur due to two main reasons. The first reason is once the Bretton Woods System collapsed, the US dollar was already deeply entrenched within global trade and foreign exchange reserves, thus it was almost impossible for the US dollar to lose this power. The second reason, which is the most important reason, is the position of the US as the largest economic superpower in the world. USA is the largest and one of the most stable economies in the world, due to the political stability and the proper decision-making of the Federal Reserve Bank. Furthermore, the financial markets in the USA are highly developed and extremely large, with the New York Stock Exchange Market having a market capitalisation of $25 trillion and the US Treasury market being worth almost $30 trillion. The economic stability and dominance of the USA result in investors and central banks having high levels of confidence in the US dollar, causing the US dollar to maintain its position as the world’s reserve currency in this current global economy.

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