Javier Graterol/Grand Central Station, New York
At the close of the Second World War, the United States represented almost a third of world GDP, and an even larger share of manufacturing. The proportion is stark: the UN’s World Economic Report for 1948 breaks a chart of global manufacturing down into two roughly equal halves: the United States and “Other”. At the time, it was unquestionable that if there was to be a global reserve currency, it would be the U.S. dollar. At the Bretton Woods conference in 1944, this was codified into a new system: the dollar was backed by the U.S.’s gold reserves, and every other major currency was backed by its exchangeability into dollars.
In 1971, that system collapsed when the gold system was closed—this was described as a temporary contingency, meaning that the temporary adjustment to the Bretton Woods system has lasted almost twice as long as the system itself. But the dollar has not yet lost its reserve status. Around the world, commodities are priced in dollars, corporations sign dollar-denominated contracts, and central banks keep 57% of their aggregate reserves in dollars, more than three times the share of the runner-up currency, the euro.
There’s always speculation that the dollar will be dethroned as the world’s reserve currency. This happens both in the sense that people make speculative claims and in the sense that traders make speculative bets. Whenever there’s a financial crisis—COVID-19, 2008, the dot com crash, the crash of 1987—the speculation gets louder. How can the U.S. dollar be a safe currency to hold when the U.S. runs chronic fiscal and trade deficits, and when China’s economy is growing faster and will be larger than the U.S.’s in just a few years? With interest rates at zero, how can a dollar whose supply is rising, in M2 terms, by 24% annually compete with gold, whose supply increases are limited by mining technology, or Bitcoin, with a supply encoded in algorithms?
These are valid questions when it comes to estimating the near-term future of the dollar’s exchange rate, but they don’t speak to the binary question of whether or not the U.S. dollar will remain the default global currency. That question raises fascinating historical questions, and provides a look at what reserve currencies—and currencies in general—really are.
Like any currency, a reserve currency serves three purposes: a means of exchange, a store of value, and a unit of account. For central banks, the store of value question is key most of the time, but means-of-exchange matters under duress. When the world trade system is simple, currency as a means of exchange requires a very direct kind of logic: for goods that a country wants, but can’t make itself, what’s the currency necessary to buy them? Historically, most trade was either finished goods or raw materials: a country might export machinery and import grain, or export coal and import clothes.
But modern trade has gotten more complicated, largely due to the rise of containerization. Container ships make it cheap to load and unload cargo, which makes it possible for countries to import and export intermediate goods. Most of the value of a smartphone exported from China consists of components imported from places like Taiwan, South Korea, Japan, and even the U.S. American software, for now, still wins out in this industry. These complex supply chains give currencies a stronger network effect: a company that does business with companies that use Won, Yen, New Taiwan dollars, and U.S. dollars might prefer to stick with a single currency to keep things simple. And for importers of finished goods, the calculus is even easier: very few companies in China have a strong desire to own Brazilian Real, Indian Rupees, or Nigerian Naira. Conversely, nearly everyone can find a use for the dollar.
So, the dollar’s dominance of trade is self-sustaining.
There are historical analogues. Before the dollar was dominant, the British Pound was the world’s preeminent currency. American, Argentinian, and Australian entrepreneurs borrowed in pounds rather than local currency, and London was the center of the financial universe. Britain declined in relative importance in the late 19th century, as the U.S., Germany, and France caught up with its industrialization. But the pound remained important. It was by far the dominant reserve currency in the late 1940s, representing over 85% of global reserves, and it wasn’t dethroned by the dollar as the top reserve currency until the mid-1950s. As recent as the late 1960s, pounds represented over a quarter of global foreign exchange reserves, at a time when Britain was a mere 4.4% of GDP.
Why was Britain’s share of reserves over five times its share of the global economy? There are several reasons:
- As Barry Eichengreen et. al argue in How Global Currencies Work (the source for the reserve data above), reserve currency status depends not just on economic output, but also on how open a country’s financial markets are, how complex its financial institutions are, and pre-existing reserves. Britain scored well on all of these counts.
- British policy went through constant contortions to convince banks to keep reserves in pounds.
The original reason Britain’s reserves were so extraordinarily high was that British colonies, and even ex-colonies, defaulted to keeping their reserves in pounds rather than dollars. Even after independence, countries like India, Canada, and Australia had a marked preference for the pound. Some of this was due to tradition, and some due to social factors: their economic policymakers tended to be well-educated, which often meant Oxbridge-educated. They had closer social ties to the former mother country than the average person.
Britain also timed its gradual decolonization to minimize the impact on the pound. Keeping the pound as a reserve currency was a point of pride for Britain, and was viewed as an important part of the country’s economic dominance. Any economy that’s weighted to finance does much better with a widely-accepted currency, and does much worse if that currency falls into disuse.
The official history of Singapore’s sovereign wealth fund tells part of the story: postwar Britain had an overvalued currency, and offered former colonies a carrot-and-stick option. If they kept their reserves in sterling, and in London, the British navy would continue to defend them. The U.S. engaged in similar currency diplomacy with Western European allies during the Bretton Woods era: the cost of U.S. troops in Western Germany was high, but its return was measured in Germany’s willingness to hold dollars and not redeem them for gold. By 1967, Britain found the system untenable, and announced a military withdrawal from Singapore, followed by a devaluation of the pound. Singapore, in turn, made two announcements: first, that its currency reserves were much higher than Britain had thought, and second, that almost half of the country’s reserves had been quietly transitioned into U.S. dollars. This, as it turns out, was the result of some accounting chicanery: Singapore’s government had been quietly understating its budget surplus, and investing the extra money in dollars.
While this illustrates the way reserve currencies fail, it also illustrates how surprisingly long they persist. Singapore had to suppress its own economic growth, engage in constant realpolitik, and mislead both allies and its own citizens to even partially escape reliance on the pound. And Singapore was and is a country with an unusually competent government; a country that doesn’t have a Lee Kuan Yew in charge will have even more difficulty with this sort of maneuver.
Today, a handful of countries are trying to escape the dollar’s orbit. But the efforts are halting, and inconsistent. For example, Russia and China completed a massive gas pipeline project last year, with the gas priced in yuan rather than dollars. For Russia, this is a way to avoid sanctions; for China, it’s a way to make the yuan a more prominent currency, and, of course, to secure a supply of gas. But relations between the countries are challenged: China is much more protectionist than the U.S., and much more powerful than Russia. The paradox of reserve currencies may be that the more powerful the country is that issues a currency, the more stable that currency is in the abstract, and the more that stability can come at the expense of its neighbors.
The euro has also challenged the dollar’s hegemony, but in a limited way. The euro’s share has fluctuated, but never come close to the dollar, in part because the euro is the descendant of the deutsche mark, which was never widely adopted as a reserve currency. That was because of Germany’s comparatively undeveloped investment banking industry, its reluctance to accept capital inflows and outflows, and German central banks’ relative conservatism. Perhaps the best evidence that the euro is mostly a rebranded deutsche mark is that financial researchers writing about long-term currency behavior simply use the mark to extend their euro-related time series to before the euro’s launch in 1999.
Currency is a Schelling Point in the simplistic sense that anything treated as a currency becomes one: if you expect your neighbors, coworkers, and tax authorities to accept a dollar or pound as a way to settle debts, then you’ll denominate your savings in them. But a reserve currency is a more deeply enmeshed kind of Schelling Point: the U.S.’s chronic trade deficits are not just the result of American overconsumption, but of the rest of the world’s desperate demand for dollars. A trade deficit can only come about when trade partners prefer the currency they get to the goods they give up. The fact that U.S. recessions are often associated with higher trade deficits, higher fiscal deficits, and a higher dollar implies that the global demand for dollars has a larger effect than the U.S.’s demand for imported goods.
If a country’s biggest export is the dollar itself, what does it specialize in? The U.S. has a large and robust financial services industry, which has been surprisingly resilient in the face of its own tendency to periodically shoot itself in the foot with massive credit bubbles. The U.S. is the world’s largest spender on defense, by far. And the tech industry can be seen as an outgrowth of both: the original Silicon Valley companies were bootstrapped by defense spending, and today’s industry is built off a virtuous cycle where the previous generation of successful founders becomes the current generation of investors.
Some countries with a desirable currency, like Switzerland, put up barriers to keep inflows from disrupting their economy. Switzerland is happy with the Swiss Franc being a safe, trusted currency, but they don’t want their exporters to face ruinously competitive prices if the franc appreciates to a fairer valuation. The U.S. is temperamentally disinclined to engage in such interventionist behavior, which has the dual effects of violating free market strictures and penalizing consumers.
So, the current state of the financial world, as bizarre as it looks, has a sort of stability to it. The U.S. consumes more than it produces, year after year. And yet, year after year, central bankers and foreign savers stash dollars, and companies around the globe price in dollars by default. The U.S.’s over-consumption means it’s overrepresented as a destination for exports, keeping the dollar’s network effect firm. Meanwhile, the U.S. tradition of militarism has coevolved with its status as a reserve currency issuer, meaning that other countries think twice before threatening America’s economic interests. And the same open system that keeps dollars flowing in keeps people flowing in, too; the U.S. is a nexus for a global bidding war for talent, and its roided-up financial system ensures that such talent gets access to all the financial resources it could possibly need.
Will this last forever? If the dollar’s status as a reserve currency is permanent, it will be the first currency—reserve or not—to last forever. So, it’s worth asking what would happen if it did not. The U.S. trade deficit has typically been about 3% of GDP in the last few years, so at one level a loss of reserve status would lead to a rebalancing that would make America roughly 3% poorer each year. Digging into the numbers, though, the U.S. has a sort of barbell distribution. America sells the world plenty of soybeans, corn, and wheat, and is increasingly in a position to sell oil. The U.S. also exports planes, cars, medical equipment, and components for electronics. A comparative advantage in commodity exports comes down to differences in how much land can produce and what materials are under it; it’s basically fixed. America’s higher value-added exports are always threatened by competing products.
So a U.S. that had to balance its trade over the long term would be a more economically uncertain country. But it would also be a country that couldn’t support as large a financial services sector as it currently has. For decades, financial institutions have been hiring ‘rocket scientists’—PhDs in physics, computer science, and electrical engineering—to design trading algorithms and value esoteric derivatives. If the U.S. did not have constant financial inflows from the rest of the world, some of those rocket scientists might find that the best use of their talents was, in fact, designing literal rockets.
For average Americans, the picture is a bit different. In the short term, a drop in global trade would hit their consumption basket particularly hard, leading to more expensive clothes, furniture, and consumer electronics. But it would also mean more localized competition, which would push inequality down. The average consumer might find that their consumption looks a bit worse, but their balance sheet looks a bit better; the portion of their earnings going to smartphones and TVs wouldn’t go as far, but their wages would be higher, so housing, healthcare, and education—all non-tradable categories—would be a bit more affordable.
The direct effects on lifestyles might be smaller than the social effects, though. America’s reserve currency status gives the U.S. government a strange social contract with the American consumer: during a crisis, the way to help is to shop. Global economic crises generally take the form of a broad dollar shortage, and the American financial system is better at supplying dollars to domestic borrowers than overseas ones. So, the American consumer’s role in a crisis is to get dollars from the government and ship them overseas. Without a reserve currency, the U.S.’s role during a crisis would be more conventional: to adjust by curtailing spending.
That’s the kind of change with real fallout. Cutting spending at a time of crisis is generally a recipe for riots. The EU found this out the hard way during its austerity policies. Its various political upheavals today are, in many ways, the ripples of the early 2010s. The variety of protests America saw during the pandemic are another example; when people have no work left to go to, and little left to lose, it only takes some ambitious and coordinated leadership to release the valves of rage. That’s why the spending alternative is attractive. A duty to shop is easier to bear than a duty to scrimp.
No global hegemon looks quite like the last one. Spain did not replace the Ming as the world’s dominant power by demanding tribute from its neighbors; the Netherlands did not replace Spain by seizing gold mines. The British did hew comparatively closely to the Dutch template— perhaps in the far future, historians will treat ‘North Sea-based colonial empires with free trade characteristics’ as a continuous category that flitted across the channel.
The U.S. model does not match the British imperial model in every particular. But while immediate circumstances change, long-term tendencies are more durable: the dominant country tends to have the dominant currency, and its dominant currency status tends to outlast other trappings of hegemony.
Byrne Hobart works in the financial services industry and writes one of the top newsletters on Substack called The Diff. He has worked at research companies, a hedge fund, and a cryptocurrency startup.