Why the Dollar Is Still King

The dollar, left for dead only a short while ago, is on a roll, and it looks unstoppable for the foreseeable future.

March-April 2015

IT’S BACK. The prime sign of American supremacy has rebounded over the past year, much to the consternation of its detractors. The dollar, left for dead only a short while ago, is on a roll, and it looks unstoppable for the foreseeable future.

The greenback’s long rise to premier status says much about the nature of a global reserve currency and its own remarkable staying power in that role. U.S. currency first began to acquire this position in the 1920s, largely because the First World War had crippled Europe economically and brought the United Kingdom, whose pound sterling had held the role for much of the previous century, to the brink of bankruptcy. But even then, the greenback did not dominate. For decades, it shared with the pound its status as a preferred medium of international exchange, sometimes gaining prominence, sometimes losing it as the policies and economic prospects of the two countries varied. Only after the Second World War did the dollar accumulate all the qualities needed for an unchallenged position, something the 1944 Bretton Woods conference acknowledged when it designated it as the global reserve.

Much of what supported this preference for the dollar was far from new and was based in long-established habit and practice. The tremendous growth of the U.S. economy since the late nineteenth century and its expanding trade links had accustomed people across the globe to dealing in dollars. Businesses, individuals and governments had established institutions and practices around that custom. The greenback had for decades been commonly available as an exchange medium in just about every major city and port from Asia to Europe to Latin America. People had long written import and export contracts in dollars, as well as the loans made to facilitate those deals. The prominence of the currency had for years led businesses, financial institutions and central banks to hold significant dollar deposits and investments as a matter of course.

In addition, the dollar’s rise in the late 1940s reflected the unparalleled security it offered. The United States and its currency had become the safe haven par excellence. It possessed a large, strong economy, along with unrivaled production prowess. The United States also offered political stability, especially rare at that time. It promised prudent fiscal and monetary policies and little danger of disruptions from radical swings to either the left or the right. American diplomacy and military power gave confidence to others that the country could and would protect its interests (including the dollar) anywhere. America’s reputation as a nation of laws further promised that it would meet its obligations and that any wealth anyone placed in dollars, wherever its owner lived, was secure from arbitrary taxation or expropriation. The Bretton Woods agreement added to the dollar’s appeal by linking it to gold, the traditional reserve going back to classical times. That, combined with the promise of prudent policy, assured people that the currency would hold its purchasing power, or, as economists like to say, made it a secure store of value.

One other crucial quality rounded out the greenback’s unbeatable résumé. The United States offered the world broad and deep capital markets. This gave the currency an essential edge by presenting its varied holders with an array of financial instruments in which to place their holdings, some offering security, some liquidity and still others higher potential returns, perhaps at the expense of security or a measure of liquidity. Through their immense size and ceaseless activity, these markets further promised anyone worldwide that they could convert their dollar investments quickly into spendable cash and then, just as quickly, convert that dollar cash into other currencies or gold. Because these markets also traded actively in futures and options, they offered dollar holders a welcome way to hedge against the risk of any fluctuations between the greenback’s value and commodities, such as gold or copper or foodstuffs, or, critically, between the dollar and their home currency or any currency in which they faced liabilities.

During the twenty-five years following the Second World War, these impeccable credentials left the dollar unchallenged. Its only shortcoming emerged, ironically, from the American economy’s overwhelming relative strength, which created a net trade surplus with the rest of the world. Ideally, the country issuing the reserve currency should run a deficit. Buying more from the rest of the world than selling to it would create a natural flow of reserves onto global markets that could meet the growing liquidity needs of expanding world trade. This dollar shortage, however, began to disappear in the late 1960s, as improving competitive abilities abroad put American foreign trade into deficit. But while that development solved an international financial problem, it laid the seeds of the system’s demise by creating a domestic one. U.S.-based producers, unaccustomed to competition, chafed as foreign firms, especially Japanese and German, pushed them out of markets, both foreign and domestic, that they had once dominated. Then President Richard Nixon felt the political pressure and sought to relieve it by altering the fixed foreign-exchange rates set by the Bretton Woods agreement. When Germany and Japan resisted, Nixon acted unilaterally and, on August 15, 1971, severed the link between the dollar and gold.

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