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.
Yet, the greenback retained its position as the global reserve. To some extent, its resilience reflected the influence of that long habit from prior years and the institutional arrangements established around it. The currency continued to be dominant in most international trade and banking arrangements. Though the dollar lost bragging rights as a secure store of value, few other currencies could claim a superior record. Some had indeed gained against the greenback, but almost all countries suffered as severe inflation as the United States. In other respects, alternative currencies had still less to offer. Some, to be sure, had elements required of a global reserve. By the 1970s, many more nations could claim political stability and the rule of law than in the late 1940s. None, however, had anything approaching America’s diplomatic or military reach, the size of its economy or the scope of its trade. U.S. financial markets, too, contributed to the dollar’s ability to retain its status. Only London could rival their depth, breadth, liquidity and versatility, but the pound sterling by this time lacked many of the other elements required of a reserve.
SINCE THEN, the relative position of the United States has deteriorated further. The dollar has continued to lose foreign-exchange value against the world’s major currencies (if not in recent years, then certainly on balance over longer stretches of time). The United States remains the world’s largest economy, but not nearly by the margins that once prevailed. China rivals America’s trade reach, and even German trade is relatively greater than it was in the 1970s. The euro zone, of which Germany is a part, certainly approaches the scale of America’s economy and volumes of international trade. Questions have arisen about Washington’s diplomatic and military reach, while its budget deficits and financial turmoil have raised more questions than ever about the prudence of U.S. policy. Some have even voiced doubts about Washington’s ability to meet its financial obligations. As if to underscore all these signs of American weakness, in 2011 Standard & Poor’s downgraded its assessment of the creditworthiness of the United States.
Now China has actively begun to attack the dollar’s position. Officials in Beijing have openly declared their objective, stating ominously through the country’s official news agency Xinhua that “it is perhaps a good time for the befuddled world to start considering building a de-Americanized world.” At the February 2014 meeting of the G-20, Chinese representatives accused the United States of abusing the dollar’s reserve status and merely living off printed money, with nothing to back its prosperity. Beijing has gone well beyond rhetoric, too. It has pressed Chinese firms, both state owned and private, to use yuan instead of dollars in cross-border transactions. At last count, some seventy thousand Chinese companies had complied. Beijing has signed agreements with Japan, Russia, India, Brazil, South Korea, Saudi Arabia, the United Arab Emirates and others to conduct their bilateral trade in their own currencies instead of dollars. As Africa’s largest trading partner, China has also successfully promoted the use of yuan in trade there.
Yet for all this activity and striving, the dollar remains securely dominant. It is by far the world’s most traded currency, involved in 87 percent of all global currency exchanges, up from 85 percent in 2010. The euro is the next largest at a distant 33 percent, with the yen at 23 percent and the pound at 12 percent. The yuan, though up quite a bit from its 0.9 percent in 2010, is still only involved in 2.2 percent of all global currency trades. Almost 90 percent of the world’s trade contracts, totaling over $5 trillion a day, are denominated in dollars, whether an American is involved or not. By comparison, the yuan constitutes an equivalent of about $100 billion a day, or only 1.5 percent of global volume. And when the yuan is used, there is always a Chinese party involved. The International Monetary Fund (IMF) reports that dollars still make up more than 62 percent of the reserve holdings of the world’s central banks, down only slightly from 71 percent in 2000. The euro is far behind in second place at 23 percent of the total, up only slightly from 18 percent in 2000. The pound sterling and the yen comprise merely 4 percent of such holdings each. In this regard, the yuan does not even rate mention.