The recent uproar surrounding tariffs has spilled over to the more encompassing question of the Dollar itself. Many voices are now asking whether the mighty Dollar will forgo its status as the world’s reserve currency, and what such an unwinding would entail. Before even attempting an answer, it is crucial to understand how the Dollar came to occupy such a position to begin with. World reserve currency First of all, what does the phrase “world reserve currency” actually mean? Simply put, it means that almost every nation around the world holds US Dollars as part of their strategic currency reserves. Every country essentially has a balance sheet with varying amounts of money denominated in different currencies. The Greenback is by far the most popular currency and makes up around 60% of all international reserves. The Euro is a distant second at 20%, and the Japanese Yen and Pound Sterling are further behind still. Countries from China to France to Brazil all hold large amounts of US Dollars. So why is the Dollar so popular? Firstly, because Dollars are essential for international trade. Even between countries not trading with the USA, the Dollar remains more appealing due to its usefulness. Imagine a scenario in which Japan wanted to sell goods to India. Would Japan rather be paid in USD or in Rupees? Rupees are all well and good, but where else can they be spent other than in India? On the other hand, those same Dollars could be used to pay for goods coming from anywhere on Earth. The other reason is that the USD is viewed as a very stable currency. Not necessarily in the sense that exchange rates are not volatile, but in the sense that Dollars are backed up by a very robust bond market, can be accessed at any time via reliable banking infrastructure and are extremely liquid. For this reason, Dollars also make up the vast majority of foreign exchange trading volumes. Background But of all the currencies in the world, why the Dollar? How did the mantle fall to the Greenback as opposed to another currency such as the Pound or Euro or RMB? To answer this, we need to go all the way back to 1944 and the Bretton Woods agreement. It is imperative to understand the backdrop against which this agreement came into being. The Second World War was drawing to a close and much of the world lay in ruins. Countries needed to rebuild, but crucially they needed to do so in such a way as to not repeat the same mistakes that sparked the conflict in the first place. A new, international financial structure was needed. One that would allow countries from around the world to grow in unison while minimising monetary warfare. To achieve this, the Bretton Woods agreement set in stone two key points: • One ounce of gold would be fixed to 35 United States Dollars • Each signing member would guarantee the conversion of their currency to the USD according to strict currency pegs The purpose of the convertibility to gold was to ensure a stable currency that could not be printed out of thin air, inflating away its value. The idea behind the currency pegs was to stop countries from engaging in competitive devaluation, which would give a short-term advantage to their export market by making their products cheaper abroad. Historically, the problem with countries weaponising their currency in this way is that every other country ends up doing the same thing, thereby resulting in an endless race to the bottom. There were several reasons why the Dollar was chosen as opposed to another currency. The first was simply that the US had more gold than anyone else did. In fact, it had roughly half of the worldwide gold supply of the time. The second was that compared to other signatory nations, the US emerged from the second world war relatively unscathed, with a strong industrial base and fully intact infrastructure. The US was in a much stronger position than anyone else. The only real competitor of the time was of course the Soviet Union, which never ratified the agreement for obvious reasons. A sometimes-overlooked element of the agreement was the military aspect of it. In exchange for using the Dollar, many countries would agree to host American military bases, allowing the US to project power around the globe and contain the USSR. As part of this arrangement, the US government promised to protect international shipping lanes. In this day and age, it is easy to take such a thing for granted, but the fact is that being able to ship cargo safely around the world is by no means the natural state of affairs. For centuries, such ventures have only been possible thanks to huge navy powers overseeing the busiest parts of our oceans. Major shipping passages such as the Suez and Panama Canals, the Malacca and Singapore Straits, among many others, all require a strong military presence, which has been provided by the US navy for the better part of a century. Without it, piracy would reign supreme. Problems And so the Dollar became the reserve currency of the world. For a while, the system worked as intended, however it would not take long for problems to develop. The major issue is that the Dollar was simply too attractive. Everyone wanted Dollars. They were useful, stable, secure, and most importantly could be traded in for gold. This increased the demand for Dollars on the world stage, which forced the US to print more and more of them to keep up. Unfortunately, printing Dollars is a lot easier than maintaining the proper gold reserves to back them up, which is eventually what broke the system. By the early 1970s, the amount of Dollars in circulation dwarfed US gold supplies by about 4 to 1, making the $35 conversion completely detached from reality. It meant that the Dollar was in fact extremely overvalued compared to what it would otherwise be worth, leading to fears of a run on the Dollar and also causing US gold reserves to rapidly diminish. It got to the point where European navies were being sent across the Atlantic to repatriate their national gold supplies and eventually culminated in the so-called Nixon shock, whereby the gold peg was abandoned and the Dollar turned into a floating fiat currency. Bretton Woods was essentially over, but the Dollar retained its status for a variety of reasons. To put it bluntly, no other nation was capable of guaranteeing a global currency but the US. The Greenback was still by far the most liquid money on Earth, it was still backed up by the largest treasuries market, and was still the backbone of international trade, which still relied heavily on the US navy. By this time, much of the world had recovered from the devastation of the Second World War and could finally shift their economies from reconstruction to expansion. The US welcomed the new capital with open arms. Had the problem been solved? Not in the slightest. Once the currency pegs had been dismissed, there was nothing to stop speculators from appreciating the value of the Dollar. Many countries engaged in currency manipulation in order to make their exports more attractive, with devastating consequences to US industry. Between 1980 and 1985, the Dollar appreciated by around 50% against other major currencies, eventually forcing the US to implement the Plaza Accords, which would devalue the Dollar significantly. More generally, the issue is that the Dollar’s problems are inherent to its status as world reserve currency. Due to its very nature, there is always a growing demand for Dollars, which the US therefore needs to supply. At this point it is necessary to talk about the actual structural advantages and disadvantages of being the world’s primary reserve currency, because such questions are just as valid today as they were back then. Advantages: Control. As the sole provider and guarantor of the international currency, the US can dictate who can and who cannot participate in the global monetary system. International Dollar transactions are typically sent via corresponding banks in the US, or at the very least use some form of US based infrastructure to settle. In effect, this tethers all USD transactions to the United States, which makes them subject to American laws and regulations. This allows the US government to sanction countries, restricting their access to global banking networks and limiting their ability to conduct international trade. This has been used time and time again against the likes of Iran or Venezuela or Cuba or example. The problem with using this tool too liberally is that targeted countries typically move towards weaning themselves off the Greenback and in extreme cases reducing their dependence on international trade altogether, making such countries more resilient to potential future sanctions, thereby reducing the Dollar’s power. Asset prices. Dollars are held all around the world, which intentionally or not creates demand for secure, reliable, Dollar-denominated investments, such as US treasury bonds or the US stock market. This translates to capital flows towards US assets, causing the American capital account to increase greatly. Low borrowing costs. Closely tied to the above, the constant demand for US treasuries also helps with government funding and allows the bond market to remain liquid and healthy. High demand for US government debt means that US bonds do not need to advertise high interest rates in order to be attractive, providing the US with cheap financing options. This argument is mostly a historical one, as many currencies now offer lower interest rates than those on the Dollar, such as the Euro or Yen for example, despite having far less demand for their respective bond markets. Imports. Countries outside of the United States typically have to pay for foreign goods with a currency that is not their own. This forces such nations to maintain sufficient foreign reserves in order to participate in international trade. A country with a trade deficit may find itself spending more Dollars than it earns, which unless properly accounted for can lead to a balance of payments crisis, meaning it can no longer pay for imports. The United States is in a unique situation in this regard because it pays for foreign goods with its own currency, meaning it can maintain much larger trade deficits. Disadvantages: Wealth disparity. The problem with inflating the Dollar or indeed Dollar-denominated assets is that it disproportionately benefits those already in possession of such. US institutions with sizeable stock portfolios are obviously all too happy for their investments to be the object of desire from investors around the world. However, for those living from pay cheque to pay cheque, an exuberant stock market means very little. Trade deficit. Developing the point made in the previous section, it is not so much that the US can maintain a large trade deficit, but more that it has to maintain a large trade deficit. As the world reserve currency, Dollars are required for international trade, creating permanent demand for the Greenback. This implies that the US continuously has to supply the globe with Dollars. To satisfy this demand, the US is essentially saddled with a permanent trade deficit, taking in goods from around the world in exchange for supplying it with Dollars. This situation is known as the Triffin dilemma and has been well understood for decades. Many parts of the world have based their entire economic model on maintaining a trade surplus, allowing them to flourish. However, much of this surplus has to be soaked up by the United States in order for their economies to keep growing. Currency manipulation. Intimately tied to the above point is the question of currency debasement. It is in the interest of export-based nations to keep their currencies at artificially low levels in order to make their exports more attractive internationally. Many parts of the world have long been accused of such tactics, particularly Japan and China, to the detriment of the United States. Local manufacturing. The above situation has had devastating consequences for American manufacturing and by extension American jobs. A stronger Dollar makes US exports more expensive and therefore less competitive on the world stage. Moreover, demand abroad remains weak because many nations have geared their economies in favour of their export markets. Domestic demand remains low in such countries, which makes them poor trading partners. The US government can combat this to a certain extent via private consumer financing and various stimulus packages, but such measures are costly and typically result in accumulating more debt. The exorbitant Dollar To summarise in very broad strokes, maintaining the world’s reserve currency is good for the US capital account, but bad for the US trade account, resulting in a huge surplus in the former and a huge deficit in the latter. Some of the main benefits are in fact not economic ones but geopolitical ones. To the obvious question then: is it worth it? Some critics claim that the US can consume far beyond its means because of the current status quo, while others make the argument that the US is in fact forced to do so. Due to the interconnectedness of the global economy, there is a zero-sum game element at play. Where there is a trade surplus, there must be a trade deficit. As it stands, the world sells and the US buys. Many parts of the world have benefitted immensely from this paradigm. The position of the United States was once described as being one of “exorbitant privilege” by Valéry Giscard d'Estaing, the French minister of finance. This may have been true back in the 1960s when the term was first coined, but it has become increasingly difficult to defend today. Some economists have even described the US as being saddled with an “exorbitant burden” instead. The future The modern Dollar system has unquestionably helped the world to flourish, including the US itself, but as in 1971, 1985 and even 2008, the cracks are beginning to show. Should the Dollar relinquish its position, it is by no means a given that the US would suffer the most. The consequences for the US would no doubt be profound, but the consequences for those nations dependent on exports to America would be no less so. The buyer stops buying and the seller stops selling. Which party is the hardest hit? The point is moot, because it is extremely unlikely that the Dollar will lose its status as the world reserve currency any time soon. No other nation comes even close to having the financial gravitas, structural flexibility or openness required to take up the mantle. China, the world’s second largest economy, does not permit free capital flows in or out of the country. The RMB faces a lack of convertibility options, opaque banking operations and currently only makes up around 2% of all foreign currency reserves. The Euro could be a possibility, after all it accounts for roughly 20% off all foreign reserves. Unfortunately, the Euro has very little liquidity outside of Europe and North America, access to European bonds is still somewhat restricted, the infrastructure backing up the Euro is nowhere near as expansive as that backing up the Dollar and the European Central Bank does not seem to have a plan to address any of these points. Put simply, the world does not transact in the Euro the same way it does with the Dollar. Before the USD became the de facto world currency, the Greenback was already a staple of international trade and had been for decades. The Euro cannot claim the same. For all the talk of a common BRICS currency, little of substance has emerged as of yet. A return to a gold standard seems equally unfeasible because it would entail either a worldwide currency or strict conversion pegs, which in turn limits the monetary sovereignty of the countries involved. One cannot have free capital flows, fixed exchange rates and fiscal autonomy. A cryptographic solution based on proof of reserves is certainly possible, but would likely take years to implement and would no doubt require a period of transition that would inevitably include the Dollar anyway. For all the arguments for or against a new monetary system, the fact is that no one is stepping forward to take on the role that the US currently occupies. The world has never had a genuine international currency before. Throughout history, there have been currencies that extended far beyond their home borders, such as Roman Denarii, Spanish silver Dollars or the Pound Sterling, but these were nowhere near as central to the world economy as the US Dollar is today. These are unchartered waters. One potential outcome is simply a reiteration of the current structure but with some much-needed adjustments. Bretton Woods was not perfect, nor were Nixon’s attempts to fix it. Many modifications have been made since the original 1944 meeting, with varying degrees of success. A number of economists have floated the idea of a hypothetical Mar-a-Lago accord, in reference to Donald Trump’s Florida residence. Such an agreement may bring back currency pegs, include permanently higher trade tariffs, or perhaps even institute some form of participation fee for using the Dollar. Economists have been debating such matters for decades. There are no easy answers. All that can be said for sure is that the Dollar will retain its place for a while longer.