How the U.S. Dollar Became the Global Reserve Currency

Hello everybody and welcome back to Breaking the Dollar. I'm your host Everett Millman and on this week's episode I wanted to take a historical look at how the US dollar became the world's global reserve currency. So this discussion is going to rely heavily on some historical events and a review of them. But I do think it's important for people not just in the United States but worldwide to understand how we got to this point. It wasn't a preordained law or rule from the beginning that somehow the United States dollar was going to be the global reserve asset. It happened based on some historical contingencies. And one of the things that I'm going to explore is whether this is purely based on the strength of the United States economy and military or if it is part of a global agreement by the free markets. And I think we will find that it is a mix of both.

So the first thing to address is the history of reserve currencies in general. And broadly speaking, there really was no such thing as a global reserve currency until about the 19th century. Now you did have some dominant international currencies. You could call them as far back as ancient times. There certainly were currencies that were used and recognized and accepted outside of their home country. But there was no centralized banking system like we have today that would make any sense for there to be a reserve currency.

Now what we mean by reserve currency is that a foreign government will hold a foreign country's currency as part of their reserve assets. This is done primarily for two reasons. One is to back up that central bank's balance sheet with some type of value like you would with any group of assets in, say, your investment portfolio. Secondly, it is used to settle any type of trade or in the course of trading that currency to influence the value of the national currency that that country issues. To put it in a slightly less complicated way, they can buy or sell different currencies in order to influence the value of whatever currency they issue.

That brings me to another point and that is that the US dollar is not the only reserve currency in the world. It is simply the most dominant. So roughly 60% of all foreign reserves are made up of US dollars. That leaves another 40% that is made up of other currencies. And primarily that is the euro, the Japanese yen, and increasingly lately the Chinese yuan. Nonetheless, all of those other currencies pale in comparison to the weighting of the US dollar. What you do essentially see is that the use of those reserve currencies is roughly proportional to the size of those economies; that those are the four largest economies in the world, the United States, China, Japan, and Europe. These are both the currencies that back up the value of all of the world's banking and financial systems and they are the currencies that are used in trade. The fact that those are the largest economic powers in the world means that that is where people and companies are spending money.

Now that's essentially the landscape of how reserve currencies work and that leads us to the main question at hand here and it is: how did the US dollar become the king? Why is it that the US dollar is on top of this hierarchy? As I teased in the question from last week from listeners, that kind of prompted this topic, this is in many ways a remnant of the gold standard. As we've gone over many times on this show, at times in the past typically the value of all currencies was backed up by gold. However much gold that country's government was in control of basically determined the value of their money and determined how much currency they could issue. It restricted how much their economy could grow. Now the system of having a gold standard really hit its peak in the 19th century thanks to the British Empire and the Industrial Revolution. At the time Britain used a gold standard, it backed the value of the pound sterling with gold and because of the Industrial Revolution, Great Britain was far and away the world leader in manufacturing and exporting all those things that it manufactured.

As a result, not only were there more British pounds circulating around the world, but in order to buy all of these great new things that were being manufactured in the United Kingdom, you had to have either British pounds or gold. In this sense, you can think of the pound becoming a reserve currency because it was as good as gold. I bring this up as an example not just to show what was happening right before we get to the United States' dominance of economic affairs, but also to show that whichever currency is the global reserve currency is tied very closely to whatever country or power has commercial or imperial dominance over the rest of its trading partners. Even before the time of the British Empire, you had some sort of pseudo reserve currencies, whether it was the Dutch gilder or the French franc or the Spanish peso.

At given times in history, these empires were the biggest commercial powers of their age. The difference is that during these times, it was just as good for another country to stock up on gold and silver by the time of the Industrial Revolution in that era of the British Empire that I referenced. This was really no longer convenient. It made more sense within the framework of the banking system to either hold the actual currency or to peg your currency to the British pound. Some interesting evidence of this process is that in a lot of places that were colonized by the British or were under their imperial control economically, the local currency is called the pound. You see that in Egypt and some places in the Middle East and in Asia. The same sort of thing goes on today, wherein so many places around the world, they simply call their currency the dollar. You have the Hong Kong dollar, the Australian dollar, the Canadian dollar and so on.

So to get back to the point, this sort of system crystallized under the British. But all of that started changing around the turn of the 20th century when we get to World War I. In each of the two world wars, the United States avoided the biggest damage and devastation not only because none of the fighting took place within North America, but also because each time the United States entered the war late. So in both cases, the US was left much stronger after the war compared to the other participants. But the United States, having gone through its own industrial revolution, was also the driving manufacturing power for the Allies in both of those wars. The US provided the materials, the weapons, the mobilization of factory power in both world wars. In order for other countries to pay for that, the US became the major creditor nation to all of those wealthy Allies. What that meant was they either paid us in gold or they paid the United States by taking on debt.

This brings me to one of the other reasons why the US dollar being the reserve currency is a remnant of the gold standard because in taking all of those payments in gold, the United States built up the largest stockpile of gold reserves that the world has ever seen. At its peak, right after the end of the Second World War, the United States held over 20,000 metric tons of gold. That is just a staggering number. It is more than twice as much as the US holds now. It represented a huge chunk of the supply of gold in the entire world at that time. That alone was not enough to cement the dollar's place as the world reserve currency. Just because the US had all the gold didn't make it a foregone conclusion that that would be the case. You can see a situation where the world would simply be on a gold standard and that would make us very powerful, but it doesn't necessarily explain how we got to the current situation.

For that, we have the Bretton Woods Agreement. Basically Bretton Woods was an international agreement by all of the biggest powers in the world and representatives of different banking consortiums and financial institutions that determined that the best way to rebuild the world's banking and financial systems after the devastation of World War II would be to agree to have the dollar as the reference point for all of their currencies in the world. Instead of having everyone on a gold standard, it was sort of an indirect gold standard that the dollar would be backed by gold. It would be exchangeable for gold and that every other country would simply use dollars in place of gold because they knew what it was backed by. From this perspective, when you look at how important of a turning point Bretton Woods was, you could say that it is simply by law that the dollar became the world's reserve currency.

On the other hand, you could say that it really is an outcropping or a decision of the free market. Banks and businesses wanted and agreed to use dollars. One of the main reasons was because the United States had the largest most powerful economy and the largest consumer base. So if you wanted to sell things to Americans, you had to be willing to trade in dollars. Even today, the vast majority of all trade and business that's done internationally is invoiced in dollars. I was surprised to find that there are actually more physical dollar bill paper notes outside of the United States than within the United States. That just goes to show you how pervasive the dollar is as international form of money.

That's why I say that you can almost blame the free market rather than any sort of law or agreement because that goes to show that the dollar is trusted around the world. Businesses and individuals have confidence in the value of the dollar. I would say that the strength and the pervasiveness of the US military plays a role in that, but it is not the deciding factor. You often hear this phrase and I think it's true that all politics is ultimately local. And that relates to this topic because if you think about it, how enforceable is it for some international body like say the United Nations to simply coerce or force every other country to use US dollars? I don't think that that is enforceable or feasible. It's not because there is some giant power forcing everyone to use dollars. It's that the free market decides that.

Now I absolutely will point out that it helped massively that so many dollars were already out there in the world to begin with. And again, this goes back to the ramifications of the World Wars and the remnants of the gold standard. Something that's easy to overlook is that the Bretton Woods system, that agreement that made the US dollar the reserve currency, completely fell apart in the early 1970s. President Nixon decoupled the dollar from gold because too many foreign countries, particularly France, were redeeming their dollars for gold and draining the US reserves. What's fascinating about that is that that happened in 1971. And then there are a few subsequent developments in the early '70s until in 1974 and '75, gold could be freely traded in the United States again. That was almost 50 years ago and nothing has really put a dent in the dollar's status as the global reserve currency. That's one of the reasons why I lean on the free market explanation a little more heavily because even when we removed gold from the equation, so to speak, the dollar still came out on top. It remains by far the most desirable medium of exchange anywhere in the world.

And to this day, without the promise of exchanging dollars for gold, the pricing of oil and all other major commodities is done in US dollars. Now the next big question that all of this leads to is when will a dollar stop being the global reserve currency? I do see quite a buzz around this question more and more lately. But I have to say, I think the hype is slightly overblown. Yes, there are certain challenges and risks for not just the dollar, but the US economy and US dominance in general. That is strongly established. But there have been many of those challenges and periods of crisis in the past. Through every single one of them, the US dollar has still come out on top.

I think it's fair to say, knowing the history before the dollar became the reserve currency of the world, it's still fair to say that it probably won't be in that position forever. At some point there will be a replacement or a new system. But in my view, that is not going to happen really anytime soon. And when it does, it will be a gradual transition as we saw in the past. As you may have picked up in the last episode I did, gold still plays an important role. It doesn't directly back the value of any currency, but it is an important reserve asset in its own right. It tends to ebb and flow with the level of confidence and trust in the financial system. With that being the case, it's pretty reasonable to expect that the dollar would have a similar fate: that it would not one day all of a sudden overnight completely lose its status or cause some sort of crash or collapse of the entire system built up around it. Rather what is far more likely is that when it does inevitably decline and be replaced, it would gradually transition into a lesser role or in some similar fashion as gold did. That is certainly a topic that engenders a lot of debate and a lot of controversy. So I will simply leave that as my personal and professional view on the situation.

That about wraps up this episode. I will turn to our mailbag and check out a question from the listeners. This week's question comes from Barbara in Kenosha, Wisconsin. And Barbara asks, I hear a lot about gold backing the value of money. Why not silver? That is a fascinating point because at one time, in not just in United States history, but in world history, a lot of countries did use a bi-metallic standard. They used both gold and silver as money simultaneously. The problem with that type of system arose because the ratio of the value between those two metals would have to stay constant in order for the system to work. That was not the case throughout all of history. The value of gold and silver tend to fluctuate against one another. So if you had a set-in-stone ratio between their two values, what ended up happening is that as the price on international markets would fluctuate, speculators would just exchange gold coins for silver coins or vice versa depending on which one was undervalued or overvalued against the other.

Probably the main point about why that was a problem is that gold and silver coins were then being bought up by foreign speculators and not doing what they were supposed to do, which is be used as money in commerce. So to kind of circle back to the question, you could have a system where only silver was backing the money, a silver standard, but then you would have to entirely demonetize or throw out gold. It simply is not a stable or functional system to have both metals as a type of standard.

So I hope you enjoyed listening that about wraps things up. I want to thank all of our listeners out there. Really appreciate you guys tuning in. Be sure to check out next week's episode where I give another rundown of what has been going in on in markets in 2020.