Tap to Read ➤

How Did The Dollar Become The Global Reserve Currency

Buzzle Staff Aug 26, 2020
The United States dollar became a global reserve currency by the end of the 20th century, and since then, has been the world's most dominant currency. This story explains how the dollar has become the global reserve currency.
Quick Info
Prior to the U.S. Dollar, in the eighteenth and the nineteenth century, the British sterling pound reigned supreme as the global reserve currency. Post the Second World War, however, the pound lost its supremacy when the dollar became the world's reserve currency.

As of the 21st century, the U.S. dollar is the most dependable and widely held currency. A reserve currency is a currency that is controlled by the governments of different countries as a part of their foreign exchange reserves. It is considered to be dependable and safe and is used in foreign transactions.
The citizens of the countries that issue a reserve currency need not exchange their currency, since it is globally accepted. The paragraphs here provide an overview of how the dollar became the world reserve currency.
What is Reserve Currency
  • Reserve currency is held by governments in sufficiently large quantities for international payments.
  • In the earlier decades, it consisted of gold and silver, but later, it included the U.S. dollar and other currencies.
  • Back then, the term, 'reserve', meant that cash can be exchanged for gold (or any expensive commodity).
At a time when most of countries followed the gold standard, the British pound sterling arose as the trusted reserve currency, due to the contribution of UK to world trade and global economy.
The world found it convenient to trust the Bank of England and deal with pounds rather than gold.
Post the Second World War, the economy of UK grew weaker, and the dollar rose in prominence as the reserve currency.
The Aftermath of the World Wars
The First World War
Prior to the World War, Britain reigned supreme in the world.
With the onset of the 20th century, however, they had begun to lose several of their colonies and consequently, power.
The First World War was a very expensive conflict for the British. As per sources, they spent more than 25% of their GDP on the war, lost more than 24% of their foreign assets, and incurred horrendous debts - equivalent to around 135% of their GDP.
Consequently, from being the world's foremost economic leader, Britain came down to the point of handling heavy economic damage, unemployment (which was at its peak in 1921), and weak productivity; in order to stabilize itself, the country borrowed heavily from the US, which emerged as a reliable nation, primarily because it entered late into the war.
According to sources, the United States spent approximately USD 32 billion on First World War, which amounted to around 52% of their GDP at that time.
During the war, Europe had purchased armaments and other goods from the U.S., and after the war ended, most European nations experienced difficult economic conditions along with Great Britain.
The two years after the war saw a very mild stability, though the situation was certainly better than the rest of Europe.
In the year 1920, the Great Depression hit the United States, which massively affected the global economy.
There were several reasons for this.
Primarily, the armed forces returned to normal civilian life, which created a widespread unemployment. There was a downfall in the labor union power, which was at its peak during the war due to the continuous requirement of goods and services.
To combat inflation, the Federal Reserve Bank increased the interest rates, which is viewed by some experts as an incorrect monetary policy.
In response to the recession, the government organized committees that contributed to unemployment relief.
By the end of 1921, it was inferred that the contractionary monetary policy of the Federal Reserve Bank was a major contributor to the recession. Towards the beginning of 1922, the economy showed signs of improvement.

The Second World War
Before the Second World War began, the U.S. economy was moderately balanced.
When Britain declared war on Germany, the former used up all their reserves (gold and cash), and borrowed large sums from the U.S. to pay for ammunition and raw material.
Thus, during the war, the entire labor force of the U.S. was employed to supply material for the war.
In other words, the war helped catapult the U.S. economy into what is referred to as the 'Golden Age'. Factory production returned to full capacity, and productivity jumped to new highs.
After the war, the capital exports of the British were down by 37%, their reserves depleted, and the British were dependent on the U.S. for military and financial support.
Thus, the downfall of the pound sterling was one of the principal reasons for the increased dependence on the dollar.
After the victory of the Allied Forces, as described by economic experts, there was a pattern of technical change, which saw a considerable increase in labor and capital productivity.
In order to avoid situations that caused the Great Depression, the Bretton Woods System was formulated, whose principal goals were to return to the gold standard, stabilize the exchange rate, and finance post-war reconstruction and trade deficits.

The Bretton Woods System
The Bretton Woods System was an agreement signed by 730 delegates from the 44 Allied nations.
It was signed at the Mount Washington Hotel, Bretton Woods, New Hampshire, United States of America (hence the name), in the beginning of July 1944.
Back then, gold played a vital role international transactions, and currency values were determined as per their relationship to the gold standard.
The agreement thus, stated that every country must adopt a monetary policy such that the exchange rate of its currency is maintained within a fixed value of gold (give or take a percentage of the value).
The reasons for drafting this agreement primarily included the aftermath of the Great Depression―the planning committee decided that for a stable global economy, the world required a proper regulated system that could strongly control the value of currencies and effectively dominate global monetary affairs.
The IMF was designated to manage the payment imbalances.
However, as the wheels of the century turned, gold production wasn't sufficient enough to match the increasing demands of global trade.
Consequently, the world found it difficult to follow the fixed exchange rate set by the agreement.
Eventually, in August 1971, the United States terminated the conversion of dollars to gold, and put an end to the Bretton Woods System. This event is called the 'Nixon Shock', and this is how the dollar became the global reserve currency.

The Significance of the Dollar
The Fiat Currency
With the end of the Bretton Woods System, the U.S. brought about the dominance of the Fiat currency.
The relationship of the U.S. dollar to gold (USD 35 an ounce of gold) made the dollar an all-powerful currency, and the consensus was that the dollar was more flexible and earned interest.
The gold reserves in the U.S. depleted dramatically around the late 1960s. The U.S., therefore, decided to revalue the dollar at a higher amount and abandon the gold standard completely.
Despite the fact that the dollar was no longer linked to gold, it still provided stability and helped settle international trading accounts.
The Reign of the Dollar
A reserve currency needs to hold its value over time.
The period between 1949 to 2003 was when the power of the dollar was at its peak, though there were quite a bit of highs and lows.
America followed a monetary system based on its own rules―the unilateral termination of the Bretton Woods agreement, being one of them.
The Fiat currency gained complete prominence over the gold standard, and the globe began to place its trust over the dollar.
One of the many reasons the dollar remained so strong is the strength of the American capital abroad.
With free-floating currencies, the overall inflation shot up and prices increased steeply.
The 1980s again witnessed slow growth and high unemployment, while the subsequent decades saw a considerable growth in the economy.
The U.S. dollar became the single, stable currency for international holdings and foreign exchange reserves.
The financial crisis of 2007 is reported to be one of the most severe cases of recession since the Great Depression.
The situation may be attributed to the liquidity crisis that took place in August 2007, when withdrawals from three major hedge funds were terminated.
The crisis affected the real estate market, innumerable businesses, the stock market, large financial corporations, and led to the loss of trillions of U.S. dollars.
Not just the U.S., but the entire global economy collapsed due to the recession. According to the IMF, huge U.S. and European banks lost more than one trillion U.S. dollars between 2007 to 2009.
To rectify the situation, banks had begun to cut down on the interest rates, and many economic reforms were introduced in the U.S. and Europe.
The condition of developing countries was worse; however, a majority of them depended on the strength of the dollar as a reserve currency, and the recession weakened its power to a considerable extent.
One of the primary reasons for the recession was the over-leveraging of the banks and financial institutions in the U.S.
Prior to the crisis, banks had begun to undertake rather risky investments, which led to increased debt burdens.
The Future and Potential Threats to the Dollar
The shocking aftermaths of the 2007 economic crisis led to increased speculation and debate about the dependability of the dollar as a reserve currency.
China has requested the IMF to consider its currency as the global reserve currency.
China has emerged as one of the foremost global economies, and has contributed to a substantial percentage of the global GDP.
The Japanese yen is also a potential threat to the U.S. dollar, for Japan followed sound fiscal policies to increase the value of its currency in the global market.
The Euro and the pound sterling are the other two currencies considered by the IMF as the possible choices for replacing the dollar.
The Dollar: A Currency of Choice - Period
If the recession has reduced the significance of the dollar, why is it still being held as a potentially dependable currency? Experts suggest that one of the reasons for this may be the absence of an equally strong alternative.
According to the National Bureau of Economic Research (NBER), the recession seems to have ended around the middle of 2009.
While a majority of the experts expected the dollar to grow significantly weaker (which it did, to an extent), its importance has been strengthened by the crisis.
Since emerging markets want to protect themselves against financial disasters, they are willing to finance the debts of the U.S., despite the fact that the dollar might depreciate over time.
Thus, the world is willing to pay a heavy price for safety and protection from economic crisis, the dollar still holds the title of the safest possible reserve currency.
While there have been debates about the Yuan or the Euro replacing the dollar as the reserve currency, the current claim is still held by the US. However, reports suggest that Yuan has already met the conditions laid down by the IMF. The dollar is still powerful, but it may not be long till the Yuan becomes global currency, provided the US affirms the same.