Future of the U.S. Dollar as the World's Reserve Currency

Introduction

The U.S. dollar is the world's reserve currency of choice, but at various points in its history, critics have pointed to other currencies as potential vehicle currencies. While in the 1970s and 1980s it might have been the yen or the deutschmark, the creation of the euro in 1999 brought a new competitor onto the scene. In its first few years, the euro became increasingly popular. With the Eurozone having an economy nearly as large and robust as the American economy to back it, the common currency began to make inroads as the world's vehicle currency. Nations with closer ties to Europe than to the United States were among the first to shift, but many major nations now conduct some operations — debt issuances, for example — in euros. Today, there is also speculation that the yuan could take over as a vehicle currency, or that a basket currency could be created using a number of different currencies (Fisk, 2009).

This paper analyzes the future of the dollar. The first step in understanding that future is understanding how the dollar became the world's reserve currency. It is also important to understand what a reserve or vehicle currency is and how the dollar currently plays this role. In addition, the new currencies that might threaten the dollar need to be examined — their relative strengths and weaknesses are important to the dollar's future trajectory. Consider that the dollar overtook the pound sterling as a reserve currency through its own strength, not necessarily because Britain actively removed its currency from that role. The analysis concludes with a determination of the likely future course of the dollar.

The Modern Monetary System and the Rise of the Dollar

The modern monetary system had its antecedents at Bretton Woods. In brief, the outcome of that 1944 meeting was that the price of dollars was fixed in local currencies, both replacing the gold standard and establishing the dollar as the leading currency in the capitalist world (Urban, 2009). The latter was essential at the time — Europe was rebuilding from the war, and once-dominant Britain had been superseded by the United States for global economic supremacy. While other currencies had their rates pegged to the dollar and were permitted minor adjustments, the dollar itself was pegged to the value of gold.

In 1971, Bretton Woods was replaced by a system of free-floating currencies. This effectively reinforced the division between the world's "hard" currencies — USD, GBP, DEM, HKD, CAD, CHF, and others — and the remaining currencies, many of which either floated freely but with high volatility, or became fixed to hard currency exchange rates. The hard currencies would be traded on global foreign exchange markets. This shift removed gold from the international currency system, placing even greater emphasis on the dollar.

Currencies under a free-floating system are fiat currencies in that they are not underwritten by any specific asset. Prior to 1971, the international currency system was underwritten — directly before Bretton Woods, and indirectly under it — by the value of gold reserves. The shift was more psychological than practical: gold is essentially a fiat store of value itself, often trading far above its intrinsic value precisely because of its traditional role as such a store (Indiviglio, 2011). The underlying asset in the modern monetary system is the economy of the nation or group of nations that backs the currency. With the United States as the world's dominant economy and the only capitalist superpower at the time, the dollar naturally became the reserve currency of choice, building on its Bretton Woods-era role.

The currencies of other nations sometimes played a small regional reserve role, but the dollar came to dominate. Other strong currencies — the deutschmark and the yen — were touted as potential successors, but for that to occur the U.S. would have had to lose its status as the world's dominant economy. Both Germany and Japan are much smaller than the United States, so unless the U.S. economy completely collapsed, neither currency represented more than a regional threat.

The Dollar's Current Dominance

The dollar's role as reserve currency is manifested in several ways. Foreign trade is often conducted in dollars — even between two non-dollar nations. This is done to mitigate foreign exchange rate risk, to provide trade terms familiar to all counterparties, and to take advantage of the dollar's high liquidity. As a result, 85% of foreign currency trades worldwide are trades of other currencies for dollars (Eichengreen, 2011). Flowing from this dollar-centric activity, 60% of the world's foreign reserves held in central banks and governments are denominated in dollars (Ibid.).

The dollar's dominance is supported by a number of competitive advantages. It benefits from economies of scale: the sheer volume of dollar trading means that the liquidity of dollar-based exchange exceeds that of any other currency pairing. Spreads are lower, and this reduces the cost of foreign exchange for companies doing business internationally. The dollar is also relatively stable, meaning that dollar-based transactions carry lower risk for counterparties than transactions in any other currency.

The dollar is the unit of currency for global commodity transactions. With the world's most critical resources priced in dollars, there is constant demand for the currency, which in turn generates significant liquidity. No other currency can match dollar liquidity in part because it is used to trade all major commodities. This liquidity is critical: the reason investors consider the dollar a safe haven from economic distress — even when that distress originates in the U.S. economy — is that the dollar possesses by far the greatest liquidity of any currency (Eichengreen, 2011).

The global use of the dollar is still underpinned by the strength of the U.S. economy. The United States has the world's largest economy. It is fractionally smaller than the European Union as a whole, but the Eurozone does not include the United Kingdom, leaving the U.S. as the largest economy backing a single currency (CIA World Factbook, 2011). The U.S. economy is diverse, backed by a massive population, a high level of average wealth, immense natural resources, robust capital markets, and a culture of entrepreneurship that has produced many of the world's leading companies. The United States also has a perfect historical track record of paying its debts — its Treasury securities — and has traditionally been understood to have the capacity to continue doing so.

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