#11 The US Dollar as the World's Reserve Currency

Gold standard? What are the benefits for Americans and others? What does the debt cycle have to do with it? Sanctions? What are the challenges?

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Q: What does currency do?

A: A currency stores value, is used for trade (medium of exchange), and is a way to price things (unit of account).1

Q: What is a reserve currency and which country holds the title?

A: A reserve currency is one held by many countries in their central banks and institutions because it is seen as valuable and dependable.

In 2023, the US has the world’s reserve currency - the US Dollar (USD).

The US dollar accounts for 59% of all foreign reserves. The Euro is second at 20% and Japanese Yen is in third at 5%. The British Pound Sterling is 4th under 5%. The Chinese Yuan or Renminbi is fifth at 2.6%.

2 Japan and China hold the first and second largest reserves of US Treasuries respectively, each at over $1 trillion.

Today, 65 countries are pegged (fixed exchange rate) to the US Dollar and 11 countries use it as their official currency.

Q: When and why did the US Dollar become the world reserve currency?

A:Until World War II, the British Pound Sterling was the world’s reserve currency.

The US Dollar took this title towards the end of World War II as it became the world’s leading economy.

In 1944, 44 countries met at Bretton Woods, New Hampshire, and agreed to create institutions and frameworks largely led by the US. These included the IMF (International Monetary Fund), World Bank, and the gold standard.

The gold standard meant currencies pegged to the US Dollar were convertible to gold at $35 an ounce. The purpose was to keep money supply and inflation under control, and it made the dollar seem very attractive.

Q: What are the benefits for Americans?

A: For Americans, there are economic and psychological benefits of having the reserve currency:

• Lower interest rates and more credit
• Ease of building value through investing at home and abroad
• Generally cheaper imports (but less competitive exports for businesses)
• Influence of American values in policy and businesses abroad
• Prestige as an economic power

Q: What are the benefits for other countries?

A: For others, using the dollar brings convenience and stability, because many currencies are volatile and so are difficult to trade with, price things or store value.

Q: When have people been concerned about the dollar?

A:

1. When President Nixon Ended The Gold Standard: In 1971, President Nixon realized the US had run trade deficits and could not fund the conversion of dollars to gold if countries were to demand it. To avoid speculation on the dollar, as well as help stabilize inflation by devaluing the dollar, he ended the standard.3 While people worried this would shock the system and end the dollar’s dominance, it had little effect, and instead anchored the dollar (and US Treasuries) in place of gold.4
2. During the 2008 Financial Crisis and COVID-19 epidemic: Similarly, the 2008 financial crisis and COVID-19 crisis made people worried but the demand for US dollars actually increased. China increased its US Treasury holdings during the 2008 financial crisis, which also helped stabilize the situation.
3. Talk of the Risk of Default: The US debt to GDP level is rising (currently in the range of 120-130%) which indicates it is more difficult for the federal government to pay its debts. Leading economies get into debt cycles, as they print more money to fund growth and pay off interest collecting debts. But there can be a crisis if government fails to find enough buyers for the debt. Every time Congress agrees to raise the debt ceiling, it is because there is bipartisan support to print more money in order to borrow so it can fund an increasing annual budget deficit.5 A default would be a broken promise on paying debts. It would be brought on by political instability and dysfunction. Higher interest rates would likely follow because the system becomes more risky and less creditworthy. There would also be a domestic and global recession likely to follow.The highest impact way out of unsustainable debt is for the economy to grow and the government to spend less.6

Q: How can the US use its currency to sanction countries?

A:

Russia: The US imposed currency sanctions on Russia after it invaded Ukraine. It froze Russia’s ability to use US dollars, banned it from the financial digital network SWIFT (Society for Worldwide Interbank Financial Telecommunication, 40% done in US Dollars), and largely seized or froze any investments in the US held by Russians.

China: While the US has restrictions on Chinese investments and individuals, it has not limited access to currency at large. One concern from a Chinese perspective is to be frozen out of the US system CHIPS (Clearing House Interbank Payments System) or SWIFT. 7

Though countries like Russia and China can impose sanctions with their currencies, with today’s market share these have a smaller impact than those made by the US.

If the US overdoes sanctions or protectionist policies, targeted countries and even others might seek more currencies, though how much is too much is debated. 8

Q: What are potential external challenges for the US dollar?

A:

1. Challenges from the Euro: This ranges from strong European integration (20 countries with good economics) to it being the next best alternative to dollars. 9
2. Challenges from the Yuan: Possibly if China’s economy grows more (it is currently 70% of US GDP) and it were to leverage its trade network, this would be a likely challenge. But it has not attracted that level of foreign investment and controls its currency’s exchange rate, so it does not seem to have this goal. A commonly referred to moment is when China and Saudi Arabia discussed trading oil in Yuan in 2022. However, 80% of global oil trade is still in US Dollars. Most Middle Eastern countries, including Saudi Arabia, are pegged to the US Dollar, making it a favorable currency for trade. The US has also become a net exporter of oil, making US Dollars useful for trade.10 China is the largest trading partner for approximately 120 countries which is impressive. The US is usually a close second. But, in the case of many developed Western trade relations, including the biggest block that is between the European Union and US, the US is well ahead of China and others due to developed services and investments.11
3. Decentralized Finance (DeFi): Out of left field, this changes the need for government currencies.

In Summary

The US dollar is the safe choice for many countries. The US has political and social stability plus economic fundamentals to be very attractive compared to other options, and it has enough good sense in its dollar policies. But the US should recognize that with great power comes great responsibility to be judicious, to make and trade more, and to lead among international institutions.

As the old saying goes, trust is the coin of the realm.

1 Caitlin Clarke, “What is Money,” Investopedia, 2023, https://www.investopedia.com/insights/what-is-money/

2 Anshu Siripurapu, “The Dollar: The World’s Reserve Currency,” Council on Foreign Relations, 2023, https://www.cfr.org/backgrounder/dollar-worlds-reserve-currency

3 The End of the Gold-backed US-$ - Nixon Shock in August 1971, Chess Coach, Youtube, 2016,https://www.youtube.com/watch?v=4-cB1Z9qceI&embeds_referring_euri=https%3A%2F%2Fbasicecon.substack.com%2F&feature=emb_title

4 US Treasury, “Appendix 1: An Historical Perspective on the Reserve Currency Status of the U.S. Dollar,” 2009, https://home.treasury.gov/system/files/206/Appendix1FinalOctober152009.pdf

5 Ray Dalio, Debt Cycle, Principles For Dealing With The Changing World Order, 2021.

6 “What is the National Deficit,” US Treasury, 2023, https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/#:~:text=Since%202001%2C%20the%20federal%20government's,the%20growth%20of%20federal%20revenue.

7 Attributed to Vivek Ramaswamy

8 Karen Yeung, “ How the US uses the dollar payments system to impose sanctions on a global scale,” South China Morning Post, 2020, https://www.scmp.com/economy/china-economy/article/3098691/how-us-uses-dollar-payments-system-impose-sanctions-global

9 The Best and Worst Countries For Doing Business, Wall Street Journal, 2023, https://graphics.wsj.com/table/DoingBusiness

10 Summer Said, “Saudi Arabia Considers Accepting Yuan Instead of Dollars for Chinese Oil Sales” Wall Street Journal, 2022, https://www.wsj.com/articles/saudi-arabia-considers-accepting-yuan-instead-of-dollars-for-chinese-oil-sales-11647351541

11 Summer Said, “Saudi Arabia Considers Accepting Yuan Instead of Dollars for Chinese Oil Sales” Wall Street Journal, 2022, https://www.wsj.com/articles/saudi-arabia-considers-accepting-yuan-instead-of-dollars-for-chinese-oil-sales-11647351541

12 Anshu Siripurapu, “The Dollar: The World’s Reserve Currency,” Council on Foreign Relations, 2023, https://www.cfr.org/backgrounder/dollar-worlds-reserve-currency