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How the US Dollar Became the Strongest Currency in the World

Jul 17, 2020 2:50 PM 4 min read
Editorial

The US Dollar has been the strongest currency in the world for a long time now. Holding the position as the de facto reserve currency, it is accepted for trade throughout the world.

According to the International Monetary Fund (IMF), more than 61% of the world’s currency reserves are held in Dollars. Even China, the fastest-growing large economy, owes more than $1trn in US Dollars.

Moreover, 80% of all $100 bills in circulation is held outside the US and about 90% of forex trading is done in US Dollars.

But the Dollar wasn’t always so strong. The 19th and early 20th centuries saw UK’s Pound sterling reigning as the major global currency reserve. It was only after 1944 that the US Dollar emerged as the primary reserve currency.

So how exactly did the Dollar become so powerful?

The Gold Standard

US President Herbert Hoover famously said in 1933:

We have gold because we cannot trust governments.

Before World War I, international trade was majorly based on the gold standard. Countries linked their currency directly to gold and all trade between nations was carried out using gold. As a result, nations with trade surpluses saw their gold reserves pile up. On the other hand, countries with trade deficits depleted their gold reserves.

Then came the First World War, shaking the government finances and triggering economic instability. The gold standard fell flat on its face, creating the need for a more pliant currency system.

This paved the way for the British Pound sterling and US Dollar to rise as global reserve currencies. The gold stock of relatively powerful countries grew as smaller countries switched to inconvertible paper money.

By the late 1920s, the gold standard had again become operative, but in a different form: the gold-exchange standard. In this system, the currency was pegged to another international gold-linked currency instead of being pegged directly to gold.

History repeated itself when this system too collapsed in the wake of the Great Depression during the 1930s. In 1931, even the UK suspended its gold standard. France and the US were the only major countries left with large gold reserves.

Then came the US Gold Reserve Act of 1934, increasing the price of gold from $20.67 per troy ounce to $35. This triggered an insane increase in US gold holdings but devalued the Dollar in the foreign market. Countries continuously converted their gold holdings into US Dollars. By 1939, the US had practically taken over the gold market.

 

The Bretton Woods Agreement

The shared need for a reliable global currency reserve led to the Bretton Woods Agreement of July 1944. Delegates from 44 countries negotiated at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire. Since the US held most of the world’s gold supply and the gold-backed Dollar was relatively stable, the delegates agreed to adopt the US dollar as the official reserve currency.

The countries pegged the exchange rates of their currencies to the Dollar with diversions of only 1% allowed. It helped them stabilise their currency value for the trade of goods and services in the international market. In return, the US profited from the beneficial exchange rates on its currency.

 

The End of the Gold Standard

However, the United States started printing more money backed by Treasury debt since it needed funds for its war in Vietnam. As a result, the country began running out of its gold stock and the value of currency reserves held by foreign countries started falling.

This alarmed foreign nations and they soon started asking for gold in return for the Dollars they owned. Finally, in 1971, seeing that the US gold supply was no longer enough to satisfy these demands, President Richard Nixon decoupled the Dollar from the gold standard.

Not long after, the value of gold tripled and economists feared that the Dollar risked losing its position as the world’s de facto currency.

 

The Continued Reign of the Dollar

Contrary to these predictions, the US Dollar has retained its position as the world’s major currency reserve. Countries already had a huge stock of Dollars and the currency also enjoyed global trust, so its liquidity remained constant.

A major reason why most countries adopted it as their official currency is its stability. It is considered to be the safe-haven currency. And it is backed by the US Treasury, which commands considerable confidence over its ability to pay up its obligations.

The US economy is another influencing factor. Even though its growth rate may not be as rapid as those of major developing economies, it is still the largest and most powerful economy in the world.

So, for the foreseeable future at least, it is unlikely that any other currency will gain prominence over the Dollar. But that doesn’t mean there haven’t been attempts to dethrone the Dollar.

 

Will the Dollar Be Dethroned?

In 2009, China and Russia called for a new global currency. They wanted a currency that is secured to a stable benchmark with a clear set of rules, flexible and independent of the economic conditions and interests of any individual country.

In recent years, there has been interest over the Chinese Renminbi emerging as a possible alternate international reserve currency. At present, though, its circulation is nowhere as widespread as the Dollar’s, and most of its usage is domestic i.e. within China. But Beijing is working hard to make it more competitive vis-a-vis the Dollar and increase its usage in global finance.

Whether China’s ambitions will come fruition is anybody’s guess, but it is safe to say that the Dollar’s position in the global market remains unrivalled...at least for now.

 

Written by Anvi Jain

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