How the Dollar Became the World’s Reserve Currency
The U.S. dollar bears a lot of responsibility when it comes to global finance: It’s the currency kept on hand by central banks and other major financial institutions around the world to make transactions and investments, and to repay debts overseas. The U.S. dollar is also the currency in which the world prices and trades vital commodities like gold and oil. And buyers and sellers in every country have to keep large amounts of U.S. dollars on hand to pay for them.
Historians disagree on exactly when the dollar became the reserve currency of the world. Some say the change took place right after the First World War, others say it happened closer to 1929, at the outset of the Great Depression. But all are in agreement that as the Second World War drew toward a conclusion in 1944, the U.S. dollar had unseated the British pound as the world’s undisputed reserve currency.
Key Points
• The U.S. dollar became the world’s reserve currency due to the U.S. economy’s strength, the British pound’s decline, and the Bretton Woods agreement.
• World War II significantly weakened the British economy, leading to the dollar’s dominance and the establishment of fixed exchange rates.
• The Bretton Woods agreement in 1944 pegged the U.S. dollar to gold and required other countries to maintain fixed exchange rates with the dollar.
• Today, the U.S. dollar dominates global trade, with 59% of non-U.S. bank reserves held in dollars, and is seen as a safe investment.
• Factors sustaining the dollar’s status include the U.S. economy’s stability, low yields on Treasuries, and its widespread use in global transactions.
The Pound vs the Dollar
The U.S. dollar as we know it didn’t actually exist until 1913, under the Federal Reserve Act of 1913, which created the Federal Reserve System.
The new central bank was created to set monetary policy and stabilize the U.S. currency, which had been issued based on bank notes issued by a number of individual banks.
At that point, the British pound was the world’s reserve currency. Though the U.S. economy was the largest in the world when World War I started in 1914, Britain remained at the center of the world’s trade, and most international transactions took place in British pounds. Like most countries’ currencies at the time, the British pound was backed by gold.
World War I changed all of that. The fighting was so ferocious, so widespread, and so costly that many countries had to deviate from that gold standard just to pay their armies.
Great Britain took the Pound off the gold standard in 1919, and the pound plummeted — which was catastrophic for international merchants and banks that traded primarily in pounds. Some scholars maintain that that was when the dollar became the world’s reserve currency.
Other historians maintain that global trade, especially international debt offerings, were denominated equally in dollars and Pounds until 1929. They even point to data that shows the British Pound was regaining ground on the dollar as the currency of choice for international trade up until 1939. Then World War II began.
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World War II and Bretton Woods
Although Germany didn’t surrender to the Allied nations until 1945, the outcome of World War ll was clear by the middle of 1944. In July of 1944, more than 700 delegates from 44 countries met in Bretton Woods, New Hampshire, to negotiate and come to an agreement on the kind of economy that would emerge from the ashes.
The Bretton Woods conference lasted three weeks, and established the U.S. dollar as the currency par excellence for the world. Attendees agreed upon the Bretton Woods system, which established a number of key global economic points:
• The U.S. agreed that the dollar would be backed by gold, which was priced at $35 an ounce when the agreement took effect.
• The countries who signed the agreement promised that their central banks would establish fixed exchange rates between their own currencies and the U.S. dollar. If their currency weakened, their central bank would buy up the currency until its value stabilized relative to the dollar.
On the other hand, if the country’s currency grew too strong compared with the dollar, their central bank would issue more currency until the price fell and the relationship with the dollar returned to normal.
• Those countries also promised not to lower their currencies to goose trade. But it allowed them to take steps to increase or decrease the value of their currencies for other reasons, like stabilizing their economy, or to help with post-war rebuilding.
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The Dollar Since Bretton Woods
By 1971, the gold owned by the U.S. government had reached a limit at which it could no longer cover the number of dollars in circulation. That’s when President Richard M. Nixon took the step of reducing the U.S. dollar’s comparative value to gold. This led to the collapse of the Bretton Woods system in 1973.
After the system fell, the countries took a wide range of approaches to how they valued their currency, and what policies their central banks would pursue. But the end of the system led to the creation of the foreign exchange or forex market, now the biggest and most active financial market in the world, with a daily trading volume of $6.6 trillion.
While the U.S. dollar — now considered a fiat currency — goes up and down in relation to other currencies every day, it is still the world’s reserve currency, with 59% of all non-U.S. bank reserves denominated in dollars, according to the International Monetary Fund (IMF).
The dollar retains its prominence not because of an international agreement, but because of a broad consensus about the size, strength and stability of the U.S. economy relative to other options. Globally, investors still see U.S. Treasury securities as an extremely safe bet, as is evidenced by their low yields.
The Takeaway
Most of the world’s trade happens in U.S. dollars. But it hasn’t always been that way. And while it’s been preeminent for about a century, the dollar’s status has changed over time. For investors interested in understanding the world’s currencies, the dollar’s rise to prominence has implications for the U.S. economy, as well as many other world economies.
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FAQ
What was the world’s reserve currency before the dollar?
The British pound was the world’s reserve currency before the dollar, and World War I was the catalyst that led to the change from the pound to the dollar.
What is the gold standard?
The gold standard is the idea that one dollar is backed by gold, or one dollar’s worth of gold. The dollar is no longer on the gold standard, and is now considered a fiat currency.
Why does the dollar remain the world’s reserve currency?
The dollar remains the world’s reserve currency largely because of a broad consensus about the size, strength and stability of the U.S. economy relative to other options.
Photo credit: iStock/fizkes
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