When it comes to currency, the US Dollar dominates all the others. No currency comes even close to having a similar power. The dollar accounts for nearly 60% of world foreign currency reserves and trillions of dollars of daily FX transactions.
When this currency moves, the rest of the world takes notice.
The Dollar’s reign though is a (comparatively) recent phenomenon. Before it took precedence in the 1950’s many other currencies ruled in its place, most notably the Pound Sterling.
Below we’ll take a look at the steps that led to the Dollar becoming King.
Before the Second World War....
As long as Capitalism has been around, there has been a currency that has dominated the rest. It started with Spanish Gold, saw the French Franc peak under Napoleon and then the Pound Sterling for the period of time that Britannia ruled the waves.
For most of the 19th and early 20th centuries, international trade was dominated by the British Empire. With a quarter of the world coloured imperial red, Sterling was the currency of commerce.
This only lasted though as long as the UK was able to maintain its global dominance. The First World War took a huge economic toll on Britain and it started the slow process of Britain losing its economic primacy to the US. By the time the UK declared war on the Nazis, the situation was perilous, without the help of the US, the UK was looking at a potential defeat.
The Bretton-Woods System
During the Second World War, it became clear that economic power was moving from one-side of the Atlantic to the other. As each month the war dragged on, the UK was becoming more and more reliant on the USA.
By 1944, it was clear that the UK’s dominance and Sterling’s reign was over. With the war moving to its final phases (with the defeat of Nazi Germany being more and more inevitable) 44 allied countries met at at the Mount Washington Hotel in Bretton Woods, New Hampshire to plan for the post-war world economy.
The key outcome of the Bretton Woods summit was that several major countries agreed to peg their currencies to the US dollar in fixed exchange rates and to promote over time this as a new international currency system. This was incredibly logical given the huge growth being experienced in the US and the ongoing consolidation of dollar strength. The Bretton-Woods system was born.
During this time the US dollar was convertible to gold at $35/ounce. As exchange rates were not commonly traded outside of central banks, currency values remained stable in relation to each other. This meant that at any point in time $35 could be exchanged for one ounce of gold.
Coming out of WW2, the US economy went into turbocharged growth. Whilst Europe and Asia was left physically and mentally devastated by the war, the US (which faced limited domestic damage) was able to push ahead.
In the 50s and 60s, the Western world started a speedy recovery in part boosted by generous US aid and loans. When consumer spending in places like the UK and Germany started to increase, it was to the US that they looked, helping to drive a boom in the US export market. Simply put, Dollar peaked because the world wanted to buy American goods and paid in Dollars for the privilege.
Collapse of the Gold Standard
As the 60s progressed though, the old system started to feel the tremors of economic turbulence.
A change in US monetary policy in the 1960s to focus on full employment led to greater inflation in the US and inflationary pressure amongst the members of Bretton Woods system.
The need for differing fiscal and monetary policy led to the collapse of the system as the dollar could not maintain its convertibility into gold (there were too many dollars and not enough gold to maintain $35/ounce). A US Dollar crisis led into a world currency crisis.
These economic problems resulted in a market being established for currencies to float, with their prices determined by supply and demand.
Although initial trading was slow as financial institutions developed capability to trade foreign exchange, the release of exchange controls in various countries created the markets that we now know today.
Whilst many key international currencies were no longer formally pegged to the Dollar, the Dollar’s reign remained uninterrupted because the US continued to pull ahead of all its rivals and dominate the world economy.
Deregulation, Deregulation, Deregulation...
By the time of the 80’s, economically the US economy dominated the globe. The Soviet Union was no longer able to compete, China was not yet the goliath it is today and Europe was in its infant stages of economic integration.
Following the lead of Ronald Reagan, financial regulations and rulebooks were torn up and markets became ever more free. Financial Centres like the City of London, Wall Street and Hong Kong boomed as capital flowed ever liberally around the globe. Underpinning this new way of doing business was the Dollar. The safe haven currency that was seen by many as invincible. With the US embodying the new economic order, the US Dollar was able to retain and even consolidate its position.
Enter China, enter the Euro, enter the 21st Century...
In recent years, following a raft of economic crisis around the world, the Dollar’s position as king has started to be questioned. The US is no longer the world’s dominant exporter and the US as a whole is no longer seen as the strong, stable colossus it once was.
China has already overtaken the US in GDP as measured by PPP and is set to overtake in real terms in the coming years.
Whilst the Dollar currently remains the world’s dominant currency, there’s no doubt that the Renminbi is snapping at its heels.
You can read much more about the current state of reserve currencies and currency power in a previous post here.