By Philip Saunders - Co-Head of Multi-Asset Growth Russell Silberston - Co-Head Developed Market FX & Rates, Fixed Income Mike Hugman - Fixed Income Portfolio Manager Sahil Mahtani - Investment Institute Strategist*
History tells us that that several reserve currencies can coexist.
The US dollar came into its own after the second world war, bolstered by the Marshall Plan, the Bretton Woods system and trade liberalisation.
The demise of the Bretton Woods’ fixed parities system threw the world into a period of monetary disorder.
Despite the financial and economic problems facing the US, there was ultimately no fundamental migration away from the dollar.
The dollar remained dominant thanks to disinflationary policies in the US, a lack of currency rivals and a self-reinforcing currency network in which the dollar remained central.
Twentieth century history provides us with a valuable roadmap to understand the rise of the dollar to a position of unipolar global dominance. While unipolar dominance may seem like the norm, history tells us that that several reserve currencies can coexist. For much of the 1930s the dollar and sterling ran neck and neck as the most important global currency.1 In the pre-world war one era, currency shares were split between sterling, the French franc and the German mark, especially in matters of trade, though less so in matters of capital.2 To track the rise of dollar dominance, it is valuable to look at the period following the second world war when the US was the pre-eminent economic power, with an output equalling that of the rest of the world combined. In military terms, the US accounted for three-quarters of great-power defence spending, possessed the atom bomb, an air force that dominated the skies and a navy that ruled the seas.3
Exorbitant privilege across time Measuring exorbitant privilege
The United States economy surpassed the UK in economic size in 1872 and the British empire sometime between 1901 and 1913, but the dollar’s use relative to the size of its economy surpassed sterling only in the mid-1920s.
Note that this metric here counts the pound sterling’s ratio as including the area of the British empire. Australia, New Zealand and South Africa are included in 1900 data. India is included until 1929 data. The key factor is when each territory becomes self-governing, i.e. is granted dominion status.
The rise of the dollar relative to the size of the US economy occurred in the 1930s and especially after World War One when the US economy and financial system just became too large to ignore. Eichengreen puts the date of the dollar surpassing reserves in the mid-1920s. However, the dollar lost its crown after a sharp devaluation in 1933, when sterling regained its place as the leading reserve currency.
By our metric, sterling became the most important currency in the 20th century relative to its diminished size after the second world war, when the UK lost India as an imperial possession. Nevertheless, most Indian reserves were still in sterling as late as 1950.
The Swiss franc also became important in the 1970s and 1980s as a result of the monetary turbulence in the US, the UK and elsewhere. Germany and Switzerland eliminated capital controls in the mid-1970s but maintained twin surpluses, and as a result, became leading alternatives. Sterling still had capital controls and could not be used for international financial transactions.
The rise of the Japanese yen, which prompted such concern in the 1980s, turned out to be less relevant in currency matters. Yen use in reserves peaked in the early 1990s and diminished until only very recently.
By this measure, the US dollar is more important than it has been at any time since the second world war. The liberalisation of global finance has been kind to the dollar. Meanwhile, the UK staged a remarkable recovery throughout the 2000s and 2010s, and became as important as the euro relative to the size of the economy during this time. The euro stagnated after the euro crisis in the 2010s.
This is the renminbi, which is less important relative to the size of China’s economy. Nevertheless, the only direction is up. How far will it go?
Source: Eichengreen, B., Mehl, A., Chitu, L., How global currencies work: Past, present, and future, Princeton: Princeton University Press, 2018, and data for 1899 and 1913 from Lindert, P., “Key currencies and gold, 1900-1913,” Princeton Studies in International Finance 24, International Finance Section, Department of Economics, Princeton: Princeton University, 1969. Currency share of reserves for the period 1960-2018 are directly provided for from IMF Annual Reports for years 1970, 1983, 1990, 1997 and 2018. The currency shares reported here exclude unallocated foreign exchange reserves post-1994. Share of world output data in PPP terms from Maddison Historical Statistics up to 2008, then IMF World Economic Outlook. PPP data prior to 2008 calculated in Geary-Khamis international dollars. UK territory in 1899 includes Australia, India and New Zealand. UK in 1913 and 1929 includes India while the euro area counts Austria, Belgium, Finland, France, Germany, Italy, Netherlands, Ireland, Greece, Portugal and Spain
The US dollar cements its position
During this period, US policy underpinned the creation of a liberal trade and monetary order in the non-communist world. After the second world war, European economies faced ‘dollar shortages’ because of war-related damage.4 US money grants and technology – principally the Marshall Plan – helped rebuild societies in Western Europe and East Asia, reviving them as thriving commercial hubs. The Bretton Woods institutions promoted reconstruction, development and economic stability within a pro-market framework, while trade liberalisation was pursued through the General Agreement on Tariffs and Trade (GATT). The dollar was at the centre of this system – there were no alternative currencies. Eventually, the system became too costly for the US to bear. The economic recovery of its allies in Europe and Asia, as well as the rise of the Soviet Union meant that US standing was in relative decline. Meanwhile, rising US deficits meant that there was now a dollar glut globally, pushing up inflation as well as the currency of surplus countries. By the 1960s, the cost of the Bretton Woods system of fixed rates began to bite. Economist Robert Triffin’s famous dilemma neatly encapsulates the challenges. On the one hand, a strong dollar might lead to insufficient liquidity and deflationary drag on the world. On the other hand, a weak dollar may result in an oversupply of liquidity, in which case the gold and liquid assets held by the United States would be insufficient to cover dollar claims.
Chronic instability leads to a run on gold
By the 1960s, the deteriorating US balance of payments, combined with military spending and foreign aid, provided the world with liquidity but also caused dollar reserves to build up in the central banks of Europe and Japan, thus increasing the risk of a gold run.5 The system was plagued by chronic instability from October 1960 onwards. There was a run on the London gold market, which sparked emergency interventions and the use of capital controls within the US. In 1971, Nixon suspended dollar-gold convertibility to thwart the looming gold run.
Yet, as economist Barry Eichengreen has pointed out, the 1970s breakdown was not as problematic as that which occurred in the 1930s. In the latter, a collapse in confidence led to a chaotic liquidation of foreign exchange reserves. Credit became scarce and interest rates experienced upward pressure, making it hard to finance trade and investment. The adjustment was rapid. By contrast, the 1971 collapse of the Bretton Woods system failed to slow growth or undermine financial stability. It led to the US recession of 1973-1975 but not anything resembling the 1930s. Part of the difference is that there was no catastrophic loss of confidence in the dollar, and the currency continued to be used by firms, banks, and governments to finance transactions.
Two types of monetary collapse—1930s or 1971 Destructive or disruptive
Source: Eichengreen, B., “When Currencies Collapse: Will we replay the 1930s or the 1970s?” Foreign Affairs, February 2012.
Monetary disorder benefits oil producers
Nevertheless, the demise of the Bretton Woods’ fixed parities system threw the world into a period of monetary disorder. The dollar, for instance, lost 43% of its value against the deutschmark from late 1972 to late 1978. When the twin oil crises of 1973 and 1978 hit, they caused an upheaval in the geopolitical order as well as a transfer of resource from consumers to producers, giving oil producers unprecedented influence.
Inflation was running in double digits; growth plummeted and unemployment skyrocketed. Some NATO allies (like the UK) were close to financial catastrophe, and France, Spain and Italy were contemplating political communism. Henry Kissinger said, “I’m convinced that the biggest problem we face now is possible economic collapse, a fall of the western order.”6 By 1979, foreign currencies became so expensive that US troops stationed in Europe had trouble making ends meet. Sympathetic West Germans were giving US soldiers care packages of food and cigarettes.7
The demise of the Bretton Woods’ fixed parities system threw the world into a period of monetary disorder.
Why did the dollar remain pre-eminent after the monetary collapse?
In retrospect, there was no fundamental migration away from the dollar. There are three main reasons for this. First, after Paul Volcker took over at the US Federal Reserve in 1979, articulating his disinflationary policies, the currency strengthened, and the share of dollars in global reserves stabilised.8 Second, the dollar did not have serious rivals. Despite the deutschmark’s attractiveness, Germany’s budget was balanced and its financial system was bank-based. Meanwhile, German authorities discouraged the use of the deutschmark as a reserve currency. For example, in 1979 the Bundesbank warned Iran not to convert dollars into deutschmarks, fearing the inflationary effects of capital inflows.
Finally, the dollar remained pre-eminent because the US recreated a currency network with dollar centrality through the recycled petrodollars that found their way back into the US economy, in part through the negotiated oil trade settlement between the US and Saudi Arabia in the early 1970s. Between 1973 and 1981, nearly US$500 billion of dollars from oil exporters found their way back into the US financial system, much of which was invested into US government securities. Billions more flowed back into the US through real estate investments, arms purchases, and infrastructure developments.9 Petrodollars financed US current account deficits, stimulated the circulation of capital and cemented the centrality of the dollar in the new currency network.10
1Eichengreen, Mehl, and Chitu, “How Global Currencies Work: Past, Present and Future,” Princeton University Press, 2018. 2Lindert, P., “Key currencies and gold, 1900-1913,” Princeton Studies in International Finance 24, International Finance Section, Department of Economics, Princeton University, 1969, as cited in Eichengreen, Mehl, and Chitu, “How Global Currencies Work: Past, Present and Future,” Princeton University Press, 2018. 3 Brands, H., “Making the Unipolar Moment: US Foreign Policy and the Rise of the Post-Cold War Order,” Cornell University Press, 2016. 4Reinhart, C., “The Return of Dollar Shortages,” Project Syndicate, 24 October 2016. 5 Ghizoni, S.K., “Nixon ends convertibility of US dollars to gold and announces wage/price controls,” Federal Reserve History, Federal Reserve Bank of Richmond. 6 Brands, H., “Making the Unipolar Moment: US Foreign Policy and the Rise of the Post-Cold War Order,” Cornell University Press, 2016. 7Eichengreen, B., Exorbitant Privilege: The Rise and Fall of the Dollar, Oxford University Press, 2011, p. 65 8 Eichengreen, Exorbitant Privilege: The Rise and Fall of the Dollar, p. 67. 9 Priest, T., “The dilemmas of oil empire,” Journal of American History, Volume 99, Issue 1, 1 June 2012, p. 236-251, and Wong, A., “The untold story behind Saudi Arabia’s 41-year US debt secret,” Bloomberg, 31 May 2016. 10Priest, T., “The dilemmas of oil empire,” Journal of American History, Volume 99, Issue 1, 1 June 2012, p. 236-251, and Wong, A., “The untold story behind Saudi Arabia’s 41-year US debt secret,” Bloomberg, 31 May 2016.
*Other contributing authors Greg Kuhnert | Peter Eerdmans | Michael Spinks | John Stopford | Iain Cunningham | Wilfred Wee | Tom Nelson | Michael Power | Imran Ahmed
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