The U.S. dollar holds a unique position in the world of finance and trade, serving as a cornerstone of the global economy
Its status as the primary international reserve currency, medium of exchange, and unit of account for a vast range of transactions has far-reaching implications for governments, businesses, and individuals alike.
In this lesson, we’ll learn the key aspects of the dollar’s global role and explore the factors that contribute to its enduring appeal.
Historical Foundation: The Bretton Woods System
The origins of the U.S. dollar’s global dominance can be traced back to the 1944 Bretton Woods Conference, which aimed to establish a new monetary system to promote international trade and economic stability after World War II.
As the United States controlled two-thirds of the world’s gold reserves at the time, the U.S. dollar became the anchor currency for the Bretton Woods system.
Uncle Sam was basically the greedy leprechaun hoarding all the world’s gold in his pot.
Consequently, countries pegged their currencies to the dollar, which was itself convertible to gold, making it the primary medium of exchange for international payments.
Why the Dollar Remains Popular in the Post-Bretton Woods Era
Although the Bretton Woods system collapsed in the 1970s, the U.S. dollar retained its status as the world’s premier currency.
This enduring appeal can be attributed to several factors:
- Economic stability: The Federal Reserve’s efforts to control inflation have contributed to the dollar’s stability, making it an attractive store of value and medium of exchange.
- Network effects: The widespread use of the dollar in international transactions has created a self-reinforcing cycle, with more individuals and businesses choosing to use the currency because of its widespread acceptance.
- Size and openness of U.S. financial markets: No other market comes even close! The depth and liquidity of U.S. financial markets enable large transactions that smaller markets might struggle to accommodate, further enhancing the dollar’s attractiveness.
At the end of the day, people want to keep dollar assets because the economic, political, and institutional fundamentals of the United States provide confidence and credibility.
The U.S. Dollar as a Reserve Currency
One of the most critical aspects of the U.S. dollar’s global role is its function as a reserve currency.
A reserve currency is a currency held by central banks in significant quantities. It is widely used to conduct international trade and financial transactions, eliminating the costs of settling transactions involving different currencies.
Central banks around the world hold a significant portion of their foreign exchange reserves in dollars, which they use to stabilize their own currencies, finance international trade, and provide a cushion against economic shocks.
Today, central banks hold about 60% of their foreign exchange reserves in dollars.
Even though the dollar’s share of central banks’ foreign exchange reserves has gone down over the years, it is still almost twice as much as the euro, yen, pound, and yuan COMBINED, which is the same as it was a decade ago.
The euro, which is its closest rival for the role of world currency, makes up about 20% of central bank reserves.
The dollar’s stability and widespread acceptance make it an ideal choice for this purpose.
Commodities Pricing and the U.S. Dollar
The U.S. dollar also plays a crucial role in global commodities markets, as many commodities, such as oil and gold, are priced in dollars.
This pricing mechanism simplifies international trade by providing a common benchmark and reducing the need for multiple currency conversions.
It also underscores the close relationship between the dollar’s value and commodity prices, with fluctuations in the currency’s strength often impacting the cost of raw materials and finished goods.
The U.S. Dollar’s Impact on Global Trade and Finance
The dollar’s global role has significant implications for international trade and finance.
Most currencies are only used within their own country or in cross-border transactions that directly involve the currency’s issuer. However, the dollar is widely used for funding, pricing, trade invoicing and settlement, and cross-border borrowing and loans even when the U.S. is NOT involved!
Its use as a medium of exchange for cross-border transactions reduces currency risk and facilitates the flow of goods and services between countries.
Additionally, the dollar’s prominence in global finance makes it a key funding currency for governments, businesses, and individuals seeking to access international capital markets.
About half of the international trade is invoiced in dollars, and about half of all international loans and global debt securities are denominated in dollars.
As a “safe haven” currency, the dollar is the preferred currency for investors during major economic crises. For example, during the global financial crisis (GFC) of 2008-2009 and the economic chaos caused by the COVID-19 pandemic in 2020, investors rushed to buy U.S. dollars (“dash for cash”) because they thought the dollar would keep its value.
How the U.S. Benefits From the Dollar’s Global Role
As you’ve learned so far, rumors of the dollar’s death are way overblown!
The dollar’s global role benefits the United States in several ways.
First, it lowers borrowing costs, enabling the U.S. government to finance budget deficits more affordably.
Second, it increases the purchasing power of Americans by strengthening the dollar’s value, allowing them to buy more goods and services from other countries.
However, this advantage comes with a downside, as a stronger dollar makes American exports more expensive, potentially leading to job losses in export-related industries.
Lastly, the widespread use of the dollar in international trade grants the United States diplomatic leverage, enabling it to impose financial sanctions on adversaries.
The Future of the U.S. Dollar’s Dominance
The U.S. dollar has persisted as the world’s main reserve currency for the past 70 years, even though there have been a lot of big changes, such as the end of fixed exchange rates, trade and financial globalization, technological progress, and changes in geopolitics.
While the U.S. dollar’s global role is currently secure, the U.S. dollar’s dominance may not be permanent.
Factors such as uncontrolled inflation, a decline in the U.S. share of the global economy and trade, excessive debt, or overuse of financial sanctions could undermine the dollar’s desirability.
As the global economic landscape evolves, the dollar’s dominance may be tested, with potential implications for trade, finance, and geopolitics.
De-dollarization or “dedollarization” is the process of reducing the reliance on the U.S. dollar (USD) as a reserve currency, a medium of exchange, and a unit of account in the global economy.
Particular attention is paid to China’s rise in the global economy and digital currencies such as bitcoin.
If another currency or group of currencies were to replace the U.S. dollar as the world’s dominant medium of exchange, the United States would lose the benefits it currently enjoys, while the countries with the new leading currencies would stand to gain.
That said, when the pound lost its power, another currency was waiting in the wings to take its place. There is no one like that today.