CHAPTER 34

The Dollar Versus Everything Else

In July 1944, as World War II raged on, 730 delegates representing all

44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire. Following 22 days of deliberation, they agreed to a system of rules that would govern their currency exchange rates. The Bretton Woods Agreement essentially fixed the exchange rate for each of the 44 countries, limiting deviations to 1 percent and tying those exchange rates to the U.S. dollar in recognition of the United States as the world’s leading economic power. As the “reserve currency,” the dollar would be fixed to gold. The United States would be on the gold standard; all other Allied nations, on a dollar standard.

The Allies next set up the International Monetary Fund (IMF) to oversee the agreement. The IMF was not a central bank, though it could be a lender of last resort to a country experiencing transitory problems maintaining its exchange rates. But only on the condition that the borrower fix its imbalance. Because international trade imbalances are often caused by domestic trade imbalances, the IMF mandate included—it still includes—usually demanding austerity measures by governments taking its loans. Some of those borrowers have grumbled over imposed austerity, but not excessively as austerity has worked to cure imbalances.

Also emerging from the Bretton Woods negotiations, the Bank for International Settlements (BIS) was assigned the task of providing the accounting mechanisms that would allow the IMF participants to settle up with one another. Payments needed to more-or-less balance in a fixed exchange rate regime, and somebody had to do the accounting and the settlement of the international accounts. John Maynard Keynes, who headed up the British delegation at Bretton Woods, arranged first to save the BIS, established in 1930, from dissolution, then to take on its new assignment.

From Fixed to Free Market

Keynes championed the idea of fixed exchange rates, arguing that they provide businesses greater certainty in international transactions. If contracts were set under a specified rate, then the rate was later changed, it would devalue the proceeds from the contract for one party and increase the value for the other party.

But despite the stability mechanisms, periodic currency devaluations did occur in countries with varying degrees of economic trauma. In the 1960s, as Europe and Japan became more competitive with the United States in terms of output, a deteriorating U.S. balance of payments threatened an international run on U.S. gold, and in 1971, President Richard Nixon took the dollar off the gold standard, effectively replacing the Bretton Woods system with floating exchange rates determined by the free market.

Many smaller countries retain fixed exchange rates with their primary trading partners—if most of your trading is with one partner, a fixed rate makes sense—but by and large, major currencies are actively traded in global markets.

The dollar is still the default reserve currency, the dominant currency for international trade, though it’s position has been challenged from time to time. When the euro was introduced at the turn of the century, it was projected to become at least an alternative reserve currency, which it has to some extent. Eurozone countries that trade most within the euro area have used the euro as a reserve currency along with the dollar. But a common currency requires the involved countries to coordinate fiscal policies, and that hasn’t happened as euro advocates thought it would. Much like U.S. states, eurozone countries can’t issue debt to finance operating deficits, and some have struggled to reduce deficits as required to get the euro to work as a default currency. Large economies like Greece and Italy might have addressed their imbalances by devaluing their currencies, but they couldn’t do that with the euro. On the other hand, Great Britain’s decision to hold on to its own currency and not adopt the euro made Brexit, its withdrawal from the European Union, less cumbersome. The euro will continue as a dominant world currency, but for most central banks and treasuries the dollar remains the reserve currency.

The Chinese yuan poses some threat to dollar dominance. It has become the reserve currency throughout Asia as China’s economy dominates that region of the world. But while it is seeing increased global use, it is still far from achieving status as a dominant global currency.

Cryptocurrencies

Cryptocurrencies’ uniqueness is in their lack of association with any sovereign government. They depend on the confidence in their technical underpinnings. Their advantage is in how easily and quickly they can be used to move wealth anywhere globally. But they are not always welcomed by sovereign governments. Most governments want to be able to track transactions as they can usually do with transactions conducted in their own currencies. Because cryptocurrencies facilitate transactions outside the regulatory purview of sovereign states, they face regulatory restrictions in many countries where their ease of transaction is cause for suspicion.

Cryptocurrencies have yet to gain traction in large international business deals. Because they have no affiliation with any sovereign currency, they have no standing in any sovereign court and are treated as foreign currencies or commodities. The world’s courts and arbitration systems are set up to resolve disputes in domestic currencies, not in cryptocurrencies. Given the global legal environment, cryptocurrencies are not likely to improve their share of use in large international transactions any time soon.

Takeaways

Equilibrium

After World War II an international currency system that fixed exchange rates to the U.S. dollar made sense, especially if the dollar were then tied to gold. Providing some stability in exchange rates would promote international business and hence increase prosperity. But a few decades later, persistent imbalances led to the adoption of market-determined exchange rates as a way to maintain equilibrium in global markets. The dollar has remained the default global reserve currency even as contenders have begun to emerge regionally.