Post #11 How did the Dollar become a world reserve currency

Central banks around the world hold assets in foreign currencies and these assets are called foreign exchange reserves. These reserves are important for various reasons - to maintain relative strength of domestic currency, to meet a country's international financial obligations, to maintain liquidity in case of economic crisis etc.

If we look at the distribution of all foreign exchange reserve by currency, the US dollar is a winner by a big margin and that is why people call it the world's reserve currency.

Chapter I: The Bretton Woods Agreement

This story of the dollar unfolded over several decades. It all started at the tail end of World War II when 730 delegates from 44 Allied nations met at Mount Washington Hotel in Bretton Woods, New Hampshire in 1944.

At this time the US held two thirds of the world's gold. At this meeting, US pledged to fix the value of dollar to gold at $35 an ounce. This meant foreign countries could hold dollars and convert them to a fixed amount of gold at any moment. This pegging seemed reasonable and most countries adopted this system. They fixed their exchange rate to dollar and the system remained stable for three decades.

Most countries holding dollars meant dollar's demand kept rising and this gave the US an opportunity to feed this demand by issuing debt. The US could use the funds collected from debt issue to run massive infrastructure programmes, expansion of jobs, technology innovation. This era came to be known as the Consumer era (1940-1970), and it transformed America at every level.

Chapter II: The Wages of War

In the late 60s, US debt escalated due to Vietnam war which required billions of dollars to be spent every month. Since the debt had risen much more rapidly than the gold reserves, nations holding this debt began to doubt if US could still honour the gold for dollar promise. Hence, they cut back on the dollar and started cashing out gold. Gold began to disappear and, due to this, in 1971, Nixon announced a suspension of dollar's convertibility into gold. Thus, the dollar which was fixed to gold and the other currencies which were fixed to dollar all began "floating" against each other. And thus, the dollar became a fiat currency.

Chapter III: A Masterstroke in Gulf

You see, a fiat currency is not pinned to any underlying asset. This reduces faith in the currency and coupled with massive fiscal deficit, it usually leads to inflation and if proper measures are not taken, inflation becomes hyper inflation and hyperinflation has destroyed many economies in history. So, the question was how would the US ensure that other countries still keep their faith in the dollar. How do they ensure they get all advantages of the fiat dollar and no disadvantage that comes associated with it. It required a masterstroke and Kissinger delivered it when he struck a deal with the Saudi prince Faisal.

Faisal possessed large share of the word's oil and he desperately needed military protection from powers who threatened to take oil by force. US desperately needed stability of the dollar. Thus, US offered military protection to Saudi Arabia and in return asked Saudi Arabia to sell oil in one and only one currency - the dollar. The deal was set and eventually all OPEC nations agreed to sell oil exclusively in dollars. So now if any country wanted to purchase oil, they had to first buy dollars and this created huge demand for the dollar amounting to trillions of dollars per year. These dollars even have a cool name - they are called the petrodollars.

The petrodollar system ensured that US would be the dominant economy for decades to come and dollar become stronger year after year.

Epilogue

In 2022, things are starting to look different. US debt has risen to monumental levels, the Saudis have, for the first time, agreed to sell oil to China in Renminbi. Countries have once again started hoarding gold.

Do you think the dollar will continue to dominate, will it require another masterstroke, or will the world see another reserve currency?

We will have to wait and see! As always, thanks for reading ❤️