How's the Dollar the World's Reserve Currency?
The first U.S. dollar, as it is known today, was printed in 1914 upon the creation of the Federal Reserve Bank. Less than six decades later, the dollar officially became the world’s reserve currency. However, its ascendancy to the throne began not long after the ink was dry on that first printing.
Understanding the U.S. Dollar's Birth
The Federal Reserve Bank was created by the Federal Reserve Act of 1913 in response to the unreliability and instability of a currency system based on banknotes issued by individual banks. At that time, the U.S. economy had overtaken Britain’s as the world’s largest, but Britain was still the center of world commerce, with much of it transacted in British pounds. Also, at that time, most of the developed countries pegged their currencies to gold to create stability in currency exchanges.
- The first U.S. dollar, as it is known today, was printed in 1914 upon the creation of the Federal Reserve Bank.
- During World War II, the U.S. supplied the Allies and got paid in gold propelling the U.S. to the largest holder of gold.
- After the war, countries linked their currencies to the dollar, which was linked to gold. The gold standard ended, but the dollar's reserve status remained.
- Today, more than 61% of all foreign bank reserves are denominated in U.S. dollars, and nearly 40% of the world's debt is in dollars.
The Rise of the U.S. Dollar
However, when World War I broke out in 1914, many countries abandoned the gold standard to be able to pay their military expenses with paper money, which devalued their currencies. Three years into the war, Britain, which had steadfastly held to the gold standard to maintain its position as the world’s leading currency, found itself having to borrow money for the first time.
The United States became the lender of choice for many countries that were willing to buy dollar-denominated U.S. bonds. In 1919, Britain was finally forced to abandon the gold standard, which decimated the bank accounts of international merchants who traded in pounds. By then, the dollar had replaced the pound as the world’s leading reserve.
World War II and the U.S. Dollar
As it did in World War I, the United States entered World War II well after the fighting had started. Before it entered the war, the United States served as the Allies’ main proprietor of weapons, supplies, and other goods. Collecting much of its payment in gold, by the end of the war, the United States owned the vast majority of the world’s gold. This precluded a return to the gold standard by all of the countries that had depleted their gold reserves.
The Dollar and Bretton Woods
In 1944, delegates from 44 Allied countries met in Bretton Wood, New Hampshire, to come up with a system to manage foreign exchange that would not put any country at a disadvantage. It was decided that the world’s currencies couldn’t be linked to gold, but they could be linked to the U.S. dollar, which was linked to gold. The arrangement, which came to be known as the Bretton Woods Agreement, established that the central banks would maintain fixed exchange rates between their currencies and the dollar. In turn, the United States would redeem U.S. dollars for gold on demand. Countries had some degree over the currencies in situations where their currency values became too weak or too strong relative to the dollar. They could buy or sell their currency to regulate the money supply.
Standing on Its Own as the World’s Reserve Currency
As a result of the Bretton Woods Agreement, the U.S dollar was officially crowned the world’s reserve currency, backed by the world’s largest gold reserves. Instead of gold reserves, other countries accumulated reserves of U.S. dollars. Needing a place to store their dollars, countries began buying U.S. Treasury securities, which they considered to be a safe store of money.
The demand for Treasury securities coupled with the deficit spending needed to finance the Vietnam War and the Great Society domestic programs caused the United States to flood the market with paper money. With growing concerns over the stability of the dollar, the countries began to convert dollar reserves into gold. The demand for gold was such that President Richard Nixon was forced to intervene and delink the dollar from gold, which led to the floating exchange rates that exist today. Although there have been periods of stagflation–high inflation and high unemployment–the U.S. dollar has remained the world’s reserve currency.
Today, more than 61% of all foreign bank reserves are denominated in U.S. dollars, according to the International Monetary Fund (IMF). Many of the reserves are in cash or U.S bonds such as U.S. Treasuries. Also, approximately 40% of the world's debt is denominated in dollars.
The reserve status is based largely on the size and strength of the U.S. economy and the dominance of the U.S. financial markets. Despite large deficit spending, trillions of dollars in foreign debt, and the unbridled printing of U.S. dollars, U.S. Treasury securities remain the safest store of money. The trust and confidence that the world has in the ability of the United States to pay its debts has kept the dollar as the most redeemable currency for facilitating world commerce.