The notion of a global reserve currency has come to mean very different things since the Bretton Woods system started in the 1940s — and particularly after it ended in the 1970s. Under the classical gold standard, which was in place from 1815 to 1914, gold served as the principal asset underpinning the reserve currency: the British pound sterling. As the world's chief superpower and creditor nation, Britain was the system's custodian, backing the pound with gold at a rate of 4.25 pounds per ounce. Other countries' banks held both gold and pounds in reserve as well. Because customers could exchange currency for gold at any time, bank runs were still a threat, keeping in check any undue credit and bank note expansion or abuse of financial power. For Britain, controlling the world's reserve currency was more a matter of responsibility than of privilege.
But throughout the early 20th century, three developments fundamentally changed the system altogether. First, European powers and the budding United States began to threaten Britain's hegemony, setting in motion a decadeslong redistribution of power that would be settled only after the conclusion of World War II. Second, Washington and Wall Street established the Federal Reserve in 1913. Two decades later, President Franklin Roosevelt passed the Emergency Banking Act of 1933, confiscating gold and weakening its ties to the United States' monetary and payments system. Then, the New Gold-Exchange Standard, one of the key byproducts of the Bretton Woods agreement, eliminated citizens' ability to redeem national currencies in gold, reserving that privilege for governments and their central banks.
And so, gold was systematically and deliberately shifted from private hands to the control of states. It could no longer act as a market-based check on the expansionary policies of governments and banks. The system of fully nationalized fiat currencies that emerged in its place in the early 1970s gave states — especially the United States — the ability to expand their power to its fullest, using a near-unlimited number of financing tools unconstrained by the gold standard. Controlling the global reserve currency then became more a matter of privilege than of responsibility.
The Battle for Currency Supremacy
Now, the United States' infallibility and the pillars that once supported the dollar's pre-eminence have been shaken. The harder Washington fights to hold onto its exorbitant monetary privilege, the more it leverages its position by expanding its debt-based growth model and its preference for fiscal and monetary palliatives over painful but necessary structural reforms. Meanwhile, lesser global powers are becoming less willing to allow Washington its privilege if it cannot or will not pay for it through hegemonic dominance, stable state finances and monetary dependability.
Still, challenges to the dollar's supremacy have not been particularly successful. Europe tried to wrestle the United States' exorbitant privilege away, but the apparent failure of the European project has called into question the euro's ability to unseat the dollar. The United States' other major challenger, China, is a productive nation with far-reaching trade ties and the capability to draw others into its currency zone by extending offshore loans. But China is going to get old before it gets rich, and its politics continue to focus inward while its finances remain fragile. To cultivate international trust in the yuan, Beijing would have to open its trade and capital accounts, allocate resources more efficiently and rid itself of debt — reforms that may create more political instability than the government would prefer.
Two Brutal Fronts
The shift in currency reserve status from custodial responsibility to exorbitant privilege has imbued the global monetary system with a self-destructive impetus that potentially inheres toward instability. This instability is caused by the world's major powers pursuing two incompatible goals: currency debasement (lowering the value of money) and fostering currency confidence. As the biggest reserve currency power, the United States means to instill confidence in the dollar so that it can maintain its privilege. But to reap the benefits of its privilege, the United States tends to adopt inflationary policies that erode confidence over time.
Other major powers, feeling the need to show that they can play minor reserve currency roles or potentially usurp the dollar, have tried to wrest back some privilege of their own through monetary inflation. After all, the essence of monetary privilege is the ability to print money without having it sold into oblivion by the rest of the world. The United States' privilege was on full display from 2008 to 2014 as it printed trillions of dollars without devaluing its currency. (Zimbabwe and Venezuela, by comparison, have tried to tap their privilege with far less success.)
The tension between the United States and other powers has set the scene for currency trench warfare on two brutal fronts. On the first, states are mounting inflationary insurrections to gather as many resources as they can before foreigners discount their currencies. Money printing, bank credit expansion and deficit spending are the weapons used in these raids, which are simply manifestations of the tragedy of the monetary commons that has arisen from the fluctuating fiat currency system.
On the second front, states vie for reserve currency stature, a battle that can be fought in one of two ways. A state can tighten its monetary policies, reduce national debt and raise productivity, an option that requires painful internal adjustment and surrender on the first front. The alternative is to create economic, financial and military dependency on itself — or leverage dependency where it already exists — to encourage other countries to adopt its currency. Trade policies, the military-industrial complex and global financing institutions are the weapons of choice on this front.
States that can fortify an advantageous position in the reserve currency battle can gain cover for inflationary raids, but that does not mean they are clear of danger; if they expend too many resources on raids, their reserve currency positions will be put in jeopardy. But striking the right balance is easier said than done, and all too often clashes break out, breeding tremendous financial and economic volatility that leaves many casualties in its wake.
Far From Assured
Part 1 of this series examined how the dollar came to be the world's reserve and trade currency. For any currency to reach that point, the state that holds it (in the dollar's case, of course, it was the United States) must be geopolitically and productively superior to other major powers. It must also be a creditor nation that can build trust and necessity into the use of its currency. Today's other important currencies, and the states that control them, fall well short of these responsibilities. Though the incumbent dollar is impaired and the United States' reliability has diminished, its prospective challengers are too embroiled in their own troubles to become viable alternatives.
Still, the geopolitical order abhors the exorbitant privilege afforded by the reserve currency and that superpowers tend to wield their full influence to maintain that privilege — even at the risk of exacerbating international imbalances. The system then becomes bogged down by inflationary insurrections and conflict as other states try to secure resources and project power to encourage greater foreign reliance on them. Eventually, the monetary order must undergo radical shifts to adjust to the tension. These shifts cause financial instability worldwide, undermining the integrity of national currencies and even the state-centric currency model itself.
The real war being waged, then, is between the political forces of centralized money and the market forces of decentralized finance. This war has been waged for centuries, if not millennia, and it has always pitted the sovereign's imperative for money nationalization against the market's imperative for monetary innovation. Currency centralization serves the state's purposes, enabling it to extract profits through seigniorage (the face value of money minus the cost of physically creating it), finance wars, regulate the banking system, control transactions and levy taxes. Decentralization does the opposite, protecting citizens from state resource predation through inflation, diminishing the state's control of transactions and curtailing the state's overall financial power. In this way, the relationship between the state and its people is profoundly affected by the orientation of the global monetary system.
Since the first half of the 20th century, the forces of centralization have emerged victorious, placing the control of currencies firmly into states' hands. But now this model is failing, and it will continue to fail as long as states keep accumulating debt and printing money. The rise of regional and non-state actors, coupled with digital technology's subversive assault on national currencies, will only put greater pressure on a system already buckling under the weight of reckless fiscal and monetary activism.
In a hyper-digital online world, gold — a stateless resource that has dramatically and profoundly returned to private hands — can be traded instantly and cheaply, reviving its practical use as a monetary medium. Meanwhile, blockchains and cryptocurrencies such as bitcoin have opened up a brave new world of transactional possibilities, and the latter is attracting waves of funding from investors who see its potential to revolutionize the monetary system.
States that wage currency wars are all the more susceptible to these new market forces seeking a share of monetary influence. Their disruptive presence could profoundly affect the world's monetary policies, banking systems, political stability, business cycles and so much more. If the market-based currency revolution is here to stay, what will the world it brings about look like? Though it is a difficult question to answer, one conclusion is clear: The future of the U.S. dollar, long the world's dominant currency, is far from assured.