The Dollar as a Reserve Currency

Much hand-wringing is taking place over the reduction or possible loss of the dollar’s reserve currency status. That’s a bit ironic since the whole concept of a reserve currency is no longer valid in a system of floating exchange rates.

Under the dollar-exchange system established at Bretton Woods, New Hampshire after World War II, countries committed to keep their own currencies in a narrow band around a par value expressed in U.S. dollars. No reserves were needed to offset upward pressure on the domestic currency since the monetary authority could sell their own currencies for dollars in theoretically unlimited amounts. But to offset downward pressure on the domestic currency, a reserve currency was needed to purchase and support the domestic currency. A country’s ability to defend its currency from downward pressure was thus limited by the amount of the currency held in reserve. Since the parity was expressed in dollars, it was convenient to use dollars as the reserve currency.

The U.S. commitment was to peg the dollar to gold at a rate of $35 per troy ounce by standing ready to buy or sell gold at that rate with foreign central banks or Treasuries. (That official rate was later changed to $42.22 when we devalued the dollar.) Other currencies were pegged to the dollar by exchange-market intervention while the dollar was pegged to gold the same way. Therefore, all currencies were indirectly tied to gold.

Under the “rules of the game,” a country’s policymakers were supposed to follow policies similar to what would happen automatically under a pure gold standard. If their currencies came under upward pressure, they should permit domestic economic expansion and/or inflation to correct the imbalance. Downward pressure on the domestic currency should prompt a policy tightening to correct the underlying imbalance while dollar reserves were used in the meantime to defend the peg.

Theoretically, the Bretton Woods arrangement was supposed to simulate a real gold standard where inflows or outflows of gold were allowed to raise or contract the domestic money supply. That was easier to do when domestic expansion was called for. Expansion is fun. It was less easy when contraction was called for. It was common for countries to “sterilize” the gold outflows and counteract their impact on the domestic economy.

In the early postwar period, and the early years of the Bretton Woods system, the world was starved for dollars and most countries gladly accumulated dollars in their reserves. This was a sweet deal for the United States because it meant we could buy real goods and services on world markets and pay with money unlikely to be redeemed in gold.

Over the years, however, the world accumulated as many dollar reserves as it needed and increasingly wanted to exchange some of them for gold, which they had the right to do. The United States, however, was not eager to lose gold; so it pressured its trading partners to continue holding dollars without demanding gold. “You don’t really want gold, do you?”

The dollars had been supplied to the world through deficits in the U.S. balance of payments and comparable surpluses by our trading partners. From our viewpoint, having the dollar used as the reserve currency was like playing poker with IOUs that the other players were willing to accept during the game and did not present for “redemption” after the game was over. (“There’s time enough for counting with the dealing’s done.” Kenny Rogers)

Eventually, the accumulated U.S. deficits had supplied more dollars than our trading partners wanted to hold. At the same time, U.S. policymakers did not want to follow the rules of the gold standard game and tighten policy to improve the balance of payments. So, President Nixon broke the last link between the dollar and gold in 1971 and we went on a system of floating exchange rates.

Under floating exchange rates, the exchange rate itself is supposed to trigger the internal economic adjustments necessary to restore and maintain equilibrium rather than changes in domestic policy. The rule of floating exchange rates is to let the market determine the exchange rate without policy interference. Let the float be clean. Policies to influence the exchange rate would dirty the float and would be considered inappropriate.

With no pegged exchange rate to defend, and with sporadic intervention considered inappropriate, there is no need for a reserve currency. Reserve currencies are a feature of fixed exchange rates, not floating rates.

Part of the angst over the potential loss of the reserve currency status of the dollar is really over the use of the dollar as a transactions currency in much of the world and in certain markets, particularly the oil market. There is now a long-standing tradition of pricing oil in dollars even if the United States is not a party to the trade. That means that a decline in the exchange value of the dollar makes oil effectively cheaper—good for buyers, bad for sellers. Of course, what has been happening is that oil sellers raise the nominal price of oil to offset the decline in the value cause by dollar depreciation. This peculiar relationship does not apply to most other commodities.

Pricing goods in dollars is a separate issue from the use of the dollar as a reserve currency.

Our reserve-currency equivalent is gold, which to my knowledge is setting in Ft Knox, on the books at $42.22 per ounce, the last official pegged price before the link was cut. And you thought all the gold was in a bank in the middle of Beverly Hills in somebody else’s name!

Comments

[Dave Wrixon:]

Yep, currency is basically backed by the Government's ability to repay its debts. And this explains quite clearly why Gold has lost its sheen. For Gold to go back to its former status it would indeed require the reintroduction of fixed exchange rates. The problem is that where these still exist in the Middle and the Far East, the US then turns around and calls foul! Of course fixed exchange rates are an anathema in the Modern World, but you cannot have it both ways.

Oct 23 04:33 AM

[chap08:]

There is no single definition of "reserve currency". Your definition is about as old as Bretton Woods. Today's definition incorporates the dollar's role as a means of trade, common pricing (not just oil) and central bank reserves. But just as under Bretton Woods, a major reason for holding dollars today is still currency manipulation. Any mercantilist that doesn't want their currency to rise, buys dollars. That is why the floating exchange rate system has ceased to work as intended. We now have an unsustainable combination of fixed and floating exchange rates.

The key point is that as the current system, one way or another, reaches exhaustion point, the demand for the dollar to fill these roles will fall. That means only one thing for the price.

Oct 23 08:35 AM

[cheapybob:]

I think the real worry is if and/or when all those dollars now being held by others as reserves get repatriated back to the U.S. as demand for commodities and cause inflation as a result. High inflation on commodities will not make for an easy day at the Fed or treasury, even with jobless rates ballooning. At some point those foreign lenders are going to say "Nada mas".

Oct 23 08:36 AM

[Bruce Krasting:]

Bob, Thanks for providing the history lesson. What we really need is some forward thinking from you. What is your thinking on POMO? Should we sustain zero interest rates? Is the Fed balance sheet too large? These are the type of things we need your input on.

The gold thing is a canard. At current market it is equal to 1% of the debt. It does not matter.

bk

Oct 23 09:15 AM

[Bull Run:]

1st of all there is NO such thing as a true floating currency, Japan has basically "pegged" it's currency with market intervention for decades, China has basically followed Japan's economic steps and pegged it's currency to the US dollar, achieving great economic progress. CDN has always tried to keep it's dollar below "par".The US dollar is the main reserve currency,by a large margin, but also it's the currency used to settle almost all international trade accounts. If the US, maintained balanced current accounts, trade accounts, and governments spending, then we would not be having this debate, BUT the world sees America continually printing dollars and printing US treasuries to support a unsustainable lifestyle, which the world has to pay for, not America. America has become the world's largest welfare case. Any other country which would attempt to print it's way out of a recessions, would have an immediate currency failure, but because the US dollar is the only currency used, as reserve and trade, the US gets a free ride. This has to END. And when it does America will really become a welfare case.

Oct 23 10:10 AM

[The shark:]

Thank you for the historical insight. I am a South African and there are strong rumors that the Government is thinking seriously of fixing the Rand exchange rate. I am not sure where I stand on the issue but it does appear to me that the current system is failing.

Over the past 13 years I have imported Jack Daniel's, Absolut, Moet & Chandon, Macallan, Famous Grouse and various other premium spirit Brands from around the world. I spend a disproportionate amount of my time and focus managing the currency swings (the Rand is an "exotic" currency and therefore subject to fairly high short term fluctuations). In addition placing the hedges is very expensive - - a 12 month hedge historical costs between an 8-12% premium). The frustrating part of this is that given the relative liquidity of the Rand, a 23 year old Forex Trader sitting in London can significantly impact the currency - with swings at times of as much as 5-10% in a month. This makes managing the wholesale price extremely difficult unless you hedge everything. Unfortunately hedging everything works as long as the currency keeps depreciating - if it does not you get caught on the wrong side of a hedge which scrambles your price point relativity to locally produced "alternatives"(unaffor... is a big factor in a market such as South Africa where disposable income levels are relatively low), your Brand's price points become irregular which frustrates consumer loyalty and you lose depletions which impacts on your overhead structures etc. A fixed rate would simplify the business and allow Executive Management time to be more focused on the real business issues.

I do not fully appreciate all the wider implications, of which I am sure there are many BUT from a business perspective it would make managing price for imported goods significantly easier. I am sure the same applies to exports - our family are also involved in the exports of grapes and the European Retailers demand rebates when the Rand strengthens, BUT NEVER release the margin back to you when the Rand weakens - Farmers don't understand this!

Perhaps a new global economic system will emerge from the current "cross-road" (the gravel junction!) that will better serve the needs for a more equality structured and sustainable cross global trade flow - I hope so!

Oct 23 11:06 AM

[ryanclarke:]

A fine recall of history, indeed. Your musings on the dollar and what to do or not to do about it's decline relative to other currencies ... tells me you are just as concerned about current Fed monetary policy as the rest of us retarded plebeians. If you desire to look into the future instead of the past you would surmise the world economy is caught in a "Kondratiev wave." Until recently, the strong dollar allowed the U.S. not only to import oil on the cheap, but gasoline as well. Until recently, this "dollar" also exported inflation to satellite banana republics of the U.S. which pegged their currency to the dollar. The market downturn last year was "necessary" not because of financial problems which could be swept under the rug as done in the past but due to gasoline demand escalation in the U.S. coupled with a HISTORIC depreciation in the U.S. dollar. Kondratiev teaches in order to transition from economic "winter" to "spring" a depression must occur in which the exising capital structure is wiped clean so new industry which does not make use of prior technology can grow ... the green shoots Bernake has mentioned. I can assure all readers of your blog, XOM and DRQ and PBR and RIG etc. etc. etc. will not allow First Solar or the Pickens Plan to reach maturity ... and even though Bernake or any other TexasRussianRedneck doesn't think $5 gallon gasoline is a problem for the U.S. consumer, I happen to believe that the Fed's printed dollars will just flow to the very industry which must eventually be discarded.

Oct 23 11:08 AM

[user396040:]

Perhaps we should think of oil as the global reserve currency. It is certainly the import that most countries would have the most difficulty in suspending. Viewed this way, the most important "central bank" would be Saudi Arabia.

Oct 23 12:21 PM

[Thomas J. G...:]

I disagree with the statement below. I think there was a huge increase in demand for dollars from China and Russia from yr=2000 to the present as they converted off of communism. I think this dollar demand masked the bad effects of the Bush administration deficit spending. Losing reserve currency status is a big deal, and will have the inverse effects from what I mention above, and will kill any politician responsible for losing reserve currency status if the electorate is smart enough to assign the correct causality.

"Over the years, however, the world accumulated as many dollar reserves as it needed and increasingly wanted to exchange some of them for gold, which they had the right to do. "

Oct 23 02:13 PM

[bob adamson:]

Thank You Mr. McTeer for a well presented analysis or the international role of the USD since the end of WW II.

I think it is fair to say that the USD is still the primary international currency of settlement and account. As such, it serves a vital function for multi-national corporations and multi-national transactions. If it ever ceased to serve this function there would be a major loss of use for the USD internationally with resulting selloff and devaluation.

One great advantage for the US in having the USD as the global reserve currency (an advantage that remains substantially but not fully intact now that that role has atrophied to becoming the primary international currency of settlement and account) is that the other major mature and emerging economies have a major interest in the US economy regaining and remaining healthy. The world could look on with relative disinterest when other nations experienced currency crises (even the UK currency crisis of the 1980s) since WW II but they know that if the USD goes into crisis it affects them negatively as well. It follows that if the US is prepared to take plausible measures of a reasonable nature to improve its economic wellbeing in an orderly fashion it will have international cooperation. Other nations in crisis have suffered the need to resort to the harsh IMF solutions or the need to take painful measures quickly to forestall attacks by currency speculators etc. The US will be much better able to retain control and set the terms and pace of its recovery provided it is seen to be serious in that endeavor.

Oct 23 09:04 PM

[R. Scott Ra...:]

Bob, is the gold really there? How much? As far as I know there is no government transparency here. It hasn't been audited for years. So how do we really know?

Oct 23 10:25 PM

[ed233:]

The dollar as a reserve currency is doomed. Emerging economies cannot afford to hold large reserves of US dollar holdings. The US economy is vulnerable to exponential rising debts as evidenced by the continued downward pressure on the US currency's value. Perhaps the biggest obstacle for the dollar is the inability to give an evaluation cost for the new administration's policies. The current law makers freely admit that they themselves have no idea concerning the overall costing going forward when these programs are implemented. Is it any wonder that there is open discussion about doing away with the US reserve currency? Consider the continued massive bond selling by the Fed and the potential build-up of inflation spreading throughout the emerging economies via infiltration of huge amounts of US dollar instruments flooding the world economy. I rest my case. LOL Looking after your money.

Oct 25 07:51 PM

[Plant the s...:]

The manipulation of dollar by exporting countries to send goods this way, means that they have a vested interest in maintaining the value of the dollar. They also sit on a lot of treasuries priced in dollars that would also lose value.

The dollar's downfall will come as the US share of world GDP and world trade shrink to the point where US weakness does not kill the world economy, out creates a cold that they can recover from.

Oct 30 12:05 PM