The Rise of the U.S Dollar as the Global Reserve Currency

Since the Bretton Woods conference of 1944 (which oversaw the creation of the IMF and World Bank), the dollar has been the world’s most important means of exchange. It is the most commonly held reserve currency and the most widely used currency for international trade and other transactions around the world. Major commodities such as oil, energy, and metals are primarily bought and sold using U.S. dollars. Many countries either use directly or peg their currencies to the USD (Saudi Arabia, Oman, Jordan, UAE, Ecuador, El Salvador and others).

What Is a Reserve Currency and Why Does It Matter?

But what is a reserve currency? It is a foreign currency held in significant quantities by central banks and major financial institutions for international trade, investment, and global financial stability. Countries hold reserves to weather economic shocks, pay for imports, service debts, and moderate the value of their own currencies (by buying or selling their own debt instruments). The U.S. dollar is the most-held reserve currency, comprising 59% of global reserves. See Fig 1.

Figure 1.

Central banks often hold currency in the form of government bonds, such as U.S. treasuries. The U.S. treasury market remains by far the world’s largest and most liquid—the easiest to buy into and sell out of—bond market.

Understanding the “Exorbitant Privilege” of the U.S. Dollar

The term "exorbitant privilege" was coined by French finance minister Valéry Giscard d’Estaing in the 1960s to describe the benefits of reserve status. The U.S. can run persistent trade deficits and borrow at lower costs because global demand for dollars remains high. This allows the U.S. to finance its current account deficit cheaply, as other nations are eager to hold dollar-denominated assets like U.S. Treasury bonds. Some experts say this isn’t so exorbitant lately, with many countries able to borrow at similarly low rates.

The benefits come with with responsibilities and risks. For example, to supply the world with dollars, the U.S. must remain open to imports and capital outflows, which can hurt export-heavy U.S. states.

However, there is a long-term trend of the greenback losing share to other currencies. See Fig 2.

Figure 2.

Why Countries Are Moving Away from the U.S. Dollar

This trend could accelerate given the trends in the US Fiscal situation. Official forecasts suggest that the country’s debt to GDP ratio could swell to a record high of 116% in 2034 and hit 172% by 2054 (see further bad news below in Implications for the US).

De-dollarization

Due to the increased debt to GDP ratio, many countries are moving away from the USD. In addition, a mutiny is taking place in the global currency market, with a growing number of countries ditching the U.S. dollar for geopolitical reasons. Some examples and motivations:

·      Russian and Chinese de-dollarization in response to U.S. sanctions and foreign policy plays. Since the Ukrainian invasion in 2022, the ruble-yuan trade has increased eighty-fold.

·      Russia and Iran explore a crypto currency backed by gold

·      The UAE and India explore the use of rupee to trade non-oil commodities

·      Brazil and Argentina have discussed the creation of a common currency for the two largest economies in South America.

Global Reserve Currency Alternatives to the U.S. Dollar

Those examples are only regional solutions- is there any single, world-wide candidate? The EUR and the renminbi are obvious choices, but each have their fatal flaws:

·      Financial markets are holding back the EU. The bloc’s economy is large, but the lack of a common treasury and a unified European bond market limits its appeal. Only a few of the eurozone’s members have a AAA credit rating.

·      China’s financial markets do not have sufficient liquidity (the renminbi only constitutes 2.3% of global reserves) to support the demand associated with reserve currency status. Furthermore, China’s financial markets are not completely open to foreign investors.

There are other, more exotic possibilities

• The IMF’s Special Drawing Rights (SDR): The value of SDR is based on five currencies: the euro, pound sterling, renminbi, U.S. dollar, and yen. But for SDR to be adopted widely, economists say it would need to function more like an actual currency, accepted in private transactions, and with a market for SDR-denominated debt.

• Gold or Commodity-backed Systems: Neutral and apolitical, but inflexible and complex to manage.

• Cryptocurrencies: Yabut- cryptocurrency as legal tender constrains a government’s policy options during a crisis, and that the volatility of cryptocurrency reduces its viability as a means of exchange.

  
  

The Consequences of Losing U.S. Reserve Currency Dominance

Capital is voting with its feet. There has been a wave of capital flight from US financial markets triggered by the Trump administration’s aggressive escalation of tariffs. Equity and bond markets have sold off. In addition, inflation is weakening the dollar on the international stage. Mismanagement trumps all - the latest bill from Congress (the “One, big, beautiful bill”) will at $3-5 Trillion to the national debt over the next decade; with $3.77T in tax cuts and $3.055T in deficit spending. These actions are not those of a country wishing to maintain its reserve currency dominance.  Debt service is already the largest line item in the Federal budget. Loss of reserve status will make servicing that debt far more expensive.

The Future: A Multipolar Global Reserve Currency System

In the long run, the global reserve system will simply shift toward a multipolar structure, using some or all of the alternatives; reducing the dollar's singular dominance, evaporating the exorbitant privilege, and increasing the historically low cost of debt the U.S. has enjoyed since 1944.