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fter nearly two years of fighting the worst inflation in 40 years, during which the US central bank the Federal Reserve has made successive hikes to interest rates, some people now seem to be celebrating victory.
They believe that the signs of interest rate cuts in 2024 vindicate the Fed’s policies. The reason for the interest in the matter around the world is the fact that the US dollar is the preferred reserve currency, with 60 per cent of central bank international reserves worldwide being in dollars. The dollar is also the currency of choice for international finance, loans, the financial markets, and commercial settlements. Yet, the US now accounts for only 25 per cent of the global economy, and China has been leading it in exports since 2009.
When former US president Richard Nixon cancelled the convertibility of the dollar into gold in 1971, he rang the death knell of the Bretton Woods system established in 1944. This originally launched the dollar as the world’s major international reserve currency. Under the Bretton Woods system, other currencies were pegged to the dollar at fixed exchange rates, and countries could settle their accounts in dollars redeemable in gold at the rate of $35 per ounce.
Nixon did away with this system, and controversy has flared since over the subsequent floating exchange rate system and possible alternatives to it. Meanwhile, the world’s major central banks have been closely monitoring the stability of the dollar, its ability to weather waves of inflation at home, and its impact on their own monetary policies, economic competitiveness, and mounting debt.
Today, many currencies of the developed and developing countries alike are still linked or pegged to the dollar to various degrees. If they use a fixed exchange rate, it is one that is pegged to the dollar, and if they use a flexible exchange rate system it is also relative to the dollar.
Even if the dollar is not directly involved in contractual arrangements or the settlement of accounts, more and more the case given the increasing use of other currencies in cross-border dealings, it still acts as the standard or a vehicle currency by which the value of other currencies is measured.
I have discussed the factors that sustain the dollar’s dominance in previous articles and the many privileges the US economy enjoys as a result. I will sum these up here in three observations made by well-known people.
The first observation was made by Brazilian President Luiz Inácio Lula da Silva, who chalked up the dollar’s dominance to “force of habit” and fear of change. The second was made by US Treasury Secretary Janet Yellen, who said last year that “there is a very good reason why the dollar is used widely in trade, and that’s because we have deep, liquid, open capital markets, rule of law, and long and deep financial instruments.”
The third observation was made by noted economist Eswar Prasad, the author of the recent book The Future of Money. The dollar still performs its main functions better than alternative conventional, emerging, or innovative currencies, Prasad said. So it remains the default reserve currency despite the economic problems in the US and policies that should imperil its status.
These include unprecedented rates of inflation, high and rising levels of public debt, and, increasingly, Washington’s frequent weaponisation of its currency in its conflicts as it did with Afghanistan, Iran, and Russia
To learn more about the future of the dollar as an international currency, some scholars have turned to history, starting with the Greek drachma in the Fifth Century BCE, then the Roman denarius, the Byzantine solidus, the dinar of the Islamic Empire, and the Venetian ducat and Florentine florin that circulated at the same time.
The first currency to be widely recognised as an international reserve currency was the Spanish silver dollar whose sway lasted from the 16th to the 19th centuries in and beyond the realms of the Spanish Empire in the Old World and the Americas.
But history is a constant reminder of how change can happen, and contemporary history tells us how fast that change can be. The dollar’s demise might not take centuries, as was the case with the Dutch guilder, whose influence grew in tandem with the Netherlands’ colonial expansion in 17th and 18th centuries. The guilder was based on the silver standard, and the Bank of Amsterdam used measures like those used by monetary authorities today to keep its value stable.
However, in time the guilder was eclipsed by the pound sterling. Based on the gold standard, this outperformed rival currencies thanks to Britain’s colonial wars of expansion and growth in exports. At the height of its influence, 60 per cent of international trade was conducted in sterling. Britain incurred heavy economic losses and massive debts as a result of World War I and World War II, despite being one of the victors. Yet, sterling continued to reign internationally for a time, whether due to a lack of awareness of the magnitude of Britain’s economic ailments or merely as a result of force of habit.
It takes time for the architects of international arrangements to accept a newcomer even as the flaws of the old and familiar become more and more apparent. Yet, by the time the Bretton Woods Agreement was drafted in July 1944 as the basis for the post-War economic world, sterling was discarded as the base currency for the new post-War financial arrangements, even though it continued to retain a 55 per cent share of the world’s hard-currency reserves until the Suez Crisis struck in 1956.
The three reasons for the continued dominance of the dollar mentioned by Lula, Yellen, and Prasad speak of countervailing forces and the possibility of its being unseated if the underlying balances change. However, any potential candidate as a replacement currency must be backed by good economic performance, open financial markets, and smoothly functioning institutions and processes, all underwritten by a credible legal system and the rule of law.
If such conditions are met, it will be just a matter of time before traders, investors, organisations, and the general public grow used to the new alternative. They would also be wise to learn the lessons of its predecessors and how their rise and fall was linked to the rise and fall of the nations that minted and exported them.
In a forthcoming article, I will discuss the management of international foreign currency reserves and how long this will continue to depend on the credibility of the dollar. I will also return to the question of the merits of introducing measures of inflation targeting framework to achieve price stability versus a monetary policy based on exchange rate as an anchor.
In a fast changing world it is important to continuously monitor international reserves currencies, as they might lose the necessary conditions for trust to serve in their functions.
This article appeared in Arabic in Wednesday’s edition of Asharq Al-Awsat.
* A version of this article appears in print in the 4 January, 2024 edition of Al-Ahram Weekly
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