by Ali M.S. Fatemi, Ph.D.

Posted on October 21st, 2009

Are we approaching the end of the days of the dollar as an international reserve currency? Is it really over for the dollar as the de facto world money? The recent unprecedented rapid fall in its relative exchange value seems to give some credence this notion. However, part of this renewed downward pressure on the dollar could be explained in terms of the post-recession US macroeconomic and monetary policy of the FED with its low interest rate tendency.

In order to better understand the present situation and gain some possible insight into this complex issue, one needs to begin with a few basic points. Contrary to the prevailing common public notion, there is no evidence to suggest that there has been a deliberate policy on the part of the US government to maintain the dollar as a world currency. This is not to say that the US does not benefit from this arrangement because aside from the so-called seigniorage ¹benefits which is considerable, the fact that other countries do purchase US commercial papers, has made it possible for the US to borrow substantially in international capital markets. Of course, given a choice, few central bankers would opt for having their national money become an international reserve currency with all the concomitant complications for domestic monetary policy. A combination of historical events and dire necessities contributed to the dollars ascendency after World War II, and even today no one has come up with a workable alternative or an acceptable substitute for the dollar and the crucial role that it plays.

Imagine a situation where one day there is no money to be used as a medium of exchange in a city or a country. No one can buy anything because one has no money and very few would sell without receiving payment in exchange. The economy would rapidly descend back to primitive bartering with the consequential fall in the standard of living for everyone. Massive unemployment and widespread shortages will in no time bring the community to its knees. The world economy is not any different than the economy of a community, a city or a country. Nations of the world need to trade with each other on a continuous basis. This mutual dependency has been further deepened with the advent of globalization. Trade will not take place without reliable means of payment.

For world trade to continue and for nations to prosper, international trade is essential and this cannot continue for long without the acceptable means of payment. World money which is technically referred to as ‘international reserves’ is what makes trade among nations take place. The US dollar is a very important and significant element of today’s international payments system. There are other currencies and instruments as the euro, the sterling, the yen and a few other national currencies as well as the SDR²or Special Drawing Rights.

How Did the Dollar Get There?

The US dollar has enjoyed a long and glorious reign as the virtual world currency since the end of WWII. It was at the resort cottage of Breton-Woods, deep into the New Hampshire country side that it was decided to use the dollar as a vehicle to rescue world trade and payments. Most people prefer not to recall the emergency circumstances under which this arrangement was decided upon. The gold standard which was the dominant form of payment prior to the two World Wars of the twentieth century had already ceased to exist because every nation, except the US, came out of the war practically bankrupt and with no gold in its treasury.

Europe was devastated and broke, there was practically no gold left in any country except in the US where deep in the vaults of Fort Knox, there was 649.6 million troy ounces (20205 metric tons) of gold which at $35.00 dollars per ounce would amount to approximately$28 Bill. After many months of negotiations between John Maynard Keynes on behalf of the UK and Harry Dexter White on behalf of the US an agreement was reached. They agreed on the establishment of the International Monetary Fund (IMF) with the following four major points as the foundation of their agreement:

1. They agreed that the flexibility of exchange rates in the 1930’s were harmful to trade but they did not wish to return to god standard either. As a results they reached a compromise between the two alternatives of flexibility of the rate and the rigidity of fix rates. It was decided to have ‘adjustable peg’ meaning that the fixity of the rate would be changed from time to time. The value of the dollar was expressed in terms of gold and the US Treasury committed to buying and selling gold at $35.00 per ounce. Therefore the dollar’s value was fixed with gold and all other currencies exchange rates were fixed based on the dollar.

2. Members were each assigned a specific quota reflecting each member’s relative economic importance. Each member could, when short of reserves, borrow the needed foreign currency up to the limit of its quota.

3. Convertibility was limited to the current account of the balance of payments only. This meant that capital could not be freely moving among nations. Obviously this was essential for maintaining the ‘adjustable peg.’

4. The voting arrangement in the IMF was established in accordance with the contribution of each member and not on the basis of one nation one vote. As a result, the US ended up with one-third of the voting rights.

It was under such dire circumstances that in practice the dollar became the de facto world currency. For almost a quarter of a century the system worked very well. It was in the mid-seventies and after the Vietnam War that the US practically run of gold and no longer could support the dollar. It was President Nixon who in 1974 announced the end of convertibility and as a result three of the above four points were no longer valid. This made no significant difference in the manner that people were using the dollar and it continued to remain as the principal means of payment among nations. As the nations of G-20 continue to discuss the future of international monetary relations and the prospects of a new ‘international financial architecture’ the dollar continues to be used as a vehicle currency for the foreseeable future.

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