The US dollar (“dollar”) is the world’s reserve currency of choice, but at various points in its history, critics have pointed to other currencies as potential vehicle currencies of choice. While in the 1970s or 80s it might have been the yen or the deutschmark, the creation of the euro in 1999 brought a new competitor onto the scene. In its first few years, the euro became increasingly popular. With the Euro zone having an economy nearly as large and robust as the American economy to back it, the ‘common currency’ began to make inroads as the world’s vehicle currency. Nations with closer ties to Europe than to the United States were among the first to make the switch, but many major nations have some operations (debt issues, for example) in Euros . Today, there is also some speculation that the Yuan could take over as a vehicle currency, or that a basket currency could be created using a number of different currencies (Fisk, 2009).
This paper will analyze the future of the dollar. The first step in understanding the future of the dollar will be to understand how the dollar came to be the world’s reserve currency. It is also important to understand what a reserve or vehicle currency is, and how the dollar is currently playing this role. In addition, the new currencies that might threaten the dollar need to be analyzed – their relative strengths and weaknesses are important to the future course of the dollar. Consider that the dollar overtook the pound sterling as a reserve currency through its own strength, not necessarily because Britain actively removed its currency from this role. Lastly, the analysis will conclude with a determination of the likely future course of the dollar.
Modern Monetary System and the Rise of the Dollar
The modern monetary system had its antecedents at Bretton Woods. In brief, the outcome of this meeting was that the price of dollars was fixed in local currencies, both replacing the gold standard and establishing the dollar as the leading currency in the capitalist world (Urban, 2009). The latter was essential at the time – Europe was rebuilding from the war and once-dominant Britain had been superseded by the United States for economic supremacy in the world. While other currencies had their rates pegged to the dollar and were allowed some minor adjustments, the dollar was pegged to the value of gold.
In 1971, Bretton Woods was replaced by a system of free-floating currencies. This effectively reinforced the division between the world’s “hard” currencies – USD, GBP, DEM, HKD, CAD, CHF, etc – and the other currencies. Many of the latter either floated freely but were volatile, or became fixed to hard currency exchange rates. The hard currencies would become traded on global foreign exchange markets. This shift removed gold from the international currency system, placing more emphasis on the dollar.
Currencies under a free floating system are fiat currencies in that they are not underwritten by any specific asset. Prior to 1971, the international currency system was either directly (prior to Bretton Woods) or indirectly underwritten by the value of gold reserves. The shift was more psychological than practical – gold is essentially a fiat store of value itself, often trading far above its intrinsic value precisely because of its traditional role as a store of value (Indiviglio, 2011). The underlying asset in the modern monetary system is the economy of the nation or group of nations that backs the currency. The United States being the world’s dominant economy at the time and the only capitalist superpower, the dollar naturally became a reserve currency of choice, following on its Bretton Woods-era role. The currencies of other nations would sometimes play a small regional reserve role, but the dollar came to dominate. Other strong currencies such as the deutschmark and the yen were touted as potential successors to the…