The Mighty Dollar

When Britain ruled its empire, sterling was the world's dominant ‘reserve’ currency. International trade was conducted largely in pounds. Sterling was linked to gold under the gold standard. The system provided stability, but war and Britain's declining economic power eventually ended sterling's dominance.

After the Second World War, the 1944 Bretton Woods agreement created a new monetary system. The dollar became the foundation of global trade, convertible into gold at $35 an ounce. Other currencies were pegged to it and therefore indirectly to gold.

But the system contained a contradiction. The expanding world economy needed more dollars. Yet the more dollars the United States supplied, the harder it became to maintain their convertibility into gold.

By the 1960s, US military spending, the Vietnam War, domestic expenditure and international demand for dollars were generating huge quantities of dollars overseas. Eventually, foreign claims on US gold exceeded what was available.

In 1971, President Nixon closed the "gold window". The dollar became a ‘fiat ‘currency, no longer convertible into gold. Its value instead depended on confidence in the US economy and its position in international financial markets.

Surprisingly, the dollar's power did not disappear. It evolved.

The US Treasury could issue enormous quantities of government debt because Treasury securities were regarded as safe assets. Oil-producing states accumulated dollar revenues and invested much of their wealth in US financial markets

The world's reserve currency allowed the United States to borrow in its own currency on an astounding scale by selling its debt abroad. This became the foundation of American economic power.

But this privilege has a price. US federal debt has exceeded $40 trillion - some 125% of its total US economic output (GDP). The cost of servicing that debt is near $1 trillion a year. This affects confidence in the currency.

The dollar's reserve-currency advantage also becomes a vulnerability when American financial power is weaponised.

The United States can impose sanctions and restrict access to the dollar-based financial system. But if access to the financial system can be turned into a weapon, why should other countries remain so dependent upon it?

Sanctions, rising debt and loss of confidence create incentives to seek alternatives. Countries are diversifying their reserves, increasing gold holdings and exploring trade outside the dollar system.

This creates a vicious circle: more debt requires more borrowing; higher interest costs make that debt more expensive; and using financial power as a geopolitical weapon encourages other countries to reduce their dependence on the dollar.

The mighty dollar is unlikely to collapse soon. But the foundations for its dominance is unstable.

There are two broad possibilities. The United States could cooperate with other nations to develop a more stable international monetary system—or attempt to preserve its dominance through economic and military power.

Trump's America First strategy points towards the second approach: using America's market power and military muscle to strengthen US economic and strategic dominance.

The question is whether such an approach will preserve the dollar's dominance—or accelerate the search for an alternative.