A reserve currency is one held in significant quantities by several central banks and other monetary authorities across the world as part of their foreign exchange reserves. The reserve currency is used in international transactions, investments and all other aspects of the global economy.
We have seen several different reserve currencies tied to the dominant powers of their time, and since the end of the 20th century the United States dollar has served as the dominant reserve currency fuelling global commerce. Today, IMF data shows that USD makes up 59% of the currency composition of official foreign exchange reserves across the world, followed by EUR and JPY at 21% and 6% respectively.
Despite its long reign, or perhaps because of it, the position of USD as the dominant reserve currency is showing signs of weakness. As a quick look in the archives shows, it is a cycle all previous reserve currencies have gone through before, and it might be time to look for a replacement currency that’s fit for the next chapter in the world’s economy.
Reserve currencies before USD
For most of recorded history, currencies used by civilizations have either been scarce and durable assets, or backed by scarce and durable assets. Some earlier forms include cowry shells and barley, but we quickly moved to coins made of precious metals as the material is harder to mine given the technology and tools available. The first metallic coins were made from bronze and copper, then silver rose in prominence for short period but eventually civilizations across the world shifted to gold.
Gold is one of the rarest metals, so it has inherent relative scarcity built-in compared to other metals like copper. Mining is expensive and slow, making it difficult to produce more at will which means the supply cannot be easily inflated. Lastly, gold is durable and easily divided into smaller uniform units like coins. Altogether, these characteristics have historically given governments, institutions, and merchants the confidence that gold will retain value and can indeed be used as a currency.
Eventually, to make portability easier governments decided to issue paper currencies redeemable for gold, which led to increased economic activity and the introduction of fiat currency. Fiat is simply a government-issued currency not backed by scarce and durable assets. Without that link, central banks are free to print as much currency as they need to, which historically has spelled bad news for reserve currencies.
Each and every time a reserve currency departed from sound principles like the gold standard, unchecked money printing and currency devaluation followed.
Since 1450, there have been 5 world reserve currencies before the US dollar, each lasting on average 94 years. The Portuguese real, Spanish real, Dutch guilder, French franc, and British pound, all followed a very similar cycle: money tied to real scarcity, reserve currency status achieved as a result from dominant economic power, debasement as a result from financing wars (or literally diluting the amount of precious metal used in coins), currency further depreciating in value and eventually losing reserve currency status.
It appears the US dollar is following a trajectory that rhymes with the cycle of all reserve currencies before it.
The USD as a reserve currency
Many countries abandoned the gold standard to finance military expenses during World War I with paper money, which devalued their currencies. The United States became the lender of choice for many countries willing to buy dollar-denominated US bonds. During World War II, the US again served as the Allies’ main supplier of weapons and other goods. Having collected many of the payments in gold, by the end of this period the US owned the vast majority of the world’s gold making it harder for other countries to return to the gold standard as they barely had any reserves of their own left.
In 1944, delegates from 44 Allied countries met in Bretton Wood to devise a system to manage foreign exchange without putting any country at a disadvantage. The arrangement known as the Bretton Woods Agreement established the world’s central banks would maintain fixed exchange rates between their currencies and the US dollar. In turn, the US would redeem USD for gold on demand. As a result, many countries accumulated USD reserves instead of replenishing their own gold reserves, solidifying the position of USD as the world’s reserve currency backed by the world’s largest gold reserves.
However, that all changed when President Nixon abandoned the gold standard in 1971, which led to the floating exchange rates we know today. While the position of USD is still strong now, with 59% of the all foreign bank reserves denominated in USD, the greenback is starting to show weakness.
The fiat trap
Confident in a strong USD, the US government printed money in limitless quantities in response to the global financial crisis in 2008 and again during the COVID-19 pandemic to keep the economy running. Of course, these measures weren’t taken lightly and arguably had to be taken to save people from abject misery, but they also resulted in further devaluation of the US dollar to the detriment of its ability to maintain reserve currency status in the long run.
Excessive money printing has been part of monetary policy for a long time, and you can see the effects it has had on the currency’s value. The chart below shows the trendline of the buying power of $100 from 1971 to 2021. In the 50 years since the USD went off the gold standard, it has lost about 85% of its purchasing power.
Additionally, US debts to the rest of the world have recently surpassed 50% of its economic output, a threshold that many economists view as a signal of an oncoming crisis. Borrowing heavily under COVID lockdown, those debts have spiked further to 67% of output. This becomes a real problem when the rest of the world starts losing confidence in the US being able to pay off its liabilities.
All of this is precisely how dominant currencies have fallen in the past. The currency starts out backed by real assets, changes into fiat in response to major developments, and eventually collapses. It has played out the same way for all the reserve currencies before the US dollar, and it seems plausible it is happening again.
What will replace USD as the world’s reserve currency?
There are numerous candidates that would want to replace USD as the next reserve currency. Europe had high hopes for the euro, but the currency has failed to gain the world’s trust due to the underwhelming performance of the eurozone’s multi-state government. China’s dream of the renminbi taking the reins has been met with disinterest for the exact opposite reason: concerns about a one-party state.
The appetite for a neutral currency is increasing among powerful nations. Russia, China, England, and Germany have all called out the disproportionate amount of power the dollar gives the US. For example, any wire transfer that involves USD, which is about 88% worldwide, eventually needs to be cleared by US financial institutions which means the US government can freeze funds and impose economic sanctions on other countries.
Cryptocurrency, and in particular bitcoin, has shown to be a serious contender as the world’s next reserve currency.
It shares all the same characteristics of what made gold suitable as a global currency: it is durable, scarce, fungible, divisible, and portable. Operating on peer-to-peer networks ungoverned by any state, bitcoin presents an alternative that doesn’t give any single country an advantage or disadvantage. No entity could intervene in a country’s bitcoin reserves, transactions could not be frozen by the dominant economic power, and any government can choose to return to the sound principles of backing a national currency with scarce and durable assets.
Today the US dollar is still the dominant currency used throughout the world. However, if it becomes less used for international settlements, the demand for dollars is likely to decrease. We are already seeing this happen with Argentina and Paraguay using BTC to settle an international export deal. To circumvent US imposed sanctions, Iran, North Korea and Venezuela have all started using BTC in both domestic and global trades.
Usually when bitcoin is compared to gold, it is to argue in favour of its function as a store of wealth, as a hedge against inflation. But perhaps we will end up taking it much further, and use bitcoin to return to a global reserve currency that is truly scarce and durable, like gold. Except this time it lives in the digital world, which works out fine for a global economy increasingly rooted in bits and bytes.
It might take a few more market cycles before bitcoin is mature enough as an asset, globally distributed and a lot less volatile, but it certainly is one of the best contenders we have at the moment for the next world reserve currency.
About the author
Joe Caselin is on a mission to Save Great Ideas from Obscurity. He has worked with several startups including crypto exchanges, DeFi projects, digital banks, and trading platforms helping to build brands rooted in purpose. When he’s not writing, he’s reading what he just wrote.