As a reserve currency, the dollar faces a difficult balance between providing international liquidity and maintaining credibility. The dollar remained the reserve currency after the collapse of the Bretton Woods system because of its economies of scale and the power of the U.S. economy.
The importance of reserve currencies is directly related to the stability of the international economy, which plays a central role in the global economic order. In particular, the credibility and liquidity of reserve currencies have a decisive impact on international financial markets. In 1960, Professor Robert Triffin pointed out the structural contradictions of the dollar as the reserve currency in the Bretton Woods system. His theory remains an important topic in international economics to this day, and the debate about the role of reserve currencies and the dilemmas they pose is ongoing.
The current account, the difference between a country’s imports and exports of goods and services, is a deficit when imports exceed exports and a surplus when exports exceed imports. “If the U.S. does not allow current account deficits and international liquidity is cut off, the global economy will contract significantly,” he said. These concerns were very real in the economic climate of the time, and highlighted the impact of the US economy on the international economy. “On the other hand, if the deficit persists and the dollar becomes oversupplied, its credibility as a reserve asset will be undermined and the fixed exchange rate system will break down.” This is the dilemma faced by countries acting as reserve currencies, and it highlights how difficult it is to find a balance between providing liquidity and maintaining credibility.
This trilemma is the trade-off between international liquidity and the credibility of the dollar. Under the gold standard, gold served as international liquidity, and the value of each country’s currency was pegged to the value of a set amount of gold. This automatically determined the exchange rate, the rate at which currencies were exchanged between countries. While the international economy based on the value of gold was fairly stable, there was a conflict between the finite nature of resources and the need for economic growth. The Bretton Woods system then added the dollar as a source of international liquidity, creating a gold standard. Established in 1944, the system obligated the U.S. central bank to always exchange an ounce of gold for $35 under the gold convertibility clause. Other countries pegged their currencies to the dollar and could only buy gold with dollars. Exchange rates were allowed to fluctuate within ±1%, except in exceptional cases of structural imbalances in the current account. This left the cross rate, the exchange rate between currencies other than the reserve currency, the dollar, to be determined automatically.
In the early 1970s, the U.S. began to accumulate current account deficits and an oversupply of U.S. dollars, causing U.S. gold reserves to plummet. The United States reached a point where it could no longer meet its obligation to convert dollars into gold. The solution was either a devaluation, which would lower the value of the dollar, or an appreciation, which would increase the value of the dollar by lowering the exchange rate of other countries’ currencies against the dollar. However, under the Bretton Woods system, a devaluation of the dollar was not possible under the rules. Major countries like Germany and Japan, which had large trade surpluses with the United States, were unwilling to do so. This began to shake the international economic order, and the world economy reached a new turning point. The prospect that this situation would be difficult to maintain led to an increase in speculative demand for the German mark and Japanese yen, which in turn put further pressure on exchange rates. In this situation, countries wanted to convert their dollar reserves into gold on a large scale. The U.S. eventually launched the Nixon Shock in 1971, when it suspended the dollar’s convertibility into gold, and the Bretton Woods system collapsed.
But even after the collapse, the dollar’s role as a reserve currency continued. This was due to the size and stability of the U.S. economy and its dominant position in international financial markets. The reason for this is economies of scale. If every country in the world had a different currency, without a single reserve currency, there would be as many different types of exchange rates as there are pairs of countries. However, by centering foreign exchange transactions around one reserve currency, costs can be reduced and economies of scale can be achieved. This economic efficiency is one of the reasons why the dollar remains such an important part of the global economy. Along with this, the dollar is used as an asset in various forms in the international financial system and remains a trusted currency.
