In 1944, representatives of 44 nations converged at the Bretton Woods conference and agreed to tie all currencies to the US dollar. They further allowed the convertibility of the US dollar to gold at $35/oz. However, with the increased popularity of currency usage, the Bretton Woods model began showing cracks. The supply of US dollars was increasing exponentially due to international trade, while the gold reserves stayed the same. The increased supply of dollars put pressure on the $35 conversion price and could could no longer be supported by the unchanged gold reserves. In 1971, the United States decided to end the Bretton Woods model and abandoned the usage of gold in backing currency. This decision led to the adoption of the US dollar as the world’s reserve currency. This action also led to many countries transitioning to a free floating currency and creating the modern day concept of exchange rates.
Even with drastic changes on the world economic stage, the US dollar continues to be the world’s reserve currency. Currency popularity is determined by its spread—the difference between how much you can buy and sell that currency. Less popular currencies have bigger spreads due to the inherent risk—you have to pay more to get them and receive less for selling them.
In contrast, the US dollar has the smallest spread of any currency as it is the most active. Demand for currency is determined by two factors—the number of transactions in that currency and the country’s economic conditions. The majority of international transactions are conducted in dollars, pounds, yuan or euros making them the most in demand.
Economic Impacts of Currency
Currency appreciation and devaluation directly affects a country’s purchasing power and therefore its economy. Countries invest a significant effort to ensure their currency remains stable and strong.
China has circumvented the supply and demand effects completely by pegging its currency to the US dollar. Pegging a currency to another reduces devaluation and volatility. China had pegged its currency at 8.62 Yuan to 1 dollar for many years. This peg is the main reason why China has accumulated such a trade surplus (sales minus purchases) against the United States. By not allowing its currency to devalue, China’s purchasing power stayed strong allowing it to sell expensive goods and import goods for less.
Currency and Government Policy
On the other end of the spectrum, the recession has played havoc with the US dollar and its economy. With the recession affecting all sectors of the economy, the Federal Reserve was forced to reduce interest rates to increase the money supply.
Looking through the lens of macroeconomics, with increased supply of the currency, its value will go down. Due to lower interest rates, investors began pulling their money out of the US dollar in order to pursue higher yield environments—creating lower demand for the dollar. These two effects working together ensured a significant devaluation in the US dollar. With the US dollar devaluing, the United States federal deficit ballooned to $1.27 trillion in 2011. At the time, experts had no idea when the recession would end and had to adjust its policy accordingly.
The two biggest drains on the United States budget were defense and healthcare —with a combined expenditure of about $900B. The government was forced to make cuts in defense—fewer fighter planes and ships, reduced benefits for veterans and reduced spending for Homeland Security etc. While reduced weapon spending doesn’t affect citizens domestically, everyone can appreciate the fact that programs like the Transportation Security Authority (TSA) does a lot of good for the country—fewer resources at their disposal could have disastrous results. Similarly, reduced spending for social security programs and Medicare had an immediate impact on United States citizens.
A question often posed in our lives is why paper currency is so valuable when it is just paper. At a micro level, currency represents the promise of a nation. Gross domestic product (GDP) is the revenue generated by a country for all of its goods and services in a year. Each dollar that is spent is contributing to the GDP, the proxy for a country’s economic power. The reason why the US dollar is the reserve currency is that the United States is the most powerful economic entity on earth. It’s for this reason that the United States can perpetually defer its interest payments on the immense debt it has racked up. There is an accepted truth that the United States isn’t going anywhere, which is why every country is confident that they will eventually get paid. We might not personally be affected from this phenomenon but with every dollar we invest, we get it back in social programs such as school funding, infrastructure improvement and defense, not to mention maintaining United States relevance on the world stage—something we can all be proud of.
This article is the opinion of the author and is not shared by India Currents or any of its staff. All investors should conduct their independent analysis before taking any actions and should not make any decisions on the information provided in this article alone.
Rahul Varshneya graduated from the Leavey School of Business at Santa Clara University with a degree in finance and is working in the technology industry as a financial analyst.