The Dollar Is the Worst Reserve Currency—Except for All the Rest

To play the role of linchpin of the global economy, the United States must let capital flow freely across its borders and absorb the savings and demand imbalances of other countries—that is, it must run deficits to offset the others’ surpluses and allow them to convert their excess production and savings into U.S. assets by purchasing real estate, factories, stocks, or bonds. This pushes down global demand, forcing the United States to compensate, often with higher unemployment or debt. Both the United States and the world at large would benefit from a less dominant U.S. dollar.


At an April summit of the so-called BRICS—Brazil, Russia, India, China, and South Africa—Brazilian President Luiz Inácio Lula da Silva demanded to know why the world continues to base nearly all its trade on the U.S. dollar. To thunderous applause, he asked, “Why can’t we do trade based on our own currencies? Who was it that decided that the dollar was the currency after the disappearance of the gold standard?”

Lula’s speech echoed one side of a debate that has heated up in recent years about the future of the U.S. dollar as the dominant global currency. Those who claim that the dollar is in decline often argue that for the last 600 years, reserve currencies have risen and fallen in tandem with their home economies. As the United States’ share of the global economy diminishes, they claim, the dollar’s role will also diminish. But the truth is that there were no dominant global reserve currencies before the U.S. dollar. It is the only currency ever to have played such a pivotal role in international commerce.

There is a downside to a dominant U.S. dollar, however. To play the role of linchpin of the global economy, the United States must let capital flow freely across its borders and absorb the savings and demand imbalances of other countries—that is, it must run deficits to offset the others’ surpluses and allow them to convert their excess production and savings into U.S. assets by purchasing real estate, factories, stocks, or bonds. This pushes down global demand, forcing the United States to compensate, often with higher unemployment or debt. Both the United States and the world at large would benefit from a less dominant U.S. dollar, in other words. But contrary to Lula’s expectations, adopting an alternative global reserve currency will not necessarily benefit surplus countries such as Brazil. Rather, it will force them to confront the reasons for their surpluses—persistently weak domestic demand based on a very unequal distribution of domestic income—and address them by cutting back on production and redistributing income.


Before the dollar’s ascent in the first half of the twentieth century, currencies and reserves that funded trade consisted mainly of specie—gold and silver coins. To the extent that central banks began to hold foreign currencies as part of their reserves in the nineteenth century, they mainly did so in the form of gold coins or currencies that they believed were convertible into specie. When historians say that British sterling was the dominant reserve currency before the U.S. dollar, they mean that the United Kingdom’s commitment to maintaining convertibility was seen as more credible than that of other central banks, which might therefore hold sterling in addition to gold.

In the pre-dollar era, moreover, a currency’s usefulness in global trade was largely unrelated to the strength of its home economy. The United States, for example, was the world’s largest and richest economy by the 1860s, but because its commitment to gold convertibility was seen as questionable, the U.S. dollar remained a minor currency until the 1920s. In large parts of Latin America and Asia, meanwhile, the dominant currency for trade was not that of a major economic power at all. Because of their purity and consistency, Mexican silver pesos ruled over even the sterling in international trade for much of the eighteenth and nineteenth centuries.

These are not just technical differences. Global trade and capital flows were structured very differently in the old specie-standard world than they are in today’s dollar-dominated one. In the former, trade imbalances were limited by the ability of each country to manage specie transfers. No matter how large a country’s economy or how powerful its central bank, its currency could be used to settle trade only to the extent that it was seen as fully exchangeable with specie. As foreign holdings of the country’s currency rose relative to the specie holdings of its central bank, the promise of convertibility would become less and less credible, thereby discouraging the currency’s use.

These limits had important consequences. One was that under a specie standard, trade in each country broadly balanced (with the exception of small imbalances driven by capital flows that funded productive investment). Another, more important consequence was that the process through which trade flows equilibrated—described by the Scottish philosopher and economist David Hume’s model of the price-specie flow mechanism—acted symmetrically on both surplus countries and deficit countries, so that demand contraction in the latter was matched by demand expansion in the former.

Both the United States and the world at large would benefit from a less dominant U.S. dollar.

The current dollar-based system is very different. In this system, imbalances are limited mainly by the willingness and ability of the United States to import or export claims on its domestic assets—that is, to allow holders of foreign capital to be net sellers or net buyers of American real estate and securities. The result is that countries can run large, persistent surpluses or deficits only because these imbalances are accommodated by opposite imbalances in the United States.

Even worse, the contractionary effect of deficits on the global economy is not offset by expansion in the surplus countries, as it was in pre-dollar systems. At the Bretton Woods conference, in 1944, the British economist John Maynard Keynes strenuously opposed a global trading system in which surpluses or deficits were allowed to persist, but he was overruled by the senior American official at the conference, Harry Dexter White. As a result, deficit countries must absorb the deficient domestic demand of surplus countries while surplus countries avoid adjusting—which would entail either paring back production or redistributing wealth to workers—by accumulating foreign assets and putting permanent downward pressure on global demand.

This adjustment process is not well understood, even among mainstream economists. Surplus countries run surpluses not because they are especially efficient at manufacturing but because their manufacturers enjoy implicit and explicit subsidies that are ultimately paid for by workers and households and so come at the expense of domestic demand. This, as Keynes explained, is how mercantilist policies work—improving international competitiveness by suppressing domestic demand—and is why they are referred to as “beggar thy neighbor” tactics. Rather than converting rising exports into rising imports, they result in persistent trade surpluses.

But surpluses in one country must be accommodated by deficits in another. Since the 1980s, the United States has accommodated the surpluses of other countries by allowing them to be easily converted into claims on U.S. assets. As a result, the U.S. dollar reigns supreme in international trade, but the U.S. economy is forced to absorb weak demand from abroad, either by pushing up domestic unemployment or, more likely, by encouraging the rise of U.S. government and household debt.


This does not mean that the United States must always run deficits to anchor the global trading system to the dollar, as many have argued. But it does mean that when the world needs savings, the United States exports savings and runs trade surpluses, and when the world has excess savings, the United States imports savings and runs trade deficits.

The United States did the former from the 1920s through the 1970s, a five-decade period during which many countries urgently needed to rebuild manufacturing capacity and infrastructure destroyed in the two world wars. With European and Asian incomes devastated by conflict, countries in these regions needed foreign savings to help reconstruct their economies. Because the United States was the world’s leading trade surplus nation in this period, it quickly moved to meet the need by exporting excess savings, establishing the dollar as the dominant global currency in the process.

By the early 1970s, however, most of the world’s leading economies had rebuilt themselves from the ravages of war. Now, they had savings of their own that they needed to export to propel their economies even higher. Once again, the United States obliged: its openness to foreign capital, its flexible financial markets, and its high-quality governance meant that it absorbed much of the excess savings of the rest of the world. It is no coincidence that the 1970s is when the United States’ large, persistent surpluses began to dwindle, giving way by the 1980s to large, persistent deficits that have continued to this day.

No other currency can replace the U.S. dollar.

This willingness to let capital flow freely and to absorb the savings and demand imbalances of the rest of the world is what underpins the dominant role of the U.S. dollar. No other country before the United States has played this role to nearly the same extent, which is why no other currency has dominated international trade and capital flows the way the dollar does today. What is more, no other country or group of countries—not China, Japan, the BRICS, or the European Union—is willing to play this role or would be able to without dramatically overhauling its financial system, redistributing domestic income, eliminating capital controls, and undermining exports—all of which would likely be highly disruptive.

For all these reasons, no other currency can replace the U.S. dollar. When the dollar’s reign eventually ends, so will the current global trade and capital regime. Once the United States (and the other Anglophone economies that play similar roles) stops absorbing up to 80 percent of the excess production and excess savings of surplus countries such as Brazil, China, Germany, Russia, and Saudi Arabia, these countries will no longer be able to run surpluses. And without surpluses, they will be forced to cut domestic production so that it no longer exceeds weak domestic demand. In other words, only the dollar’s widespread use has permitted the huge imbalances that have characterized the global economy of the past 50 years.


But an indispensable dollar is not a good thing, either for the United States or for the rest of the world. The global economy would be better off if the United States stopped accommodating global savings imbalances that allowed surplus economies to dampen global demand. The U.S. economy in particular would benefit because it would no longer be forced to absorb, through higher unemployment or more debt, the effects of the mercantilist policies of surplus countries. Washington and Wall Street would see their powers curtailed, but American businesses would grow faster, and American workers would earn more.

Getting to a post-dollar world will not be easy, however. What much of the debate about the eventual demise of the dollar misses is how economically disruptive the change will be for persistent surplus countries, which will have to dramatically downsize entire industries that are currently geared to exports. The transition will entail more than just selecting a new currency in which to denominate trade. It will involve building radically different structures for trade and capital flows. And while these may be more sustainable and beneficial to the U.S. economy in the long run, their adoption will be messy and painful for the world’s surplus economies.

The answer to Lula’s question of who designated the U.S. dollar the global reserve currency is ironic: it was surplus countries such as Brazil and China. And despite what their leaders might say, none of them are in a hurry to upend the current system. Until these countries fundamentally transform their domestic economies—or until the United States decides it will no longer pay the steep economic cost of performing its accommodating role—they and the rest of the world will have no choice but to accept the continued dominance of the U.S. dollar.