The Twists and Turns of the Greenback

The dollar is King, and when it comes to currencies, Kings are difficult to dethrone.

At a monetary conference in Vienna back in 2014, the distinguished Frenchman, friend, and occasional collaborator Jacques de Larosière proclaimed that the current world monetary order should be termed an “anti-system.” He has a point – an important point. Among other things, such an anti-system invites an enormous amount of instability, as well as uninformed loose talk that influences public opinion and policy.

The Chinese yuan has been at the centre of much of the recent misinformation and disinformation about currencies. During the first presidential debate between Donald Trump and Hillary Clinton, Trump fingered China as the world's best practitioner of currency devaluations – devaluations that Trump claims power China's exports. Clinton didn't object to Trump's thesis. Indeed, she boarded the same train. Japanese yen, and the British pound. As part of China's yuan promotion campaign, it declared that the yuan would be a serious challenger to the greenback as the world's premier currency. While the yuan's international use has grown rapidly, it started with a base of zero.

The dollar is King, and when it comes to currencies, Kings are difficult to dethrone. Even after the introduction of the euro in 1999, the USD has maintained its top spot as the currency held as official reserves, accounting for 63 percent of the total. When it comes to foreign exchange trading, the dollar is even more dominant, accounting for almost 88 percent of the turnover. Dollar notes are widely used internationally, too, with as much as two-thirds of all the greenbacks in circulation circulating overseas. In terms of the transactions handled by the Society for Worldwide Interbank Financial Telecommunication (SWIFT), the outfit that moves “money” among banks, the U.S. dollar has increased its dominance over the past few years, accounting for almost 52 percent of the total transactions (see the accompanying chart).

As with the introduction of the euro, claims that the yuan will dethrone the King are off the mark. For the past three millennia, there has always been a dominant world currency, and it's very hard to challenge the King. This is evidenced by the longevity of dominant currencies. On average, they've reigned for 300 years. This would suggest that the U.S. dollar, unless the U.S. government makes a big mistake or a new disruption technology enters the stage, is probably going to be on the throne a while longer. Why?

To answer that question, we borrow from the work of Nobelist Robert Mundell. In Mundell's study of the world's dominant currencies over the past three millennia, he found that there was always one currency that dominated, and that the following five characteristics were associated with each dominant currency: 1. The transactions domain was large. On this score, the U.S. clearly qualifies. Until recently, it has been the world's largest economy measured on a purchasing power parity basis. Today, its GDP accounts for 16.1 percent of the world's total. China has recently surpassed the U.S. on that measure, with 16.9 percent of the total, and the Eurozone has 11.9 percent. So, in terms of their transaction zones, both the yuan and the euro could challenge the greenback.

2. Monetary policy inspired confidence. No currency ever survived as a top international currency with a high rate of inflation or with a recurring risk of debasement or devaluation. So, unless there are significant U.S. monetary policy mistakes, challengers will face a Sisyphean task.

3. Exchange controls were absent. Exchange controls, such as those in China, are always a sign of weakness, not strength. Controls alone eliminate the Chinese yuan as a challenger to the greenback's dominance. This explains why China is working to