Genesis of the US dollar hegemony

The US dollar hegemony dates back to 1944, when it officially became the world’s reserve currency. As World War II was coming to an end, 44 Allied nations met in July in New Hampshire, the US, to design a new set of rules that would govern the post-war international monetary order.

One of the most critical outcomes of this Bretton Woods Conference, officially known as the United Nations Monetary and Financial Conference, was the establishment of a system of payments based on the US dollar, against which all other currencies were pegged. To ensure confidence in the system, the US dollar itself was convertible to gold at a fixed rate of US$35 an ounce — the US, at that time, held some three-quarters of the world’s official gold reserves.

The agreement effectively tied countries around the world to the US dollar. Any student of economics will tell you that independent countries cannot use the same currency while running their own fiscal policies without eventually causing a balance of payments problem. This is similar to what we saw happen in the eurozone, with the euro common currency, in more recent days. Therefore, it is highly unlikely that the architects of the Bretton Woods system could not have foreseen this.

The system worked well enough in the initial years, on the back of robust demand for US goods and services from Europe and Japan for their post-war rebuilding efforts. It started to fray, however, going into the 1960s, when European and Japanese exports became more competitive and the US share of world output declined. Huge military spending during the Vietnam War further pushed the US into persistent deficits. Demands for the US to balance its budget were ignored. A balance of payments crisis emerged. Official US dollar liabilities held overseas mounted, exceeding its gold stock multifold — the US dollar was overvalued! By the second half of the 1960s, European nations demanded gold for their US dollar holdings, creating a run on US gold reserves.

With rising inflation, unemployment, a weakening US dollar and the risk of running down all of its gold reserves, President Richard Nixon ended gold convertibility on Aug 15, 1971. This also, effectively, ended the Bretton Woods system. He went on to impose a wage and price freeze to control inflation and levied import tariffs to boost US production and jobs. The US dollar crashed and the word “stagflation” was coined.

For over two decades, the US dollar, where it could be exchanged for gold, enjoyed global hegemony as the world medium of exchange and trusted store of value. This hegemony remained, even after the collapse of Bretton Woods. The international monetary system transitioned from a gold standard to one based on pure fiat money, backed not by any underlying asset with intrinsic value but by faith in the US government. Why was this so? It was due, in no small part, to the rise of “petrodollars” in the 1970s.

Indeed, the role of petrodollars in protecting the endurance of the US dollar hegemony cannot be understated. In 1974, Saudi Arabia made a deal with the Nixon administration that includes the condition that its oil exports would be traded exclusively in US dollars. This “oil for dollars” was later embraced by other members of the Organization of the Petroleum Exporting Countries (OPEC). Given oil’s critical importance in every economy, this all but cemented the US dollar’s position as the preeminent medium of exchange as well as store of value. The recycling of petrodollars into US dollar-denominated assets, including Treasury bonds, further anchored its reserve currency status. Over time, US dollar dominance extended to the entire commodities complex and the rest of the world. Today, central banks typically hold about two-thirds of their foreign reserves in US dollar assets.

This insatiable demand allowed the US to exact “exorbitant privilege” — sustain the world’s largest current account deficit, with no negative consequences. The US is able to finance ever-growing fiscal spending with cheap borrowings — to keep building on its military superpower status, fortify its unparalleled influence in economics, finance and technology, pursue expansive social programmes, support American consumerism and elevate living standards for its population, all the time compounding the positive feedback loop. We have no doubt that US dollar hegemony has driven American foreign policy over the years.

As we have mentioned, US exceptionalism was paid for largely by the rest of the world. Its dominance is a legacy of the Bretton Woods system, which it created nearly eight decades ago. It will stay with us for the foreseeable future. The only question is, will this remain the case 20 years from now?