This blog post examines why the dollar retained its status as the reserve currency after the collapse of the Bretton Woods system. We will analyze this primarily through the lens of the influence of the U.S. economy and the structure of financial markets.
A reserve currency is a currency used as a means of payment in international transactions and serves as the benchmark for determining exchange rates. The importance of such a reserve currency is directly linked to the stability of the international economy, playing a central role in the global economic order. In particular, the reliability and liquidity of the reserve currency exert a decisive influence on international financial markets. In 1960, Professor Robert Triffin pointed out the structural contradictions of the dollar, the reserve currency under the Bretton Woods system. His theory remains a significant topic in international economics to this day, and discussions about the role of the reserve currency and the resulting dilemmas continue.
The current account balance, representing the difference between a country’s imports and exports of goods and services, is in deficit when imports exceed exports and in surplus when exports exceed imports. Triffin stated, “If the United States were to refuse to run a current account deficit, halting the supply of international liquidity, the global economy would suffer a severe contraction.” This concern was a very real problem given the economic circumstances of the time, starkly illustrating the impact of the U.S. economy on the international economy. He also noted, “Conversely, if the deficit persists and the dollar becomes oversupplied, its credibility as a reserve asset will decline, and the fixed exchange rate system will collapse.” This represents the dilemma faced by a nation serving as the issuer of the reserve currency, illustrating how difficult it is to strike a balance between supplying liquidity and maintaining credibility.
This Triffin dilemma concerns the tension between securing international liquidity and maintaining the dollar’s credibility. International liquidity refers to a universally accepted means of payment. Under the gold standard, gold served as international liquidity, and each nation’s currency value was fixed to a defined amount of gold. Consequently, exchange rates—the ratios for exchanging currencies between nations—were automatically determined. The gold-based international economy was quite stable, but a conflict arose between the finite nature of resources and the need for economic growth. Subsequently, under the Bretton Woods system, the dollar was added as an international liquidity medium, creating a gold exchange standard. Established in 1944, this system obligated the U.S. central bank to exchange one ounce of gold for $35 at any time, per the gold redemption clause. Other nations fixed the value of their currencies to the dollar and could only purchase gold using dollars. Exchange rates were permitted to fluctuate only within ±1%, except in exceptional cases involving structural imbalances in the current account. Consequently, cross-exchange rates between currencies other than the dollar, the reserve currency, were automatically determined.
In the early 1970s, the U.S. began accumulating current account deficits, leading to an oversupply of dollars and a sharp decline in U.S. gold reserves. Consequently, the U.S. reached a point where it could no longer meet its dollar’s gold redemption obligation. The solutions were either to devalue the dollar by lowering its value or to revalue other currencies against the dollar by raising their value. However, under the Bretton Woods system, devaluation of the dollar was impossible by regulation. Major countries like Germany and Japan, which held large trade surpluses with the U.S., were unwilling to revalue their currencies. This began to destabilize the international economic order, leading the global economy to a new turning point. Anticipating the unsustainability of this situation, speculative demand for the German mark and Japanese yen increased, inevitably intensifying pressure for exchange rate fluctuations. In this climate, nations sought to convert large holdings of dollars into gold. Ultimately, the U.S. implemented the Nixon Shock in 1971, suspending the dollar’s convertibility into gold, leading to the collapse of the Bretton Woods system.
However, even after the collapse, the dollar continued its role as the reserve currency. This was due to the scale and stability of the U.S. economy, as well as its dominant position in international financial markets. One reason for this is economies of scale. If every country in the world used a different currency without any reserve currency, the number of exchange rates would be as numerous as the possible currency pairs between any two countries. Conversely, conducting foreign exchange transactions centered around a single reserve currency reduces costs and achieves economies of scale. This economic efficiency is one factor that has kept the dollar in a crucial position within the global economy. Furthermore, the dollar is used as various forms of assets within the international financial system and remains firmly established as a trusted currency.
