A FORTHCOMING paper in the Journal of Development Economics looks at the dollar’s ascendancy to global reserve currency. Barry Eichengreen, of the University of California, Berkeley, and two economists from the ECB up-end the conventional history of when the dollar became top dog.
Economic historians have typically believed that until the second world war the British pound sterling remained the leading international currency. The system was geared in favour of sterling, the argument goes: bankers instinctively used the pound because everyone else did. Economists refer to this as inertia. An extension of this logic is that there can be only one major international reserve currency—in the same way that Blu-ray discs, not HD DVDs, came to dominate the high-definition video market. It's easier if everyone uses the same thing.
Mr Eichengreen show that for reserve currencies these arguments are dodgy. For one, the dollar became a strong reserve currency much earlier than expected. Data on the international bond market from the United Nations paint a clear picture. From 1914 to 1946 sterling and the dollar accounted for about 97% of global foreign public debt. But by the 1920s, not the 1940s, the balance of power had shifted decisively:
Global foreign public debt for 28 countries—arithmetic averages (GBP and USD as % of total; at current x-rates)
The graph above excludes Commonwealth countries, which were lassoed to sterling for political reasons. Even if we include them, the dollar was hot on the heels of sterling by the late 1920s.
Why did the dollar end up dominating? The Federal Reserve Act of 1913 lifted the ban on foreign branching by American banks. That made it easy to issue debt in dollars by American banks operating abroad. The growing size of the American banking sector also helped: from 1918 to 1932 the US banking assets rose from 70% of GDP to 100%. The growing size of the American economy probably made a difference.
Individual countries went American even earlier. By the first world war the dollar was the dominant currency of foreign-debt denomination in Belgium, Poland* and Switzerland, among others. Swiss bonds were sold in New York from the late 19th century. The American State Department supported this development: they reckoned that as countries became dependent on American lending, they would be more inclined to buy American exports.
The paper has interesting implications for today. It stresses that financial development is crucial to reserve-currency status. As we reported in June, people exaggerate the importance of the yuan. Just $0.3 trillion of Chinese assets are open to foreign investors, compared to $56 trillion of American ones. That makes the yuan a poor candidate for a global reserve currency.
Another important finding is that there can be more than one international reserve currency. The dollar and the pound trundled along together for two decades, before sterling slid away as Britain stagnated economically. Even when the yuan is ready to be a global reserve currency, it will share the pedestal with the greenback.
* Correction: the dollar only became the dominant currency of foreign-debt denomination in Poland in 1919. Sorry.
