Central banks around the world hold a significant portion of their reserves in US currency, private companies used it for international transactions, and US treasury bonds were the most liquid markets in the world.
As a result, the US economy only benefited from a currency that lubricated the wheels of the global financial system.
And this state of affairs is quite unusual from a historical point of view according to the statements set forth in a new book by Barry Eichengreen, professor of economics and political science at the University of California, Berkeley, and ECB economists Arno Mel and Libya Shitu.
Having studied the data on central bank reserves from 1910 to the early 1970s, focusing on the period of the 1920s and 1930s, Eichengrin and his co-authors found that world reserve currencies could well coexist with each other.
For example, between the two world wars, the British pound and the US dollar shared the status of the world currency on an equal footing.
Do World War I, although sterling remained the most important currency, the French franc and German mark also had international significance.
"From this point of view, the second half of the 20th century is an anomaly when the lack of alternatives allowed the dollar to monopolize the role of the world currency," they write.
However, now, according to scientists, the days of the dollar as the dominant reserve currency are numbered. We may well return to the time when currencies coexisted on the most equal basis in international markets.
In the future, the dollar will be forced to compete with the yuan and the euro. And the speed of these changes will depend on the line of behavior of Donald trump, says Eichengreen.
He notes that the traditional point of view is that there is only one real international currency on the world stage.
A new point is that financial technology is developing, network effects are not so strong.
Today it’s much easier to switch between currencies.
If the policies of the governments and central banks responsible for these currencies remain robust and stable, the evolutionary process can proceed smoothly.
On the other hand, if there is any political or financial shock, if we witness the inability of the US Congress to raise the debt ceiling, or if a trade war occurs, the situation can change dramatically.
This will depend on whether people consider US Treasury bonds to be unsafe assets or whether they consider the RMB securities to be unsafe because the rule of law in China is unreliable.
It would be a failure for government bonds to lose their reputation for safe haven.
This will seriously undermine the foundations of the global economy and the idea of globalization, since Cross-border trade and financial transactions are based on the dollar.
If liquidity runs out because people don’t want to hold and use dollars, what can be used instead? The Swiss franc remains, and control over Chinese capital makes it difficult to get the yuan.
There will be a global liquidity shortage. Awful scenario.
Two years ago it would even be hard to imagine.
But with the election of Trump, I had to seriously think about events that we could completely ignore before. For example, countries that rely on the United States as a "security umbrella" hold a larger share of their reserves in dollars than countries that do not.
This is a way to make the US understand: we are on your side. But this is also a way to provide US hostages.
So what are the benefits of international reserve currency status? This has some economic value, because it is convenient for banks and firms to conduct cross-border business in their own currency, while the government can borrow at a lower price due to the additional demand for treasury securities as reserves. In addition, if you are a leading international currency, you are also a refuge. When something goes wrong in the global economy, everyone rushes to your financial markets, even if you are the cause of the crash.
We observed this situation in the case of Lehman Brothers and the financial crisis of 2007-2008.
What are the political consequences of losing this status? It is unlikely that in an era when the United States plays a less influential geopolitical role, one should expect major negative factors.
Britain's power and position on the world stage has declined significantly since it became the issuer of the leading international currency. Can the US suffer the same fate?
Great Britain was the most extreme case. It was a sick economy for a long period after World War II with huge debts and financial problems. The ratio of debt to GDP exceeded 200%, which is two times more than what is observed in the United States. Under these conditions, it is simply inconceivable that sterling can remain the same influential currency as it was before.
The US is not in that position right now, but it will all depend on how good or bad economic management is.
Every true world currency in the history of the world was the currency of a democratic state. And China understands that it needs to carry out political reform to strengthen the rule of law and the reliability of contract enforcement.
You want a strong and reliable government that implements predictable investor friendly policies. Meanwhile, the US is acting randomly, and there is no European government, there is rather a set of governments trying to collaborate on the Capital Markets Union. Perhaps China is becoming an attractive issuer.
And for the currency to play a global role, four factors are needed: size, stability, liquidity and security.
Europe’s economy must continue to grow, and the region needs to move forward so that the Capital Markets Union becomes a more liquid market.
Europe has made progress in developing a course of action in times of crisis, and its economy is growing again. Markets for assets denominated in euros are growing and becoming more liquid.
The most optimistic scenario is if globalization continues at a faster pace than in the recent past, with the support of the global financial system, which relies on three pillars: the dollar, the euro and the yuan.
The pessimistic scenario is that progress is too slow and something is happening that undermines confidence in the dollar. Meanwhile, the euro and the yuan did not have time to grow, and a global liquidity crisis developed that hinders globalization. Rather, you should prepare for the first scenario, but do not forget about the second.
Finally, it's worth talking about cryptocurrencies. Money has three functions: means of payment, unit of account, and storage of value. Digital currencies are a promising way to reduce transaction costs and can be a more effective means of payment. But Bitcoin is not a good way to preserve value; it is practically unable to keep up with its volatility.
History shows that a reliable means of preserving value should be the government.
Digital currencies have a future – digital currencies issued by the central bank. But then the question arises: will the central bank digital currencies crowd out private digital currencies such as bitcoin? Or will central banks try to squeeze them out of business because they are mainly used for money laundering, tax evasion, terrorist financing and drug deals?
Over time, we will see that central banks and governments occupy this space, providing truly effective ways to pay for the services that people need. We observed this in a story with evolution from gold coins to tokens, from paper money to bank deposits and now to digital currencies.