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Welcome to the Alts Sunday Edition 👋

Hope you enjoyed last week's issue on the ​Traffic Ticket Industrial Complex​.

Much like English is the language of international business, dollars are the currency of international finance. And the US dollar isn’t just America’s currency — it’s the world’s currency.

Global central banks hold the majority of their assets in US dollars, and essentially every major commodity market is priced in US dollars – including oil, natural gas, and gold.

I'll explore:

If you’ve ever wanted to know why the dollar is so hard to dethrone, this issue is for you.

Let's go 👇

Psst — I write more about currencies and macroeconomics in my newsletter, ​Banking Observer​. Check it out!

What does being a "reserve currency" actually mean?

The dollar is often referred to as the global reserve currency. But in reality, ‘reserves’ are only part of the story.

When investors talk about reserves, they’re referring to official foreign exchange reserves, or FX Reserves.

These are international currency assets that governments hold, usually to manage exchange rates or pay for essential imports.

US dollar-denominated assets currently make up about 58% of these reserves. The euro is in second place at 20%, followed by a handful of other major currencies.

But the US dollar’s importance to the international financial system goes far beyond just reserves:

Remember, the US makes up roughly one quarter of global GDP. So the dollar punches far above its weight.

Now, the dollar isn’t as dominant as it once was. Back in 2000, over ​70%​ of FX reserves were held in dollars.

But there’s no getting around it: the dollar remains the currency of international business and investment.

How did the US dollar come to dominate?

From D-Day to Dollar Day

The dollar’s dominance is no accident. It’s the result of a deliberate plan hatched by US policymakers in the wake of World War II.

In July 1944, just three weeks after D-Day, the Allied countries held a famous conference in ​Bretton Woods, New Hampshire​.

The goal of the conference was to create an international system that would avoid the economic factors that fueled the Great Depression — including trade wars and competitive currency devaluations. (Sound familiar?)

As the Bretton Woods conference unfolded, two big names rose to the top: Harry Dexter White of America, and John Maynard Keynes of Britain.

Keynes had a dream, but White had the leverage

Keynes favored a system in which international financial power would be widely dispersed, with multilateral institutions in charge of enforcing the rules. (He even wanted to create a new currency for international trade owned by no nation — "bancor.")

But White and the Americans disagreed. They wanted a US dollar-centric system in which America would run the show.

In the end, the Americans had all the leverage. Not only did the US hold two-thirds of the world’s gold reserves, but the UK was ​significantly indebted​ to their wartime ally.

As a result, White’s vision won out. The US dollar became the international currency:

The dollar breaks free from its golden anchor

Eventually, the Bretton Woods system began to crumble when the volume of dollars outstanding meant the US could no longer honor gold redemptions.

In 1971, US President Richard Nixon ​unilaterally ended​ dollar-gold convertibility. Two years later, the modern system of floating international exchange rates was formally adopted.

But while the Bretton Woods system may be dead, the global dollar it created lives on.

Why is the dollar a good reserve currency?

I think it’s fair to say that Bretton Woods was essentially a ‘top-down’ imposition of the dollar as the global reserve currency.

But it’s now been more than 50 years since the end of Bretton Woods, and the dollar is still king. Why has the dollar been able to keep its crown?

Sure, this is partly attributable to inertia. But the dollar has also served as a remarkably effective reserve currency — for four key reasons.

1) The US has deep capital markets

Governments around the world hold about $6.6 trillion in dollar reserves, a figure that doesn’t even account for private holdings.

When you’re dealing with capital at this scale, you can’t just stick these dollars in a bank account. You need to invest them.

But most economies are too small to handle this scale of investment – there literally aren’t enough assets to buy.

The US, however, is an exception. The country has incredibly deep capital markets, meaning it's large enough to effectively absorb global demand without sending prices soaring.

But it's the US fixed-income market that’s most important here.

When reserve managers are looking to invest their cash, they’re searching for safe, liquid assets.

(To be fair, that's not universally true. ​Korea Investment Corporation​, for instance, invests a portion of Korea’s reserves in assets like private equity and infrastructure.)

But overall, it doesn’t get much more safe and liquid than US Treasuries.

The US Treasury market is a massive ​$28.6 trillion​. Of this, about $8.8 trillion is held internationally, including $3.9 trillion by official institutions.

The importance of the US treasury market to the dollar’s reserve status cannot be overstated.

Brad Setser, a senior fellow at the Council of Foreign Relations (who writes the excellent ​Follow the Money blog​) puts it this way:

2) The US is a monetary sovereign

Admittedly, this factor isn’t part of the ‘mainstream’ understanding of what makes a good reserve currency.

But in my view, the dollar’s dominance is inextricably tied to the fact that the US is a monetary sovereign with the ability to freely issue its own currency.

This is not trivial! France and Germany are two major economies that sacrificed the power to issue their own currency when they adopted the euro.

Why does the US being a monetary sovereign matter for the dollar’s reserve currency status? Two big reasons.

America has an uncapped dollar supply

Recall why the Bretton Woods system ultimately failed: global demand for dollars outstripped America’s ability to honor gold conversion.

The US faced two main choices here: 1) Sever the dollar’s connection to gold, or 2) Cap the amount of dollars the US was willing to provide the world.

The US decided to go with option 1, embracing monetary sovereignty. (Option 2 would have signed the dollar’s death warrant as a reserve currency!)

Ever since, there have been no fundamental limits on the volume of dollars the US can supply the rest of the world.

America has (basically) no Treasury default risk

Because the US is a monetary sovereign, Treasuries don’t have ‘default risk’ in the traditional sense.

Yes, inflation risk is still present. But because the US can print dollars, it can never be forced to default on its own debt.

(And yes, in theory US could voluntarily default on its debt – but that would be extraordinarily foolish.)

And this lack of default risk is partly why foreign governments are comfortable holding trillions of dollars worth of Treasuries.

In contrast, consider a country like Greece, which defaulted on a portion of its debt in 2015. That can’t really happen to America.

3) The US has liberalized financial institutions

This factor combines a few different points, but I’m grouping them all under the idea that the US has liberalized financial institutions:

In developed countries, we take these things for granted. But some of the world’s biggest economies don’t have them!

China is a clear example here. Not only does the country maintain a system of strict ​capital controls​, but foreign parties don’t always receive ​fair legal treatment​ (although the Chinese government has made pledges to ​change that​).

4) The US runs twin deficits

Finally, but arguably most importantly, America runs large and persistent ​twin deficits​:

America’s trade deficit means that dollars regularly flow out of the country as payment for imported goods and services. Those dollars are held by foreigners.

America’s fiscal deficit, meanwhile, means the government issues huge volumes of Treasuries — providing safe assets for those foreigners to recycle their dollars into (and contributing to the depth of US capital markets...round and round we go.)

And here’s the thing: because the US economy is so large, these deficits are staggeringly huge compared to the rest of the world.

Simply put, America sends lots of dollars out to the rest of the world, while also providing a safe place to hold them. These twin deficits make the dollar a ‘natural’ reserve currency.

In contrast, consider a country like Japan.

Japan mostly fulfills the factors on this list. But the country ​only recently​ began running trade deficits, which aren’t that large compared to the size of the global economy.

There’s not a huge amount of yen structurally flowing into the international market year after year. It would be hard for foreigners to get their hands on enough yen to rival the dollar.

Trump and the dollar’s future

In the previous section, I established a framework for thinking about the reasons why the dollar has global supremacy.

Now, let’s use this framework to think about the dollar’s future — especially in the age of Donald Trump.

Trump has repeatedly emphasized the importance of maintaining the dollar’s status as reserve currency.

In a 2024 interview, he said that the US would become a third-world country if the dollar lost its reserve status — and that he’d be willing to use tariffs to punish countries that abandon the dollar.

Nonetheless, many of Trump’s key policies go directly against the very factors that drive the dollar’s reserve status!

In theory, Trump may want the dollar to remain the global reserve currency. But every single one of these actions makes that less likely!

And not everyone on Trump’s team is enthused about the dollar maintaining its global dominance. In a 2024 paper, Trump’s chief economic adviser Stephen Miran argued at length that the dollar’s reserve status has done ​far more harm than good​.

Why the dollar will remain king

Despite all this, I believe that the dollar will remain the leading global reserve currency — throughout Trump’s presidency and beyond.

And the reason why is simple: While Trump’s actions might dent the attractiveness of the dollar, there’s just no meaningful alternative to serve as a global reserve currency.

Every other option comes with very significant drawbacks:

Of these, the euro is clearly the most compelling competitor. But it would take a dramatic expansion of the ​supranational EU debt market​ to rival the Treasury market.

With all this being said, I do expect more diversification in official reserve holdings, and for the EU and China to take greater economic leadership roles within their respective spheres of influence.

But when it comes to truly replacing the dollar, I simply don't see a compelling case for any other currency.

Closing thoughts

One aspect I didn’t really explore today is whether the dollar’s reserve status is good for America.

This is a contentious debate, but yes, I do believe the global dollar strongly benefits America.

There are plenty of reasons why, but one stands out: The dollar can be used to buy almost anything in the world, and the US is the only country that can (​legally​) create US dollars.

This is an incredible level of economic power that seems absurd to give up!

Generally, Americans who dislike the dollar’s global role believe that it causes the currency to be overvalued, resulting in decreased export competitiveness. ​I’m skeptical of this view​.

What about everyone else? Is the dollar’s reserve status good for the world?

Well, that's an even more contentious debate.

Perhaps a topic for another time. 💵

That's it for today!

Thanks for reading, I'd love to hear your thoughts, comments, or critiques in the ​Alts Community​.

See you next time,
Brian

Disclosures