Strength and Power of the US Dollar

Reasons Why the U.S. Dollar Is So Powerful

Strong Dollar
The dollar is accepted as legal tender throughout the world. Photo: DigitalVision Vectors/Getty Images

The power of the U.S. dollar depends on its use as a global currency. This itself is backed by the power of America's economy. Here are three reasons behind the power of the dollar. They explain why no other currency will quickly replace it.

The Dollar Is a Global Currency

After World War II, the world's developed countries created a plan in Bretton Woods, New Hampshire. They fixed the rate of exchange for all foreign currencies to the U.S.

 dollar. The Bretton Woods agreement promised that the United States would redeem any dollar for its value in gold. By the early 1970s, countries began demanding gold for their dollars to curb inflation. Rather than allow investors to deplete Fort Knox of all its gold reserves, President Nixon untied the dollar from gold. By that time, the dollar had become the world's dominant reserve currency. (Source: "Strong Dollar, Weak Dollar," The Federal Reserve Bank of Chicago, June 1998.)

The Dollar Is the New Gold Standard

In essence, the dollar is like the gold standard. Most global contracts, especially those for oil, are denominated in dollars. Many large economies, such as China, Hong Kong, Malaysia and Singapore, peg their currency to the dollar. When the dollar weakens, so do the profits of their exporters. These countries also hold large deposits of U.S. Treasurys. In theory, they could sell their holdings and cause a dollar collapse.

But that's not in their best interest.

The Dollar Has Always Recovered from Prior Declines

The dollar declined during the 1970s, the early 80s and from 1991 to 1993. During these declines, there were also forecasts of a dollar collapse. Many countries considered removing their currencies' pegs from the dollar.

 But there was no real substitute for the dollar as a global currency, so a collapse did not happen.

Could the Euro Replace the Dollar as a Global Currency?

In 2007, former Federal Reserve Chairman Alan Greenspan argued that the euro could replace the dollar as a world currency. At the end of 2006, 25 percent of all foreign exchange reserves held by central banks were in euros, compared to 66 percent in dollars. Furthermore, 39 percent of cross-border transactions were being done in euros, compared to 43 percent in dollars. In many areas of the world, the euro is replacing the dollar. To support this, the European Union has now become one of the world's largest economies. (Source: "Greenspan Says Euro Could Replace Dollar," International Herald Tribune, September 17, 2007.)

Even if the euro is destined to replace the dollar, it would happen slowly. It would not cause a dollar collapse because it’s in no one's best interest. A dollar collapse would destroy the entire global economy. Also, the United States is the world's best customer. The countries that could cause a dollar collapse are the same ones who need Americans to keep buying their products. Therefore, they have no incentive.

Another reason the shift to the euro, if it occurs, would happen slowly is because of the eurozone crisis.

 It forced the EU to realize that it must become a fiscal and governmental union if it wants to continue its monetary union. Germany's Chancellor Angela Merkel wants this to happen, but other members are cautious. Germany's domination during World War II is a too-recent memory. The European Union's progress toward this monumental undertaking will determine the future strength of the euro in comparison to the dollar.

Why the U.S. Dollar Has Risen in Value

The dollar index tracks the value of the dollar. It has risen 25 percent since July 2014. Why? First, in June 2014, the European Central Bank said that it would consider quantitative easing to lift the EU out of a deflationary, slow-growth spiral. Foreign exchange traders worried this would lower the value of the euro and started moving to dollars.

In July 2014, the Federal Reserve announced that it would end its quantitative easing program in October. This signaled the central bank's confidence in the U.S. economy. For more, see FOMC Meetings Schedule.

Later in July 2014, the Bureau of Economic Analysis announced that the United States’ gross domestic product growth was an astounding 4 percent for the second quarter (April-June). This was based on across-the-board growth. It was a welcome change compared to the first quarter's 2.1 percent contraction. For more, see Current GDP Statistics.

In October, Saudi Arabia announced it would not support the price of oil at $70 a barrel by limiting supply. It reversed its prior positions. A major reason was due to the strength of the dollar. Oil contracts are priced in dollars. A stronger dollar meant oil revenues were worth more. That created a flight-to-safety toward U.S. Treasurys and the dollar. For more on how these are related, see Value of the U.S. Dollar

For a detailed timeline of these events in 2014 and 2015, see Why Is the Dollar So Strong Right Now?