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. That 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, to curb inflation, countries began demanding gold for their dollars. Rather than allow investors to deplete Fort Knox of all its gold reserves, President Nixon untied the dollar to gold. However, by that time, the dollar had become the world's dominant reserve currency. (Source: "Strong Dollar, Weak Dollar," The Federal Reserve Bank of Chicago.)

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. They could conceivably 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 in 1991-1993.

During these declines, there were also forecasts of a dollar collapse. Many countries discussed removing their currencies' pegs to 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 held in euros, compared to 66 percent for the dollar. Furthermore, 39 percent of cross-border transactions were being done in euros, compared to 43 percent for the dollar. In many areas of the world, the euro is replacing the dollar. Furthermore, the EU has now become one of the world's largest economies. (Source: "Greenspan Says Euro Could Replace Dollar," IHT.com, November 17, 2007.)

Even if the euro is destined to replace the dollar, it would happen slowly, and not cause a dollar collapse. That's because it's in no one's best interest for the dollar to collapse since it would completely destroy the global economy. Furthermore, the United States is the world's best customer. Therefore, the very countries that could cause a dollar collapse are those 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. That forced the EU to realize it must become a fiscal and governmental union if it wants to continue its monetary union. Germany's Chancellor Angela Merkel wants this to occur, but the other members are very wary, as Germany's domination in World War II is a too-recent memory.

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

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

Later that month, the Bureau of Economic Analysis announced that U.S. GDP growth was an astounding 4 percent for the second quarter (April-June).

That was based on across-the-board growth. It was a welcome change in direction from 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 large part was due to the strength of the dollar. Oil contracts are priced in dollars, so a stronger dollar meant oil revenues were worth more. That created a flight-to-safety towards 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?