The power of the U.S. dollar lies in its use as a global currency. The dollar is also backed by the power of America's economy.
Here are a few reasons behind the enduring power of the dollar. They explain why no other currency will quickly replace it.
1944: The Dollar Is Declared the Global Currency
After World War II, the world's developed countries met in Bretton Woods, New Hampshire, to create a more stable monetary system. In the Bretton Woods agreement, they promised to tie the value of their currencies to the U.S. dollar. The United States agreed to redeem any dollar for its value in gold.
Why dollars? The United States held three-fourths of the world's supply of gold. No other country had enough gold to back their currency's value. Bretton Woods allowed the world to transition from a gold standard to a U.S. dollar standard.
The Bretton Woods Agreement established the U.S. dollar as the most powerful currency in the world economy.
Bretton Woods allowed the dollar to become a substitute for gold. As a result, the value of the dollar began to increase relative to other currencies.
The 1970s: The Dollar Replaces the Gold Standard
By the early 1970s, double-digit inflation lowered the eurodollar's value. Foreign banks began demanding gold for their dollars. The United States could no longer meet this growing obligation. 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. The dollar completely replaced the gold standard at this point.
Most international commodities contracts, including oil, are denominated in U.S. dollars.
The dollar's power means that many large economies, such as China, Hong Kong, Malaysia, and Singapore, peg their currency to the dollar. A powerful dollar improves the profits of their exporters. These countries also hold large deposits of U.S. Treasurys. In theory, these countries could sell their holdings and cause a dollar collapse. But with export profits tied to the strength of the dollar, that's not in their best interest.
Why the Euro Won't Soon Become the Global Currency
In 2007, former Federal Reserve Chairman Alan Greenspan said in an interview with German weekly Stern magazine, "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency.
Greenspan said this because, at the end of 2006, the euro was gaining in power. According to the International Monetary Fund (IMF), 25% of all foreign exchange reserves held by central banks were in euros in the fourth quarter of 2006, compared with 17.7% in the first quarter of 2001. In many areas of the world, the euro was replacing the dollar.
The euro's strength is tied to the European Union's strength, which is one of the world's largest economies.
The chance of the euro becoming a world currency was damaged by the eurozone crisis that lasted between 2009 and 2012. It revealed the difficulties of a monetary union that's guided by separate political entities. For example, German Chancellor Angela Merkel wanted to impose austerity measures to get debt under control, whereas French President Francois Hollande wanted to fund stimulus programs by creating a bond program for the economic block.
How the Power of the U.S. Dollar Affects You
The dollar's power gives you many benefits and few disadvantages.
A powerful dollar means interest rates are low. A strong dollar increases demand for U.S. Treasury notes, which are sold at auction. When demand is high, investors are willing to pay more for the bonds and require less return than when demand is weak. As a result, Treasury note yields are lower. That reduces interest rates on long-term bonds, such as 15-year and 30-year mortgages.
Future taxes are low when the dollar is strong. Congress can increase the deficit when interest rates are low without increasing the interest on the national debt. As those payments remain modest, it's less likely Congress needs to raise taxes to pay them.
Imports cost less. A strong dollar lowers the price of foreign goods relative to those made in the U.S. That translates to lower prices for French cheese, Korean televisions, and Japanese cars.
A stronger dollar can mean lower gas prices because oil contracts are priced in dollars. A stronger dollar means oil revenues are worth more to oil-exporting countries. Oil prices are a huge determinant of the cost of gas at the pump.
The biggest disadvantage is that U.S. export prices are high relative to foreign goods and services. As a result, U.S. products become less competitive in the global marketplace. This costs American jobs as U.S. manufacturers are priced out or are forced to source overseas to lower their costs.