What is a reserve currency?
Let start by explaining what a reserve currency is.
“A reserve currency (or anchor currency) is a currency that is used internationally for trade and held in significant quantities by governments, institutions or wealthy investors as part of their foreign exchange reserves."
In short English, it’s the currency that is widely accepted around the world. To this day, the US Dollar holds that position. Wherever you go, chances are big people will recognize the US Dollar as money and will accept it when selling their goods and services. But it hasn’t always been that way. Over the centuries we have seen many reserve currencies come and go.
Which nations held that position before the Dollar? And why did this change? In this article, we dive into the last 500 years to see the history of reserve currencies. But before we start, let’s explain why the world needs them.
Why do we need a reserve currency?
A reserve currency often expresses the value of international commodities such as gold and oil. It facilitates trade as each party is looking at the same charts. It also keeps the value of national currencies at a fixed rate relative to the reserve currency. You can see it as a benchmark of how monetary policies are performing against the same asset, in this case, the US Dollar. Nations have to keep a balance between preserving their wealth by not printing too much money and keeping their national currency attractive for export. That’s why countries prefer to keep the value of their currency lower than that of the Dollar. For example, China pegs the value of the Yuan to the Dollar. When China stockpiles Dollars, it increases the value of the Dollar and decreases that of the Yuan. As a result, Chinese goods become cheaper at the international market and thus increasing China’s export.
Another reason is providing confidence to its citizens and foreign investors. Countries hold significant quantities of foreign exchange reserves to preserve their wealth in case of war or economic crisis. Such events could trigger a sudden flight where investors and corporations withdrawal their deposits. This could cause an effect where the value of the national currency plumped, causing hyperinflation as we’ve seen in Venezuela, Argentina, Zimbabwe, etc. Enough foreign exchange keeps confidence in markets stable.
A brief history of reserve currencies
The Portuguese currency was the dominant currency for 80 years between 1450 en 1530. But it changed. In 1484 Christopher Columbus approached the king of Portugal in search of funds for financing his fleet that would sail westward. He believed to find a new trade route to East Asia. This was a very costly and risky exploration and, thus the king denied. Columbus didn’t give up and found more luck with the new rulers of the newly united Spanish kingdom. As we all know, Columbus didn’t discover a new trade route but hit the jackpot by discovering America. Spain conquered America and established immense gold and silver mines which enriched Spain and left Portugal behind.
Through discoveries of Columbus and others who followed, Spain became a dominant empire in Europe. It ruled over Europe, and vast chungs of North and South America, the Philippine Islands, and the coasts of Africa and Asia. As a result, Spain saw its currency becoming the dominant trade currency for over 100 years, from 1530 till 1641. But it wasn’t meant to last forever.
The small and windy swamp of the Netherlands was fighting for its independence from the Spanish kingdom. They managed to not only become independent but also became the masters of the ocean highways thanks to inventing genius credit systems. As trust in the Spanish kings was eroding, the Dutch were securing the trust of the burgeoning European financial system through repaying loans on time with nice profits. They famously were the investors of the joint-stock companies (aka VOC). Before this invention, investors had to put all his money in one vessel, while now he could spread his investment over a fleet of vessels, spreading his risk. The Dutch saw their currency becoming the international trade currency from 1642 till 1720 until France did its entrance. The Dutch were getting involved in more and more wars such as losing their colony of New Amsterdam to the British, renaming it New York. Eventually, they lost their place as Europe’s financial capital.
France was a rich, and populous nation, but it proved to be very unworthy thanks to the Mississippi Bubble in 1717. The Mississippi company was a French company who wanted to colonize the lower Mississippi valley, establishing the city of New Orleans. To finance these ambitious plans, it had to sell shares on the Paris stock exchange. They spread stories of fabulous opportunities while it was nothing more than a swamp. Shares skyrocketed, 20 times the original price. People sold their possessions to buy stocks and get rich. Eventually, reality kicked in, and shares plummeted. The central bank of France wanted to stabilize prices and started to buy stocks themselves through printing new money. Now France owned worthless shares, and the public started to lose faith in the French banking system. It managed to become the international trade currency for almost 100 years from 1720 till 1815, but now the French empire was crumbling. And another nation was expanding rapidly, Britain.
Britain empire was run largely by private joint-stock companies based in London. It colonized India and North America. Britain was seen as the leading finance of trade and opened branches globally. The decline of the British pound started when World War I happed. For 105 years, the British empire was the largest the world has ever seen from 1815 till 1920. After world war I, they lost their spot to the current ruler, the United States of America.
United States of America
In 1944 the Bretton Woods agreement was established whereby the US Dollar was pegged to the price of gold. At the time, the Dollar was the most powerful currency, and the only currency backed by gold. It led to the US becoming the world-leading power. As a result, many other currencies linked their national currency to the US Dollar and thus believed they were indirectly linked to gold. But unfortunately, in 1971, US President Nixon decided to abandon the Bretton Woods system and thus releasing the Dollar from its peg to gold. Now the US Dollar is a free-floating currency with no hard assets backing it.
So what can we learn from this?
Well, modern reserve currencies have an average life span of 95 years. This would say that the US Dollar should have collapsed in 2015. Quite a bold statement if you ask me. But apart from reserve currencies, all other (and smaller) currencies throughout history have eventually collapsed, except for those which are still in circulation. The one asset that still dominates for over 5000 years is gold. It’s the best form of money we have as a society .. except it isn’t. Have you ever tried paying someone in gold? Not convenient, is it? But as an investment to store your wealth, it’s pretty reliable for almost 5000 years.
The last couple of years, we see nations again stockpiling gold instead of reserve currencies. Russia, Hungary, China, Qatar, Kazakhstan, India, … bought gold in bulk last year. Most of these central banks do this because of financial stability. This week, Russia announced that it would change currencies from the Dollar to the Euro for its trading activities with China.
What does this have to with Bitcoin?
Just looking at the statistics, the US Dollar should already be at the end of its reign. What happens next? Well, it won’t be Bitcoin. That’s just too early to become the next reserve currency. Confidence has to grow for a couple more years/decades. Who knows? But it just happens to be that the chairman of the Federal Reserve called Bitcoin a store of value “like digital gold” in front of Congress. It has similarities with gold as the supply is limited, and it’s hard to produce new bitcoins. That’s definitely a sign in the right direction.