Today approximately 160 currencies are used worldwide. Some countries share the same currency, while others use the currency of another country. However, not all currencies are equal. One currency always tends to become the dominant currency in international affairs, known as the global reserve currency. There are benefits for the country that issues the global reserve currency. However, there are also major drawbacks and the two cannot be separated.
Learn more about global reserve currencies and the Triffin dilemma on this episode of Everything Everywhere Daily. Get started with the commerce platform made for entrepreneurs. Shopify is specially designed to help you start, run,
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Economic issues such as budget deficits, trade deficits, and exchange rates are frequently discussed and debated in the news. They've been discussed and debated for decades and will probably continue to do so for many more. Many people pay very little attention to these matters because they can be very difficult to understand. However, all of these issues that I just listed are all interconnected.
What I want to discuss in this episode is something that touches on subjects that I've covered in previous episodes. However, this time I'm going to be looking at matters in a slightly different way. It all starts with the concept of a global reserve currency. As I mentioned in the intro of this episode, there are about 160 different currencies in the world today.
The vast majority of them are ones you've probably never heard of before. The Laotian Kip, the Samoan Tala, the Burmese Kiat, the Papua New Guinea and Kina, the Malawian Quacha, the Polish Zwarte, and of course, the Vietnamese Dong. The reason you've probably never heard of most of them is because they have no use or value outside their own country and there's little demand for them.
Throughout history, there has been a tendency for the money of one nation to become dominant. These weren't the same as modern reserve currencies, but they did exhibit similar behaviors. The Persian Empire's gold Darek, introduced by Darius the Great, became one of the earliest widely accepted currencies across multiple civilizations. It was dominant from about 550 to 330 BC in the Middle East.
After Alexander the Great's conquest, Greek silver coins, particularly from Athens, gained widespread acceptance. The Athenian owl Tetradrachm became recognized for its reliability and purity, circulating well beyond Greek territory. As Rome's power expanded, its silver denarius and gold aureus became the foundation of commerce throughout the Mediterranean world and beyond.
After Rome's decline, the Byzantine Empire's gold solidus, later called the Byzant, became the premier international currency. As Islamic empires expanded, the gold dinar emerged as a significant international currency. The Florentine Florin, the Venetian Ducat, Spanish Pieces of Eight, and the Dutch Gilder all had dominant periods during the Middle Ages and the Renaissance.
every one of the currencies I've mentioned was just a different type of gold coin. Why would one particular gold coin be valued above other gold coins? Official gold coins carried the stamp of the issuing authority, the Persian king, Byzantine emperor, or the Venetian republic. These marks served as an early form of anti-counterfeiting technology and quality assurance.
Once a particular coin achieved widespread use, it benefited from what economists call network effects. The more people used it, the more valuable it became as a medium of exchange. For example, the Spanish pieces of eight became the preferred coin for Asian trade, not just because of its silver content, but because everyone knew it would be accepted in the next transaction. Chinese merchants would accept Spanish dollars knowing that they could use them in other markets.
Following the Napoleonic Wars, Britain emerged as the dominant global power and the pound sterling rose as the world's premier reserve currency. All of these currencies gain dominance organically. But this changed after the Second World War with the Bretton Woods Agreement. I covered Bretton Woods in a previous episode, but to summarize, the Allied nations came together in 1944 to devise the post-war global economic system.
The cornerstone of the Bretton Woods system was that the U.S. dollar would be the global reserve currency. The United States pegged the dollar to gold at $35 per ounce, and then other countries pegged their currencies to the dollar by holding dollars in their reserve. So in this context, what exactly is a global reserve currency?
A global reserve currency is a currency that's widely held by central banks and other major financial institutions around the world as part of their foreign exchange reserve. It's used to settle international transactions, conduct cross-border trade, and stabilize national currencies. Essentially, it acts as the primary medium of exchange, store of value, and unit of account in the global financial system.
The Bretton Woods system eventually fell apart when the United States could no longer maintain its gold peg. In 1971, President Richard Nixon killed the Bretton Woods system by taking the United States completely off gold. Instead of a peg to the US dollar, other currencies were able to have floating exchange rates, which is still the regime we're under today.
In its place, the Nixon administration negotiated with Saudi Arabia and other oil-producing countries to establish the petrodollar system. These countries agreed to price and sell their oil in U.S. dollars in exchange for defense guarantees by the U.S. I also covered the petrodollar topic in a previous episode. So the United States didn't just want the dollar as a reserve currency, much of the rest of the world did as well.
However, there was a problem. Yale economist Robert Triffin identified it in the 1960s. The Triffin dilemma is one of the most fundamental paradoxes in international monetary economics. At its core, it identifies an inherent contradiction that emerges when a single national currency simultaneously serves as the world's primary reserve currency.
The core of the dilemma is that for a country to supply the world with enough of its currency to meet international demand for trade, reserves, and investment, it must run a balance of payments deficit. In other words, it must let more of its currency flow out of the country than is coming in. The dilemma comes into play because persistent deficits over time undermine confidence in the currency's value and stability, potentially threatening its status as the global reserve.
Triffin outlined this problem in the 1960s when the U.S. dollar was tied to gold under the Bretton Woods system. For global trade to grow, the United States had to supply more dollars than it had gold to back them. This created a conflict. Either stop the outflow of dollars to protect the gold reserves, risking a crisis in global liquidity, or keep supplying dollars, risking a collapse of confidence in the dollar-gold convertibility.
The dilemma explained the collapse of the Bretton Woods system in 1971 when Nixon suspended the convertibility of gold. Triffin actually testified before Congress in 1960, predicting that the Bretton Woods system would eventually collapse due to this inherent contradiction. The establishment of the petrodollar system enabled the dollar to remain the global reserve currency, but it did not resolve the Triffin dilemma.
At the start of this episode, I said that many important economic issues, especially in the United States, are linked and can be understood through the Triffin Dilemma. And the first subject is the trade deficit. I mentioned that whenever a nation's currency is used as the global reserve currency, it has to run a balance of payments deficit. Money has to flow out of the country to meet the demand that exists for the currency.
A trade deficit is just part of a balance of payments deficit. The easiest way for people outside of the United States to obtain dollars is to sell items in exchange for them. Also, when a currency is the reserve currency, it increases in value relative to other currencies. And that makes everything in the country with the reserve currency relatively more expensive, putting it at a competitive disadvantage.
It is possible to have a trade deficit without being a reserve currency. However, having a reserve currency all but guarantees the likelihood of a trade deficit. Now, with all those dollars floating around outside of the United States, what does a nation, company, or person who holds U.S. dollars do with them? You invest them in dollar-denominated assets.
In the 1970s, news stories began to emerge of Arab sheiks purchasing American real estate. In the 1980s, similar stories circulated about Japanese investors acquiring American landmark properties such as Rockefeller Center. Why were they doing this? Because they had a lot of U.S. dollars that they had to park somewhere. These properties were attractive investments. Real estate isn't even the biggest class of dollar-denominated investments.
The U.S. stock market has seen dramatic growth over the last several decades. Well, there are many reasons for this, including the rise of technology companies. A significant contributing factor is foreign dollars investing in American dollar-denominated stocks. However, perhaps the biggest source of investment has been in U.S. Treasury note.
When the Nixon administration negotiated with the Saudis to create the petrodollar system, they explicitly requested that Saudi Arabia invest their surplus dollars in U.S. government debt. As of the recording of this episode, the total amount of foreign-held U.S. government debt is approximately 20%, but it has been as high as 33% as recently as 2014. The two largest foreign debt holders are Japan and China, which have both run large balance of payment surpluses with the United States.
Now, I should note that despite the word deficit, the federal budget deficit and the trade deficit are different things. In terms of capital, the trade deficit is dollars going out of the country. The federal budget deficit involves selling bonds, some of which are purchased by foreign investors, which involves dollars flowing back into the country.
Also, while being a reserve currency all but guarantees a trade deficit, it doesn't guarantee a budget deficit. At any point, Congress could just pass a balanced budget. Money that goes into treasury bonds would just be invested somewhere else instead of those bonds if they weren't available. However, being a reserve currency does make it much easier to run a budget deficit.
A country with a reserve currency can obtain lower interest rates, and there's a built-in pool of money seeking investment opportunities. So this is the problem. If the government debt gets too big, and if economic activity becomes too imbalanced, then the confidence in the currency is undermined, which then hurts it as a reserve currency. Is there any way out of the Triffin Dilemma?
For starters, you can't easily undo being a reserve currency. There are trillions of dollars floating around the world, and that can't be easily undone. All of the proposed solutions would involve having a global reserve currency that is not controlled by any single country. Prior to the 20th century, gold served this function. While some nations had their coins preferred, at the end of the day it was all just gold.
One proposed modern solution would be something akin to the special drawing rights, which is a special reserve asset class created by the International Monetary Fund. It's not a currency, it's just an asset that's used by countries. And finally, another solution would be a neutral asset that is controlled by absolutely no government or any person, such as Bitcoin.
The Triffin dilemma illustrates that there are costs and trade-offs associated with everything. It's seldom that any action will have entirely positive outcomes. It can also help illustrate how seemingly different economic things can be very closely related, even if they don't appear so at first. The executive producer of Everything Everywhere Daily is Charles Daniel. The associate producers are Austin Oakden and Cameron Kiefer.
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