As World War II was coming to an end, 44 Allied nations met in July 1944 in New Hampshire, the US, to design a new set of rules that would govern the post-war international monetary order.
1994: Bretton Woods Conference
In 1944, the US dollar officially became the world's reserve currency. The Bretton Woods Conference pegged all other currencies against the US dollar. To ensure confidence in the system, the US dollar itself was convertible to gold at a fixed rate of US$35 an ounce. The US at that time, held some three-quarters of the world's official gold reserves.
The system worked well enough in the initial years, on the back of robust demand for US goods and services from Europe and Japan for their post-war rebuilding efforts.
1960s: Balance of payments crisis emerged
It started to fray going into the 1960s, when European and Japanese exports became more competitive and the US share of world output declined. Huge military spending during the Vietnam War further pushed the US into persistent deficits. Demands for the US to balance its budget were ignored.
A balance of payments crisis emerged. Official US dollar liabilities held overseas mounted, exceeding its gold stock multifold - the US dollar was overvalued. By the second half of the 1960s, European nations demanded gold for their US dollar holdings, creating a run on US gold reserves.
1971: End of Bretton Woods and end of gold convertibility
With rising inflation, unemployment, a weakening US dollar and the risk of running down all of its gold reserves, President Richard Nixon ended gold convertibility on Aug 15, 1971. This also, effectively ended the Bretton Woods system. He imposed a wage and price freeze to control inflation and levied import tariffs to boost US production and jobs. The US dollar crashed and the world "stagflation" was coined.
The international monetary system transitioned from a gold standard to one based on pure fiat money, backed not by any underlying assets with intrinsic value but by faith in the US government. It was due in no small part, to the rise of "petrodollar" in the 1970s.
1974: Rise of Petrodollar - "oil for dollars"
In 1974, Saudi Arabia made a deal with the Nixon administration that includes the condition that all its oil exports would be traded exclusively in US dollars. This "oil for dollars" was later embraced by other by other members of the OPEC. Given oil's critical importance in every economy, this all but cemented the US dollar's position as the pre-eminent medium of exchange as well as store of value. The recycling of petrodollars into US dollar-denominated assets, including Treasury bonds, further anchored its reserve currency status.
Over time, US dollar dominance extended to the entire commodities complex and the rest of the world. Today, central banks typically hold about two-thirds of their foreign reserves in US dollar assets.
US enjoys an "exorbitant privilege".
US dollar as a world reserve currency allows US to enjoy an "exorbitant privilege".
The insatiable demand for US dollar allowed the US to sustain the world's largest current account deficit, with no negative consequences. The US is able to finance ever-growing fiscal spending with cheap borrowings - to keep building on its military superpower status, fortify its unparalleled influence in economics, finance and technology, pursue expansive social programs, support American consumerism and elevate living standards for its population, all the time compounding the positive feedback loop.
Many believe that the US dollar hegemony has driven American foreign policy over the years. This US exceptionalism was paid for largely by the rest of the world. Its dominance is a legacy of the Bretton Woods system, which it created nearly eight decades ago. Will this remain the case 20 years from now?
Reference: Tong's Portfolio 2 Its all a matter of trust