How Global Currencies Work

1. Global Currency Dominance is Not a Natural Monopoly

For all these reasons, a single national unit will tend to dominate as the international unit of account, means of payment, and store of value.

Challenging assumptions. The traditional view of global currencies posits a "winner-takes-all" scenario, where one dominant currency, like sterling in the 19th century or the dollar in the 20th, monopolizes international transactions due to strong network effects. This book argues against this natural monopoly, suggesting that multiple national currencies can and often do play significant international roles simultaneously. Historical evidence, even from periods often cited as examples of single-currency dominance, reveals a more nuanced reality.

Historical coexistence. Before World War I, the pound sterling was indeed prominent, but the German mark and French franc also accounted for non-negligible shares of central bank reserves and were actively traded in global markets. For instance, while sterling was traded in all markets, the French franc was traded in 80% and the German mark in 60% of markets around 1900. This demonstrates that the financial engineering of the time allowed for a reasonably open system where several international currencies could coexist, rather than one crowding out all others.

New view's foundation. This "new view" is supported by advancements in financial technology, which have reduced transaction and information costs, making it easier for market participants to switch between currencies or manage diversified portfolios. Modern foreign exchange markets, with electronic platforms and sophisticated hedging instruments, lower interchangeability costs, diminishing the "lock-in" effect once attributed to dominant currencies. This technological evolution suggests that the conditions for a natural monopoly in international currency status are weakening, paving the way for a more multipolar monetary system.

2. The Dollar's Rise to Co-Dominance Was Swift and Early

Our new estimates are at variance with previous pictures. We find that the dollar first overtook sterling as the leading reserve currency not in 1928, 1938, or 1948 but already in the mid-1920s, and it then widened its lead in the second half of the decade.

Revising history. Contrary to popular belief that the dollar only surpassed sterling as the leading international currency after World War II, new archival evidence reveals a much earlier and more rapid ascent. By the mid-1920s, the U.S. dollar had already achieved co-equal status with the British pound, and in some aspects, even surpassed it, challenging the notion of strong persistence in currency dominance. This swift transition highlights that incumbency advantages are not insurmountable.

Wartime catalysts. World War I played a crucial role in this shift. Britain's deep engagement in the war strained its finances and limited its capacity to provide international credit, while the U.S., entering later, emerged as a net creditor. The Federal Reserve Act of 1913, which allowed U.S. banks to branch abroad and the Federal Reserve to act as a market maker for trade acceptances, provided the necessary institutional infrastructure for the dollar to capitalize on these wartime shifts.

Evidence across functions. This early co-dominance wasn't limited to reserve holdings.

• Reserves: By 1929, the dollar and sterling together accounted for 97% of global foreign exchange reserves, with the dollar holding a slight lead.
• Trade Finance: Dollar-denominated trade acceptances quickly grew to match and, for a period, surpass sterling-denominated ones in the 1920s.
• Bond Markets: Excluding Commonwealth countries, the dollar overtook sterling as the leading currency for international public debt by 1929.
  These findings consistently demonstrate a rapid rise of the dollar across various international currency functions, contradicting the idea of prolonged sterling dominance.

3. Financial Market Depth and Liquidity Drive Currency Status

Financial deepening was the most important contributor to the increase in the share of the dollar in global bond markets between 1918 and 1932.

Market fundamentals. The attractiveness of a currency for international use is fundamentally tied to the depth, liquidity, and stability of the financial markets in which its assets are traded. Investors, whether central banks or private entities, prioritize the ability to buy and sell large blocks of securities quickly without significantly moving prices. This characteristic, known as market liquidity, is a direct outcome of financial development.

Dollar's advantage. The rapid rise of the dollar in the 1920s, particularly in international bond markets, was largely driven by the deepening of U.S. financial markets. The Federal Reserve's establishment provided a crucial backstop, fostering a liquid market for dollar-denominated assets. This institutional support, combined with America's growing economic size, allowed the dollar to overcome sterling's historical head start.

Lessons for aspirants. The experience of the dollar, and conversely the struggles of the yen and the renminbi, underscore that simply having a large economy is insufficient. Countries aspiring to internationalize their currencies must prioritize:

• Developing robust primary and secondary markets for government bonds and other short-term instruments.
• Ensuring transparency and efficient price discovery to attract diverse investors.
• Cultivating a broad base of market participants to enhance liquidity.
  Without these foundational elements, even significant economic power may not translate into widespread international currency adoption.

4. Government Policy and Central Bank Action Are Pivotal

It is probable therefore that we must continue for some time a somewhat paternalistic attitude towards the market for dollar bills in this country.

Active intervention. The emergence of an international currency is rarely a purely organic market phenomenon; it often involves deliberate government policy and central bank intervention. The Federal Reserve's "paternalistic attitude" towards the nascent dollar acceptance market in the 1910s and 1920s exemplifies this. By actively purchasing trade acceptances and keeping its discount rate close to market rates, the Fed subsidized the market, ensuring liquidity and encouraging banks to originate dollar-denominated trade credits.

Strategic liberalization. Policy choices regarding capital controls and financial market liberalization also play a critical role. Japan's initial financial repression, designed to channel funds for industrial development, severely limited the yen's international role. Conversely, the gradual liberalization of its financial system, partly driven by external pressure, allowed the yen to gain some international traction in the 1980s. This suggests that while market forces are important, policy can either enable or constrain a currency's internationalization.

Asymmetric effectiveness. Interestingly, policies designed to discourage international currency use tend to be more effective than those intended to promote it.

• Discouraging measures like capital controls, unsupportive official statements, or exchange rate devaluations can significantly reduce a currency's international appeal.
• Promoting measures such as financial openness or supportive official positions, while necessary, often yield less immediate or dramatic results, highlighting the difficulty of overcoming established market habits and network effects.
  This asymmetry implies that while governments can effectively limit a currency's global reach, actively building its international status requires sustained, multifaceted efforts beyond mere encouragement.

5. Political Ties and Credibility Influence Currency Adoption

These alliance-related foreign balances were, if anything, more important than those of empire; revealingly, Japan’s sterling reserves were larger than India’s.

Beyond economics. The choice of an international currency is not solely driven by economic factors like trade volume or financial market depth; political considerations, including alliances, imperial ties, and a country's geopolitical standing, significantly influence adoption. Before WWI, countries like Japan held sterling to solidify ties with Britain, while Russia held deposits in Paris to strengthen its alliance with France. These strategic motivations often outweighed purely pecuniary calculations.

Credibility as a cornerstone. Confidence in a currency's value and the stability of the issuing country's policies are paramount. Investors, especially central banks holding reserves, prioritize reliable stores of value. Factors like low inflation, stable exchange rates, and sound fiscal management enhance a currency's credibility. The dollar's relative stability compared to sterling in the 1920s, and the yen's struggles with inflation in the 1970s, illustrate how policy credibility directly impacts international appeal.

Institutional frameworks. The institutional environment, including the rule of law and constraints on arbitrary government action, also underpins credibility. Democracies, with their checks and balances, are often seen as better able to make credible commitments to honor financial obligations, fostering deeper and more liquid bond markets. While China seeks to build confidence through internal party institutions and anti-corruption campaigns, the historical precedent suggests that transparent, predictable governance is a key, albeit complex, factor in securing long-term international currency status.

6. Sterling's Post-WWII Dominance Was a Temporary Anomaly

Sterling’s numerical dominance of foreign exchange reserves in 1946, the first postwar year, is striking, given the situation in the 1920s, when the pound and the dollar were coequals.

Wartime accumulation. The pound sterling's numerical dominance in global foreign exchange reserves immediately after World War II was an artifact of wartime finance, not a reflection of its intrinsic strength or renewed market appeal. Allied nations, particularly members of the British Commonwealth and Empire, accumulated vast sterling balances by supplying goods and services to Britain during the war, often under duress due to exchange controls and shipping limitations. These holdings were less a choice and more a consequence of the conflict.

Managed decline. Post-1945, these holders sought to liquidate their sterling balances, but the British government actively managed this decline through capital controls, moral suasion, and geopolitical influence. This prevented a precipitous collapse of the currency but resulted in a gradual, inexorable reduction in sterling's share of global reserves. The 1949 and 1967 devaluations further eroded confidence, signaling that maintaining sterling's international position was secondary to domestic economic priorities.

Regional rather than global. While sterling retained some importance, particularly within the Sterling Area (a group of countries with historical and economic ties to the UK), its role became more regional than truly global. The economic rationale for holding sterling diminished as Britain's relative economic size and trading power declined, and as other countries diversified their trade and financial links. This episode demonstrates that even a historically dominant currency can see its international role diminish rapidly when underlying economic and political fundamentals shift.

7. Japan's Yen Offers a Cautionary Tale of Missed Opportunity

Until 1975 the share of identified global foreign exchange reserves in yen was too small even to be distinguished by the IMF, the official arbiter of such matters, even though it was already some years since Japan had surpassed Germany as the second largest economy.

Financial repression's cost. Despite Japan's "economic miracle" and its rise to become the world's second-largest economy by the early 1970s, the yen played a negligible international role. This anomaly stemmed from a deliberate strategy of financial repression, which prioritized channeling funds for industrial development over fostering open, market-based financial systems. Strict capital controls, foreign exchange concentration, and reliance on authorized banks severely limited the yen's utility in international transactions.

Hesitant liberalization. While external pressure, particularly from the U.S. in the 1980s (e.g., the Yen-Dollar Agreement of 1984), spurred some financial liberalization, Japan's approach was often hesitant and reactive. The creation of new short-term financial markets and relaxation of some controls did lead to a noticeable, albeit modest, increase in the yen's international use in the late 1980s. However, these reforms were insufficient to build the deep, liquid markets necessary to truly rival the dollar.

Crisis and retreat. The "lost decade" of the 1990s, marked by banking crises and deflation, reversed much of the yen's international progress. The crisis exposed weaknesses in Japan's financial system and policy responses, further undermining confidence. By the time comprehensive financial deregulation (the "Big Bang" of 1998) was implemented, Japan's economic dynamism had waned, and other aspiring currencies were emerging. The yen's experience highlights that a strong economy alone is not enough; timely and comprehensive financial reforms are crucial, and domestic crises can derail even well-intentioned internationalization efforts.

8. The Euro Proves Multipolarity is Possible, Regionally and Beyond

Yet despite the global financial crisis and then the euro area’s sovereign debt crisis, and the setbacks they entailed, the euro remains the second most important international currency even today, behind only the dollar.

Instant second-in-command. Upon its launch in 1999, the euro immediately became the second most important international currency, succeeding several European legacy currencies (like the Deutschemark) that already held significant international roles. This rapid ascent demonstrated that the international monetary system could accommodate multiple major currencies, challenging the "natural monopoly" view. The euro's initial success was driven by the sheer economic size of the Eurozone and the integration of its capital markets.

Resilience amid crisis. Despite facing severe challenges, including the global financial crisis of 2008 and the subsequent euro area sovereign debt crisis, the euro has maintained its position as the undisputed second international currency. While its international use saw some setbacks, particularly in bond markets and reserve holdings during the crisis, it has shown remarkable resilience. This resilience underscores that once a currency establishes a significant international footprint, it can withstand considerable shocks, though its growth trajectory may be affected.

Regional strength, global ambition. The euro's international role has a strong regional dimension, serving as a key anchor and transaction currency for neighboring European and African countries. However, its ambition extends globally, and its continued strength is tied to ongoing efforts to deepen European economic and monetary union. Initiatives like "capital markets union" and "banking union" aim to enhance the depth, stability, and liquidity of euro area financial markets, which are crucial for buttressing the euro's global standing and further challenging dollar dominance.

9. The Renminbi Faces Significant Financial Market Hurdles

Thus, while China has made substantial progress in encouraging importers and exporters of commodities and merchandise to invoice and settle their transactions in renminbi, it still faces a long march on the financial front.

Trade vs. finance. China has made impressive strides in promoting the renminbi for international trade settlement, leveraging its position as the world's largest exporting nation and a major trading partner for numerous countries. However, this progress in trade has not yet translated into a commensurate role in global financial markets. The renminbi's share in international bonds, bank liabilities, and foreign exchange turnover remains small, lagging far behind the dollar, euro, and even other major currencies.

Underdeveloped markets. A primary obstacle is the relative underdevelopment of China's financial markets. Despite having the fourth-largest financial system globally, its depth and liquidity, when scaled by GDP, lag behind not only advanced economies but also many emerging markets.

• Bond markets: Dominated by buy-and-hold banks, leading to limited turnover.
• Equity markets: Characterized by high volatility, lack of transparency, and heavy government intervention, deterring international investors.
  These issues stem from a long tradition of state-led financial development, where implicit guarantees and suppressed information hinder genuine market-based pricing and risk assessment.

Reform imperative. For the renminbi to achieve true international currency status, China must undertake far-reaching reforms to create deep, liquid, and transparent financial markets. This requires:

• Reducing government intervention in market pricing and trading.
• Enhancing transparency and disclosure for issuers.
• Allowing for defaults to foster genuine credit differentiation.
• Strengthening bank capitalization and commercialization.
  These reforms represent a fundamental shift from China's historical approach to financial sector development and will require sustained commitment over an extended period, making the renminbi's path to internationalization a gradual and challenging one.

10. A Multipolar Currency Future Brings Both Stability and Volatility

Which scenario is more likely for the future? The answer is uncertain. It is for policy makers and their publics to decide.

Diversified liquidity. A future with multiple international currencies offers reassuring benefits. Countries would have better-diversified sources of international liquidity, reducing reliance on a single supplier (the U.S.) and mitigating the "Triffin Dilemma" where the dominant country's capacity to supply safe assets is constrained. This multipolar system would also distribute the "exorbitant privilege" more widely, as several nations could issue claims regarded as safe and liquid.

Shared responsibility. In such a world, the burden of providing emergency liquidity in times of crisis would no longer fall solely on the Federal Reserve. Other central banks, as issuers of widely accepted international currencies, could also extend swap lines, acting as "global lenders of last resort." This shared responsibility could enhance the stability of the international monetary system, making it less vulnerable to the policy choices or political constraints of a single nation.

Increased volatility risks. However, a multipolar system also carries worrisome risks. The existence of several liquid markets could enable central banks and private investors to rapidly rebalance portfolios at the first sign of trouble, potentially leading to more volatile exchange rates. Small shocks or minor news could trigger sharp currency movements, catching investors off guard and potentially precipitating crises. The stability of this multipolar future hinges critically on the policies of the issuing countries: stable, predictable policies would minimize these risks, while unstable ones, reminiscent of the interwar period, would heighten them.

Last updated: March 20, 2026