Institutional change supported the role of the dollar, with the creation of the Federal Reserve System providing, for the first time, a market-maker and liquidity manager in US dollar acceptances. This was particularly helpful for promoting the use of the dollar in trade credit, reinforcing its use as a means of payment and invoicing currency.
Yet the US was, at least at first, an unwilling hegemon. Under the gold standard, the Fed’s absorption of gold inflows exported significant deflationary pressures to the rest of the world.38 Europe was dependent on the recycling of capital flows by the US, which lent much of its surplus back to Europe to enable payments of war reparations and debt. Europe suffered severely when this stopped in 1928. Moreover, the increase in price levels that occurred as a result of the First World War left the global economy with too little gold in total to sustain money supply at the level consistent with full employment. Supplementing gold reserves with foreign exchange to boost money supply led to competition between the UK and the US to provide that service to other countries.
The resulting world with two competing providers of reserve currencies served to destabilise the international monetary system, and, some would argue, the lack of coordination between monetary policy makers during this time contributed to the global scarcity in liquidity and worsened the severity of the Great Depression.
The experience of the interwar period is a cautionary tale.
When it comes to the supply of reserve currencies, coordination problems are larger when there are fewer issuers than when there is either a monopoly or many issuers. While the rise of the Renminbi may over time provide a second best solution to the current problems with the IMFS, first best would be to build a multipolar system.
The main advantage of a multipolar IMFS is diversification. Multiple reserve currencies would increase the supply of safe assets, alleviating the downward pressures on the global equilibrium interest rate that an asymmetric system can exert. And with many countries issuing global safe assets in competition with each other, the safety premium they receive should fall.
A more diversified IMFS would also reduce spillovers from the core and by so doing lower the synchronisation of trade and financial cycles. That would in turn reduce the fragilities in the system, and increase the sustainability of capital flows, pushing up the equilibrium interest rate.
While the likelihood of a multipolar IMFS might seem distant at present, technological developments provide the potential for such a world to emerge. Such a platform would be based on the virtual rather than the physical.
History shows that the rise of a reserve currency is founded on its usefulness as a medium of exchange, by reducing the cost and increasing the convenience of international payments. The additional functions of money – as a unit of account and store of wealth – come later, and reinforce the payments motive.
Technology has the potential to disrupt the network externalities that prevent the incumbent global reserve currency from being displaced.