You’ve heard it before: A grandparent complaining about how kids today don’t know the value of a dollar. These days, that grandparent might be right.
The economy post-COVID has seen historically high inflation, rising interest rates, and big shifts in how we spend our money. Just consider what $100 can buy in 2019 compared to today and what you were likely to spend it on then versus now.
On a larger scale, the dollar plays an incredibly important role in both the U.S. and global economies, as well as the stock market. In fact, the U.S. dollar is the world’s global reserve currency, meaning it underpins a significant amount of world trade and is a critical part of the world financial system.
This article digs into what that really means: What a global reserve currency is, why we use the dollar instead of gold, and what a strong U.S. dollar means for companies here in the U.S. as well as economies around the world.
The dollar as global reserve currency
When a currency is widely accepted or the preferred currency for transactions, countries tend to keep that currency in reserve. The U.S. dollar is the primary reserve currency in the world; most financial institutions around the globe keep U.S. dollars on hand both as a store of value and a medium of exchange.
The dollar isn’t the only reserve currency in use. The euro, Japanese yen, British pound, Chinese renminbi yuan, Canadian dollar, and Swiss franc are all used as well. (And are increasing in popularity.)
The title of global reserve currency isn’t something official or overseen by a central body. Often, preference for different currencies can shift with global politics and other factors. Historically, the “pound sterling” (British pound) was more popular than the dollar, and it’s possible other currencies will supplant the U.S. dollar in the future.
Notably, the yuan is gaining traction due to China’s growing economy. The Chinese government is attempting to promote this via cross-border payment initiatives and a digital yuan. But don’t worry yet—the U.S. dollar still outpaces the yuan on a global scale and it’s unlikely to be overtaken anytime soon. In fact, the yuan didn’t surpass the dollar as the reserve currency of choice within China until April 2023.
The benefits of being a global reserve currency
The dollar’s status as a global reserve currency grants the U.S. certain benefits.
Foreign governments may be more likely to buy and hold U.S. Treasuries (or debt), since our government makes interest payments in dollars, and those countries want dollars to hold in reserve.
This allows us to borrow money at lower rates than other countries. It also makes U.S. companies popular with foreign investors and gives the country influence over global economics and world affairs.
These perks are a big reason behind China’s push to make the yuan a popular reserve. But beyond foreign competition, economists worry that domestic issues could make the U.S. dollar less appealing.
Just consider the frequent squabbles over the debt ceiling, which put the country at risk of default with alarming regularity. If instability continues, countries seeking a stable currency might begin to shift their reserves, and their economies, to be less dependent on the dollar.
Why we’ve moved away from “the gold standard”
Some critics argue that we can only have a truly stable monetary system if we return to the gold standard.
Currencies today don’t have absolute value; they’re valued by what they can buy or how they compare to a different currency. For instance, a dollar can buy a soda and it’s worth a certain number of euros. The number of dollars it would take you to buy an ounce of gold changes by the day.
A century ago, however, any paper bill or coin could be converted into gold at a fixed rate of exchange, and every country measured the absolute value of its currency against gold. This system had a clear appeal in theory: There’s a finite amount of gold in the world, so fixing global currencies to gold can keep the value of those currencies steady over time.
But pinning a global and growing economy to a finite asset became problematic. Not only does it put an immense amount of pressure on the physical security of an asset (consider the pop culture references to Fort Knox, where the U.S. government stores its gold bars). Beyond that, governments were limited in their ability to stimulate their economies during depression or war.
Ultimately it was these things—the Great Depression, World War II, and the push to rebuild Europe—that pushed the world away from the gold standard. At first, global currencies were pegged to the U.S. dollar, which was in turn tied to gold, adding a layer of flexibility (and complexity) to the mix. In 1971, amidst rising inflation, President Nixon ended the gold standard entirely, which ultimately allowed the Federal Reserve to get inflation in check.
Today, currencies are traded in pairs. The dollar is worth a certain amount of euros and a certain amount of yen. Those values are influenced by a wide number of factors and change constantly.
Since currency pairs can be complicated, currency indexes simplify the question of value by consolidating how a currency is trading relative to a swath of its peers.
The impact of a strong dollar
You may hear politicians or economists discuss a “strong” or a “weak” dollar. When the dollar is strong, it has a high value relative to other currencies. For instance, when a dollar is worth 2 euros, it’s viewed as stronger than when that same dollar is worth 0.50 euros. The reverse is true for a weak dollar.
When demand for the dollar is high, its value tends to increase. Similarly, when supply increases (for instance, if the U.S. government is printing money as part of a stimulus package), it may weaken the dollar. As with all things, there are pros and cons to both a strong and a weak dollar.
When the dollar is strong, it’s cheaper for Americans to travel abroad or buy foreign goods. Similarly, American companies pay less for imports and U.S. companies may increase in value relative to foreign competition. On the other hand, a strong dollar makes American products more expensive, so U.S. companies hoping to export their goods to other parts of the world may not be able to sell as much.
In general, when the dollar fluctuates in value it can impact commodity prices and supply chains, the global bond market, the jobs market, and more.
Currencies and your portfolio
You’ve heard us discuss how important it is to diversify your portfolio. That includes making sure your portfolio isn’t only invested here in the U.S.
Making sure you have international exposure can be complex, since many U.S. companies have a global footprint, and many international companies trade on U.S. stock exchanges. We look to data-driven analysis from our Helios research partners to help us. Helios data considers currency risk when analyzing performance and making recommendations.
We leverage the sophisticated economic and market research analysis provided by Helios, which allows us to factor in currency risk when monitoring client portfolios.
At the end of the day, however, it’s important to remember that money is the tool—not the goal. While it’s helpful to understand how financial markets tie the world together, what’s more important to us is the purpose behind your portfolio, so we can work to align your investments with your long-term vision for the future.
